Economic Reporting Review
By Dean Baker
OUTSTANDING STORIES OF THE WEEK
Tighter Rules For Options Fall Victim to Lobbying
Leslie Wayne
New York Times, July 21, 2002, Section 3 page 1
http://query.nytimes.com/search/abstract?res=FA0F10F6355D0C738EDDAE0894DA404482
This article reports on the corporate lobbying effort that has been able to prevent any congressional actions that would change the
accounting rules for stock options.
S.E.C. Is Suffering From Nonbenign Neglect
Stephen Labaton
New York Times, July 21, 2002, Section 3 page 1
http://query.nytimes.com/search/abstract?res=F60714FA345D0C738EDDAE0894DA404482
This article examines the current state of the Securities and Exchange Commission. It reports that it is grossly understaffed for its
mission. In the last decade, its staff has been cut in almost every area, even as its work load has increased enormously.
The Stock Market
Adding to Loss of Investments, A Loss of Faith
Floyd Norris
New York Times, July 20, 2002, page A1
http://query.nytimes.com/search/abstract?res=F60714FA345D0C738EDDAE0894DA404482
Market Continues Four-Month Rout; Dow Plunges 390
Jonathan Fuerbringer
New York Times, July 20, 2002, page A1
http://query.nytimes.com/search/abstract?res=F60D10FA345D0C738EDDAE0894DA404482
Investor Confidence Ebbs As Market Keeps Dropping
Gretchen Morgenson
New York Times, July 21, 2002, page A1
Investors Brace For Opening Of New Week on Wall Street
Alex Berenson
New York Times, July 22, 2002, page C1
Wild Day Leaves Dow Under 8000
Steven Pearlstein
Washington Post, July 23, 2002, Page A1
http://www.washingtonpost.com/wp-dyn/articles/A47079-2002Jul22.html
Stocks Tumble And the Fallout Is Going Global
Floyd Norris and David E. Sanger
New York Times, July 23, 2002, page A1
These articles report on the recent downturn in the market and assess the likelihood that it will
be reversed. All of the articles include comments that assess the probability of a turn around
based on the market's recent movement. For example, the article by Berenson comments that,
"in the short run, the best reason to expect a strong rally is the market itself. Stocks do not move
one way forever." The article by Norris reports that, "historically, such rapid declines
have come near the end of bear markets and have often been followed by rapid advances."
None of the articles explicitly assess the prospects for the market by examining its
price-to-earnings ratio and the likely trajectory of future profit growth. While stock prices can
and do move erratically in the short-term, the value of shares of stock is ultimately
determined by the earnings they command. Any assessment of the market's prospects should refer to its
price-to earnings-ratio; this is the only basis for determining whether it is fundamentally
undervalued or over-valued. The path that got the market to its current price-to-earnings ratio,
whether a rapid decline from prior peaks or a gradual increase from an earlier trough, is
irrelevant.
The Times article by Fuerbringer compares the recent 44.5 percent decline in the S&P 500 (as
of 7-20-02) to the 48.2 percent drop in the 70s. This comparison understates the relative
decline in the seventies, since it does not take account of inflation. The cumulative
inflation over the period of decline in the seventies was approximately 20 percent, making the real decline in
the S&P 500 close to 57 percent. By comparison, the cumulative inflation since the stock
market peak in February of 2002 has been about 5.0 percent. This makes the real decline about
47 percent in the recent downturn.
The article by Morgenson notes that, "what economists fear most is that investor losses will
translate to a slowdown, or worse, in consumer spending." While this is probably an accurate
statement about the views of many economists, it is also worth noting that there are
solid economic reasons for not viewing this outcome as a negative development. As a result of the
illusory wealth created by the stock market bubble, people increased their consumption, causing
the savings rate to fall to a record low. This means that tens of millions of people have not saved
as much as necessary to provide the retirement income which they expect. If these workers are
to enjoy comfortable retirements, it will be important that they start saving at a much
higher rate. The loss in demand will pose a serious economic problem, but in principle it can be replaced
with additional government spending or net exports, if the fall of the dollar is allowed to continue.
At one point, the article by Norris and Sanger refers to the views of unnamed critics of Treasury
Secretary Paul O'Neill. According to the article, these critics question his effectiveness in
"articulating a clear federal policy for a dollar whose value has been declining along
with the stock market." This is a peculiar basis for criticizing Mr. O'Neill. The prior treasury secretaries,
Robert Rubin and Lawrence Summers, both supported a dollar policy that was unsustainable
and necessitated the current decline. As a result of the high dollar policy pursued by Rubin and
Summers, the United States is currently borrowing nearly $500 billon a year from abroad.
