~~~OT~~~ The Global Economy's Trouble Spots
By Rudi Dornbusch a professor of economics and international business at the Massachusetts Institute of Technology.
Lawrence Summers is taking over as Treasury secretary at an opportune time. Stability has been restored to the financial markets after the crises that swept Asia, Brazil and Russia--which may be why Robert Rubin is leaving now. But Mr. Summers and Fed Chairman Alan Greenspan, whose role is even more important, do have at least two big trouble spots on the horizon: Both the U.S. stock market and Japanese bonds are mispriced, and may be due for a rendezvous with reality. A major realignment of these prices would shake world capital markets hard.
U.S. stocks are overpriced for a world in which inflation is not totally dead. In the most likely scenario, an adjustment will be turbulent but ultimately soft. Deep confidence in the economy, and the available policy tools, makes probable a good outcome and a controlled shock to the rest of the world.
Every bubble is inflated by some truth and lots of rationalization. U.S. stocks are better than that; there are a few reasons they should be priced very high indeed. America has business-friendly government and powerful stockholders who force CEOs to be efficient. The integration into the world economy has allowed deep cost cuts in restructured businesses, and formidable technology has revolutionized the way business is done. A well-functioning labor market has largely replaced unions.
There is also, importantly, the possibility that recessions are no longer inevitable. Inflation is low and hence the Fed need not stage the regular bloodletting of the past to slow down the economy. Just in case, the budget surplus provides a strong fallback position. If anything goes wrong, tax cuts will be on the table in no time (Mr. Summers knows how important they are during a downswing), and households will spend them as fast as the mail arrives.
That is not to say that the Fed will stand by and allow inflation to build up again once the world economy gets going. U.S. disinflation has been helped by distress in the rest of the world. Just now we are in a virtuous cycle of low price inflation and good productivity performance, which translates into low wage settlements and rising real wages. On the domestic front, inflation has virtually ceased to be a cyclical issue. Not so in the world economy. With Japan and all of Asia and Latin America tanking, commodity prices have been falling sharply, assisting good U.S. performance, which in turn has kept the Fed at bay. That is now over: World recovery is coming on and will gather strength. And as it does, so will commodity prices from chips to steel to a broad range of manufactures. U.S. inflation will jump.
The good news is that the negative impact of global recovery on U.S. inflation, while certain, is also small. We are not remotely talking of inflation rates going to 4% or 5%. But even an inflation rate of 3% is too much. If the Fed did not act, wage inflation would pick up, as would price inflation, and so on. Hence, if we believe in a world pickup then we must draw the conclusion that an interest rate hike from the Fed is coming. It is a small step from there to recognize that stocks will tumble and the dollar slide. This is bad but not awful news, for the inflation issue is small and so is the cure required: slowdown but surely not recession.
In fact, a stock-market correction will be the main result. Piling sizeable interest-rate hikes on top of this would be overkill. The goal is to absorb an inflation shock, not to wring inflation out of the system or go bubble busting, Japanese style. The Fed is fully capable of making this hazardous landing without crashing the plane. But the passengers will hold their breath as it happens. And so will the world economy, particularly in emerging markets. When there are tremors at the center, nobody wants to hang out on the periphery.
Things are much worse in Japan, which could become the biggest financial crisis of the postwar period. The Japanese recession has already hampered the rest of the world both directly (because Japan is one of the world's biggest economies) and indirectly (because its performance is limiting the recoveries of its Asian trading partners). The reason that things could get worse is that we have yet to feel the full repercussions of Japan's huge public debt and its massive unfunded pension liabilities.
The high existing debt, the poor state of the economy and the rapidly aging population (which will require fewer workers to support more retirees) combine to create a disastrous public-finance situation. Debt escalation simply cannot be avoided; Japanese bonds deserve a junk rating. The problem is out of control, and Japanese leaders are both distracted by politics and deeply confused as to the depth of the deterioration that has already taken place.
According to International Monetary Fund data, Japan's public debt is now 130% of gross domestic product. In addition, the Organization of Economic Cooperation and Development estimates that the net present value of pension liabilities is above 107% of GDP. The combined debt is the largest public liability in the world, though the Japanese economy is only half the size of the U.S. or Euroland. Recovery is not in sight; according to the consensus forecast, growth this year is negative and next year zero. High debt and deficits as far as the eye can see are a prescription for disaster.
A deep deregulation of Japan, aimed at creating new jobs, is clearly part of the solution but it isn't coming from a dysfunctional political system. The central bank also could play a constructive role, printing money to buy stocks and dollars to pull the economy out of the swamp. But for the moment, Japan's central bank, like the Fed in the 1930s, keeps waiting for someone else to accomplish a miracle. Corporations aren't doing much better. Their restructuring is mostly defensive: fewer jobs, not more.
Given that there is unlikely to be an escape from the fatal debt dynamics, how will this end? One scenario is a financial meltdown of Japan, driven by deteriorating credit ratings, increasing risk spreads, worsening balance sheets and debt dynamics, loss of confidence and deepening recession. Neither the IMF nor the U.S. can stage a bailout (as in Mexico or Brazil), because the numbers in Japan will be so staggeringly large. Nor is anyone prepared to step in and engineer a pre-emptive restructuring, because there is no consensus on what needs to be done.
The Japanese situation may result in a truly nightmarish scenario. Image that, faced with no easy way out, Japan responds to its troubles by reversing financial liberalization. The high savings rate would be targeted at rolling back the debt; savers would be taken hostage to postpone the inevitable. Much of Asia would join in an Asian financial area with heavily regulated finances and controls on the export of capital. This would spell the end of the increasingly open world economy. This is more or less what happened in the 1930s and is surely a very plausible result of the otherwise unmanageable Japanese debt.
Japan already moved two years ago for an Asian financial area from which capital can't escape, and it is seeking free-trade agreements with its neighbors. A Japan crisis with its huge potential for asset collapses and competitive depreciation could well lead the rest of Asia to join Japan in turning back the clock. In the new economy, a shock anywhere is a shock everywhere. And with leverage significant, even small shocks become big; big ones go nuclear. With that in mind, complacency about Japan's debt is dangerous.
Good luck to Messrs. Greenspan and Summers. |
