GLOBAL ECONOMY: Cauldron bubble
The world survived market toil and trouble in 1998. But beware, says Martin Wolf, the dangers are not past-FT report
The global economy got through 1998 without a recession thanks to two offsetting mistakes: an excessively expansionary US policy was balanced by excessive contraction in Japan and other parts of Asia. In normal times, the US expansion would have been much too inflationary. As it was, the impact was cancelled out by unexpectedly severe contraction in Asia, and strong US growth helped support Asian exports. Only an optimist would expect another such miracle in 1999.
In its December Economic Outlook, the Organisation for Economic Co-operation and Development estimated growth in US final domestic demand at 5 per cent this year, up from 3.8 per cent in 1997. The US private sector accounts for a fifth of global demand. Its enthusiastic spending has done far more than anything else to keep the world economy moving.
According to the International Monetary Fund's interim World Economic Outlook, out this week, the US current account deficit will deteriorate by $76bn between 1997 and 1998. This is almost two-thirds of the total improvement in the Asian newly industrialised economies ($53bn), Asian developing countries ($33bn) and Japan ($34bn).
Blessed then are the spendthrift for they will save the earth. Yet this was a happy blunder. It was not what the US Federal Reserve could have intended. If the Asian crisis and Japanese recession had not put downward pressure on prices, the surge in US demand would have been far more inflationary than it was. But, as luck would have it, it was perfectly timed.
While US domestic demand has exploded, Japan's has shrunk 3.2 per cent. Japanese private consumption has fallen 1.8 per cent, while private residential investment has shrunk 13.5 per cent and non-residential gross fixed investment has dwindled 9.6 per cent. If it were not for the improvement in Japan's net exports, equivalent to 0.7 per cent of GDP, total output would have fallen still more than the estimated 2.6 per cent. The US and Japan have, in short, been mirror images. In the former the bubbling stock market has encouraged the private sector to unprecedented net dissaving. In the latter, the opposite has happened.
The Asian collapse looks similar to Japan's, but more extreme. Between 1996 and 1998 the shift toward surplus in the current accounts of the five most afflicted economies has been $118bn, equal to 11 per cent of pre-crisis GDP. The fall in domestic demand has been still more dramatic than in output, though the latter has been startling enough: in the year to the third quarter of 1998, real GDP shrank 17 per cent in Indonesia, 11 per cent in Thailand, 9 per cent in Malaysia and 7 per cent in Hong Kong and South Korea.
The difference between Japan and the rest of Asia is that the latter had no choice, while Japan's ills were home-grown. The world's largest creditor nation should not suffer collapsing demand, falling prices and a banking industry with non-performing loans unofficially estimated at 30 per cent of GDP. It is the worst piece of macro-economic mismanagement since the great depression.
Asia (outside Japan) is, in contrast, a victim of the herd behaviour of international investors: excluding foreign direct investment, net private flows to developing countries moved from plus $94bn in 1996, to minus $27bn in 1997 and minus $58bn in 1998. After Russia's August default, flows dried up.
As for Europe, it is a bystander. The economies of the euro-zone grew 2.8 per cent this year, according to the IMF, with an almost unchanged current account surplus (estimated by the IMF at $112bn in 1997 and $103bn in 1998). These countries have, by and large, aimed at balanced growth - and achieved it.
This then has been the pattern of 1998: partially offsetting and growing macro-economic imbalances between the US, on the one hand, and Asia (including Japan), on the other; balanced, if modest, growth in the EU; and withdrawal of loans from emerging market economies, accelerated by the Russian default.
The overall outcome has been world economic growth at 2.2 per cent, roughly half the rate of 1996 and 1997. The US and the EU have been growing fairly rapidly, but Japan has been in recession and developing countries as a whole managed growth of only 2.8 per cent, much the worst performance of the 1990s. The sharpest deterioration has been in developing Asia, including China - where growth is expected to fall from 6.6 per cent in 1997 to 2.6 per cent in 1998 - and the western hemisphere - down from 5.1 per cent to 2.5 per cent.