Nearly all economists recognize that borrowing of this magnitude cannot be sustained for
long, just as a budget deficit of this magnitude cannot be sustained. The only way to correct a deficit
of this size is through a large decline in the value of the dollar.
Resurgent Profits Mostly Unnoticed
John M. Berry
Washington Post, July 26, 2002, Page E1
http://www.washingtonpost.com/wp-dyn/articles/A2406-2002Jul25.html
This article reports on the fact that the stock market dropped the previous day, in spite of
several better-than-expected profit reports. The article asserts that investors are ignoring profit
figures out of fear. At one point, it paraphrases an economist's assertion that stocks will rise if
investors begin to pay attention again to price to earnings ratio.
In fact, the downturn in stock prices might present evidence that investors are paying attention to
price to earnings ratios. The price-to-earnings ratio of the overall market is still close to 16 to
1, using the pre-recession earnings as the denominator. (It would be close to 20 to 1 measured
against currently depressed earnings levels.) This is somewhat higher than the historic average of
14.5 to 1.
Farm Subsidies
U.S. Proposes Global Cut in Farm Subsidies, Tariffs
Paul Blustein
Washington Post, July 26, 2002, Page E1
http://www.washingtonpost.com/wp-dyn/articles/A2494-2002Jul25.html
This article reports on a proposal by the Bush Administration to have a world-wide reduction in
farm subsidies. It notes that this proposal comes after weeks of intense criticism of large U.S.
subsidies. It notes that one reason for the criticism was that subsidies, "tend to
drive down world prices and lower incomes of farmers in developing countries."
The article then reports that the proposal would drastically lower average tariff rates, from 62
percent to 15 percent, with a ceiling of 25 percent. Most of the countries with high tariff rates on
agricultural products are in the developing world. These tariffs protect the income of their
domestic producers. Most farmers in developing nations sell far more of their output to the
domestic market than on the international market. This mean that the cut in protective tariffs in
developing nations, called for in this proposal, is likely to have a much larger negative effect on
their income than any gains from the proposed reduction in subsidies.
Social Security
Bush Continues to Back Privatized Social Security
Amy Goldstein
Washington Post, July 23, 2002, Page A6
http://www.washingtonpost.com/wp-dyn/articles/A59621-2002Jul24.html
This article reports on statements by President Bush's spokesperson, that the administration is
still fully committed to privatizing a portion of the Social Security system. At one point the article
asserts that Social Security is "destined to face enormous strains by the middle of the next
decade as the baby boom generation retires." This is inaccurate. According to the most recent
projections from the Social Security trustees, Social Security will be able to pay all
scheduled benefits until the year 2041, with no changes whatsoever. At that point, the youngest baby
boomers will be age 77 and the oldest will age 95. The actual problems of the system have little
to do with the baby boom generation. The real problem is simply that people are expected to
live longer lives in the future than at present. This raises the cost of retirement.
Many politicians have tried to scare the public about the health of the Social Security system in
order to advance their political agenda. For this reason, it is especially important that reporting
on the issue be accurate.
Russia
Russian Economy Finally Feels the Heat
Peter Baker
Washington Post, July 25, 2002, Page A8
http://www.washingtonpost.com/wp-dyn/articles/A59821-2002Jul24.html
This article discusses the sharp drop in Russia's main stock index the previous day. The article
actually doesn't discuss the strength of Russia's economy at all, it only reports on the movement
of its stock index. There is no necessary connection between the market index and
the economy, so the headline is inaccurate.
At one point the article notes that Russia's government has been trying to follow the advice of
western economists, commenting that, "Russia faces the prospect of losing ground even if it is
doing what the West has advised." It is worth noting that Russia has seen its economy shrink by
close to 50 percent under its transition from a centrally planned economy. During this transition it
was moving rapidly to a market economy under the advice of the I.M.F., World Bank, and
others. Losing ground as it follows advice from the West is not a new experience for Russia.
The Trade Deficit
Trade Deficit Surged In May
Paul Blustein
Washington Post, July 20, 2002, Page E1
http://www.washingtonpost.com/wp-dyn/articles/A34608-2002Jul19.html
Trade Deficit Widens, but Inflation Remains Tame
Reuters
New York Times, July 20, 2002, page B5
http://query.nytimes.com/search/abstract?res=FB0812F7355D0C738EDDAE0894DA404482
These articles report on the Commerce Department's release of trade data for May, which
showed the deficit hitting a new record. If the trade deficit remains at this level, it would imply
that the United States would borrow approximately $500 billion from abroad over the
next year. This has approximately the same impact on future living standards as a budget deficit of this
magnitude. While the Times has regularly given front page coverage to articles on far smaller
budget deficits, it only ran a wire service story on this release. This article appeared in the middle of its business section.
