Much high-profile economic news has occurred recently, most notably an advance estimate released last Friday that the U.S. gross domestic product grew at an annual rate of 7.2 percent in the third quarter.
In addition, every day brings more news of fraudulent practices in the mutual fund industry, including close-to-home revelations about Strong Capital Management based in Wisconsin. Between the two stories, mutual fund problems are far more important to the nation than one estimate of GDP.
Here is why. Growth in GDP is good news, but performance in any single quarter has few implications for the long run. While disclosures about fraudulent practices in mutual fund companies are less dramatic, they potentially are of greater long-term importance.
GDP measures the value of output. For national income to grow, output had to grow almost by definition.
While one can conjure theoretical scenarios in which employment rises without any increases in output, in practical terms output has to rise for unemployed workers to get jobs again. So while an increase in GDP does not imply that all economic problems will be solved, it is very good news.
One advance estimate of strong GDP growth, however, does not make a boom. GDP numbers are estimates and the quicker they are made after the end of the quarter in question, the less reliable they are.
The U.S. Commerce Department’s Bureau of Economic Analysis releases three consecutive estimates of GDP for each quarter. The first is an “advance” estimate announced a month after the end of a quarter, i.e. Oct. 30 for July, August and September 2003. A more accurate “preliminary” version comes out nearly a month later and a “final” version a month after that. The specific release dates for preliminary and final numbers for the third quarter are Nov. 25 and Dec. 23 respectively.
The revisions in these subsequent estimates often are substantial and they tend to be greatest when the “advance” release is a large departure either upward or downward from previous trends. Don’t be surprised if the 7.2 percent growth number is revised downward. It still is very good news, however.
Meanwhile, the unfolding news about mutual funds is troubling.
Mutual funds are wonderful institutional innovations that have contributed to the dynamism of our economy in recent decades. These funds facilitate the movement of capital from households that save to firms at low cost and with relatively low risk.
Fewer real resources are used up in the stage between capital savers and users. Both households and businesses are better off as a result, and our economy is more productive.
The efficient working of all capital markets, however, depends on a high degree of trust that the game is basically a fair one. The greater the reality — or even the perception — that some participants are getting a better deal than others, the less efficiently that capital moves.
If savers decide that mutual funds are dishonest or rigged against the small investor, they will return to traditional alternatives such as bank savings and life insurance which, on the whole, are higher-cost vehicles for moving capital from savers to borrowers.
That would hurt the productivity of our economy over the long run. It is hard to quantify the exact degree of damage that less efficient capital markets would inflict on output. It probably would not be more than 0.1 percent to 0.2 percent of annual growth of GDP. That does not sound like much, but compounded out over the years is more significant than any quarter-to-quarter fluctuation in output.
That is why it is important that governments accomplish two things. First, abuses by mutual fund managers must be thoroughly rooted out and, secondly, individuals and firms that engaged in fraudulent practices must be punished severely.
More importantly, the Securities and Exchange Commission needs a good shaking up. Defenders of the SEC argue that the commission staffers are hard-working and dedicated. That may be, but it is not encouraging to read in the Wall Street Journal that fraudulent abuses “have been open secrets in the industry” and “critics have long complained, but securities regulators, principally the SEC, have largely brushed them aside.”
The Bush administration did not cause abuses in the mutual fund industry or any of the other problems that have come to light in financial markets. Some of these apparently have gone on for years.
Yet, the Bush administration does have the responsibility of responding to the problem. SEC chairman William Donaldson, appointed by Bush to replace Harvey Pitt, has not demonstrated the initiative needed to get the SEC on top of problems. Something has to change, and the administration is responsible for ensuring that change happens.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.