Capital Markets

Proceed with Caution

Economist Philip Arestis warns that recent signs of revival are largely illusory.
A CFO InterviewOctober 1, 2003

After a number of false starts, the U.S. economy seemed to be gathering steam this summer. Consumer confidence was up. Home sales remianed robust. Business conditions were improving. And while joblessness continued to spread, the unemployment rate is often considered a lagging indicator. All of which seems to explain why the S&P 500 has staged such an impressive six-month rally—regaining more than a third of the value it lost after peaking in March 2000. Surely, most signs point to a sustained revival.

Not so fast, says Philip Arestis, a professor of economics at the Levy Economics Institute of Bard College, in Annandale-on-Hudson, New York. He, along with independent financial analyst Elias Karakitsos, recently authored a public-policy brief published by the institute, warning that “imbalances” in the private sector—chiefly soaring levels of personal debt—will limit the extent of any rally and put the U.S. economy at risk of a property-market crash and a double-dip recession (see “A Critical Imbalance” and “Can Stocks Outpace Income?” at the end of this article).

In the brief—”Asset and Debt Deflation in the United States: How Far Can Equity Prices Fall?”—the authors contend that the 2001 recession, though relatively mild, is part of a lengthier process of asset and debt deflation associated with the bursting of the telecommunications and Internet bubble of the 1990s. The imbalances created by that bubble, they contend, will continue to undermine any long-term economic recovery.

To be sure, lower interest rates have boosted the economy in the wake of the equities bubble. But, say Arestis and Karakitsos, they have also fueled a property-market bubble. And weak corporate profits, sustained primarily not by returns on new investment but by cost cutting, could force an overly indebted personal sector to curtail spending, sparking another, potentially more severe recession and perhaps a crash in the property market.

Unlikely? The authors see clear parallels between the economy’s current imbalances and those produced by previous asset bubbles, including the depression of 1876 to 1890 (associated with the railway bubble), the depression of 1929 to 1940 (associated with the electricity and automotive bubble), and deflation in Japan that began in 1989 (associated with the electronics bubble). In fact, Arestis and Karakitsos say the current period has far more in common with those eras than with most post­World War II downturns, which were shorter and shallower, and typically followed increases in the prices of commodities, money, or both.

Disheartening as it may be, their conclusion—that we’re in for a long period of painful retrenchment—deserves serious consideration, if only as a reality check on the glib, optimistic pronouncements emanating from parts of Wall Street and Washington, D.C. Arestis, who holds a PhD in economics from the University of Surrey in the United Kingdom, has authored a number of books and recently published work on such topics as monetary and fiscal policy and the relationship between finance and growth and development in such academic journals as the Cambridge Journal of Economics; the Eastern Economic Journal; the Economic Journal; Economic Inquiry; International Review of Applied Economics; the Journal of Money, Credit and Banking; and the Journal of Post-Keynesian Economics. He met with CFO deputy editor Ronald Fink in late August to discuss his outlook for the economy.

What makes you think the recent recession was more comparable to those associated with previous asset bubbles than to more-recent downturns reflecting the specter of inflation?

The [recent] economic downturn is not typical. It’s not the kind of downturn we had in the ’70s, for example. This is because of overinvestment in the late ’90s, and that’s very important. Most people would agree that there was New Economy thinking, in IT in particular, though we overinvested not just in telecommunications but in other areas as well.

And that the bursting of that bubble was not directly tied to a rise in interest rates?


Your policy brief is quite pessimistic. Yet we’ve seen some very positive signs in the economy of late. What’s the basis of your concern?

The private sector has taken on more debt, there’s no question about that. [In fact], net wealth is decreasing to its more or less [historical] mean, or tending toward it. And while that might not appear so worrisome now, it could lead to a weak recovery or even a new recession in the future.