The Post article notes the large deficit and comments that it raises concern about the U.S.
dependence on foreign capital to finance the deficit. Actually the causation goes in the opposite
direction. The inflow of foreign capital raised the price of the dollar, which made
imports cheaper and U.S. exports more expensive to foreigners. If the inflow of capital were to slow
substantially, the decline of the dollar would continue. This would eventually lead to a large falloff
in imports, as they become too expensive, and an increase in U.S. exports, which will be much
cheaper to foreigners. As a result, the trade deficit would be automatically eliminated or at least
substantially reduced. Although this process could prove painful, since higher priced imports
would lead to an increase in the rate of inflation and lower living standards, it is important to note
that there is an automatic adjustment mechanism intrinsic in the financial system. Therefore, there
is no need for the U.S. to find foreign capital to finance its trade deficit.
Trade
Changing Customs: Can Free Trade Flourish With Focus on Terrorism?
Edward Walsh
Washington Post, July 26, 2002, Page A31
http://www.washingtonpost.com/wp-dyn/articles/A2936-2002Jul25.html
This article reports on the obstacles that security inspections pose to trade. There is no reason
that the word "free" should appear in this headline.
Privatization in England
Radical Union Leaders Are Threatening a Hot British Summer
Warren Hoge
New York Times, July 23, 2002, page A3
This article reports on the growing militancy of Britain's unions, and their apparent willingness to
challenge Prime Minister Tony Blair's plans to privatize various public services. It refers to these
plans as efforts to "modernize the government" and to "improve public services."
It is not clear that Mr. Blair's motive in promoting privatization is exclusively a concern with the
public good. Several privatizations in Britain have failed badly. In the case of the privatization of
the rail system, the resulting deterioration in services was so bad that public anger forced a
re-nationalization of segments of the system. In the case of London's subway system, Mr. Blair
wanted to push ahead with privatization even though the consultant he hired concluded that
the publicly run system would be more efficient. The track record suggests that Mr. Blair may have
motives other than efficiency and improving service quality in his promotion of privatization.
The Housing Market
New Milestone for Hot Real Estate
John M. Berry and Catherine E. Mayer
Washington Post, July 26, 2002, Page A1
http://www.washingtonpost.com/wp-dyn/articles/A2633-2002Jul25.html
This article reports on the strong housing market both locally and nationally. It attempts to assess
whether the housing market is currently subject to a bubble. One of the experts it relies upon is
Federal Reserve Board Chairman Alan Greenspan. It is worth noting that Mr. Greenspan failed
to recognize the stock market bubble, the largest financial bubble in the history of the world(he
did question whether the market was characterized by "irrational exuberance in December of
1996, but reversed himself and did not question the explosive run-up in stock prices that
followed over the next three years).
In assessing whether the housing market has a bubble, it would have been worth considering the
pattern of rental prices, which reflect what people are willing to pay to actually live in a house or
apartment, rather than to hold property as an investment. The rate of increase of rental prices
has slowed sharply in the last half year, from a 4.9 percent annual rate in the fourth quarter of
2001, to a 3.0 percent annual rate in the most recent quarter. While rental and ownership prices
usually move together closely, ownership prices have outpaced rental prices by close to 20
percent over the last six years. This is strong evidence of a bubble --
omeowners are buying houses with the expectation that they will rise in price, not because they
actually place the value of living in the house at the current market price.
European Stock Markets
As the World Tracks Wall St., U.S. Leadership Is Two Edged Sword
Mark Landler
New York Times, July 25, 2002, page C1
This article reports on the plunge in stock markets around the world, which has largely paralleled
the decline in U.S. markets. At no point does the article explicitly discuss the price-to-earnings
ratios in these markets, which is the most important measure of their current value.
Near the end, the article notes the weakness of the European economy and reports that "critics
say that European governments have shied away from steps, like liberalizing labor markets and
lowering taxes, that would bolster corporate investment and consumer spending." The
evidence about the effectiveness of these measures is actually quite ambiguous. (Tax cuts for most nations
would be prohibited at present, as a result of limits on government budget deficits in the
Maastricht agreement that established the euro.)
