Economic Reporting Review
By Dean Baker
July 22, 2002

OUTSTANDING STORIES OF THE WEEK

Yes, He Can Top That
Floyd Norris
New York Times, July 17, 2002, Page A1
http://www.nytimes.com/2002/07/17/business/17PLAC.html

This article reports on Alan Greenspan's congressional testimony. It discusses his responsibility for the development of the stock market bubble, since he failed to take any steps to deflate the bubble after his famous "irrational exuberance" comment.

An Idea Gone Haywire: Linking Executive Pay to Sales
Gretchen Morgenson
New York Times, July 14, 2002, Section 3 page 1
http://query.nytimes.com/search/abstract?res=FB0613F83A540C778DDDAE0894DA404482

This article reports on the perverse incentives created by a clause in the contracts of several CEOs, which linked their compensation to sales. One result has been that the executives developed creative ways to artificially inflate sales.

Unconventional Transactions Boosted Sales
Alec Klein
Washington Post, July 18, 2002, Page A1
http://www.washingtonpost.com/wp-dyn/articles/A21983-2002Jul17.html

Creative Transactions Earned Team Rewards
Alec Klein
Washington Post, July 19, 2002, Page A1
http://www.washingtonpost.com/wp-dyn/articles/A28624-2002Jul18.html

These articles reveal some of the extraordinary bookkeeping techniques that AOL used to maintain the appearance of strong revenue growth in the months prior to its merger with Time-Warner.


Bangladesh is Sipping Arsenic As Plan for Safe Water Stalls
Barry Bearak
New York Times, July 14, 2002, Page A1
http://query.nytimes.com/search/abstract?res=F30C10FB34540C778DDDAE0894DA404482

This article reports on the drinking water crisis in Bangladesh. Tens of millions of people are drinking well water that is contaminated with large quantities of arsenic.


No Suits Allowed
Caroline E. Mayer
Washington Post, July 14, 2002, Page H1
http://www.washingtonpost.com/wp-dyn/articles/A64365-2002Jul13.html

This article reports on the spread of clauses in contracts, such as home purchase agreements, that require that disputes be resolved by an arbitrator rather than going to court. Since the firm usually selects the arbitrator, there is reason to believe that their decisions will be biased against consumers.


The Stock Market Downturn

Fed Chief Blames Corporate Greed; House Revises Bill
Richard W. Stevenson and Richard A. Oppel Jr.
New York Times, July 17, 2002, Page A1
http://www.nytimes.com/2002/07/17/business/17CONG.html

This article reports on Alan Greenspan's testimony before Congress on the state of the economy. At one point it notes Greenspan's famous "irrational exuberance" warning about a stock bubble, and then adds that Greenspan "did not address whether the Fed's subsequent willingness to keep interest rates low as stocks rose and the economy boomed had contributed to the anything-goes climate decried today."

There is no obvious reason that Mr. Greenspan would have addressed the question posed in the article. The market plunged in response to the irrational exuberance comment. It resumed its rise after Greenspan backed away from this remark. In later years he quite explicitly stated that he thought that market valuations may be justified by profit growth.

Given the respect he commands from financial markets, there is no reason to believe that Mr. Greenspan would have found it necessary to raise interest rates to prevent the stock bubble. As the initial response to the irrational exuberance comment showed, if Greenspan had used his public appearances to carefully explain why stock prices had risen to levels that could not be justified by plausible projections of profit growth, it would almost certainly have deflated the market bubble at an early stage.


