Leon Levy started his career on Wall Street as a security analyst and became a partner in Oppenheimer & Co., then a small brokerage firm, in 1951. He and his partner, Jack Nash, built the firm into one of the leading brokerage and mutual fund companies in the nation. They sold Oppenheimer in 1982 and formed the investment partnership Odyssey Partners. Odyssey is now being liquidated after producing one of the highest rates of return to investors of any such partnership over more than fifteen years. Levy is currently the chairman of the board of trustees of the Oppenheimer Funds based in New York. He is president of the Institute for Advanced Study in Princeton and also president of the Jerome Levy Institute for Economic Research at Bard College, which he founded in 1986.
The following interview took place on September 5.
Jeff Madrick: With the US economy widely considered strong by most conventional measures, many people are confused by how the turmoil in financial markets overseas—from Asia to Russia to Venezuela—could do so much damage to the US stock market. As we are talking in early September, the Dow Jones Industrial Average stands nearly 18 percent below its high of the year. Did you think foreign events could precipitate such a decline?
Leon Levy: You never know what will trigger a decline in the stock market. That word precipitate is an interesting one. When you keep piling up bags on a scale, finally at some point you might put a few too many bags on the scale and break it. What caused the problem? These international markets may be the immediate issue, and problems there do affect the US. But did they precipitate the market decline? That’s way too simple. The causes of America’s problems are deeper and more complex. The US economy is vulnerable, and has been for some time, and that’s the main point that is getting lost amid all these analyses. The stock market usually reflects—at least over time—the course of the nation’s economy.
J.M.: Nevertheless, all eyes seem to be on the international scene. Some people say that, while the collapse of the Russian ruble may have started the recent turmoil in the US stock market, the Japanese recession is the main problem. Is it the linchpin?
L.L.: I don’t think so. But that doesn’t mean the problems aren’t severe. Japan attracts the most attention. It’s the largest economy in the Pacific Rim. It went down first. But I think its problems are typical of the region. I think the same thing happened in Malaysia, Thailand, Korea, wherever you go in East Asia. They are all over-extended.
J.M.: In what ways are they over-extended?
L.L.: Start with Japan. The solvency of its banks, some experts whom I respect tell me, is largely questionable. In the late 1980s, when so many people thought that Japan was economically invincible, it was spending as much as 30 percent of its Gross Domestic Product (GDP) on capital investment. A lot of this was financed by huge loans from banks. As you know, economists think capital investment is almost always good. But, typically, businessmen go too far, especially if they can raise capital when the stock market is high and interest rates low. There is no way Japan can use that many new buildings, that much new plant, that much new machinery. The overexpansion of capital goods is often the great cause of recession or even depression.
J.M.: Few people were saying this in Japan’s heyday.
L.L.: You never know for certain when capital spending is too high. Only afterward. Take New York City, for example. If you owned an office building, and rents are high, and everybody wants to move in, things would be fine. But if the stock market should not be as expansive, which is what happened in Japan and may be happening here, then a firm may decide to rent much less space. Suddenly, conditions are not tight. It now looks as if you have overspent on your building.
J.M.: And this happened more or less across East Asia?
L.L.: Yes. It’s pretty typical of human nature. Why should the East Asians be any different? Remember the real estate market was way too high in Thailand. It collapsed a couple of years ago. If Japan were stronger, maybe it could have done more to bail these countries out. But that would have occurred after a lot of damage had been done. These countries are now all in serious disarray, I would say depression.
J.M.: How do their problems directly affect the US market?
L.L.: They stop buying our exports, first of all. That might not be so bad if we had a strong trade balance. But we don’t. We import more than we export. This is getting worse. The trade deficit is setting new records all the time.
Then, other markets around the world get nervous even at the smallest sign of trouble. Investors want higher rates of return, which weaken economies further. Russia is in bad shape but they are in no way the trigger for our problems, either. They are only a small part of our trade, even though German and US banks are apparently losing a lot of money on their investments there. More important, profits of many other US companies are reduced as sales fall to all these regions. The US market gets more nervous as a result, and stock prices fall further.
