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By Philippe Legrain 1 COMMENT

For years, they denied it was a bubble. Sceptics just didn’t get it. Then, they swore that it wasn’t as bad as it seemed. The worst would soon be over. Now, they prematurely herald a recovery. Fear not: America’s economy is back on track; the world can breathe a sigh of relief.

The first-quarter rebound merely confirmed optimists’ convictions. The economy grew at a 6.1% clip: the good times are back. America’s miracle economy has paused for breath – a dip so shallow that it was scarcely a recession – and is now on the up again. The stockmarket has "corrected" and is ready, according to irrepressible bulls like Abby Joseph Cohen at Goldman Sachs, to resume its flighty rise. Alan Greenspan has yet again saved the day.

Some go further. In the May/June issue of World Link, Brad DeLong of the University of California at Berkeley predicted that America’s productivity – and hence economic – growth would accelerate over the next decade. Were it not for the wreckage of the high-tech boom – the biggest waste of capital in history – one might think the bubble had never happened.

As for the doomsayers’ predictions that its bursting would cause a long and deep recession, well, they had been wrong all along.

But a few awkward facts intrude on this flight of fancy. Start with the gaping hole in America’s current account: $398 billion in the year to March – over $1 billion a day – and counting. Even relative to the vast US economy, that’s big: over 4% of GDP. And this, so the optimists have it, at the trough of the economic cycle, when spending on all things foreign is subdued. How huge might the deficit get if America’s economy really took off again?

Not to worry, the Panglossians insist: this yawning gap is an inevitable consequence of America’s success. The rest of the world may be mired in the stone age of the old economy, but even foreign cavemen know a good thing when they see it. America’s superior productivity growth amply justifies foreigners’ desire to invest there; Americans’ profligacy is simply the mirror image of that.

Never mind that many of the vaunted productivity gains from the new economy have proved to be hot air; assume, for the sake of argument, that US productivity growth will outpace gains elsewhere. Is this enough to sustain a growing current-account gap? Hardly. Foreign investors care about future returns, not putative productivity gains. If they are to pour ever more money into the US, they must be convinced that American shares will outperform foreign ones, and that the dollar will remain strong. Neither of those assumptions is plausible.

US stockmarkets have fallen from their lofty heights. The Dow is down by a fifth or so; the broader S&P 500 by a third; the Nasdaq by more than two-thirds. Time to buy? Not at all: American shares are still not cheap. As Martin Wolf has pointed out in the Financial Times, the price/earnings ratio of the overall stockmarket is around double its long-run average. Shares are more generously valued than at any time bar the peak of the recent bubble and 1929.

Look at it another way. Investors are betting that US company profits will grow at double-digit rates in years to come. But in the long run, profits cannot grow faster than the economy as a whole. History confirms this: over the past 50 years, profits have remained remarkably stable as a share of GDP. Allowing for, say, 2.5% inflation and 3.5% real GDP growth, this means profits can grow by only 6% a year. Even in the go-go years of the late 1990s, profits – as measured by government statisticians, not Andersen – rose less fast than national output: they peaked as a share of GDP in 1997. Most of the gains from new technologies have ended up lightening consumers’ bills (and lining bosses’ pockets) rather than stuffed in shareholders’ pockets.

So even if – a huge if – America is experiencing a productivity miracle, shares are overpriced. They cannot reasonably rise as fast as investors expect. The infusions of foreign money that America’s economy needs to stay afloat are predicated on a punt that US share prices and the dollar will remain – indeed, become more – overvalued. America’s recovery relies on the bubble mentality remaining strong. It is living on borrowed time.

The US economic recovery is unsustainable. Americans cannot live beyond their means forever.

For years, they denied it was a bubble. Sceptics just didn’t get it. Then, they swore that it wasn’t as bad as it seemed. The worst would soon be over. Now, they prematurely herald a recovery. Fear not: America’s economy is back on track; the world can breathe a sigh of relief.

The first-quarter rebound merely confirmed optimists’ convictions. The economy grew at a 6.1% clip: the good times are back. America’s miracle economy has paused for breath – a dip so shallow that it was scarcely a recession – and is now on the up again. The stockmarket has "corrected" and is ready, according to irrepressible bulls like Abby Joseph Cohen at Goldman Sachs, to resume its flighty rise. Alan Greenspan has yet again saved the day.

Some go further. In the May/June issue of World Link, Brad DeLong of the University of California at Berkeley predicted that America’s productivity – and hence economic – growth would accelerate over the next decade. Were it not for the wreckage of the high-tech boom – the biggest waste of capital in history – one might think the bubble had never happened.