The more obvious basis for criticism, which the article does not mention, has been the tight
monetary policy pursued by the European Central Bank (ECB). While the Federal Reserve
Bank has lowered short-term interest rates in the United States to 1.75 percent, the
ECB has set them at 3.5 percent even though the euro zone nations have higher unemployment and lower
inflation than the United States. Even the I.M.F. has criticized the ECB for its overly tight
monetary policy.
The State of the Economy
Fed Shows No Sign of Another Rate Cut
John M. Berry
Washington Post, July 25, 2002, Page E1
http://www.washingtonpost.com/wp-dyn/articles/A59773-2002Jul24.html
This article assesses the probability that the Federal Reserve Board will cut rates again in the
near future. At one point it notes efforts by the Fed to track the economy's prospects,
commenting that "two of the indicators most closely watched by Fed officials for signs of
where the economy is headed, initial claims for unemployment insurance and sales of new motor vehicles, continue to point to economic strength."
The article does not indicate its source for its assertion about which indicators the Fed follows,
but these would be especially bad ones. Initial unemployment claims are not only erratic, but
they are also a lagging indicator of the economy's movements. The monthly average at
the start of the last recession in 1990 did not exceed the January level until September, three months after
the economy has entered a recession. Car sales are also very erratic and heavily influenced by
manufacturers' incentives. It is very difficult to disentangle the underlying strength of the car
market from the effect of special incentive programs that tend to affect the timing of car
purchases.
Growth Steady, Reports Show
John M. Berry
Washington Post, July 26, 2002, Page E3
http://www.washingtonpost.com/wp-dyn/articles/A2391-2002Jul25.html
Data Suggest Weak Spots in Economy
Associated Press
New York Times, July 26, 2002, page C8
These articles report on new economic data released the prior day. The Post article assessed the
data positively, focusing on a decline in the number of people filing new claims for unemployment
insurance and continued strong sales of new and existing homes.
The Times article noted a sharp 3.8 percent drop in new orders for durable goods in June, which affected nearly every sector of the
economy. While monthly durable goods orders are erratic, the broadly based nature of the June decline provides serious grounds for concern.
Consumer purchases and home buying have sustained the economy thus far this year, but this
cannot continue for long if investment doesn't pick up soon. The extraordinary decline in durable
goods orders reported for June is indicates that investment may remain weak for some time to come.
The Budget Deficit
Bush Bids to Regain Economic Initiative
Joanthan Weisman
Washington Post, July 24, 2002, Page A1
http://www.washingtonpost.com/wp-dyn/articles/A53511-2002Jul23.html
This article examines the current economic strategy of the Bush Administration. At one point, it
discusses the administration's intention to blame excess spending by Congress for the budget
deficit. It also notes the intention of Democrats to blame the Bush tax cuts. Since few readers
have the time to examine the validity of these competing claims, it would be helpful to look at the
numbers.
As was noted in a previous ERR (7-1-02), the main reason for the shift from surpluses to
deficits is a falloff in tax revenue due to the recession and the collapse of the stock market. While
higher-than-projected spending accounted for $60 billion of a $333billion shift towards deficits
in the 2002 fiscal year, all but $27 billion of this additional spending was defense related. Tax
cuts added $32 billion to the deficit, compared to the baseline projections made in January of 2001.
This article also refers to President Bush's efforts to gain fast track authority to negotiate
"free-trade treaties." There is no reason to refer to these agreements as "free-trade," since some
of the likely provisions, such as the extension of patent and copyright protection,
actually involve increased protectionism. It would be more accurate to refer to them as simply "trade" or
"commercial" agreements (since the impact of the investment, intellectual property, and other
non-trade provisions of the agreement could very well be greater than any changes in trade rules -- as was almost certainly the case for NAFTA).
A.O.L Time Warner
AOL Time Warner Discloses EC Probe
Alec Klein
Washington Post, July 25, 2002, Page A1
http://www.washingtonpost.com/wp-dyn/articles/A59973-2002Jul24.html
This article reports on the initiation of an SEC investigation of AOL's accounting practices. At
one point it notes that the questionable accounting pertains to transactions that total $270
million, which it describes as "a small portion of AOL's nearly $5 billion in ad and commerce revenue
during the period reviewed." It is not clear that the comparison to total revenue is very
informative It would probably be more meaningful to compare the $270 million to total
profits. If AOL's profits were equal to 20 percent of revenue (which would be high), then the questionable
transactions were equal to more than a quarter of its profits during this period. Also, the $270
million could be quite large relative to the companies increase in revenue; and since Internet
stocks were being valued at the time on the basis of on their growth rates, this accounting
misstatement could have led to a very large increase in the reported growth rate and
thereby AOL's share price.