The Changing American Financial Situation

Honoured guests, ladies and gentlemen: The highly regarded business magazine, Barron's, said of our speaker, "When Henry Kaufman talks people listen." You will agree, I think, that this is an important attribute for a speaker to have. But then the writer of the Barron's article goes on to say, "More precisely they fret, panic, scramble or rejoice depending on whether they are long or short."

It is doubtful that any economist of our day has more influence in moving and shaking the world's financial market than has Henry Kaufman. After receiving his B.A. in Economics from New York University and a Master's degree in Finance from Columbia, Henry Kaufman went on to earn a Ph.D. in Banking and Finance from N.YU. Graduate School in 1958. Twentyfour years later, this same institution awarded him an honorary Doctorate of Laws. In the quarter-century interval between these two degrees, Dr. Kaufman had been winning a multitude of other kinds of honours and awards. After serving as an economist at the Federal Reserve Bank of New York, Dr. Kaufman joined the prestigious firm of Salomon Brothers and became a general partner in 1967. When this firm merged with the commodity traders Phibro Corporation in 1981, our speaker became Executive Vice President and Chief Economist of the large combined corporation.

Today he is Vice Chairman of Phibro-Salomon and Executive Director of Salomon Brothers. His weekly newsletter has long been regarded as a most important source of informed opinion and good judgement by investors in the United States and indeed around the world. In 1982, a poll commissioned by U.S. News and World Report put Dr. Kaufman high on the list of the most influential men in America. The fact that people in important places listen to Dr. Kaufman is not necessarily because they like what he says. As one writer put it, "He says what the financial world doesn't want to believe, but must hear anyway." Dr. Kaufman, the audience before you is eager to hear what you are going to say regardless.

Ladies and gentlemen, Dr. Henry Kaufman.

Dr. Kaufman

Madam Chairman, ladies and gentlemen: I am highly honoured to have been asked to speak to this prestigious club; one that is well known not only in Canada but in my country, and I am also very delighted to be in Canada again - a country for which I, as well as many of my American friends and associates, have a great kinship for and a great feeling of friendship.

I want to speak to you this morning about developments of the financial and economic kind in the United States. As some of you know there are some fears today that the American economy may slow somewhat further from the reduced pace of the third quarter in which perhaps real growth slowed to three per cent or less. I believe that these fears that the economy will slow further from the reduced pace of the third quarter are unfounded. Indeed, the economy is now re-accelerating. Real growth in my country is likely to reach an annual rate of four per cent in this quarter and to stay in the three and a half per cent to four per cent range during the first half of next year. As a result, by mid-1985, unemployment should fall just below seven per cent, business capacity utilization should reach 84.5 per cent and corporate profits will be rising at an annual rate of five per cent from year-end 1984 levels. Thereafter, however, the pace of economic activity will probably be constrained by physical capacity limitations, the adverse consequences of a cyclical rebound in inflation and the inability to generate an enlarged domestic savings flow.

In the meantime, however, the continued strength of the American economy is going to be reflected by a re-acceleration in final demand fueled by a very healthy pace of increases in personal income. In addition the remarkable improvement that we have experienced in business spending for plant and equipment will remain a stimulant. Interest rates, which have fallen in the last few months, therefore have become a stimulant for economic activity and not a retarding force. Perhaps only in housing activity will we continue to see as we move through the early part of 1985 some receding from the cyclical peak that was reached earlier this year.

It would seem to me that we are still in an environment of good economic expansion in which there are no real constraints on the American economy. There are, however, a number of other financial developments that are now coalescing and many of these, I believe, will affect the events of the next twelve months. I want to speak to you today about some of those salient financial developments of current and future significance.

... the demand for credit in the United States is accelerating ...

One is that the demand for credit in the United States is accelerating at an unprecedented pace. Total credit demands in my country this year will reach $761 billion, the demands of households, of corporations and of our governments. The $761 billion compares with 1537 billion in 1983, and with $409 billion in 1982. And I believe that perhaps the full scope of credit creation is being masked by new financing techniques, accounting procedures and international transactions that are not recorded in the credit complications by our authorities. But looking even at the data that is recorded, the growth of credit in this second year of economic expansion in terms of rate of increase and dollar of increase is far greater than at any other time in the comparable period of previous economic expansions.

Another important development that will persist in the year ahead is that household borrowing is rising and will continue at a good clip. While the fall-off in new housing activity should retard this pace, aggressive merchandising by consumer lenders and reasonably good household balance sheets will result in a continued high volume of consumer credit extensions, and this will support strong final demands.

