Macro Updates

April 1, 2003

Here is what I have been watching recently:

The U.S. economy after the Iraq conflict. Some have suggested that the current slowdown in the U.S. economy is due to more than the geo-political uncertainties. This line of thinking argues that the U.S. economy will continue to suffer even after the Iraq situation is resolved due to 1) excess capacity built up during the “bubble economy” and 2) continued economic weakness around world will retard U.S. exports. 

I’m not so sure. Economists have consistently underestimated the power of the American consumer. Remember all of the “economic pessimists” who, after the September 11th terrorists’ attacks immediately claimed that the U.S. economy would spin into a recession (yours truly included)? Well…we were wrong. The American consumer continued to spend and 2001 ended on a (slightly) positive economic note. I’m not making any predications of rapid economic growth (yet) but watch those American consumers…they have surprised us before. If the consumers start spending, watch the talk of excess capacity go away very quickly.

As for the rest of the world…yes, they could be doing a great deal more to help the global (and American) economy. Japan still looks sluggish, although keep on eye on American investment in (and recapitalization of) the Japanese banking system. Potentially, very interesting. Europe, still has deep problems. More about them later.

Iraq after the Iraq conflict. There is a great deal of talk about “rebuilding Iraq” after the war. This is a very good idea, but what does it mean, exactly? What I am afraid of is that American government will try to “fix Iraq” the way they have tried to solve a lot of other problems: simply by throwing money at the problem. We need to think deeper about this problem. We need to have a serious discussion about we can (and should) do to truly help the Iraqi people rebuild their economy, country and their lives. Dumping money into the country is not going to solve the problem. Neither is expecting them to live off of oil revenues. As Texans, we learned the hard way, of what happens if your economy becomes too dependent on the oil industry.

So how can we truly help Iraq? We need to look at what countries need to do in order to ensure long term economic growth. We need to think about helping them establish a sound legal system, one that defines and enforces property rights, without corruption. We need to help them establish well diversified financial markets so that entrepreneurs can get the capital they seek. We need to help established well functioning labor markets and help them to increase their stock of human capital (skills, knowledge and education of the labor force). And we need to ensure that their public sector operates as efficiently and effectively as possible.

Are we ready to do this? I hope so. For the sake of the Iraqi people and people of that entire region, I hope we don’t fall back into the “give them money” scenario of economic development.

Warren Buffett maybe rich, but… Did you see how Buffett attacked derivative contracts in his annual letter to shareholders of Berkshire Hathaway? He described them as financial weapons of “mass destruction” and financial “time bombs” that posed a threat to the entire economic system. Will futures, options, and swaps lead to the collapse of our capitalist system? I doubt it. 

We have all heard the stories of Long-Term Capital Management, Orange County California and Barings Bank disastrous use of financial derivatives. Everyone loves to hear the horror stories. But these are example of the misuse of derivatives contracts and of this important market for risk. When used correctly, derivative contracts are an excellent vehicle to manage risk exposure. But, to most people, they are very complicated financial vehicles. They require oversight and understanding. When market participants get lacks or lazy they can get burned in the derivatives markets very easily. Does this mean that these markets need to heavily regulated or even shut down? I think this would be an over reaction.

But, it has happened before. When policymakers start to view financial markets as mysterious things, where a few get rich at the cost of many, they are temped to step in with very bad, poorly thought out regulation and policy change. Just think of: The Glass-Steagall Act of 1933, the Garn-St. Germain Act of 1982 and you will see my thought process. Keep an eye on this issue and watch how policymakers react.