by Archie M. Richards, Jr., CFP^®
November 3, 2003

Tom questions the optimism I expressed in my September 29, 2003 column (see www.archierichards.com). I said America is approaching its golden age. Tom writes that the U.S. financial system and the big banks are shaky because of risky loans and excessive reliance on derivatives. Underfunded pension liabilities and the growing debt of consumers and government are serious problems. The unfunded pension liability of General Motors alone is greater than the company's current market value.

I can't remember a time, Tom, when some market pundit didn't proclaim that the U.S. had excessive debt. Yet for the most part, the economy has kept moving up.

Bear markets (those are the disagreeable kind) are caused by bad government policies, not excessive debt. Policies are better than they were in the 1970s and a great deal better than the ones that caused the Great Depression in the 1930s. Our economy is not teetering on the edge of disaster. If it were, it would have fallen over the edge during the 2001 recession.

Actually, high-tech stocks did fall over the edge. From March 2000 to October 2002, the Nasdaq fell 76 percent. (Nasdaq is an index of 5400, large, mostly high-tech stocks not traded in any one place, such as the New York Stock Exchange. They're traded electronically in cyberspace.)

In 2000, many high-tech companies had enormous debt. But this didn't cause the failures. As described in my column of March 3, 2003, high-tech companies faltered mostly because of damaging regulatory policies of the Federal Communications Commission. I doubt that the Commission will repeat.

U.S. banks survived the bankruptcy of hundreds of high-techs in 2001 and 2002 and are not riddled with bad loans now.

In some parts of the economy, derivatives are potential problems. (An investment company that incurs risk in one market acquires opposing investments in other markets to offset the risk. A mutual fund manager who's bearish short term, for example, might sell S&P 500 futures contracts instead of liquidating his long-term holdings. If the market falls, the money lost in the portfolio is offset by gains in the futures contracts. This is a simple example; most derivatives are highly complex.)

The major mortgage companies, Fannie May, Freddie Mac, and the Federal Home Loan Banks, are too big. They hold too many of the nation's mortgages and depend too much on derivatives. If they guess wrong about the derivatives needed to offset their risk, big trouble could result. The fault is the federal government's. It has given an implicit guarantee that if those companies falter, the government (that's you and me, kid) will cover the losses. Whenever the government guarantees against loss, people take advantage by incurring excessive risk.

Congress is now addressing this issue. I doubt it will revoke the implicit guarantees, as it should. But Congress will probably resolve the problem well enough before disaster strikes.

In general, derivatives hedge risk. The U.S. banking system and the entire economy would be more vulnerable without them.

As you say, General Motor's unfunded pension liability ($28 billion) exceeds the company's current market value ($24 billion). But most of GM's pension payouts will occur in the future, while the company's market value is current. After U.S. stock prices rise by 50 percent (this won't take many years), unfunded pension liabilities will seem less of a problem.

Besides, General Motor's market value is only 0.2 percent of the nation's $11 trillion Gross Domestic Product. (GDP is a measure of the entire economy.) Even if the company went busted (which it certainly won't), the economy is too diverse and resilient to be brought down by it.

Personal debt is high, but mostly because tremendous increases in mortgages, which are secured debt.

Federal debt is 37 percent of the GDP. That's relatively low. In 1946, federal debt was 108 percent of the GDP! Despite that, stock prices rose. In 1993, federal debt was 50 percent of the GDP. Stock prices again went up. With the debt now only 37 percent, stock prices have every reason to do the same.

I'm bullish. The U.S. stock market is taking off, and foreign stock markets are rising even faster. Buy stocks from throughout the world!