2001 AD: From Boom, to Gloom, to Doom

Michael Roberts looks back at the year 2000, the year when the US hi-tech stock market bubble burst, and views the economic prospects for the coming year.

Year 2000 was when the five-year US hi-tech stock market bubble burst. And burst it did with a vengeance. In March 2000, the stock market index of hi-tech companies called the NASDAQ reached over 5,100. That compares with under 1,000 back in 1995 when the great hi-tech revolution in the internet and e-commerce really began. But when the stock markets closed on December 29, the last working day, the NASDAQ had fallen back to under 2,500, the heaviest decline in its 18-year history as an index.

The more general indexes of measuring stock market prices in the US are the Dow Industrial and the S&P 500. They include all the big US companies, not just the "new economy" sectors of internet companies like Yahoo or America Online or the cyber equipment suppliers like Cisco, or the software giants like Microsoft. They also cover the auto companies, the retailers, the big chemical and energy companies. In other words, what are now called the sectors of the "traditional economy". But these indexes did not do much better than the NASDAQ. Last March the Dow rose to 11,700 compared to under 8,000 just two years before. But by closing at the end of 2000, it had fallen back to 10,800. The S&P fared similarly.

None of this was exclusive to the US. In Europe, stock markets also lost ground along with the Euro. The Japanese stock index, the Nikkei took a terrible plunge. And Asian markets followed the NASDAQ down like a dog behind its master.

What does this tell us? It tells that capitalist investors lost their confidence and enthusiasm for buying hi-tech companies and are starting to lose confidence in companies in general.

That loss of confidence is usually an indication of the worries and uncertainties about the future not the present. Indeed, the year 2000 was one of general success for capitalism. The US economy grew at a heady pace by its standards, up nearly 5%. European economies, including Britain, also grew by around 3-3.5%. Asian economies continued their recovery from their horrific collapse in 1997-98 and jumped by 5-10%. World trade rose at a record rate. Only Japan continued to wallow in economic despair, achieving just a 1.5% uplift in real GDP.

Apart from oil prices, inflation remained moderate, if slightly accelerating, during the year. As the year ends price rises are hitting 3% in the US, 2.5% in Europe, 2% in Asia and still falling in Japan. And the great energy price fear is disappearing as oil prices drop back from highs of $35 a barrel to $20 a barrel.

So what is spooking the stock market investors? Two things: first, throughout most of the year, the central banks of the world have been raising interest rates. The US Fed, the European Central Bank, the Bank of England and even the Bank of Japan have hiked rates because they thought that growth was getting out of hand (apparently you can have too much of a good thing under capitalism) and that energy prices were going to cause inflation.

Bankers are only worried about two things. The first is whether you can pay them back and the second is inflation. That's because money lenders want to maximise the returns on their lending. If prices rise, it means that when you pay them, even with interest on top, the value of their original loan has fallen. So keeping inflation down is the bankers' obsession. Indeed, it is written into the objectives of most central banks as their main task.

Raising interest rates means that the cost of borrowing increases. So households and businesses reduce their borrowing. They invest and spend less and they save more because the interest rate is better. The result, so the theory goes, is a slower growing economy. Demand for goods falls back into line with supply and inflation slows. But, of course, a slower economy and higher interest rates mean less profit for manufacturers compared with bankers. That spooks investors into buying less shares.

And that brings us to the second thing worrying financial markets. Up to the second half of 2000, profits had been growing at a record rate in the US. Corporate profits had reached nearly 10% of US GDP, a figure not reached since the mid-1970s.

But now the US economy is slowing down fast. In the third quarter of 2000, the growth rate dropped to an annual rate of 2.4% from 5.9% in the second quarter. At the same time, more and more US companies announced that their profits in the last quarter of 2000 and going into 2001 would be a lot less than most investors had been expecting. These "profit warnings" really worried potential share buyers. Instead, they began to sell.

But the big selling binge was in hi-tech companies. Their prices had rocketed to such levels that investors were paying over 180 times annual profits. In other words, it would take 180 years to make enough in dividends to cover the price of the stock! Of course, investors did not buy on that basis. They expected the price of their hi-tech stocks to rise so they could sell them at a profit later. Such is a stock market speculative bubble: you don't buy for the dividend or share of annual profit, but to sell at a higher price.