Next, the other development of a cyclical kind that is now surfacing in my country is that corporations are finding that their borrowing needs are stepping up. External financing of corporations is now rising for several reasons, and this sector will continue to be a dynamic demander of credit until this economic expansion terminates.

The prevailing interest rate structure is conducive to furthering this type of financing, and there is today a massive structural change taking place in the financing of the private sector, one that is far different from anything that we have had in the post-war period. Both the household sector and the business sector are moving down the maturity scale in financing. Years ago it seemed like an American right that all Americans had the opportunity to finance a home at a fixed rate for twenty-five or thirty years. This has changed. Nearly seventy per cent of private home financing is done through adjustable rate mortgages. American corporations years ago in the second year of an economic recovery emphasized very significantly the funding of liabilities and the financing long term. In the first eight months of this year American corporations issued $28 billion of corporate bonds, but only $2 billion of that $28 billion consisted of traditional bonds; twenty-five to thirty years with fixed interest rates. All the rest consisted of variable interest rate financing, floating rate notes, two to three and four year type of notes with fixed rates, notes and bonds with puts attached to them; and in addition of course there has been a massive issuance of commericial paper, of bank borrowing and in many instances part of that credit has been received through guarantees and letters of credit that have been attached to the open market financing. Indeed similar vehicles of credit insurance, of letters of credit are backing up a variety of state and local borrowing in the United States. It is another way in which credit creation has been accelerated and facilitated; at the same time much of it has been in the short term sector. Now that has implications for the interest rate structure as I will comment on perhaps later on.

We are also, in the United States, at the end of liquidity building. This is seen when you look at the counterpart through the direct borrowing by households and by business corporations in terms of what is going on at American financial institutions. Our commercial banks are not buying government securities today. Our commercial banks have liquidated government securities this year. In 1982 and in 1983 they were net buyers of roughly $50 billion. Our thrift institutions are also not buying U.S. government securities because the inflow of funds to them - into savings accounts and other types of deposit forms, is now not large enough to finance the take-down of mortgages for which S & L's and savings banks have committed themselves. So liquidity building has ended, and this too is a cyclical manifestation that tends to occur as we go through an economic expansion.

... liquidity building has ended ...

The other perhaps unusual dimension in the American credit market today is that there is unlikely to be a significant reduction in the U.S. budget deficit which in recent years has been outsized. As you go through an economic expansion the tendency in the past has been - at least that type of borrower with a revival of economic activity, larger revenues by the government, some slowing in expenditures - the deficit would decline. That prospect is not in store for us in the immediate future. Indeed my fear is that the current political season in the United States is politicizing the issue of the federal budget deficit.

What do I mean? Well, as you know, Vice President Mondale has indicated that taxes will have to be raised, whether he becomes president or President Reagan remains in office. President Reagan, on the other hand, has indicated that he will not raise taxes in the foreseeable future. If by some chance the President is reelected, and as you know the public opinion polls do suggest this, then the chances are that the initial effort to alleviate the budget deficit will be through slowing expenditures; and that will be inadequate in 1985 because the issues and the sectors involved are politically very sensitive to deal with. You cannot lower defence expenditures in a short time span. There are too many contrasts involved, there are too many work items in process, there are too many commitments that have been made. On the other hand, to deal with medicare and medicade and to leave - as both candidates are now saying - social security intact, will require the passage of very difficult and long periods of negotiations and very difficult negotiations.

That leaves interest payments, and interest payments you cannot do anything about. It is a residual item in the budget. I would expect, therefore, very little will be done, and that the budget deficit in the third year of American economic expansion will be close to $165 to $170 billion. Let me also indicate that both candidates, President Reagan and Mr. Mondale have plans for reducing the budget deficit over the next five years. I suspect there are shortcomings to that kind of an approach. And they are as follows:

... we as economists do not have the talent to forecast economic conditions five years out ...

First, we as economists do not have the talent to forecast economic conditions five years out. It is difficult enough to deal with the next quarter and the next year. Secondly, Mr. Mondale states that his projections and his legislation that he would call for will reduce the budget deficit to $143 billion in fiscal 1989 - five years away. This year it is $165 to $170 billion - a very small decline, to say the least. And the President states that much of the reduction in the budget deficit will come about through American economic growth. It will require annual rates of real growth in the United States - from here on through 1989 - of at least five and a half per cent. It will require that the inflation rate during this period be held to four per cent while the unemployment rate falls to three and a half per cent. We, however, are in 1985 entering the third year of economic expansion not the first year, and we never ever - starting with the third year through the next five years - have had that kind of an economic achievement. It would be unprecedented and therefore it seems to me unlikely.