Bear on Prowl As Market Ends A Dreary Week
Alex Berenson
New York Times, July 13, 2002, Page A1
http://query.nytimes.com/search/abstract?res=F50D13F835540C708DDDAE0894DA404482

Markets Reel, Recover; Dollar Falls Below Euro
Steven Pearlstein and Ben White
Washington Post, July 16, 2002, Page A1
http://www.washingtonpost.com/wp-dyn/articles/A10091-2002Jul15.html

Bear Market Ignores Bush's Bullishness
Dana Milbank and Jonathan Weisman
Washington Post, July 16, 2002, Page A8
http://www.washingtonpost.com/wp-dyn/articles/A10058-2002Jul15.html

The Dow Plunges 440 Points, Then Roars Back
Alex Berenson
New York Times, July 16, 2002, Page C1
http://www.nytimes.com/2002/07/16/business/16STOX.html

These articles assess the likelihood that the market will bounce back as opposed to drop further. None of them discuss the ratio of current stock prices to corporate earnings, nor the prospect for profit growth over the next five to ten years. It is impossible to make any meaningful assessment of the market's future prospects without evaluating its price to earnings ratio and the prospects for medium-term profit growth. This would be comparable to trying to assess the value of a piece of commercial real estate without ever considering the rent it was expected to command.

The Post article by Milbank and Weisman includes assessments of President Bush's efforts to lift the stock market. A rising stock market is primarily a redistribution from people who own little or no stock, who are mostly middle income and poor, to people who own a great deal of stock, who are mostly rich. It is not clear why it would be in the public interest to foster such an upward redistribution of income, especially when the stock market is in the process of retreating from unsustainably high prices.


New Reasons to Wonder If the Worst Is Over
Tom Redburn
New York Times, July 14, 2002, Section 3 page 4
http://query.nytimes.com/search/abstract?res=F30A10FF3A540C778DDDAE0894DA404482

This informative article assesses the stock market's future prospects. It reports on a recent article in an academic journal, which pointed out that the market will have to fall further, before stocks can provide the same rate of return in the future as they did in the past. While this is accurate, it is misleading to present this view as a new breakthrough. The logic of this argument is quite simple, can be demonstrated with basic arithmetic, and has been explained any number of times (e.g. see "Letter to Martin Feldstein, May 15, 1999 [http://www.cepr.net/Social_Security/letter_to_feldstein2.htm]). Unfortunately, the media almost completely ignored this fact while the stock market bubble grew ever larger.


The Falling Dollar

Confidence Falls With the Dollar
Paul Blustein
Washington Post, July 16, 2002, Page E1
http://www.washingtonpost.com/wp-dyn/articles/A9957-2002Jul15.html

Euro Edges Past The Dollar In a Victory For Europeans
Steven Erlanger
New York Times, July 16, 2002, Page C1
http://www.nytimes.com/2002/07/16/business/worldbusiness/16EURO.html

These articles report on the rise in the euro against the dollar. At one point the Post article comments that there is "a growing preference among American investors to move money overseas, even though other big economies including Europe and Japan are expanding less rapidly than the United States."

The bulk of the money that flows between nations is held in short-term deposits. Currently, short-term interest rates are more than a percentage point higher in Europe than in the United States. Europe also has a slightly lower inflation rate and has a large trade surplus with the United States. Both factors make it likely that the euro will rise against the dollar in the near future, making the difference in returns on money invested in the Europe and the U.S. even larger. Investors care about the return on their money, not how fast an economy is growing.

The Times article includes a quote from an economist who attributes the weakness of the dollar to "twin deficits" -- a trade and budget deficit. Actually, this was exactly the situation that the country faced in the eighties, as the dollar was soaring against other major currencies. The conventional view at the time was that the budget deficit pushed up interest rates, which raised the value of the dollar, thereby causing the trade deficit. While this analysis was probably wrong at the time, the explanation given in the article completely reverses this standard view ? with a budget deficit actually leading to a low dollar rather than a high one. A more simple and likely explanation is that the trade (or current account) deficit by itself must lead to a decline in the value at the dollar, which may be hastened as the incoming capital that finances the current account deficit is reduced (due to the falling stock market).


