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Business outlook for '89 - gateway to the '90s.

Business Outlook for '89 - Gateway to the '90s

When Gene Sullivan asked me to address you, I thought to myself that I had spoken to St. John's University just recently. But then I looked back and it was on November 17, 1964, when I spoke at the business conference at St. George Hotel in Brooklyn, New York. I recall that moment because it was a placid period of time in the American economy and in the financial markets.

Very few of you here will remember that, in November 1964, the long term government bond yield was at 4.17 and the three month Treasury Bill rate was around 3 1/4 percent, and the size of the American credit market was close to touching a trillion dollars as compared with nine trillion dollars today. It was a relatively good year in terms of housing financing when about $18 billion net of residential mortgages came to the market, as compared with over a $150 billion last year.

I realize, as we all should, that much has changed and much probably will continue to change. Whether we are in business, in finance, or in the academic world, we are forced to make a whole series of economic judgements. The dilemma is that in making these judgements we are inclined to look for comparability and for similarity of events; seasonality and cyclicality are stressed. The international orientation of all of us over the last 25 years has really intensified.

Just this morning, the market was looking very closely at industrial production and housing starts. Over the next week or so, it will be consumer prices. All of us will try to anticipate and reflect in terms of our near term decisions on business finance and the markets in general. And of course, it is true that in making economic judgements about the future, we are really very much influenced by the situations today and in the immediate past.

The future very often is interpreted as an extension of the recent past. When conditions are good, the tendency is to conclude they'll get better and vice versa. Sometimes this approach works, particularly in the short term analysis. But surprise free scenarios do not contain the elements of change that influence the longer term. The time element when we make judgement is very vexing to say the least. Serious assessments can hardly be made on the basis of events that span a week or a month. But in many cases, calendar or fiscal years or political terms in office hardly provide an adequate framework either. When business and political leaders assume their roles, they undertake them in the midst of a mix of complex and ongoing activities.

Often, the real value of management decisions doesn't become apparent until many, many years later. Perhaps what we ought to try to do is to analyze the impact of decisions in any one period on longer term performance. The time element involves fashions in economic judgements. Those who lived prior to the 1929 crash thought that they were in a new era when there were no real risks. As the crash and subsequent events took their toll, theories of economic maturity and stagnation became popular and the views of John Maynard Keynes dominated the classrooms and the boardrooms. These theories were not challenged until inflation eclipsed unemployment as our major economic concern, and then monetarism came to the fore led by Milton Friedman. And similarly in the years right after World War II, the prevailing opinion was that 2 1/2 percent interest rates on long-term U.S. government bonds would last forever and that common stocks had limited investment value. Twenty years later near the end of the 1960s, one financial magazine forecast that bonds would follow dinosaurs into extinction, while stocks it said would dominate investor portfolios. And not long ago, portfolio managers prided themselves on the individuality of their investment decisions. And now of course, the vogue has become indexation. It is believed that very few can out perform the market in general.

There really is no simple, no scientific procedure that yields accurate judgement about the long term. Even so, let me make a few observations as we look into the 1990s. First, it seems to me that history shows that to project the future merely by extending the past is a dangerous thing. In this century alone, as all of you know, each decade has really differed from the previous decade. Second, fashions in economic judgements are dangerous. They contribute to unsustainable events either up or down. Back in the early 60s, it was fashionable for people who were following the financial markets to look very closely at free reserves (hardly anybody does that today) or business loans. In recent years, it was fashionable to focus on M1, M2, M3, M1A, or M1B. Very few look at money supply now as closely as they did just a few years ago. Within the last year or two, it's been fashionable to look at trade figures and consumers prices, as if this was going to be the beginning and end all of telling what will happen in the future.

Third, leadership, be it in business, finance, industry, or agriculture, really has a definite life cycle whether we want to admit it or not. The duration of this cycle varies. In a broad perspective, we need look only at the Roman Empire, Ancient Greece, and Spain for examples. In the business world, IBM was unknown when the American railroads were the elite in the credit marketplace of the United States. It is also true that finance is the handmaiden of economic growth. It serves both as a stick and in some ways as a carrot. But finance itself never created the computer, never invented the wheel. We in finance follow that activity, and we follow it very quickly.

