The value of a buck

Tuesday's announcement that WorldCom Corp. understated its expenses by $3.8 billion over the last two years, thereby overstating its profits, is yet another blow to a stock market struggling to rise above its post-9-11 lows. Not only must investors deal with almost daily revelations about cooked books at major corporations, but they also have to figure out whether the economic expansion is for real or a temporary respite before relapsing into a double-dip recession. Among the factors that investors are focusing on closely in recent days is the falling dollar. Since the first of the year, the dollar has fallen about 5 percent against major currencies. Investors fear that this may be a harbinger of inflation, which could cause the Federal Reserve to tighten monetary policy, and could put a damper on foreign capital inflows. Foreign investors have been important in fueling the stock market upward in recent years. As long as the dollar was rising, they got the benefit of both higher stock prices and higher exchange rates. All other things being equal, the stock market should be a lot higher than it is now, given the underlying economic conditions. Those conditions, insofar as we have data, are quite strong. Industrial production, consumer spending and home sales are all doing very well. Only capital investment is still lagging, but inventories remain low. This suggests that business spending could rebound quickly. It is worth remembering that the economy's problems and those of the stock market resulted from the same factor: an excessively tight monetary policy by the Federal Reserve. The Fed thought stock prices were too high and that economic growth was too strong, both of which fuel inflation in its economic model. This led the Fed to sharply raise interest rates and tighten monetary policy. The result was a deflation; that is, falling prices rather than the rising prices that characterize inflation. Whereas inflation is too much money chasing too few goods, deflation is the opposite, with too many goods and too little money. Among deflation's effects is crashing corporate profits. Companies make investment and other plans in expectation of getting certain prices for their products. When deflation causes those prices to be less than expected, profits necessarily take a hit. When profits fall, stock prices fall. The Fed was relatively quick to recognize its mistake, however, and has been aggressively easing monetary policy for a year and a half. Under normal circumstances, we should have seen signs of a rebound just around the time Sept. 11 hit. And just about the time the effects of that blow began to wear off, we had the Enron scandal. Since then, many major corporations have had to restate their earnings; some spectacularly, as in the case of WorldCom. But almost every big company has made adjustments to its books in order to squeeze any questionable accounting out of them. Thus the stock market has suffered a double blow over the last nine months. But the important thing to remember, is that both Sept. 11 and the Enron-WorldCom effect on earnings were one-time events. Once they are over, they're over. They won't cause earnings to be permanently lower forever, the way a tax increase would. Once the effects of these events is absorbed into stock prices, their future course should be a function of the economy's underlying strength. Some have argued that the future may not be as bright as the economy's current positive state would suggest. They argue that the Fed has eased too much, setting the stage for inflation. The falling dollar, they say, is a sign of that. But if prices and exchange rates are only returning to normal after a period of deflation, then this is a good sign, not a bad one. Indeed, some increase in prices and some fall in the dollar is the inevitable consequence of Fed easing, and a necessary prerequisite for sustained economic growth. Others say that the Enron-WorldCom accounting scandals may bring forth anti-business legislation and regulations. They fear that the Bush administration will cave-in to them in hopes of currying favor with moderate voters, as it caved-in to protectionist pressure in imposing steel tariffs. But this would be a penny-wise/pound-foolish action, because anti-business laws and regulations will push the market down further, costing the administration far more votes than it might gain. My view is that the fall of the dollar is not yet something to worry about, and may in fact be the final sign that a deflationary trend is finally over. If so, as prices regain lost ground, so will profits. Assuming there are no more terrorist attacks or WorldCom-type announcements, I think we should soon start to see higher profits at major corporations. Higher stock prices will quickly follow.