Last month’s surprise resignation of US Treasury secretary Paul O’Neill and White House economic adviser Lawrence Lindsey smacks of desperation in the Bush administration. Only two weeks earlier, O’Neill had indicated that a costly stimulus package was unnecessary as the US economy was recovering nicely. He suggested that a simplification of the tax code was his sole priority and that government funds should be directed only to troubled sectors, such as the airlines.
However, economic data had begun to show that the US economy was not looking so rosy. The monthly survey of manufacturing activity suggested a recession and the jump in retail sales at the start of Thanksgiving tailed off sharply. Above all, there was the hugely disappointing employment report for November.
So president George W Bush has decided to go for another fiscal binge. The US budget deficit is much smaller than those in Europe, and with the US 10-year bond yield low it will be easy to finance extra borrowing.
Bush clearly saw O’Neill as part of the problem rather than the solution in getting a fiscal stimulus package implemented quickly. He wants a bigger stimulus packaged than previously envisaged for 2003. He hopes it will provide him with an insurance policy against further deterioration in the economy and in case Iraq goes horribly wrong.
The new US Treasury team will probably launch this fiscal package in the New Year. As a first step, the double taxation of company dividends will be eliminated. If it increases the net dividend for individual investors, it may give a slight populist fillip to equity markets.
Accelerated tax cuts
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Other boosters might include speeded-up depreciation allowances for industry and extended unemployment benefits. But the extra benefit to the taxpayer might reach only $100 billion, 1% of GDP, at best. It is possible Bush could also suspend for one year the social security payroll tax on the first $10,000 of workers’ income and increase child credit. That could add another $100 billion to the package. But this is expensive and would provide only short-term relief to employers.
Overall, I reckon a new fiscal package could boost Americans’ take-home pay by up to $160 billion at most and maybe not all in 2003. How effective would that be in keeping a tired American consumer going? There are two problems. First, less buoyant income from jobs and a rising burden of debt make it more likely that households will use tax handouts to rebuild savings. If they save half the government handout, the maximum boost to personal spending growth in 2003 would be 1% point of GDP. More likely, it would only add half a percentage point to spending growth next year. At best, that would push real consumer expenditure growth to around 2% next year. It’s likely to be lower.
In my view that would still not drive top-line corporate sales sufficiently to meet expectations of profit growth next year. The S&P500 is currently selling on a reported P/E ratio of 27, compared with an average multiple of 11 to 12 times depressed earnings at the exit point from all recessions since 1949. So the market P/E ratio is still way above fair value, given that I expect only 5% earnings growth in 2003 and only 6% to 8% annually over the next three to five years.
The second problem is that while the federal government may have room to spend more, the states and local municipalities do not. Many of them will increase taxes not cut them. As a result Americans may find that the extra spending power from Bush could be wiped out by increased outgoings.
All this means that I remain pessimistic about global economic recovery and equity markets. All the major global central banks are easing like mad. Some Fed officials are even blathering on about debasing the dollar to fight deflation. And Japan’s politicians are clamouring to do the same for the yen.
That’s the trouble with devaluation. The new US Treasury team may opt for a weaker greenback to help US competitiveness but the strategy won’t succeed. Japan and the eurozone are in just as much trouble and won’t allow their currencies to appreciate sufficiently against the dollar.
So the risk of global deflation remains. In OECD markets the falling prices of many products are being driven by Asian competition. Consequently, US Inc must continue to cut costs, which means consumer jobs and incomes. The US consumer will have to deleverage massively as lower work income, falling prices and a burst housing bubble drive up the real debt burden.
David Roche is president of Independent Strategy, a London based research firm.