Given market turmoil, the disappearance of funds from emerging markets and the recession in Japan, 1998 was not as bad as it might have been. It was still bad. During the two months immediately after the Russian default, the world economy looked horrifyingly fragile.
Fortunately, the cavalry arrived: central banks in the US, Canada, the UK and the euro-zone eased monetary policy;
Japan announced new measures to address banking sector difficulties and stimulate demand; Brazil promised fiscal tightening, and received substantial support from the IMF and the international community; the Asian crisis countries began to stabilise, though at a low level of economic activity; and additional resources were made available to the IMF.
Thus the world leaves 1998 behind with relief - and many hope that the worst may now be behind it. This is almost certainly too optimistic: 1998 bequeaths big risks and unsustainable imbalances to 1999.
Even the IMF cannot be accused of excessive optimism, with global growth forecast at a mere 2.2 per cent for a second year. The Japanese economy is forecast to shrink yet again; US growth to halve, to 1.8 per cent; and even the euro-zone to achieve only 2.4 per cent. The recovery in emerging markets is forecast to be slow, with growth in the western hemisphere falling to 1.5 per cent and Asia's growth rising only to 4.3 per cent. Of the five most affected Asian economies, only Thailand is expected to show growth, at 1 per cent, next year.
As the IMF also notes, "the balance of risks remains on the downside". It stresses five: another collapse in western stock markets; a still deeper decline in the Japanese economy; instability among the three big currencies; continued drought in private financing of emerging market economies; and protectionism. But behind these lies a single, disturbing truth: the positions of both the US and Japan look unsustainable.
In the US, the motor of the private sector is the stock market, which is more highly valued than at any time since 1926. The high value of equities has driven private spending, which, in turn, has expanded the external deficit. Behind the stock market, however, is strong monetary growth, with annual growth at 11 per cent in November. History may even call this era the Greenspan bubble.
This looks triply unsustainable: the stock market will not remain at historically unprecedented valuations indefinitely; the private sector cannot be a vast net dissaver forever; and the US will not run a very large trade deficit permanently. Merely to stabilise the current account deficit the trade deficit must move towards balance, to offset the deterioration in net investment income.
Japan's economic position looks as unsustainable as that of the US, but in a different way. As is argued in a frightening report from the Japan Center for Economic Research, Japanese business has invested far too much, given the growth in demand.* The rational course is to slash investment, as it did in 1998. But, argues the report, without strong recovery in domestic demand, there remains far more capital than the country needs.
Under plausible assumptions, argues the JCER, private investment in plant and equipment will fall at an average annual rate of almost 7 per cent until 2003 and its share in GDP will fall from 15.6 per cent in 1997 to 10.6 per cent and the economy will, as a result, shrink at an average rate of 0.7 per cent a year. Only a successful offsetting fiscal and monetary stimulus could halt such a collapse. With Japan's general government fiscal deficit forecast at 8.5 per cent next year and the market in Japanese government bonds weakening, this is simply not going to happen.
In addition to these fundamental risks in the US and Japan, the Brazil programme may also fail, leading to uncontrolled devaluation and yet another disruption of capital flows to emerging markets. All these possible developments are likely to cause currency turmoil, with the yen and the dollar probably falling against the euro, possibly sharply. Such developments are likely to cause protectionism, particularly in the US and the European Union.
What might all this mean? According to the worse of two IMF scenarios, growth in world output could be 1.3 percentage points lower in the first year than otherwise and 0.7 percentage points lower in the second, before recovery begins. It is quite easy to imagine far worse outcomes. What happens will depend heavily on the the new European Central Bank, in charge of the one big economic area that is not exposed to severe internal or external imbalances.
As the witches told Macbeth, "Double, double toil and trouble; Fire burn and cauldron bubble." The market has been bubbling - and has also caused a great deal of trouble. But 1998 could have been still worse if the US had not bubbled as much as it did. Optimists now predict global recovery. But pessimists can easily see why things could become worse: neither US private dissaving, nor Japanese private investment looks sustainable; emerging market economies remain vulnerable; and stock markets are as irrationally exuberant as ever. The world needed a good deal of luck to struggle through 1998. It will need just as much in 1999.
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