Commentary

The Fearful Economy

This article originally appeared in Forbes on October 4, 2004.
One reason economic statistics are weak: Businesses are hoarding cash and stockpiling commodities. Can we blame them? Recent economic indicators resemble that old chestnut about the weather—if you don’t like it today, just wait until tomorrow. This volatility, coupled with the lack of discernible trends, has kept stocks on edge for months.

Will the stomach-churning swings in the economic data end soon? Probably not. The invasion of Iraq has opened Pandora’s box, unleashing a plethora of troubles. The ponderable ones are risks that can be quantified, managed and insured or hedged against, at a cost. The imponderables generate uncertainty. Beyond the quantifiable pale, uncertainty forces even the shrewdest executives to take a leap in the dark. Operating under the increasing weight of risk and uncertainty, the economy, not surprisingly, has hit a soft patch.

Increased levels of risk and uncertainty cause people to make adjustments. We have to look no further than the reaction of Floridians to the hurricane alerts that have gone out in recent weeks. With the first signs of trouble, people in the prospective path of destruction go on hoarding and stockpiling sprees.

The rush for provisions has also accompanied the increased level of risk and uncertainty associated with the so-called war on terrorism. Indeed, U.S. businesses have taken hoarding to new levels. Moody’s has reported that the ratio of liquid financial assets to debt on the balance sheets of U.S. nonfinancial companies has recently hit a 35-year high.

Given the course of events in the Middle East, the hoarding of cash has been prudent. How has it been accomplished? By cutting costs and improving productivity, businesses have increased cash flow. They have hung on to the cash by shying away from capital expenditures.

While the hoarding of cash has dramatically improved the balance sheets of businesses, it has left the economy starved of fuel. For one, employment growth has been sluggish. Also, investment—the big swing factor that gives rise to booms and busts—has been flat.

In addition to accumulating cash hoards, businesses have attempted to increase their stocks of commodities. They don’t want to be caught short. Their quest for liquidity in the commodity sphere has thrown most commodities into a bull market phase. This is evident in their prices. When inventories are lower than desired, spot prices exceed those in forward markets, become much more volatile than forward prices and exhibit strength. All of these features have characterized most commodity markets in recent months. I can take credit for recommending in my Dec. 8, 2003 column that you put 10% of your portfolio in commodities. Since then the Goldman Sachs Commodity Index has climbed 26%.

Crude oil merits a few more words. Just as private businesses were scrambling to increase their crude inventories, the U.S. government decided to fill the Strategic Petroleum Reserve to capacity (see my column of Aug. 16). This added competition for inventories is one big reason why the speculators jumped into the oil market and why the price of a barrel of oil peaked at $48.66 on Aug. 19.

Wars are expensive and eventually have to be paid for. What makes the current war effort unique is that its scale, scope and duration are undefined. This injects more risk and uncertainty about future tax increases into the picture.

If all this wasn’t bad enough, we must remember that when the 2001 and 2003 tax cuts were passed, Congress and the Bush Administration created a convoluted series of “phase in” and “phase out” schedules for many different tax rates, credits and incentives. Consequently, the tax cuts are temporary and tax hikes are already part of the current law.

President Bush has indicated that he wants to make the tax cuts permanent, while challenger John Kerry has pledged to allow some of them to die a natural death. To further cloud the picture, President Bush has promised to establish a bipartisan advisory panel on tax reform, if reelected. The aim of the panel will be to simplify our byzantine tax code. Given the financing requirements for the war on terrorism, “tax simplification” will, no doubt, become code for “tax hikes.” The idea of the temporary tax cuts becoming permanent is little more than a pipe dream. The problem is that we don’t know what will be left on the cutting-room floor after either a Bush or Kerry Administration takes office. Talk about risk and uncertainty. No wonder businesses are hoarding cash and commodities, and investors are hesitant!

Keep your commodity allocation at 10%. And don’t expect the stock market to exhibit much strength this year, no matter who is elected.

Steve H. Hanke is a professor of applied economics at The Johns Hopkins University in Baltimore and a senior fellow at the Cato Institute in Washington, D.C.