Now one consequence of this persistence of a large budget deficit is really that the government will have to continue, and we as an economy, to depend heavily upon foreign funds to finance American economic expansion. This is not an easy task - the dependence on foreign sources of funds. It means that opportunities in the United States will have to continue to be attractive. It means, number two, that our interest rates will have to remain competitive, and it would suggest also that we must continue to have an economic expansion and a competitive inflation rate vis-a-vis the rest of the world.

Already foreign sources of funds total some $90 billion, helping to finance the American economic expansion. But of this the composition is worth noting - it is not all in terms of foreign money coming into the United States to make security investments or direct investments. One of the important sources of funds has been American banks borrowing dollars abroad to finance domestic economic activity; while for many years in the past American banks were lenders of funds abroad rather than borrowers of money abroad. Therefore the international factor will be critical - quite critical - during the coming year. The continued strength of the dollar in the foreign exchange markets will help to contain the unlikely rise in inflation. If the dollar had not increased sharply this year's inflation rate in the United States would probably have been one to one and a half percentage points higher, and in addition to attracting foreign funds into the United States the expected continued strength of the dollar is also holding down the inventory financing needs of American business corporations. Now if by some chance the dollar would weaken, we all know that this would increase the value of U.S. imports initially and after a delay it would contribute to inflationary pressures at a time when inflationary pressures in the United States are likely to rise significantly.

Now the dilemma here is how long will the dollar remain strong? I believe that dollar strength probably will persist as we go into at least early 1985. The likely economic and financial developments that would suggest that the dollar would weaken de,---ids on economic growth in Europe, and in Japan in particular. A stronger economic recovery in Europe and in Japan, together with signs that the American economic expansion is aging, would be the fundamental developments that would suggest that the dollar in the United States is about to weaken. The earliest that I find that this kind of pattern will emerge in the United States from a fundamental view - not an expectational one - is in the latter half of 1985. By that time American real growth may be in the range of two to three per cent. By that time European economic growth may be comparable to American real growth, and the capacity to produce and to sustain the economies of Europe on an upward path may be better than they are for the United States, where capacity utilization is high and the American recovery and expansion in 1986 will be entering its fourth year.

... it would seem to me that the setting in the United States is reasonably good for continued economic expansion, for a moderate rate ofinflation over the near term, and for interest rates perhaps to creep up rather than to gallop up ...

In the meantime it would seem to me that the setting in the United States is reasonably good for continued economic expansion, for a moderate rate of inflation over the near term, and for interest rates perhaps to creep up rather than to gallop up. We have had in the United States the following interest rate pattern: Interest rates reached their lows cyclically in May 1983 with long-term government bonds at ten and a quarter per cent; then in May and June of this year and in July at fourteen per cent; and now we are at twelve per cent. We are up 175 basis points. Long-short term interest rates are up by roughly net from their cyclical low by a little bit more, let us say 200 basis points. FYom here on my belief is there is no immediate reason to have dramatic rises in interest rates. The value of the dollar is strong, monetary growth is within the acceptable range set by the Fed. Economic growth has slowed and perhaps now is re-accelerating; the value of the dollar, as I indicated, is strong and inflation is still moderate by recent standards.

However, I indicated to you a number of events that are in the process of unfolding. One of these is the movement to short-term financing by the private sector in the United States; thus the key issue for participants to watch is not the long-term rate - it is the short-term rate. The short-term interest rate has become the financing rate for the private sector. As long as this rate moves upward only gradually rather than dramatically, the American financial system and economic system will adjust for quite some time; but when that rate has to be lifted dramatically in the latter stages of this economic expansion, it will begin to inflict pain into the system and it will be a retarding force. That problem I think will not surface in the next four, five or six months - the earliest is sometime in the latter part of 1985. But the more gradual the rise in short-term interest rates the longer the economic expansion and eventually, without a lowering of the budget deficit as we move to the very mature stage of this economic expansion, the risk is that there will be a severe explosion in American interest rates at the end of this economic expansion.

In the meantime we should all, both here and in the United States, enjoy the pleasure of the moment.

The appreciation of the audience was expressed by John D. Herrick, a Director of the Club.