In terms of the personal and corporate sectors, we see these problems becoming reality, especially if unemployment increases further and disposable income goes down. In that case, the current huge increase in property prices becomes unsustainable. So we could very well have a property bubble as well. And if the corporate sector does not invest, its current imbalance of debt to income may very well continue.

But indications are that corporate profits are recovering. Isn’t that cause for optimism?

The trend is driven by cost cutting. At the macro level, this means lower revenues for other businesses and lower income for consumers. One should also make the point that the recently enacted tax incentives on depreciation have had a major role to play. But then these are ephemeral. That is not a sustainable basis for recovery.

Why not?

We’re talking about balance sheets. And if we look carefully at the balance sheets of the three components—personal, corporate, and trade—of the private sector, then things begin to get worrisome.

Let’s start with the personal sector and come back to the corporate and trade components. Why should we be concerned when consumers have been refinancing? After all, the debt may be the same, but refinancing has meant foregone cost that has enabled consumers to increase their disposable income and their spending. That’s good news, you might say.

At the same time, however, two things may happen. First, if unemployment exceeds 7 percent, or continues to be above 6, or even above 5, for some time, consumer spending may very well retrench. If people cannot find work, we may very well experience a situation of a slowdown in the growth of disposable income or see a decrease in absolute terms potentially. Unemployment has just begun to increase. It was around 5 percent not that long ago. Now it’s 6.2 and is expected to go up—at least this year. What will happen after that? If I’m right, unemployment will increase even more.

What is the second scenario you envision?

If I am wrong and unemployment doesn’t increase, the spending emanating from increased disposable income will continue. If it continues, though, the Federal Reserve may begin to worry about inflation. And if the Fed worries about inflation, interest rates will go up.

That’s where we may have a real problem. Increasing interest rates enlarges the debt burden of consumers, and this would have a devastating negative effect on spending because people will have to address their huge debts. The opposite process to the one I described [previously] would take place.

Under what circumstances do you think the Fed would address inflation?

The 3.1 percent increase [in annualized GDP growth] that we saw in the most-recent quarter might even go higher. In fact, over the next year or so, current monetary and fiscal policies are bound to help in this sense. This scenario could very well produce inflationary pressures alongside the devaluation of the dollar.

How likely is that? I don’t think it’s very likely. In fact, the latest pronouncement from the Federal Reserve is that it is going to keep [interest rates] as low as necessary. [But] one has to be careful how to interpret that. If economic circumstances turned out to be as I just described, the Fed may have no choice but to raise interest rates.

Isn’t the deleveraging of corporate balance sheets that we’ve seen significant enough to sustain a recovery?

It may very well be. [But] a more significant factor would be more-robust investment activity. And then you have to ask yourself what determines investment. You would think that would be consumer demand, yet in your view that will be held back by unemployment.

Exactly; consumer demand would help if unemployment does not become such a contributory factor in holding it back. So what must happen to induce [companies] to up their investment? The majority of economists agree that there are two important factors. The first is the level of economic activity; the second is the rate of interest. Economists differ, though, on where you put the emphasis. Is it on the rate of interest or on economic activity?

Where do you believe the emphasis should be?

There isn’t much of a relationship between the rate of interest and investment for a number of reasons. In fact, from our work, and that of other colleagues, we conclude that the rate of interest doesn’t matter much on this score. We just cannot get the results that the people who support the rosy scenario expect. We get results that suggest that the impact of monetary policy is rather weak. A brief look at the 13 reductions in interest rates initiated by the Federal Reserve since early 2001, without much impact on investment, makes the point vividly. Monetary policy does not appear to have had the impact proponents have suggested it would.

So the emphasis really should be on economic activity?

What would really make companies invest is expectations of greater levels of economic activity. Will economic activity be healthy in the future? Will they be able to sell their products if they undertake more investment? At the moment, the answer in the eyes of these people is “we don’t know.”

How does the federal deficit—which is now estimated to reach $525 billion in fiscal 2004—figure into this picture?