Mexico

Mexico Plays a North-South Divide
Graham Gori
New York Times, July 16, 2002, Page W1
http://www.nytimes.com/2002/07/16/business/worldbusiness/16MEXI.html

This article discusses the nature of Mexico's economic links between the United States and Canada through NAFTA, as well as it cultural ties with Latin America. It asserts that "the benefits of the partnership with the United States and Canada have been huge." The evidence it presents for this fact is the size of the trade and investment flows between the United States, Canada, and Mexico.

The fact that most of Mexico's trade is with the United States and Canada does not prove that it has benefited from this pattern of development. Prior to the fall of the Soviet Union, the vast majority of Poland's trade was with other east block countries; however, few economists would claim that this was beneficial to Poland's economy.

Economists usually turn to GDP growth as the best measure of economic
performance. By this standard, Mexico has done very poorly -- either in spite of, or because of, its expanding ties to NAFTA partners -- with per capita GDP growth averaging less than 1.0 percent a year over the last decade. This is very slow by historical standards, e.g. compared to Mexico's 3.9 percent annual per capita GDP growth from 1960-1980.


Budget Deficit Projections

Deficit Estimate Signals New Round in Budget Fight With Hill
Dan Morgan and Jonthan Weisman
Washington Post, July 13, 2002, Page A4
http://www.washingtonpost.com/wp-dyn/articles/A63401-2002Jul12.html

White House Says It Expects Deficit To Hit $165 Billion
Richard W. Stevenson
New York Times, July 13, 2002, Page A1
http://query.nytimes.com/search/abstract?res=FA0C14F935540C708DDDAE0894DA404482

These articles report on a new set of budget projections from the Office of Management and Budget, which shows a deficit of $165 billion for 2002, in addition to smaller deficits in the following two years. The Times article points out that the main reason for the increase (compared to earlier projections) in the size of the projected deficit for 2002 is lower capital gains tax revenue due to the stock market decline.

As was pointed out in the previous ERR (see the discussion of "White House Expected to Project A Deficit Topping $150 Billion," by Richard W. Stevenson, New York Times, July 12, 2002, Page A15; ERR 7-15-02), capital gains tax revenue for 2002 is based on the capital gains realized in 2001. The stock market's performance in 2001 was known at the time when earlier budget projections were made in January and February; therefore this downward revision in the projections is attributable to inaccurate calculations by the Office of Management and Budget and the Congressional Budget Office, not to the recent falloff in the market.

The article later comments that Democrats hope to argue that the government is now on a long-term deficit path, "eventually limiting its ability to pay Social Security and Medicare benefits -- and hurting the economy by driving up interest rates." It would have been appropriate to point out that the latest projections show that Social Security will be able to pay benefits until 2041, with no changes whatsoever, and even after that date it would always be able to pay a higher real (inflation-adjusted) benefit than current retirees receive. Under the law, Social Security is financed by a separate tax and cannot be affected by the budget deficit, unless the government defaults on the national debt -- a proposition that no one regards as a serious possibility.

It would also have been appropriate to note that standard estimates of the relationship between deficits and interest rates indicate that the deficits the nation is currently projected to run would only have a modest impact on interest rates, and would subtract less than 0.05 percentage points from the annual growth rate. This means that any negative economic impact of the current deficits would be almost impossible to detect.

The Post article makes three separate references to the recent farm bill as an appropriation that will increase the budget deficit in coming years. At $18 billion a year, the average level of annual subsidies over the next decade is higher than the $9 billion provided in the last bill. But, Congress has made large emergency appropriations to farmers in each of the last three years, which brought total subsidies to more than $20 billion a year. This means that the subsidy level stipulated in the farm bill is substantially less than what Congress has actually been spending on farm subsidies.



Social Security Privatization

Democrats See Scandals as Chance to Attack Privatizing Social Security
Alison Mitchell
New York Times, July 13, 2002, Page A9
http://query.nytimes.com/search/abstract?res=F30B10F835540C708DDDAE0894DA404482

This article reports on efforts to use the recent spat of corporate scandals as an argument against privatizing Social Security. At one point the article comments that "if the market does not turn around soon, the president's ideas for Social Security will become untenable."