So with that in mind, what is it that we ought to recognize as we move into another decade not too soon from now? Well, while the U.S. financial markets will continue to have a powerful influence on the global marketplace, the key aspect of the situation today is that all major financial markets have become highly interdependent, very sensitive to developments anywhere around the world. Just as business activity has leap-frogged over national borders, financial markets are doing so with even greater abandon, raising questions whether the markets can ultimately discipline themselves to be supportive of reasonable economic growth, or perhaps whether the markets will have to adhere to more intensive official supervision and regulation.

One large imbalance in U.S. savings and investment will be the requirement of continued massive foreign funds to finance the resulting current account deficit. This will not end this year. Just consider the following: out of an estimated $140 billion or so of the U.S. current account deficit last year, $55 billion was financed by Japan and $32 billion by Hong Kong, Singapore, Taiwan, and Korea. Such current account deficits automatically increase the linkage between the United States and the rest of the world. As a consequence, we have to accept foreign purchases of securities and foreign purchases of real assets. This increasing financial market interdependence, I think, would have materialized anyway without major trade account balances, because of at least three developments that will continue as we go into the 1990s. These are financial deregulation, innovation, and technology.

The daily average volume of government bond futures has increased from $17 billion in 1986 to $28 billion in the United States in 1988 - in Japan, from $5 billion to $55 billion during the same period. Technology, both hardware and software, that tended to originate in the United States is now diffused through the entire global market. This technological explosion is leading to greater transaction volume, an increasing use of short-term oriented trading practices, and more rapid swings in the competiveness of individual financial institutions.

Now having said this, what does it suggest for this global market place in terms of challenges for the immediate future? The greatest need is going to remain for foreign nations to finance a large American trade deficit. Very little progress will be made to reduce the deficit from here on and perhaps well into the 1990s. The American economic expansion is strong, and the rapid gains in exports cannot be sustained. As domestic demand remains high, the U.S. trade deficit will remain large until the next significant economic slowdown occurs in the United States. Indeed under the current conditions, sharp further declines in the value of the U.S. dollar would do very little to reverse the trade deficit. Further dollar declines would merely strain operating capacities and aggravate the inflation rate.

Consequently for the time being, U.S. dollars will continue to pile up on foreign shores, and their ready acceptance will depend on the attractiveness of American interest rates and the performance of the American economy. This is bound to produce further linkages in the financial markets around the world. It's also not clear but that the future economic slowdown in the U.S., sometime in the next few years, will take place while other industrial nations will continue to enjoy economic growth, thus allowing the United States to make a meaningful reduction in the trade deficit. I suspect this is still the likely course, that we will peak out first. But nevertheless, the chances of cyclical economic convergence among the major industrial countries has increased during the past year or so. Many now show some common characteristics, disparities in economic growth are diminishing with just a few exceptions.

Capital spending has become the major force supporting growth around the industrial world. Consumption remains high, and with the exception of Japan, perhaps inflation is becoming an increasing influence on national stabilization policies. As a result, interest rates in major financial centers are rising, and they have become an anti-inflation weapon and, to some extent, the tool for maintaining exchange rates within some reasonable range. It is, nevertheless, extremely difficult in the emerging period of the 1990s for domestic monetary policy to stabilize economic behavior in a setting of global financial markets.

To some extent, there is a loss of domestic autonomy. This is because massive amounts of funds can move from one country to another country and from one currency to another even on relatively small changes in interest rates or the expectation of inflation. This raises the question of whether this loss of domestic monetary policy autonomy can be prevented.

Can this be moderated and offset by correct policy actions on the fiscal side? Here the record does not speak well for responsive fiscal policy action. The progress of the U.S. in reducing the budget deficit, as all of us know, is disappointing, and the burden remains heavily on the central bank. The U.S. budget deficit in the fiscal year ending this September is going to $160 billion plus, very little different from the previous year even though the Gramm-Rudman target for this fiscal year was around $136 billion. Now, this of course makes it far more difficult for us to put our own economic and financial house in order.

