Complacency trap.....ft/ 18 wed 98
Even if policymakers have saved the world economy for the moment, they must guard against a crisis of over-confidence.
With the Dow Jones Industrial Average back around 9,000, nobody can gainsay the success of Alan Greenspan's Federal Reserve. He can do more than walk on water. With a few words and two small cuts in US interest rates, he smoothes the troubled waves.
By Monday, the S&P composite index had regained 80 per cent of its post-July decline, to stand a mere 4 per cent below its peak. The price-earnings ratio on the S&P, at just under 29, is only fractionally below its all-time high. The big jump in spreads between riskier and safer bonds has also shrunk, if by far less: the spread between C-rated corporate bonds and treasuries is still around 12 percentage points, against 8 percentage points before Russia's mid-August default.
It is little wonder then that the Organisation for Economic Co-operation and Development offers a guardedly optimistic analysis in its latest forecasts. It notes, in particular, that the policy actions recently taken should prevent further damage.
These actions included:
•The easing of monetary policy, with a half a percentage point decline in US short rates, a three quarters of a percentage point reduction in UK rates and convergence within the euro-zone on the German level of 3.3 per cent.
•An enormous ¥60,000bn ($496bn) programme, equivalent to 12 per cent of gross domestic product, to recapitalise Japan's banks, to which can be added yet another fiscal stimulus package, this time worth ¥24,000bn
•The lifeline of $41bn provided to Brazil, $37bn of which is to be available in the first year.
•The late-October communiqué from the Group of Seven leading industrial countries, with its ideas for reform of the international financial system.
Not only financial markets have taken heart. So has the OECD. Its central forecast for 1999 is world growth at 2.1 per cent, followed by a recovery to 2.9 per cent in 2000. This includes 1999 growth of only 0.2 per cent in Japan, but 1.5 per cent in the US and 2.2 per cent in the European Union (giving 1.7 per cent in the OECD region as a whole). Economic growth outside the OECD was 5 per cent in 1997; it is expected to fall to 1.7 per cent this year, before recovering, modestly, to 2.5 per cent in 1999 and 3.8 per cent in 2000.
The 1999 forecasts inevitably contain significant downward revisions from those of last March: by 1.1 percentage point for Japan and 0.6 percentage point for the US and EU. Behind the revisions lie Japan's deepening recession, lower oil and commodity prices, the redirection of financial flows from riskier borrowers and declines in confidence. The US and EU economies have been directly harmed by downward pressure on the profitability of manufacturers, increased market perceptions of risk and the trade adjustment.
The US current account deficit is forecast to rise to 3.1 per cent of gross domestic product next year, up from 1.9 per cent in 1997. But the OECD forecasts virtually no change in the external surplus of the EU, expected to be 1.3 per cent of GDP in 1999 and 2000. This contrast will surely prove a potent source of conflict.
Leave aside, for the moment, the "millennium" bug, that timely chiliastic prophecy. Four other dangers now menace the OECD's central forecast:
First, emerging markets could perform still worse than is now expected. The Brazil package announced last Friday could readily fail: all such attempts to hold exchange rate pegs are a gamble. The Chinese slowdown could become severe, generating pressure for devaluation, while the debt-burdened Asian crisis countries could experience another year of decline. If so, some governments may replace orthodoxy with exchange controls, involuntary writedowns of foreign debt, or both, sending another shock through credit markets.
Second, the Japanese economy could continue its downward slide. Loans to Asian emerging markets amounted to 133 per cent of the (exaggerated) capital of Japanese banks in 1997, while exports to Asia were 4.5 per cent of GDP. The banking recapitalisation could also fail, either because banks do not take the money or because they then lend less, as Paul Krugman of the Massa-chusetts Institute of Technology has argued (FT, October 27). The succession of fiscal packages could also fail to restore buoyancy to demand, while the yen appreciation is bound to harm exports.
Third, equity markets could go into reverse, particularly if the Federal Reserve became more worried about inflation or, more plausibly, investors began (at last) to re-adjust their expectations of future earnings growth. With US household savings negative, stock market weakness could lead to a turnaround in consumption. Instead of rising faster than disposable incomes, it would then grow more slowly. Lower stock market prices could also affect US corporate investment.
Fourth, credit could continue to be severely rationed to riskier borrowers. Risk spreads are still large. Furthermore, there is some evidence of tightening credit standards among banks, at least in the US. It is often forgotten that European banks are also highly exposed to emerging markets, with total loans outstanding equal to 91 per cent of their aggregate capital in 1997.
If these risks were all to come together, there would be further declines in oil and commodity prices. There would also, quite possibly, be a decline in the dollar and the yen against the euro, as the Federal Reserve loosened and the Japanese were driven to wholesale monetisation.
What would be the outcome? The OECD suggests that US growth next year could be minus 0.4 per cent with unchanged real interest rates. Japan's economy would shrink by more than 2 per cent for the second year in succession. As for the EU, its economy would expand by less than 1 per cent.
In all, the downside the forecasters see is stagnation in the OECD next year and sluggish recovery thereafter. This looks just about right: the US and EU are poised between stagnation and modest growth, while Japan is balanced between stagnation and continued decline.
The more buoyant outcome is what any sensible person must hope for. But it also creates a nagging worry. Suppose investors conclude that no conceivable turbulence can slow the US economic battleship. What then happens to market perceptions of risk?
Big financial crises come when investors have long seen only golden opportunities - the more prolonged that period, the more spectacular the crash. This is among the most significant lessons from Asia's woes. This was a region of sustained high growth, sound fiscal and monetary policies and stable exchange rates. Investors largely forgot about risk. Was Tokyo's land worth more than the entire US? Quite right, concluded investors, in a fast-growing and land-short economy.
Thus western policymakers face two dangers: the more immediate is that they do not sustain confidence. The more distant is that they do. For what might then prevent the Dow from marching to 15,000? The Nikkei was, after all, once at 39,000.
Capitalist economies balance between greed and fear. If Mr Greenspan removes fear, what is left to curb the greed? Let him succeed - but not too well.
Email Martin Wolf: Martin.Wolf@FT.com
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