Toshio Matsuda, Commentator & Intl Economist

Straight from the Shoulder No.495

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The day after both the United States Senate and House of Representatives passed the financial institution bailout bill hammered out by the Treasury Department and the Federal Reserve Board (a measure calling for the use of the equivalent of 70 trillion yen in U.S. taxpayer funds to buy up toxic debt), stock prices soared. In no time at all, however, they headed south once again. Then last week, when U.S. Treasury Secretary Henry Paulson Jr. fell into policy line with his European counterparts in announcing that 25 trillion yen of the aforementioned public funds would be injected into nine major U.S. banks, stocks perked up again. Just like before, though, they lost ground from the following day to the point of not only wiping out their original rebound gains, but also plummeting even deeper than before. This period promises to go down in history as spawning one of the most violent fluctuations in market prices on record.

As I have noted before in my “Straight from the Shoulder” column, simply coming to the aid of financial institutions is not sufficient to rescue the U.S. economy, which continues to display increasing signs of recession of late. Financial institutions, as the very nomenclature implies, are institutions involved in the financing and circulation of capital. In other words, they are “auxiliary engines” at best, and by no means represent the main drivers or units of the economy. For the U.S. economy to emerge from the jaws of recession will require resuscitation measure at the true core of the nation’s economic activity.

Simply stated, the trump cards for core economic growth are “consumption” and “capital investment.” Without expanded spending and private sector investment in plant and equipment, the revival of the economy is a pipedream. At present, both U.S. consumption and capital investment continue to tumble, while the jobless rate is spiraling upward. Viewed by these yardsticks, America is truly descending into a state of recession. The collapse of the housing bubble has thrown investment banks, brokerage institutions literally loaded down with bad loans, into financial trouble, with a serious credit crunch advancing.

Though the U.S. government has acted with considerable speed in throwing together the emergency measures outlined above, the market reaction has been largely downbeat. This is because the market’s take on these moves is that they place excessive emphasis on rescuing distressed, high profile financial institutions, while neglecting policies aimed at revitalizing the critical core of the U.S. economy.

Over the weeks and months to come, in the absence of potent measures aimed at expanding public investment and employment in tandem with bold tax cuts for low-income earners, U.S. stocks are likely to continue their downhill ride. President George W. Bush talks a good game about public works spending for roads and other infrastructure, measures to stimulate employment and other action. But with no concrete proposals being submitted to Congress, the market summarily dismisses such rhetoric as mere lip service. With the U.S. presidential race now gearing up for the final stretch, it will be tough for either the government or the Congress to act quickly regardless of what type of economic reconstruction policies may be floated. Inevitably, such steps will need to be carried out from next year, under the leadership of the newly elected President.

Yet, the current realities are grim. It appears that perhaps half of all housing mortgages are lapsing into bad debt territory, with the prices of homes continuing to tank. A sustained slide in housing prices will help shrink the hidden assets in family budgets, prompting a lowering of credit limits. That promises to put a further damper on consumption. Less spending convinces companies to restrict their supply streams, which in turn leads to delays or rescheduling of capital investment. Declines in both consumption and capital outlays will force the gross domestic product (GDP) into the minus column, with the economy edging toward recession.

Without breaking out of this vicious circle, which sees the main economic engines in decline, rebuilding the U.S. economy will be a mighty mission indeed. As if it isn’t enough to be in tough financial straits, as long as tax revenues are used only to bail out financial institutions (clearly the secondary locomotives of the economy) while disregarding measures to resuscitate the essential core of economic activity, U.S. stock prices can be expected to remain devoid of any serious upward motion for some time to come.

I have no doubt, moreover, that the linkage between U.S. and Japanese stock prices will eventually wind down, with Japanese equities rising to eclipses all rivals. However, that transition is still somewhere down the line. As things stand now, the New York Dow-Jones average may be heading toward $6,000, while the Nikkei average could very well plunge to the 7,000 yen level. The only viable option for investors at present, therefore, is to hold onto the shares that you own, while fiercely resisting the urge to change horses to stocks that appear more promising. If you have any surplus funds on hand, meanwhile, you could average down your purchase costs by adding to issues currently in your portfolio if and when the Nikkei does fall into 7,000-yen territory.

Regardless of how long the central banks of the developed nations continue to inject capital for rescue plans, the impact will be little more than sprinkling a cup or two of water onto a dry sandy beach. Without stimulating private sector demand, the economy will continue to retreat. In my view, the alliance patched together by the major powers is moving in a totally erroneous direction.

I repeat: At this pace, the stagnancy in stock prices is destined to drag on long term.