As you can see, these market declines have two effects. They have an effect in the real economy when interest rates rise, as they have in many countries abroad. And they also affect the business mood, which can also then have an effect on the real economy. It makes people less willing to undertake an activity. They hesitate to buy something, or build a plant, or expand their business in other ways. This is true in the US as well.
J.M.: What should Japan do to solve its problems?
L.L.: They should use deficit spending to try to stimulate the economy and they may have to do something drastic to save their banks. If the problems in Russia could be solved, that would be helpful also. But what’s going on is no surprise there, either. I feel terrible for them. But they lived under the tsar and they lived under communism. To bring about a deep social change, how long does it take to reeducate a people? I think that takes a few generations. But let’s be clear about this. The US has more of its own internal problems than those posed by these foreign economies, and that’s why our market has been falling so fast in response to them.
J.M.: As you well know, many people believe quite the contrary. The US economy is strong, we are told over and over again. Unemployment and inflation are low. Interest rates are also low, profits are up. Capital spending is strong.
L.L.: All of this is true. I’ve been worried about the economy for a while, and it’s kept growing. But all these things you mention tell us what the economy has done, not what it is going to do. They are mostly lagging indicators. Unemployment is a lagging one. Corporate profits can be a leading indicator, because they can stimulate investment, but we are usually talking about last quarter’s profits. We don’t know about next quarter’s.
J.M.: Is a recession in the US possible?
L.L.: More than possible. I think it is likely. And it could occur within six months. That doesn’t mean I know that it will occur. I’ve been wrong before, as I said. But I think we could get a lot of unemployment as a result. And I think it may be hard to pull out of such a recession for a while.
J.M.: Then let’s talk about the weaknesses of the US economy that might lead to recession. What are they?
L.L.: I think there are three major ones. First, there is the trade deficit. It is growing worse. It reduces growth because sales are going to foreign countries. It makes the US even more vulnerable to declines in overseas economies because they will buy less from us and sell more to us at lower prices. So that’s a big problem.
And now we may get more competitive devaluations in East Asia and Russia and maybe elsewhere. They cut the values of their currencies. That will drive the price of their exports even lower and make our exports relatively more expensive (which is what happened during the GreatDepression).
J.M.: What are the other factors?
L.L.: Americans are saving very little money. On average, people spend almost everything they earn. While some invest in retirement funds, others borrow a lot. As you know, the government revised the savings numbers down recently to an almost negligible amount. Now there may be some troubles with how that’s measured. But it’s clear that one reason the economy has been strong recently is that people are spending so much on goods and saving so little. That can’t continue.
J.M.: Why not?
L.L.: The big reason may be that they feel free to spend because their stocks are doing so well. If people have more and more money in the stock market, and stock prices keep going up, why should they bother to save? Or why should they deny themselves something that they would like to have? This is called the wealth effect.
J.M.: It only works when the market is up.
L.L.: Yes. But what makes it particularly dangerous today is that so many people own stocks and the savings rate is so low. We made a very thorough study of this in 1962 when the stock market was down 30 percent. At that time, we discovered there was no wealth effect at all. But that has all changed, because of the remarkable promotion of mutual funds and other kinds of equity savings instruments. In other words, as people felt richer, because their mutual funds were going up, or their IRAs were going up, they felt they didn’t have to set aside as much money for their retirement or their kid’s college expenses—which, by the way, are the two main reasons for savings.
As stock prices start going down, will this make people spend less money? I daresay it will. The man who is building the largest house in the Hamptons may have second thoughts if he suddenly loses $10 million in the stock market. The same will be true for the average investor. He may not buy a car, or eat out as often, or spend as much at Christmas. And by now some may think they own enough goods. In the Twenties there were so many industries just coming into existence. Autos, the radio, washing machines, refrigerators. Electricity in general. Today we have electronics products. I don’t know how to measure this, but I don’t know how many more we need. I have a number of friends who keep on buying new computers, and they finally get machines that are more powerful than they need.