This puts an increasing burden on international financial policy and economic policy cooperation. I would have to say that while some progress has been made, it leaves a lot to be desired. There are weak links in the international system that are still apparent. First, there is no agreed upon international standard of reconciling domestic and international considerations in the area of appropriate exchange rates. Second, there is no consensus as to who should bear the burden of adjustments - whether there should be symmetry of equal burden sharing between the surplus and deficit countries, or whether the deficit countries because of the obvious limits of financing capacity should bear a disproportionate share of the adjustment. Third, only slow progress is being made to limit the risk of financial vulnerability. The use of new financial instruments, new markets, and up-to-date technology introduces a very real danger of collective vulnerability. For instance, some new products, such as interest rate swaps, reduce the exposure of interest rates but do involve a greater degree of credit risk. Futures and option markets are also used as a way to lay off risk onto others.

But there is a significant danger that, under extreme circumstances, this interlocking network of customers, brokers, and dealers will be fractured. If this happens, some participants may walk away from their positions. It's ironic that doubts are now being raised in the United States, where financial deregulations really took hold early, about the wisdom of allowing a great deal of deregulation sophistication of supervision than is now committed in a wide range of activities.

Now from an international perspective, it's also going to be interesting to see how a monitoring of this free-wheeling, intricately intertwined, global financial network can be improved without stifling perhaps the creativity of markets by driving business onto unregulated shores. Certainly, one of the critical issues that will face us in the 1990s is not further movement towards deregulation, but the speed with which and the nature of where we're going to have some reregulation. Already some of this has become evident. Capital requirements are now being raised both for commercial banks and other institutions, not only in the United States but for major banking institutions around the world. Of course, there's going to be a key question raised about the regulation of a much more consolidated financial system, as the consolidation takes place in the 1990s and as borders come down for banking and other financial institutions throughout the United States and especially in Europe.

A second issue is what will the government do as some more ailing financial institutions come to the force. We have two problems of significance right now; one is the thrift problem requiring aid of about $150 billion or more. The problem has implications for housing activity. The FDIC has started to take over, and it has one or two choices. It can warehouse all of these ailing institutions and their assets, or it can go into those institutions, reduce their size, consolidate them, and then have an impact on the asset side of the balance sheet and in turn have an impact on open market transactions and open market values.

Then there is the issue of the developing countries. The secretary of the Treasury last week unveiled a plan, and the critical issue is who will provide new money to the developing countries. If you look at the structure of the American financial system and the activity that is available here and outside the United States, the chances are that the American financial institutions do not have the capacity and do not want to finance the LDCs. The massive consolidation that will take place in our financial system in the 1990s provides a huge number of opportunities for profit that exceeds the rate of return that will be offered by these ailing developing countries. Europe is integrating, providing an extraordinary opportunity for business and institutions in that part of the world. The level of in the Far East is so strong, the demand for credit is so large that private institutions will have a range of opportunities far greater than what is available in the ailing developing countries of Latin American. So the issue will become: how do we socialize that cost.

Finally, one of the major issues, probably the most important issue that confronts all of us as participants in the business and financial community, is this: our growing trend toward the greater usage of debt and the smaller usage of equity. The greater usage of debt is apparent in the household sector and will gradually diminish, perhaps in the 1990s in the governmental sector, as pressure is on to contain the deficit. But the private use of debt has not been shackled. If the private use of debt particularly in the business community continues, eventually the creditors of business, a myriad of financial institutions, will play a more dominant role in the decision making process of the business sector. That will be a dramatic change from the style of management of our business since this country was born. We will move then to a social democracy rather than an economic democracy. We will move closer to the kind of relationship that exists in Europe and in Japan between business and government.

We still have a choice. We can interact in this process by changing a variety of governmental rules and regulations. But that choice will dimish rapidly as we move through the 1990s. If any of you want to have an important influence in the 1990s on the direction of where we're going or on whether we are going to have a social democracy 20 years from now rather than an economic democracy, it's up to all of you to assert your views very soon.

Thank you very much.

Henry Kaufman is President of Henry Kaufman & Company in New York City.
COPYRIGHT 1989 St. John's University, College of Business Administration
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Title Annotation:address to the 27th annual Business Conference
Author:Kaufman, Henry
Publication:Review of Business
Article Type:transcript
Date:Dec 22, 1989
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