Cracks in Wall Street
And Time to Stop Lecturing Japan
by Samuel Brittan
The most worrying feature of the world economy is the future of a US boom stoked up by inflated share prices. The main economic query for 1999 does not concern the euro. It does not even concern the emerging economies or Japan. It concerns the US.
Indeed it is time western policymakers stopped lecturing Japan on what to do. That country accounts for about a sixth of the output of the industrial world. Its exports amount to less than 9 per cent of its gross domestic product.
Over the years, US hectoring of Japan has had a negative influence. Professor Ronald McKinnon has argued that: "American mercantile pressure on Japan from 1971 to 1995 to get the yen up, and fear that that pressure may return, is the root cause of Japan's current deflation and slump." *
Whether or not it is "the root cause", the appreciation of the yen from Y300 to the dollar in 1971 to around Y100 in 1995, partly under US prodding, did indeed make an important contribution to Japan's current malaise. Prof McKinnon is, in any case, right to argue that the dollar exchange rate cannot be used as an "instrumental variable" for reducing the US current account deficit "which mainly reflects extremely low saving in the US itself".
It would, in fact, be unfortunate if US savings behaviour were abruptly corrected. For what happens in the US is make-or-break for the world economy this year and next. The US economy is twice the size of Japan's. Like Japan, it is a continental economy. But the US has a much greater effect on the rest of the world. Wall Street's ups and downs, for instance, usually trigger large sympathetic movements in other stock exchanges.
The US boom has been fed by a record rundown in the financial balance of the private sector. The deterioration has been in the entire private sector and not just in personal finances. The rundown has been sustained, up to now, by portfolio appreciation due to the rising level of stock prices. As Andrew Smithers has pointed out,** the large buyers of equities, who have been keeping the market up, have been US corporations buying their own stock or engaged in takeover operations.
The US Federal Reserve now faces a classic dilemma. Should it tighten policy to let the air out of the Wall Street boom or should it loosen policy for fear that alarms about emerging markets and falling domestic confidence might already be sowing the seeds of recession?
Most forecasting organisations expect US growth to slow from about 3½ per cent in 1998 to 1½ per cent in 1999. This is something with which the world can live. It would, indeed, be a healthy reaction to excessively rapid growth in the past. It is the fear that Wall Street prices are much too high, and could therefore snap, that produces the risk that the US could experience a serious downturn rather than a benign slowdown.
The Organisation for Economic Co-operation and Development has studied many different estimates of the effects of Wall Street on the level of spending in the US. The remarkable consensus is that a 20 per cent fall in US equities could lead to a drop in consumption of about 0.7 per cent, accompanied by a larger proportionate impact on investment. So even without secondary or confidence effects, real GDP would be about 1 per cent lower than might otherwise be expected. If equities were to fall by 40 per cent, the US economy would almost certainly tip over into a serious recession.
US equity prices are now much higher than in December 1996, when Alan Greenspan, chairman of the Fed, made his famous remark about "irrational exuberance".
As always, there are two sides to the argument. The most sober case of the optimists has been presented by Goldman Sachs. Its economists avoid the trap of talking about the "new paradigm" which is supposed to give the US rapid, inflation-free growth forever. Instead, they put the emphasis on the new world of low or negligible inflation. This should reduce the nominal interest rate at which future dividends are discounted. They also believe that the level of risk will be lower in an environment of stable prices, thus justifying a lower risk premium.
Nevertheless, the IMF, in its December Interim Assessment, did take into account lower interest rates when it asked what level of nominal equity earnings growth would justify recent equity price levels. Its estimate is 7½ per cent a year. This is not very different from the average of the last four decades when inflation averaged more than 4 per cent. But it is scarcely credible that profits could grow at the required rate if inflation remains at its current level of just over 1 per cent.
The most pessimistic case comes from Tim Congdon in the December Lombard Street Research Economic Review. He reminds us that measures of broad money and credit, so far from indicating any kind of crunch, have shown near double digit growth in the last few months. In his view this has been associated with large, although suppressed, overheating of the US economy. The overheating has not shown up in inflation partly because of the fall in commodity and oil prices, but also because much of the excess demand has gone into imports. On present trends, he projects that the US would have net overseas liabilities equal to 50 per cent of GDP by 2010.
My own guess is that those who worry about Wall Street are near the truth; and I would expect a severe enough correction in US equities to have a spillover impact not only on the US but also on the world economy.
But, unlike Mr Congdon, I would not put so much emphasis on the US balance of payments. Not only does such an emphasis play into the hands of protectionists, it overlooks the numerous ways in which the balance of payments takes care of itself in a world of floating exchange rates and free capital movements.
It was this balance of payments obsession and distrust of self-correcting forces that explains, but does not excuse, the willingness of otherwise moderate and sensible British officials to draft the hideous idiocy of Operation Brutus, a fallback plan which would have imposed an almost Stalinist siege economy in Britain in the event of severe problems with sterling in 1968-69. This was a horror which the British establishment successfully concealed from us until the opening, at the end of last year, of the official papers for 1968 under the 30-year rule.
For the time being the US is acting as world buyer of last resort; and it is quite rational for residents of countries with surplus savings, such as Japan, to lend to it. Obviously the US external debt ratio cannot rise indefinitely. A soaring US current account deficit will eventually hit the dollar. And if the dollar fell too quickly, even in an economy where trade accounts for only around one tenth of GDP, it would eventually affect the inflation outlook and cause monetary policy to be tighter than it would otherwise be.
The Fed's best course - which is easier for Greenspan's born-again critics to recommend than to prescribe in detail - is to try to keep US nominal demand rising at a non-inflationary rate and not to fall back into the mercantilist trap of becoming obsessed with overseas trade returns.
*Exchange Rate Co-ordination for Surmounting the East Asian Currency Crises, Economics Department Stanford
**Piling Up Debt, Smithers and Co.
Contact Samuel Brittan
The Financial Times, Jan. 7, 1999 |
