America's death by euphoria
Bill Martin
Sunday August 26, 2001
The Observer
It would seem that reports of the death of America's business cycle were somewhat exaggerated. New Era productivity gains and the wonders of whiz-bang technology have not, in the event, prevented a collapse in American growth.
And the repercussions have spread: Europe is slowing, Japan's depression is deepening, and in the rest of Asia, yesterday's economic superstars are today's collateral damage. The world is experiencing a synchronous slowdown of a kind not seen since the 1980s.
Yet hope springs eternal. The economic forecasters who collectively failed to believe just that expect a restoration of robust growth, at least outside Japan, courtesy of lower interest rates, tax cuts, and stable or lower oil prices. John Llewellyn nicely put forward the optimistic point of view in this column two weeks ago. Consensus opinion sees the American economy growing by around 3 per cent a year over the next few years, high enough to keep unemployment low and to outpace Europe.
This view may well prove far too sanguine. Although the tax rebate now swelling pay packets should give a short-term lift to American activity, the economy's fortunes over the medium term are likely to be dominated by the attempts of previously overly exuberant companies and households to reduce borrowing. Whatever the short-term ups and downs, the result may well be a prolonged period of anaemic growth accompanied by a substantial loss of jobs.
One problem with the consensus view is that it pays little heed to the very unusual nature of the American expansion of the Nineties. A minor downturn prompted by a bit of inflation and higher interest rates is one thing - and is easily fixed by conventional means. But America's boom was unique and so, alas, will be its bust.
Since the mid-1990s, that boom has been based on a premise, increasingly spurious, about the scale of future expansion and the durability of stable economic conditions. Seduced by visions of a shiny techno wonderland, growth expectations became too high and assessments of risk became too complacent - changes of mood aided and abetted by a liberalised financial system. Credit flowed easily, enabling households and businesses to raise their collective rate of spending relative to income, and at a quite remarkable rate.
By the autumn of last year, the flaky official figures suggest the excess of private spending over income had reached 6 per cent of America's gross domestic product - funnily enough a rate of borrowing identical to that seen in Britain 11 years earlier during the heady Lawson Boom. As in Britain, the shift in American spending behav iour represented a profound change from the norm. In the 40 years up to the mid-1990s, spending by American households and companies was typically less than after-tax incomes to the tune of 2 per cent of GDP.
Was this remarkable shift in behaviour justified by America's New Era? It seems unlikely. Some point, for justification, to the genuine improvements in productivity. But average productivity growth was materially higher in the Golden Age of the 1960s, when private spending behaviour was 'normal'.
Others say that economic stability justified higher stock market prices, a boost to shareholders' wealth that propelled private spending upwards. So convinced were they of the low-risk nature of the stock market that two authors, who may prefer to remain anonymous, famously entitled their polemic Dow 36,000 .
It is certainly true that the American economy was unusually stable during the 1990s, a fact that some attribute to better monetary policy; others to the better control by businesses of their inventories. The latter explanation gives no basis for optimism, however, in view of Japan's condition, notwithstanding its lead in best-practice inventory management.
More important is the possibility that America's unusual stability was something of a fluke, aided by the decoupling of America's business cycle from those in Europe and Japan. Big events in the 1990s peculiar to these economic regions, such as German unification, Japanese deflation and America's productivity surge, meant that strength in one region coincided with weakness or normal growth elsewhere. This decoupling was the main reason why the industrial world collectively avoided large, destabilising cycles in the 1990s.
Booms are born in depression, come of age in scepticism, mature in confidence and die in euphoria. Once irrationally exuberant expectations of higher growth and stability took hold, American progress became a knife-edge. There could be boom, there could be bust, but there was most unlikely to be a soft landing. Wynne Godley and I precisely spelt out the reasons, way back in 1998.
Our knife-edge proposition went like this: With the dollar firm and the budget restrictive, the expansion of overall demand would be dependent on further increases in private spending relative to income. But what would encourage households and businesses to borrow ever larger amounts and at a record rate? The answer would have to be continuously upward reassessments of future growth and increasing complacency about risk, both serving to drive the stock market higher. In other words, the bubble had to keep on inflating.
The boom was self-evidently unsustainable, but there were strong forces of persistence at work. The economy was on a roll, and stock market investors, unsettled by seeing others getting effortlessly rich, drove stock prices up, ignoring all warning signs. Wall Street's industry of spin gleefully pumped up the tulips.
For these reasons, Godley and I could not forecast the timing of the end of the boom. But we were sure of two things. First, the longer the boom and excess borrowing persisted, the more vulnerable the economy would become to seemingly innocuous shocks. This is why the economic forecasters who knew all about higher oil prices and interest rates last year still signally failed to predict the collapse in activity. Second, we knew that the bigger the boom, the bigger would be the bust. Although budgetary policy is no longer restrictive and the dollar is weakening, it would be remarkable if America avoided the post-bubble trauma that has afflicted economies that have experienced similar prolonged periods of excessive exuberance and borrowing in the past.
The fallout will be global. Canada, Asia and Latin America are the most vulnerable but all economies are being affected by the reduction in trade and decline in stock markets. Although Britain is one of the least exposed via trade, a shock to its large financial services industry will have repercussions.
The wobbly Washington Consensus that still influences global economic policy-making will be further challenged. It will turn out that economic instability is not just the fault of mischievous or incompetent politicians. Reinforced by liberalised financial markets, the private sector is itself prone to profound instability thanks to persistent waves of optimism and pessimism.
This fact, once understood, has been airbrushed out of the mainstream. And it leaves the world vulnerable to a backlash. More effective than any anti-capitalist protest, America's hard landing is likely to call into question the future of globalisation.
• Bill Martin is chief economist at Phillips & Drew. William Keegan is on holiday.
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