The latest views of Morgan Stanley Dean Witter Economists
Nov 24, 2000
Global: Prepare for a Hard Landing
Note: The following appeared as an editorial feature in the 22 November edition of the Financial Times.
There is great danger lurking in the global economy. The healing that followed the financial crisis of 1998 is turning out to be surprisingly short-lived. The risks of a hard landing, or an outright recession, are high and rising -- especially in the US. I would assign a 40% probability to such an outcome in the first half of next year. For me, that is tantamount to maximum alert.
The case for a hard landing rests on the combined impacts of two sets of macroeconomic forces -- a natural deceleration in the global economy and the possibility of a destabilizing shock. Several factors point to a natural deceleration in the global business cycle in 2001.
First, there are the lagged effects of 1.75 percentage points of monetary tightening by the US Federal Reserve and 2.25 percentage points of tightening by the European Central Bank, in the past 17 months. Most of those impacts are still in the pipeline.
Second, there is the sharp recent rise in energy prices, which acts as a tax on the energy-consuming industrial world. Third, the recent widening of credit spreads in the US and Europe will undoubtedly take a toll on business spending, especially in the technology-intensive telecommunications sector.
Fourth, there is new vulnerability in the developing world, especially in Asia where structural reforms have been lagging. A downturn in the global technology cycle could wreak havoc on these export-dependent economies. Fifth, there is the impact of a negative wealth effect in the US; after 5 years of 25% gains, the stock market will probably be down this year. That should give saving-deficient US consumers considerable pause for thought. Finally, there is what economists call cyclical payback -- the tendency for a year of vigorous growth to borrow from gains in the subsequent year.
The interplay between these factors should be enough to push down growth in world gross domestic product from the boom-like outcome of 4.9% in 2000 -- a 17-year high -- to a more modest 3 to 3.5% growth rate in 2001.
The problem arises in the transition from this year’s vigor to next year’s slowdown. These transitions are typically uneven and often quite precarious. They normally entail a few quarters of below-trend growth, as inventories and production are reconfigured in a climate of softer demand. During that transition, the world economy often slows to its "stall speed" -- a sluggish growth rate that could easily give way to recession, should an external shock occur. That brings the second set of macro forces into play: the impact of the shock. Rapidly growing economies have ample cyclical immunities to withstand shocks. Economies inching ahead at
their stall speed do not. The soft-landing call for 2001, therefore, rests very much on our ability to anticipate the next shock.
Three possibilities are most worrisome, the first being a full-blown energy shock arising from war in the Middle East or a market-driven spike in prices of refined petroleum products and natural gas. The second possibility is an earnings shock in the US. Profit margins could be squeezed by energy costs, corporate financing costs, labor costs, and technology costs. As volume growth slows, earnings could tumble, which would drag the US stock market down further. Then the dreaded negative wealth effect could bite -- prompting wealth-dependent US consumers to replenish long-depleted saving balances.
Finally, there is the possibility of a dollar shock. The armor-plated greenback has been vital to America’s virtuous circle. Yet the dollar is a disaster waiting to happen. America’s record external deficit is only part of the problem. A downturn in the global cycle of global mergers and acquisitions threatens to crimp capital inflows into the US. A narrowing of the growth differential between the US and the rest of the world could challenge the notion that investors are willing to attach a permanent premium to
dollar-denominated assets. And the recent political neutering of US leadership could be a problem, too. If the dollar goes, America’s virtuous circle could turn vicious very quickly. Europe and Japan could then be struggling with stronger currencies.
This depiction of the hard landing fits the last recessionary experience of the US economy to a tee. The US economy was hovering at close to its stall speed in mid-1990, when the shock of a sharp, but brief, rise in oil prices triggered recession. Therein lie the risks for 2001. By our reckoning, real GDP growth in the United States could slow into the 2 to 2.5% range in the first half of next year, mimicking the stall speed that presaged the hard landing a decade ago.
Stall speed combined with shocks is the recipe for a classic hard landing. If the US -- long the engine of the global economy -- sneezes, the rest of an increasingly integrated world will quickly catch the same cold.
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