And up to March, investors were buying companies that did not even make a profit. Indeed, nearly all the internet companies or online retailers were using huge amounts of investor cash to spend and predicting no profit for one, two or even five years! As the profit warnings started to come and the economic slowdown became a reality, investors began to realise that most of these hi-tech ventures were going to fail and it was time to get out.

A colossal shakeout is now under way. It will continue through 2001. You can take a firm bet that 90% of the current "new economy" companies listed on the NASDAQ, Japan's JASDAQ, or Germany's Neuer Markt will not exist in five years time. That is the result of all previous stock market bubbles in new industries and this time will be no different. Indeed, if NASDAQ prices in relation to realisable profits fall to reasonable levels, the NASDAQ index will have to fall to below 1,000. That's over 85% down from its height last year.

And investors have not realised yet that much of the profit increases recorded by the companies they have bought are really fake. That's because many hi-tech companies have spent huge amounts of investors' money not just on research and development of new software or on computer and telecoms equipment. They have also bought up other hi-tech companies to incorporate their potential growth and they have speculated on the stock market as well! For example, Cisco Systems is one of the biggest companies in the world in stock market terms. It makes internet and telecoms equipment. It is at the heart of the hi-tech cyber revolution. It is making considerable profits. But over 25% of its profit comes from investing in other companies on the stock market. If the stock market collapses, so does Cisco's profits. The virtuous circle will turn vicious.

But will the stock market collapse further in 2001? Most capitalist commentators say no. Indeed, their forecasts in the pages of the Financial Times, the Wall Street Journal, Forbes or Finanzen predict a new rally in stock prices. Behind their optimism lies a belief that, although the US and the world economy may slow down in 2001, it will be a "soft landing". In other words, the capitalist economy is not heading for a recession where output actually falls for at least half a year and unemployment rises; or even worse a depression, where the world economy does not come out of its collapse for years, as in 1883-5 and 1929-32. That would be a "hard landing".

The optimists base their view on three things. First, the internet hi-tech cyber revolution is here to stay. It has permanently raised the productivity of labour. Whereas, output per worker used to rise by 1-1.5% a year in the US and Europe, it is now rising at 3-4% a year thanks to hi-tech investment. That guarantees sustainable faster growth back at the levels of the golden age of the 1960s. So growth in the advanced OECD economies will still be around 3% next year and beyond, at worst.

Second, higher productivity means that faster growth can be achieved without any significant burst of inflation. Unemployment levels will stay low but workers will not be able to force up wages too much because of the fear of losing their jobs to new techniques and equipment. And even if they do, companies can compensate for this through cost savings from new computerised systems and the internet.

And third, as the world slows down, central banks will reverse their policy of hiking interest rates as they did in 2000. Interest rates are set to fall fast in the coming year. That will cut the cost of borrowing and increase the appetite among investors to buy stocks, while ensuring that any economic slowdown will avoid recession. All power to the elbow of President Bush with his planned tax cuts for corporations and to Federal Reserve Bank chairman Greenspan with his expected interest rate reductions! So the "Goldilocks" economy (not too hot and fast and not too cold and slow) is set to continue.

Well, you would expect tipsters on the stock exchange to take a rosy view. After all, they have to sell shares to make a living. But what do the capitalist economists think? They are divided, as you would expect from economists.

The big debate is about the productivity benefits from the cyber revolution. What is established is that between 1995-2000, the annual growth in the productivity of labour doubled from about 1.5% achieved each year since 1973. Clearly the heavy investment in computers and telecommunications, accounting for more than half of all investment in the US in the last five year, has played a significant role in this productivity upsurge. But some economists argue that all this productivity increase has been confined to the "new economy" sectors where the investments have been made. So when investments slow down or stop in this area, then productivity growth will collapse back to previous levels and all the old problems of inflation, slow growth and capitalist boom and slump will return.

However, not surprisingly, it's the "official" economists of the Federal Reserve Bank that express the optimistic view. They argue that about 30% of the increased productivity rate can be explained by increased investment in new equipment, which has been rising at over 11% a year since 1995. Another 30% can be explained by full use of all the available labour supply in the US economy, including increased (legal and illegal) immigration of cheap and plentiful labour from across the Mexican border. But up to 40% is down to the new techniques of the hi-tech revolution. If they continue, then even if investment in equipment slows and extra labour dries up, there will be a permanently higher rate of productivity, say at 2-2.5% a year that will ensure steady economic growth.

