A bad year for economic punditry
Hamish McRae on the events Of 1997
Tuesday 23 December 1997
The most obvious example of bad news not picked up was the deterioration in the East Asian economies, a process which clearly has some way to run. But there was also a failure to see good news, particularly with regard to the UK. Few saw the recovery in sterling, the continued low inflation, or the improvement in the current account, now clearly heading for a surplus of around pounds 4bn.
Since this is the last column I will be writing in this slot this year so it seemed most helpful to try to identify the soft parts of next year's outlook - the areas where the mainstream forecasts may prove equally wrong. The best starting point is the International Monetary Fund's new World Economic Outlook, out at the weekend, because it compares what most good, sensible (but of course wrong) forecasters were saying at the beginning of the year, what actually happened, and what they are saying now.
Unsurprisingly, as the main organisation trying to pick up the pieces of the East Asian crisis, the IMF is preoccupied by the fact that it didn't see it coming. If you have to sign the cheques for the rescue, it is small comfort that other forecasters, and the financial markets, were equally blind. Unsurprising too, because the story has still some way to run, the IMF can only offer a tentative explanation of what went wrong.
It cites several factors, but two stand out. One was the long period of regional over-investment. Because investment is supposed to be a good thing (unlike consumption) we have been trained to think that there cannot be too much of it. But actually it led to an imbalance just as serious as that of Latin America in the early 1980s, when the problem was over- consumption. Over-investment meant that the economies of the region had to grow faster and faster to keep in balance. Otherwise they would end up to too many factories producing too many goods for the market, and financed by borrowed money. The moment growth faltered, the bubble burst.
The other fact was a financial panic. The collapse of East Asian share prices (by contrast to those of the rest of the world ex-Japan - see graph) made a bad situation worse. The sell-off affected all developing countries, including those in the Western hemisphere, but the collapse in East Asia was vastly more serious.
Looking ahead, what stands out? The IMF shows how everyone, including themselves, has been cutting growth forecasts for next year, and its best guess now is for world growth to be 0.8 per cent lower next year than it would otherwise have been. But it is still expecting growth next year to be 3.5 per cent, against 4.1 per cent this year.
But while that is fine as a starting-point, it would be surprising if it proved to be right, for it requires everything to go fairly well through the year: the bail-outs to be accomplished, growth in the US to remain solid, a continued recovery in Europe, the start of a decent recovery in Japan and so on. The risks, surely, are mostly on the downside, for we are heading into a period of global deflation, in which economies will behave in a different way than in previous cycles.
To put some perspective on this, think back 25 years, for I think we are seeing in the East Asian crisis something similar to the OPEC oil shock of 1973/4, but in reverse. In the 1970s a world economy which was already under mounting inflationary pressure was struck by an external inflationary shock. Now a world economy which is mostly under mounting deflationary pressure has been hit by an external deflationary shock. Then, the countries which were best able to cope were those where inflationary pressure was relatively weak, in particular Japan and Germany. The UK was hard hit, partly because of high domestic inflation and partly because of the wrong policy response.
Now those best able to cope will be those where deflationary pressure is relatively weak, like the US and UK and those hardest hit will be those already suffering from deflation, like Japan and much of continental Europe.
The difference in sentiment between the US and UK on the one hand and Germany and France on the other is best caught by the graph on the right, which shows the differences in consumer confidence. There has been a modest recovery in confidence on the Continent, but it is still very low by comparison. Both France and Germany have had good autumns, but demand has been almost entirely sustained by exports. If the cold deflationary wind from the east becomes more intense they will need to replace export demand with domestic consumption. Will that wind strengthen?
It is hard to know how worried we should be. The financial fall-out is perhaps two-thirds of the way to being in the open. There is probably a China devaluation still to come (though this is not yet inevitable) which will put a new round on pressure on its regional competitors, and the Japanese market may well make one further downward shift in the first half of next year. But I think by the middle of the year the financial stage of the crisis will be under control and we will be concerned with the weakness of the real economies. Strong downward pressure on prices will continue, through lower prices of goods produced in the region, lower exports to the region, and probably lower commodity prices too.
My guess is that by the middle of next year the financial markets of East Asia will have recovered their cool, but the financial markets here will be making the long adjustment to a world of stable or slowly falling prices. Bond yields will be falling, but equity markets will still be learning to live with higher yields.
The other preoccupation will be EMU, for by the middle of the year EMU members will have moved to pretty much a single interest rate. On balance this is likely to be mildly deflationary. For some countries, those already experiencing a boom like the Netherlands and Ireland, the reverse will be true. But Europe as a whole seems likely to experience both higher interest rates and continued pressure to narrow budget deficits. The new IMF forecasts for continental Europe next year are quite bullish (2.6 per cent growth for Germany, 2.7 per cent for France as against only 2.4 per cent for the UK), but the risks for all, including ourselves, are surely on the downside.
And what then should we be looking for here? Everything this year has turned out better than expected; is it reasonable to expect a repeat performance?
It can't really, can it? The front half of next year will be fine: there is great momentum now, and that will not evaporate instantly. The autumn will be the tougher time, when growth comes off the curve and we might start to get the first signs of rising unemployment. If the global economy is in trouble, then that will reflect on attitudes here. Those consumer confidence figures shown in the graph are not sustainable neither here nor in the US. And if you have time to pop into the shops today, note the number of sales. Maybe a glimpse of things to come?
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