Commentary: Let's Not Talk Ourselves Into A Downturn

Forget Viagra. Somebody get the Prozac. The financial markets and the pundits who track them have fallen into a funk. Japan is stuck in its decade-long rut. Russia is a wreck. And Latin America is on the brink. At home, the Standard & Poor's 500-stock index is off almost 18% from its highs this year. And lenders and investors have swung from a belief that no investment is too risky to a gnawing fear that none is too safe. As a result, investors have been fleeing to the mattress-like safety of Treasury bonds as if anticipating a 1930s-style depression.

Yet, the nation's economic fundamentals remain solid. Sure, unemployment was up a tick last month. But it remains at 4.6%--a stunningly low level not seen since the 1960s. And while consumer confidence has fallen from its peak in June, it's still twice as high as it was five years ago, according to the Conference Board. Consumers continue to spend--auto sales were up 6% last month. And the overall economy is likely to grow at well over 2% for the rest of the year. That's no boom, but it is hardly a recession.

But if we work hard at talking ourselves into it, there's still a chance of falling into a deep and prolonged slump. It's a task the financial and media elite have taken up with gusto. Says Federal Reserve Chairman Alan Greenspan--who's usually a major gloomster: "If you read the newspapers in the morning, one gets the impression that the economy has collapsed, and we all might as well go home and go fishing."

Greenspan, like other observers, is left scratching his head. Investors are acting as if they're stuck with devalued Malaysian ringgits, not shares in U.S. corporations. And as frenzied American money managers dump stocks and corporate bonds in favor of government paper, look at how much spreads have widened between Treasury rates and corporate bonds. While 10-year Treasury yields have plummeted to 4.2%, the lowest levels in three decades, top-rated long-term corporate bond rates are stuck at about 5.9%. Says First Union economist Veronika White: "Nobody wants to hold corporates."

There are signs that bankS are tightening their purse strings as well. A recent Fed survey of loan officers suggests they are raising credit standards and demanding more collateral for loans. That's not all bad, as long as lenders don't get carried away. If they all batten down the hatches, William J. McDonough, president of the Federal Reserve Bank of New York, told reporters on Oct. 5, "there is a significant possibility of a credit crunch."

It's even worse with equity financing. Initial publIc offerings are disappearing, and financing for real estate investment trusts is nearly impossible to find. "Pretty much across the board, the cost of equity capital has gone up," says Fleet Financial Group Chief Economist Nicholas S. Perna.

Consider retailer Kmart Corp. First-half net income was $80 million, up 158% over 1997. Sales are up a solid 5% so far this year. Kmart's stock price? Off 45% in four months.

So far, this squeeze hasn't had a huge impact on the real economy. Capital investment is slowing, but still growing at more than 7%. Many companies continue to buy new equipment, in part to sub for chronic shortages of skilled workers.

But some parts of the economy show signs of slowing, thanks to a shortage of money. One victim: commercial real estate. "It's the first time the capital markets have stopped development," says Dennis Yeskey of Deloitte & Touche.

LIQUIDITY TRAP. The perverse bottom line: While consumers are flush, and lenders and investors are sitting on plenty of dough, the U.S. could be heading for a liquidity trap. If access to capital becomes more difficult, investment may dry up and unemployment could rise. Then, there would be nothing for those mall-happy consumers to do, except to put away their wallets and credit cards.

Before that happens, everyone needs to stop and think for a minute. The worldwide economic malaise is slowing domestic growth--and the threat becomes more dire if Latin America is allowed to fall victim. But the U.S. economy has been so robust that a slowdown hardly means recession. Bankers and investors just need to keep their wits about them.

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