How should a Marxist view this debate? Marxists start from the premise that value cannot be created in a capitalist economy unless living labour expends effort and time. No machine produces any value without labour. In the US, the maximum available labour force is being used (and unemployment in the US is down to record lows not seen since the 1950s), and workers are putting in as many hours in a day as possible (American workers work more hours in year than anybody else in the OECD countries). So the only way to increase productivity is to raise the efficiency of the labour force through investment in capital equipment. As we have seen, investment in new equipment and plant has been substantial. This is an investment boom. That's why productivity growth has accelerated and kept inflation down.

But eventually the cost of this new equipment will not be enough to compensate for the slowdown in value added by the labour force, which can no longer expand either by size or time. So the return or profit on each extra investment of capital will start to fall. This can be put off if new investment in capital equipment involves innovation and new techniques that cut the cost of production drastically. That has been the experience of the internet revolution in the US in the last five years. But even on the most optimistic estimates, that innovative part of investment has contributed only 40% of the rise in productivity growth. If the labour time cannot be increased and if investment in equipment slows because it no longer produces sufficiently extra returns, then at the very least, productivity growth is going to drop back sharply.

Once profitability falls and overall profit growth slows, then all the huge new investments in equipment and all the hectic investment in the stock market begins to look like money wasted. Capitalists are going to cut back in a big way. The process has already started. US spending on non-armaments capital goods is slowing already, while unfilled orders for electronics goods (which expresses how far supply of new technology is behind demand) have begun to disappear.

That means the huge speculation in hi-tech companies, which has been so fruitful for many investors, is now going to go sour. Such has been the borrowing by US industry in order to finance the investment boom in hi-tech that American companies are running a financial deficit equivalent to 5% of annual US GDP. Between 1995 and 1999, corporate debt rose 46%, reaching the unprecedented level of 50% of GDP. As long as profits keep coming in, as long as interest rates stay low and as long as the value of companies on the stock market keeps rising, then these debt levels are no problem. That's the conclusion of the Federal Reserve economists. In a recent study, they showed that the debt of US companies in relation to their value on the stock market in 1999 averaged just 22%, the lowest for over 30 years - so nothing to worry about there!

But since that study, the US stock market has declined by 10% and corporate debt has risen another 10%. The ratio of debt to stock market valuation has risen for the first time since the recession of the early 1990s. And it's going to rise again sharply in 2001. The burden of debt on US companies is mounting. Banks continue to lend them more money and companies continue to try and issue more bonds to finance investment. It's a build-up to bankruptcy, not just for the small, failing internet companies as we saw in 2000, but also for larger more traditional companies in 2001.

Ah, argue the optimists, but central banks will be cutting interest rates over the next 12 months. That will get the costs of servicing company debt down and keep American households spending. So investment won't collapse, unemployment won't rise too much and the slowdown will be guided to a soft landing.

Well, that's what they said in 1929. Back then, the Federal Reserve started to cut interest rates several months before the stock market crash of October 1929 and continued to cut them right through until summer 1931. But the recession turned into depression and continued right through until summer 1932, while unemployment remained at high levels right up until the US started to gear up for its war with Japan. That's partly because real interest rates (after taking into account prices) remained relatively high because prices started falling as well. Deflation (rather than inflation) was the order of the day as consumer demand collapsed. If that happens this time, then no amount of Fed rate cuts will stop the US economy slipping into what the great capitalist economist, Keynes, called the "liquidity trap".