A much better way to conduct fiscal policy is to enable U.S. state governments to avoid tackling their deficits through expenditure cuts. State after state recently initiated cuts in expenditures to avoid deficits, which they have to do, of course. They just have to balance their books. If the federal government came forward and honored the shortfalls so that states wouldn’t have to cut back on schools, infrastructure, et cetera, then we’d have the same deficit, but all these cutbacks would be avoided. This would produce an environment where the corporate sector revises expectations and would begin to be more optimistic about future levels and speed of economic activity.

In other words, if states didn’t cut back on education, transportation, and infrastructure, companies would have more confidence that consumer demand won’t fall. But how would the federal government be able to honor those obligations without further increasing the deficit? Are you suggesting that we repeal the tax cuts?

The deficit could very well be the same if you don’t reduce taxes the way they have been. But in the absence of that, this imbalance in the corporate sector will be with us for a long time.

What about the dollar? Wouldn’t a decline in its value help eliminate our current account deficit, what you describe as our third private-sector imbalance?

We cannot go on ad infinitum importing from abroad and not exporting anything. Everybody would go bankrupt at some point. So long as the trade deficit is maintained within some reasonable margin, however, there shouldn’t be any problem, especially if the rest of the world is prepared to finance the U.S. deficit. And this is what’s been happening.

But there are worries about the extent to which the rest of the world will continue to finance our deficit. And the challenges are, first, if the rest of the world begins to worry about the U.S.’s ability to sustain its economic muscle and reserve-currency status, and reverses capital inflows that finance external deficits. It hasn’t happened, but if it did, how would the U.S. deficit be tackled? Inevitably, through deflationary economic policies, and that would be disastrous.

More than half of the most-recent quarter’s growth in U.S. GDP reflected defense spending. What impact will the costs of the reconstruction of Iraq have on foreign investors’ willingness to finance our trade deficit?

If the rest of the world begins to worry about the U.S. economy and therefore loses its faith, then it’s going to take its money somewhere else. And people looking at the world situation say, “Look, this enormous defense expenditure is going to create huge deficits on top of everything else, so where are we being led?” Around this time last year, there were a lot of very worrying signs that the rest of the world [was] not prepared to continue financing our deficit. After the war, people may have taken the view that the situation might not be bad. [But] things are not as rosy as we had been expecting.

What about U.S. productivity? The Federal Reserve’s monetary policy during the late 1990s was predicated in part on the gains we were showing in that area.

They happened essentially in the IT sector. And though there have been improvements in other sectors as a result of IT improvements, there is evidence that it’s not widespread. Still, productivity gains or not, we come back to the same question: How can business executives be persuaded to actually go ahead and expand investment activity?

Doesn’t it come down to their balance sheets? The consensus seems to be that notwithstanding the improvement in equity prices, companies need to de-leverage further. Yet wouldn’t that favor cost cutting over investment?

More cost cutting might cure the problem to some extent. But cost cutting means more unemployment. What’s more, it’s bound to come at the expense of those who cannot follow suit—not just consumers, but other businesses. So at the macro level, cost cutting isn’t going to do it. And we come back to the conclusion that what would be best for business is to expand investment, which would promote more consumption, more economic activity, more revenue, and enable companies to begin to balance their books.

But your view is that under current conditions, that would take a very long time.

Indeed, but let us be careful here. What we are suggesting is that the current growth gains can, and most probably will, continue to take place in the short run. But with no signs of job creation and with the imbalances we have talked about, this cannot be a sustained recovery.

What would give you confidence that the recovery is here to stay?

The answer to this question follows logically from what [I’ve] said so far. Clearly, to the extent that the imbalances we have talked about disappear, or are mitigated significantly, this would give us great confidence that the recovery is sustainable. But two further indicators would also be very important. The first is substantial recovery in investment activity. But recovery in the rest of the world also, especially Europe, is paramount. Monetary and fiscal policies in the European Economic and Monetary Union can and should do a great deal more than they have been providing. Alongside these initiatives, a concerted action globally would be an excellent [step] forward, and a significant pointer in the [right] direction. In other words, international coordination of economic policies would produce a global climate of sustainable recovery. The U.S. economy would benefit a great deal from such coordination of policies.

