Jewish World Review March 20, 2003/ 16 Adar II, 5763
David R. Kotok
The War economy, then and now: WW II and War on Terror
The war economy and war markets theme continues. Monday's rally around the Iraq related news events
9/11 is the inflection point for this current war period just like Pearl Harbor was for WW2. The 1941-1945
timeframe is our historical metaphor.
1. Setting Then. It took the attack on Pearl Harbor to galvanize America. Isolationism yielded immediately
to action. Roosevelt had the catalyst he needed to gain political momentum and engage in world war. His
"Day of Infamy" speech stirred the nation to national purpose. Totalitarian leadership in the form of Hitler,
Mussolini and Imperial Japan combined to define the enemy.
- 1. Setting Now. The United States has been attacked repeatedly abroad by Islamist terrorists and on our
own soil in the 1993 World Trade Center bombing. Our parochial mentality distinguished attacks "over
there" from activities here. We didn't link them. Warnings like the 1994 CNN documentary by Steve
Emerson were unheeded. The country didn't have a political stomach for action until 9/11. Witness
President Clinton's feeble response to Iraq's ending inspections in 1998 or his failed response to Al Qaeda
by firing a cruise missile into Afghanistan. Whether we like him or not, President Bush is acting consistently
and with determination. He is a changed man after 9/11. Even his speeches and references ring with WW2
metaphors. His post 9/11 remarks were styled after Roosevelt's "Day of Infamy." His "Axis of Evil;" parallels
the WW2 Axis powers.
- 2. Federal Budget Then. Military and security spending leapt which meant expansion of the federal budget
and, hence, a rising federal deficit. In the WW2 era the budget went from a 2% of GDP surplus in 1941 to a
3% of GDP deficit by the end of 1942. The deficit continued to rise for the entire WW2 period because of
the huge borrowing needed to finance the war. At war's end government debt was 100% of GDP.
- 2. Federal Budget Now. Military and security spending are rising rapidly. In 24 months we have seen a
federal budget shift from a 2% of GDP surplus to a 3% of GDP deficit. The deficit is projected to rise.
Financing needs as a percent of GDP will not match the WW2 era but will expand and may reach 5% of
GDP. Iraq is the present budget impact; North Korea could be next. Add a terrorist incident which would
force additional security systems in our ports or train stations and you quickly ratchet up the Homeland
security budget by orders of magnitude.
- 3. Fed Policy Then. The Federal Reserve assisted in financing the war deficits by maintaining very low
interest rates. In WW2 the Fed held the short term treasury bill rate at 3/8s of 1% for 90 day paper and 2
1/2% for the longest term treasury bond. Those interest rates were unchanged during the entire WW2
period. The Fed maintained an unlimited bid at those yields.
- 3. Fed Policy Now. The Fed rapidly lowered rates and has held the Federal Funds Rate at 1 !/4% for
months. Discussions within the Fed have focused on policy options now that the Fed Funds rate is
approaching a level at which further rate cuts are of questionable value. There are indications that the Fed is
looking at targeting the interest rate on the two year treasury or even the ten year treasury. This policy may
be explicit or through a discretionary implicit instruction. Fed officials including Alan Greenspan have
referred to the WW2 period when describing policy options.
- 4. Tax Policy Then. Taxes were raised dramatically during the WW2 period. The country had to pay for the
war and taxpayer compliance was high due to patriotism.
- 4. Tax Policy Now. Tax cuts are in place and more are coming in some form. The Bush Administration
proposals will certainly be modified by Congress but some form of additional tax cut is likely. Tax policy is a
major difference between the WW2 economy and the present anti-terrorism war economy.
- 5. The Dollar's Value Then. Currency values played little role during the WW2 period. Global trade was
small. Monetary standards were tied to gold. The U.S. dollar was the most important currency in the world
and was globally sought.
- 5. The Dollar's Value Now. America is the world's largest debtor nation. Our currency has been weak
recently. Our current account deficit is 5% of our GDP and climbing. There is no gold standard to anchor
money. The currency value is another area where the present period is quite different than the WW2 era.
The dollar could get much weaker.
- 6. Stock Market Setting Then. The U.S. economy had been through the Great Depression and the stock
market crash of 1929-1933. The period leading up to Pearl Harbor was one of relative weakness in
- 6. Stock Market Setting Now. The bursting of the NASDAQ bubble has similarities with the 1929 stock
market crash. The economy has been weak for three years. In both periods the war economy expansion
came at a time when the economy was operating at a sub par growth rate and had room for growth due to
excess productive capacity.
- 7. Stock Market Then. Stocks initially slumped after Pearl Harbor. Equities performed poorly until events
crystallized the populace's view of the enemy and the direction of the war. Our raid on Tokyo marked the
turning point. From their 1942 low, stocks nearly doubled by the end of the war.
- 7. Stock Market Now. Have the recent successes against Al Qaeda helped us become clearer about taking
the war on terror to our enemy? Is Iraq a target that adds to that clarity and resolve? Will the Iraq attack act
as a catalyst for the markets? If yes, the stock market is headed higher, perhaps, much higher.
- 8. Inflation Then. Inflation climbed into double digits during the war. The Fed ignored it and continued to
keep interest rates very low throughout the period. Price controls and rationing were used and a huge
government bureaucracy engaged in an attempt to keep prices from rising. Black market transactions
occurred in spite of the national patriotism.
- 8. Inflation Now. So far we do not see inflation evidenced in any dramatic way. Our country's economic fear
is of deflation not inflation. Markets are pricing bonds as if inflation will remain very low for many years. Such
was the case prior to Pearl Harbor during the 1930s.
The big questions!
Will markets follow the war economy pattern like they did in the WW2 era? Will the Fed's printing press bring
about a future inflation which will cause bond yields to eventually rise? We think the answer is "yes.".
Time will tell how closely these two periods are going to track each other. That will be measured by the
historians. Meanwhile the WW2 era gives us guidance and encouragement. We should study it for help in
organizing market strategies.
The Iraq attack must be seen in this greater context. This is not just a replay of 1991. Iraq is part of
larger anti-terrorism direction the United States is taking in the post 9/11 era.
All this means that the outlook for stocks is improving and that the risk of some inflation and higher bond
yields is rising.
JWR contributor David R. Kotok is President and Chief Investment Officer of Cumberland Advisors, Inc. His articles and financial market comments have appeared in The New York Times, The Wall Street Journal, Barron's, The Bond Buyer and numerous other publications. He can be seen on CNN, CNNfn and CNBC. Comment by clicking here.
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© 2002, David R. Kotok