Look at the experience of Japan in the 1990s. The Bank of Japan has followed a "zero-rate interest policy", but real interest rates have stayed up because prices have been falling. With Japanese households worried about unemployment and wage cuts, they have been saving, not spending. So Japanese industry has not dared borrow, even at zero rates because, in real terms, it costs money. So the economy has remained in deflationary stagnation for ten years. The Japanese experience will become that of the US and Europe over the next few years. And if the US goose no longer lays the golden eggs, investors around the world are going to sell US stocks and company bonds. The US runs a huge deficit on its trade with the rest of the world as it sucks in electronics goods from Asia, oil from OPEC and consumer goods and services from Europe. It now needs $1bn a day to finance this deficit. Up to now, it has successfully obtained this money from abroad as foreigners have invested huge sums in US hi-tech companies, bought bonds issued by US telecoms companies and the US treasury. US companies used this money to buy the goods they need from abroad and to pay interest on the debt already run up. That debt is now equivalent to 25% of annual US GDP.

But what if foreign investors no longer buy as much of the US stock market and bonds as before, and even start selling what they have? That means the US trade deficit cannot be financed, except by the US government using its dollar reserves, and central banks elsewhere providing the US with dollars from their reserves. If the demand for dollars dies (while the supply of dollars continues to expand as Americans buy more goods from abroad), then the value of the dollar will plummet. If that happens, everywhere investors holding huge amounts of dollar financial assets (stocks and bonds) will suffer big losses. As America sneezes, the world catches a cold. If America gets a cold, the world gets influenza and pneumonia.

One of the arguments of the optimists is that this time the Federal Reserve Bank will not make the mistakes it made in 1929-32. Then it started cutting interest rates from 6% in mid-1929 to 1.5% in mid-1931. But prices kept falling faster, so that real interest rates started to rise. Now, in 2001, if the Fed cuts rates, real interest rates will also fall because price inflation will not decline and prices certainly won't fall as they did in 1929-32.

In 1931, the Fed reversed its policy of cutting rates to compensate for the stock market crash. This seems like a crass error. But there was a good reason. Foreign investors in the US stock market were selling and taking their money out. This huge outflow of capital was driving down the value of the US dollar - or to be more exact, because the price of the dollar was fixed to gold in 1931, the US treasury was forced to sell gold to keep the dollar's price fixed. By raising interest rates, the Fed hoped to attract capital back into the US and stabilise the "gold standard" price of the dollar. As a result of its policy, the Fed saved the dollar, but only at the expense of prolonging the economic slump.

Exactly that same problem could arise for the US government this year. The Fed will want to cut interest rates to avoid a stock market collapse and achieve a soft landing for the economy. But if foreign investors sell out, then it may need to hold up interest rates in order to avoid a collapse of the dollar, which in itself would provoke a further fall in stock market prices and drive up inflation. At the very least, that could slow the hand of the Fed. At worst, it could mean that real interest rates stay up as inflation slows, and so ensure a hard landing. Either way, "fine-tuning" a soft landing for the economy ain't going to be so easy as the optimists imagine.

Never before in the history of capitalism have the prospects for economic growth, employment and incomes been tied so closely to the stock market. The cyber revolution and the importance of foreign investment have created a synthesis between the real economy and the fictitious. Last year, US companies issued over $100bn in shares in order to launch themselves on the stock market, while existing companies issued extra shares worth over $200bn to finance new investment. That's double the figure in 1999 and five times larger than in 1995. At the same time, venture capitalists (high-risk investors) supplied another $100bn to start up new companies, over 20 times more than in 1995! The hi-tech telecoms sector also borrowed over $100bn from the bond market and the banks to finance the purchases of new licences and ventures. This huge influx of cheap money has been a driving force behind the US economy's growth.

Just as important and dangerous for the prospects for the US and global capitalist economy is the extent to which American households now depend on the stock market for their savings and spending power. Now over 25% of all families with annual household income of up to £15,000 (not very much) own some stocks compared with just 13% in 1989 and stocks constitute 60% of the value of Americans' financial assets. If the stock market crashes and stays down, then companies will lose the funding they need to maintain investment and households will lose the backup to spend. Unlike 1987, a Wall Street slump this time will mean an economic recession.

Although hi-tech stock market prices slumped in 2000, the prices of traditional stocks have generally stayed up. But with corporate profitability set to fall and overall profit growth to disappear and the size of debt to finance investment reaching unprecedented levels, the US and European stock markets cannot sustain their current levels. If share prices continue to slip, it could become a landslide as "investor confidence" falls away. And this time the fall in the value of fictitious capital will auger a fall in the value of real capital. Investment in technology, raw materials and labour will stop and the global economy will hit the ground hard