Are there any practical steps that you think finance executives can take to deal with these issues?

Finance executives should attempt to reduce the corporate imbalances we have talked about. [Addressing] either the high levels of corporate debt or the rate at which debt levels increase is a practical step that can and should be taken. To the extent this could take place in tandem with higher investment activity, finance executives would have done a great job for their companies and for the U.S. economy as a whole.

A Critical Imbalance?

The gap between personal net wealth and savings.

% of personal
disposable income
Ratio of savings to personal
disposable income
Household Net Wealth
Source for chart: National Income and Product Accounts, Flow of Funds, and author’s calculations

Since the current bear market has its roots in asset and debt deflation, the authors of a public-policy brief recently published by the Levy Economics Institute contend that traditional methods of valuing equity markets based on monetary and other supply-side factors are inappropriate. The valuation method used by the brief’s authors, Philip Arestis and Elias Karakitsos, is therefore based on the degree of imbalance in the personal balance sheet—the extent to which assets and liabilities (or net wealth) deviate from their means. Net wealth is defined as assets (tangible and financial) less liabilities (mainly mortgages and consumer credit). The chart above shows household net wealth as a percentage of personal disposable income.

The chart also shows the ratio of personal savings to personal disposable income, on a four-quarter moving average basis. According to the thesis that Arestis and Karakitsos adopt in their brief, when asset prices rise more than expected, households more easily meet their targeted real wealth and, therefore, relax their effort to save. Consequently, savings, as a percent of personal disposable income, fall when real wealth rises more rapidly than anticipated, and vice versa. Since asset prices move procyclically, this feature implies a negative relationship between real wealth (expressed as a percent of disposable income) and the savings ratio, as reflected in the chart. —R.F.

Can Stocks Outpace Income?

The S&P 500 Index compared with its corresponding value when net wealth returns to its historical mean.

% S&P 500 Index
S&P Long Term Valuation
Sources:, Karakitsos (2002), and author’s calculations

The long-term method of valuing equities that Philip Arestis and Elias Karakitsos employed in their recent policy brief determines corresponding values when net wealth returns to its historical mean (see “A Critical Imbalance?” above). This method, according to the brief, assumes that the whole adjustment process is borne by equities for any given level of personal disposable income. Over time, however, as disposable income rises, the degree of the fall in equity prices required to restore net wealth to its mean diminishes. In other words, there is no need for a plunge in equity prices. Even with level prices, imbalances will be eliminated over time and net wealth will be restored to its mean value through a gradual rise in disposable income. Unfortunately, the authors note, equity prices never remain unchanged, since they reflect expected developments in the real economy. Hence, they say, an imbalance is usually corrected with a fall in asset prices.

Using quarterly data from 1996 to 2002, the accompanying chart shows the results of applying this methodology to the S&P 500. The fair (or equilibrium) value of the S&P 500 increases through time as disposable income rises. However, the rate of increase in asset prices during this period was much more rapid than the rate of increase in disposable income, and this disparity resulted in the bubble. At its peak, in fourth-quarter 1999, the S&P was overvalued by 122 percent. Subsequently, in spite of three years of falling equity prices, the S&P 500 was still overvalued by 9 percent at the end of 2002, when its equilibrium value is now estimated to have been 810. Earlier this year, based on daily rather than quarterly data, the S&P 500 was again undervalued as a result of the expected consequences of the Iraq war, but became slightly overvalued during the rally that followed the onset of war. For reasons enumerated in the accompanying interview, Arestis and his co-author doubt that this rally heralds the beginning of a new bull market. —R.F.