As an economic matter, President Bush's ideas for privatizing Social Security will be more untenable if the market does turn around, than if it does not. His commission assumed that stocks would provide an average real return of 6.5 percent. This is impossible given recent price to earnings ratios and the rate of profit growth projected by the Social Security trustees (see "Letter to Martin Feldstein, May 15, 1999 [http://www.cepr.net/Social_Security/letter_to_feldstein2.htm]). The only way that it will be possible to get the stock returns assumed by the commission -- or any return that is substantially greater than the yield on government bonds, is if stock prices continue to fall. Only if the price to earnings ratio falls below its historic average, to about 14 to 1 (approximately 15 percent below the current level), will it be possible to get the returns assumed by President Bush's commission. This would imply that stocks must fall by roughly one-third from their current level.

This article also asserts that both Democrats and Republicans sought to use high returns from the stock market "as one element of plans to ensure the solvency of the Social Security system as the baby boom generation retired." Actually, the Social Security system has always been projected to be secure well into the retirement of the baby boom generation. The latest projections show that the fund will be full solvent until 2041, at which point the youngest baby boomers will be age 77 and the oldest will be age 95. Most baby boomers will be dead before the projected shortfall appears.


Child Labor

In Ecuador's Banana Fields, Chile Labor Is Key to Profits
Juan Forero
New York Times, July 13, 2002, Page A1
http://query.nytimes.com/search/abstract?res=F30E11FA35540C708DDDAE0894DA404482

This informative article discusses the use of child labor throughout Latin America, with a focus on the banana fields in Ecuador. A one point it comments that, " while rights activists regard such labor as unacceptable, many parents -- see it as necessary." The article goes on to point out that many families rely on income from their children's work to make ends meet.

This fact should not be counted as an argument against the regulation of child labor. The point of such regulation is to change the situation in which these families find themselves. If farms and factories could not rely on children to work at incredibly low wages, then they would have to pay their adult workers more money. This would allow them to make ends meet without having their children work.

This was exactly the logic that led workers in the industrialized nations to support restrictions on child labor 100-150 years ago. These workers also relied on their children's wages to sustain their families. But they hoped -- correctly as it turned out -- that if child labor was restricted, it would raise their wages. The realities of global competition may make the problem more difficult to address at the national level, but the logic is the same.


Prescription Drug Prices

Michigan Senator Who Ran on Prescription Drug Issue Will Lead
Democrats in Battle
Over It
Robert Pear
New York Times, July 15, 2002, Page A11
http://www.nytimes.com/2002/07/15/politics/15STAB.html

This article discusses plans by Michigan Senator Debbie Stabenow to find ways to bring down prescription drug prices. At one point the article comments that, "growing numbers of lawmakers say they are willing to use the power of the government to make drugs available at affordable prices." It is worth noting that the power of government is already being used to keep these prices high. If the government allowed drugs to be sold in a competitive market, instead of enforcing patent monopolies, most drugs would sell for just 20-30 percent of their current price.


Controlling Corporate Abuses

Corporate Abuses Giving Democrats A Campaign Issue
Adam Nagourney
New York Times, July 14, 2002, Page A1
http://query.nytimes.com/search/abstract?res=F40A11F934540C778DDDAE0894DA404482

This article discusses the extent to which Democrats are likely to be able to make an election issue out of corporate corruption. At one point it asserts that "Democrats, in particular, given their history, need to be careful about making political moves that might be portrayed as undermining Wall Street."

The article does not indicate the basis for this judgment. According to data from the Federal Reserve Board just over half of families own any stock at all, and half of this group held less than $25,000 before the stock market declines of the last two years. This means that three quarters of the country has relatively little at stake in the stock market. While the Democrats may have to appeal to wealthy stockholders as contributors, there is no obvious reason that the votes of these people would be necessary to win elections.