As for the doomsayers’ predictions that its bursting would cause a long and deep recession, well, they had been wrong all along.

But a few awkward facts intrude on this flight of fancy. Start with the gaping hole in America’s current account: $398 billion in the year to March – over $1 billion a day – and counting. Even relative to the vast US economy, that’s big: over 4% of GDP. And this, so the optimists have it, at the trough of the economic cycle, when spending on all things foreign is subdued. How huge might the deficit get if America’s economy really took off again?

Not to worry, the Panglossians insist: this yawning gap is an inevitable consequence of America’s success. The rest of the world may be mired in the stone age of the old economy, but even foreign cavemen know a good thing when they see it. America’s superior productivity growth amply justifies foreigners’ desire to invest there; Americans’ profligacy is simply the mirror image of that.

Never mind that many of the vaunted productivity gains from the new economy have proved to be hot air; assume, for the sake of argument, that US productivity growth will outpace gains elsewhere. Is this enough to sustain a growing current-account gap? Hardly. Foreign investors care about future returns, not putative productivity gains. If they are to pour ever more money into the US, they must be convinced that American shares will outperform foreign ones, and that the dollar will remain strong. Neither of those assumptions is plausible.

US stockmarkets have fallen from their lofty heights. The Dow is down by a fifth or so; the broader S&P 500 by a third; the Nasdaq by more than two-thirds. Time to buy? Not at all: American shares are still not cheap. As Martin Wolf has pointed out in the Financial Times, the price/earnings ratio of the overall stockmarket is around double its long-run average. Shares are more generously valued than at any time bar the peak of the recent bubble and 1929.

Look at it another way. Investors are betting that US company profits will grow at double-digit rates in years to come. But in the long run, profits cannot grow faster than the economy as a whole. History confirms this: over the past 50 years, profits have remained remarkably stable as a share of GDP. Allowing for, say, 2.5% inflation and 3.5% real GDP growth, this means profits can grow by only 6% a year. Even in the go-go years of the late 1990s, profits – as measured by government statisticians, not Andersen – rose less fast than national output: they peaked as a share of GDP in 1997. Most of the gains from new technologies have ended up lightening consumers’ bills (and lining bosses’ pockets) rather than stuffed in shareholders’ pockets.

So even if – a huge if – America is experiencing a productivity miracle, shares are overpriced. They cannot reasonably rise as fast as investors expect. The infusions of foreign money that America’s economy needs to stay afloat are predicated on a punt that US share prices and the dollar will remain – indeed, become more – overvalued. America’s recovery relies on the bubble mentality remaining strong. It is living on borrowed time.

Pain Postponed

For sure, the day of reckoning could be delayed for a good while yet. The world’s biggest economy can defy the odds for far longer than, say, South Korea or Albania. The Bush administration’s Keynesian splurging (sorry, defence spending) has given demand a big boost. Alan Greenspan’s 11 interest-rate cuts have made borrowing dirt-cheap. While US companies are using this breathing space to get their house in order, consumers are betting the house, and more. Shrugging off the stockmarket slump, they are adding to their already huge debts: the personal sector’s financial deficit is nearly 4% of GDP. Fizzy house prices give consumers new grounds for exuberance; banks are more than willing to lend. But it cannot last forever.

The bubble could finally burst in several ways. American consumers might take fright and pare back their spending, precipitating a recession. (The Federal Reserve cannot ride to the rescue: at 1.75%, interest rates cannot fall much further.) Foreigners might pull their money out, pushing Wall Street and the dollar down – and the cost of borrowing up. Both of these shifts could conceivably happen gradually. But that is unlikely. Markets – in a word, people – are fickle. They swing from irrational exuberance to the depths of despair. The adjustment, when it finally happens, is likely to be sudden and painful.

It may have already begun. US share prices have fallen further than European ones this year, while Tokyo’s have risen. The flow of funds into the US is drying up. The dollar has slumped by 15% against the euro since January: at the end of June it was flirting with parity with Europe’s much-maligned new currency.

Foreigners could perhaps be forgiven a little schadenfreude: all the crowing about the wonders of US capitalism had begun to grate. Asians might point to Enron and WorldCom as examples of "crony capitalism". But non-Americans should not rejoice too much. Irrational or not, Americans’ free-spending ways have long kept the world economy going. Who will fill the gap? Not Japan, still in the doldrums a decade after its own bubble burst. This should, not for the first time, be Europe’s hour. Will it seize the moment?

  1. Pooch. says:

    What a joke. Since you wrote this article, US GDP has greatly outgrown Europe’s, even with respect of GDP/Capita. Plus, there is no impending economic doom, and the dollar is not about to collapse.

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