What are they smoking on Wall Street?


WHY IS THE stock market booming? And what, if anything, does the surprise run-up tell us about the real condition of the economy?

Last week, in its annual economic report, the Bush administration offered an astoundingly sunny view of the nation's economic prospects. The recession would be shallow and short, and recovery would come by summer. The stock market seemed to concur.

However, this is a bull market in more ways than one. The first bit of bull is the assumption that the recession was brought on by the war and will be cured by a quick victory.

It's true that the spike in the price of crude oil hastened the onset of recession, and that war anxiety further dampened consumer appetite for major purchases. But we were overdue for a recession anyway, and this recession has far deeper causes that will not vanish when the shooting war ends.

One long-term cause of economic distress is the chronic federal budget deficit: The war worsens it, but even without the war, deficits well in excess of $200 billion stretch into the next century.

The deficit, coupled with America's low rate of domestic savings, has also forced us to incur foreign debts. This habit, too, shows no sign of abating.

Taken together, the deficit and the foreign debt mean that interest rates in the United States are higher than they should be. This makes U.S.-made goods less competitive in world markets. Despite talk of an export boom, we still have a chronic trade deficit in one industry after another.

It is bizarre to read the financial pages, with their rosy stock reports, alongside continuing stories of bank collapses, layoffs, bankruptcies and serious retrenchment on the part of the bluest of the blue chips.

So, what are they smoking on Wall Street?

The market is up, first, because interest rates are down. Interest rates are down because the Federal Reserve is easing credit. Lower interest rates often portend a recovery, and they also pump up the stock market because they drive investors out of bonds (whose yield is based on interest rates) and into stocks.

The market is also up because the price of oil is down. The abrupt rise in oil prices was terrible news for the economy, and lower prices signal some relief.

But mostly, the market is up because investors watch other investors. As a stock investor, you are not guided by the real economy, but by what other investors are doing. If they are pouring money into stocks, that will bid the market up, even if their economic assumptions are wrong. And if the market is heading upward, you're supposed to follow. As they say on Wall Street, "The trend is your friend."

Over the long term, say, decade to decade, the stock market is a pretty good barometer of the real economy. But in the short run, financial markets tend to overshoot. They panic on the downside, and they behave euphorically on the upside -- precisely because investors are following the behavior of other investors.

If the market is booming, everybody wants to get in on the action. If it is falling, everyone's impulse is to bail out. That's why trends feed on themselves -- and why the truly smart money keeps its eye on the real economy over the long term.

This bull market is a very skittish one. In its heart, it knows that the real economy is soft, and the bulls will stampede at the first rumblings of gloom. That could be signaled by ~ ~TC longer-than-anticipated land war, or an uptick in the price of oil, or by troubles imported from Germany or Japan.

A selling panic will almost surely ensue when Federal Reserve chairman Alan Greenspan finds that, given a nearly $300 billion deficit, he can't lower interest rates any further without setting off inflation. And at that point, expect one of those many hundred-point "corrections."

The stock market, day-to-day, is a terrible guide to the real economy, as well as a weird way to earn a living. The real economy would be better served by fewer bulls and bears. What's needed are more beavers, bees and other creatures who make real things.

Robert Kuttner writes regularly on economic matters.

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