East Asia: the oil shock in reverse
Sunday 18 January 1998
Teams of economists everywhere are calculating the probable scale of the East Asian downturn, the impact on world trade, the effect of the devaluations and so on. While there is a certain understandable reluctance to consider the extremes if things really get out of hand, we do at least know the bottom limits of the shock. We know that in financial terms, East Asia is going to be at least as big as the Latin American debt crisis of the early 1980s. And we know that in economic terms it is likely to knock at least half a percentage point off world growth this year, but maybe double that.
This is all useful work. More important, though, will be the likely dynamics of the blow: how it will hit some economies harder than others, why this will be so, and how this shock will bear on longer-term trends in the world economy, in particular the process of global disinflation. Here we really are flying blind, for we have no experience since the 1930s of global deflation, a dreadful period which, while an uncomfortable warning, was so different from the present that I don't think it is really helpful.
On the other hand, we do have relatively recent experience of the reverse: the first oil shock in 1973/74. The East Asian crisis is a deflationary shock hitting a world already going through a process of disinflation. The first oil shock was an inflationary blow, hitting a world which was already facing rising inflation.
Of course, the one is not precisely the mirror image of the other. The region which benefited most from the rise in the oil price - the Middle East - is not as large or diverse as East Asia. The oil shock initially reduced overall demand in the developed world (though it added to inflation) and the boost to the world economy only came when the oil producers began to use their revenues. The inflationary trend in the world in the early 1970s was more firmly established than the deflationary trend today.
But if we don't have a mirror-image, we have a similar degree of surprise and similar confusion in official circles as to the appropriate response. We will also find that some countries in the developed world weather the blow much better than others. Here are six possible lessons.
Lesson One seems straightforward. Obviously the countries most immediately hit will be those which have the largest trade with East Asia, just as countries which relied heavily on oil imports were hit harder than those which were relatively self-sufficient. A lot of calculations have been done here, showing for example that while the US will not be hit so hard directly, some of its companies will be seriously affected. The effect on profits is already evident in the fall in US fund managers' confidence over the last six months, as indicated in the Merrill Lynch survey (see left-hand graph).
Japan sends 40 per cent of its exports to the region, much higher than any other G7 country, but it may not be as seriously affected as this might suggest because there are substantial offsets. For example, Japanese companies with production facilities elsewhere in East Asia benefit from the devaluations there. Anyway, foreign demand is not Japan's problem: it is lack of domestic demand.
But things are not quite so simple. Lesson Two is that countries which adjust early to the shock do better than those which move late. After the oil shock Japan seemed likely to be the hardest hit: it relied on oil for most of its energy needs, having no fossil fuel resources of its own. But it embarked on a vigorous energy conservation programme and adjusted to the higher prices so swiftly that when the second oil shock came at the end of the decade, it was well-prepared. The US, in contrast, did little by way of energy conservation, leaving it vulnerable.
So now the message should be that countries which are prepared for sharp cuts in the prices of East Asian products and which undertake the necessary structural adjustments will do better than those which delay. The consumer electronics industry is the obvious victim, as world prices will be driven down, but there will be downward pressure on prices in many other sectors, including cars.
Lessons Three and Four conflict with each other. After the oil shock, countries which were already facing inflationary pressure suddenly found the pressure much worse. Prices shot up further and eventually led to sharp rises in interest rates - the UK was a good example. Countries where inflationary pressure was more muted, like Germany, came through better. Lesson Three would therefore suggest that countries where there is least deflation will weather this deflationary force best. In the G7 at the moment there is good private sector domestic demand only in the US, UK and Canada. Domestic demand is flat in Germany and Japan, and only inching up in France and Italy.
So if the oil shock parallel holds the Anglo-Saxon economies are cyclically better placed to cope with a deflationary shock than the continental ones, and especially Japan.
The trouble with this (and this is Lesson Four) is that the Anglo-Saxons may run into balance-of-payments difficulties. The EU as a whole and Japan are in large current account surplus (right-hand graph) while the US deficit is back to late 1980s levels. The UK is just in surplus, but the trend seems to be deteriorating. So, while the Anglo-Saxons do have a way of combating global recession (if that is the result of this shock) by allowing strong domestic demand to continue, there are limits to the credibility of such a strategy. After the oil shock, countries which neglected their balance of payments were forced into sudden change. We don't yet know what this shock will do to international financial flows - maybe not too much - but the lesson of the 1970s is that countries should not be overly relaxed when the deficits start to balloon. Lurking here somewhere is the danger, maybe a distant one, that the US will have to correct its deficit suddenly.
Lesson Five is qualitatively different from the previous ones. Remember the worry in 1974 about the banking system's ability to cope with the oil producers' surpluses, the need to recycle the funds? As it happened, the banks coped well. Sure, some dreadful loans were made and some banks had to be rescued. But the overall capacity of the banking system proved remarkably large and robust.
I think we may find that the world's banking system now is pretty tough. There may have to be individual bank rescues in East Asia, and there will be several months of nail-biting ahead. But the capacity and resilience of the system will, I think, surprise us. Deflation puts great pressure on banking, but inflation created dreadful problems too.
Finally, Lesson Six. This is that policy makers will make mistakes both at a macro and a micro level. The response to the first oil shock was not, with hindsight, optimal. Several countries ran into serious trouble because of a poor macro-response, and there was a global recession. And because they did not make the right micro-response (not enough energy conservation) there was a second oil shock.
The world will make mistakes this time, too. The East Asian countries already have, and the IMF's performance is certainly tarnished. We will make more mistakes. That is the bad news. The good news is that they may not matter too much because they can, at a cost, be corrected later. The important thing to realise is that ultimately markets are self-correcting, even if the correction seems to take an awfully long time.
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