Today's Financial
Euphoria Can't Last

By HENRY KAUFMAN

The conventional view is that, to be successful in his second term, President Clinton will have to continue to reduce the federal budget deficit, which means putting Social Security and Medicare on sound footings. While these are worthwhile objectives, they pale beside a risk he cannot control: a stock market crash, with all the negative economic, financial and political consequences it will spawn.

Such a contingency is hardly on the minds of most investors as equity prices continue soaring, driven by astonishing flows into mutual funds and by many corporations' large-scale share repurchases. Ratios of stock prices to cash flows and of market to book values are lofty by historic standards, while dividend yields are the lowest ever. As the chart shows, yearly increases in financial wealth have far eclipsed fresh savings out of personal incomes, reinforcing the prevailing bullish mentality.

Temporary Euphoria

Today's high spirits are not entirely groundless. The economy is chugging along at a moderate tempo and will probably move ahead without pushing up inflation very much. Corporate profits will rise further, though at a slowed pace. Credit is readily available, interest rates are at accommodating levels, and tight monetary policy is not imminent.

Yet a few cautionary words are in order. Today's financial euphoria is not immortal. To begin with, the current business expansion has benefited from several unusual developments that may not last. Further reductions in the federal budget deficit can't be as large as in the past four years. Corporate downsizing and restructuring, once necessities for survival, are now more discretionary.

More importantly and somewhat paradoxically, U.S. business expansion has been aided by the sluggish business recovery in the rest of the industrial world. Other countries' very liberal monetary policies have indirectly helped finance America's economic expansion. This combination of limp business activity abroad and highly liquid monetary conditions will not last indefinitely. At some point, enlarged credit demands abroad will slow the flow of funds into the U.S.

In the meantime, the exaggerated financial euphoria is increasingly conspicuous. Some claim that we are in a brand-new era because of many breakthroughs in science and technology and because of political liberalization around the world. According to this view, securities deserve higher valuations.

Perhaps. But unfortunately, history is replete with similar exalted expectations. The most compelling analogy to our present economic and financial condition was the 1920s, also a period of relatively moderate economic growth combined with fairly low, steady inflation. Our economy outperformed Europe's, as it is has in the 1990s. The (modest) federal budget was usually in balance or close to it. Financial markets were innovative. A broad portion of the general public was drawn in to the financial arena for the first time. Bold entrepreneurs demonstrated extraordinary flair and speculative appetites. Irving Fisher, one of the outstanding economists of that or any era, proclaimed just before Oct. 29, 1929, that stocks had reached a "permanently high plateau."

Another manifestation of financial euphoria is the popularity of foreign investing, especially in emerging countries. This, too, has its parallels, again most notably in the 1920s. Then as now, the dilemma is that foreign investing in emerging countries is a fair-weather tactic, mainly driven by the industrial world's excess liquidity. When the liquidity disappears, investors withdraw. By the mid-1930s, 14 Latin American nations, 10 European states, Canada and China were in arrears on some or all of their external debt. While today's markets are far more developed, some of the risks are similar.

The exploitation of financial leverage is also a symptom of financial euphoria. Today, the financial positions of American families vary greatly across society. Overall, households have gained considerable wealth from the appreciation of financial assets. But for many age and income groups, household debt burdens are approaching historical highs, while ownership of equities is still quite modest. Few American corporations, meanwhile, are increasing their credit quality despite enormous gains in profits. One reason is that many are buying back their shares in the market, some even increasing their borrowings to keep this going.

Of course, the excessive use of leverage goes way back. In the 1920s, the variety of new instruments included highly leveraged obligations of public utility holding companies and investment trusts, which went to large premiums over the already bloated values of the underlying stocks.

Today's thrilling stock market ride depends on economic growth that is sufficient to lift profits, while the inflation rate is flat. The ride will end either because growth will slow a lot more than optimistic earnings estimates foretell or because inflation moves up. If inflation creeps up because of routine pressures on an economy trying to operate in the vicinity of full employment, then U.S. interest rates will rise. That rather natural cyclical progression might cause a relatively contained correction of equity prices, but in and of itself is unlikely to provoke a sudden crash. So what else would it take?

One cause would be a sharp drop in the dollar. Already many U.S. businesses are lobbying for a weaker dollar to relieve competitive pressures. If the administration abandons its support for a strong dollar, large-scale outflows of foreign funds are inevitable.

Second would be a backsliding toward aggressive trade policies to appease protectionist elements in both political parties. That would touch off fears of higher inflation and dredge up long-forgotten memories of how the 1929 crash degenerated into global economic and political catastrophe because of the Smoot-Hawley Tariff, passed in June 1930 but already under consideration in October 1929.

Third would be an abrupt reversal of flows into mutual funds. Anything that drove U.S. interest rates up sharply could seriously test the tenacity of households to stay the course as equity investors.

Fourth, when the equity market's speculative fervor fans out to envelop other asset markets, including commodities and commercial real estate, leveraging will mushroom, and the financial bubbling will be mutually reinforcing. Then a downturn in any one of these markets will damage others.

How can this threat to our well-being be prevented? A combination of tightening fiscal policy and excellent monetary guidance contributed importantly to this decade's noninflationary expansion. Yet fiscal policy can do very little to deal with today's financial bubbling. Indeed, legislating a balanced budget, a not impossible event in the next year, would further encourage financial euphoria.

At some point, the Federal Reserve will have to face the larger question of whether to take actions that may not be necessary to pre-empt a rise in inflation, but may be decisive in heading off an unsustainable financial bubble. There is a wide variety of preventative measures available, ranging from simple reminders from Chairman Alan Greenspan that risk exists even in a powerful bull market; to greater restrictions on the use of leverage in equity purchases; to considering the state of the equity markets when determining monetary conditions.

Endangered Prospects

Embarking on such a policy course would not find widespread public acceptance. Business leaders do not want profit prospects or their stock options endangered. Middle-income Americans would have mixed feelings; after all, their wealth has ballooned in recent years. But preventative action is consistent with the broader mandate to maintain the financial well-being of society, including discouraging financial excesses.

Thus, to a significant extent, the success of President Clinton's second term hinges on the astuteness and fortitude of Mr. Greenspan.