Forecasters fall foul of passing fashions
One of the most useful things the BIS report does is to explain why things are not what they might have been
Tuesday 09 June 1998
The great thing about the Bank for International Settlements' annual report - more a commentary on the world of finance than a regular bank report - is that it acknowledges and defines the areas of uncertainty. Unlike the research departments of the commercial financial institutions, which feel they have to give a firm view of future developments, the BIS can stand back and think. This may not be quite so useful for people wanting to be told whether to buy or sell, but for anyone trying to understand what is happening it is a breath of fresh air.
In its analysis of the world economic situation, the BIS focuses on the way things turned out differently last year from previous expectations: the United States and UK did not slow down as expected, and the Japanese recovery failed to sustain itself. In the rest of Europe, small countries tended to grow swiftly while the larger ones underperformed. Yet inflation in the small countries was actually lower than in the big.
To understand the future you have first to understand the present, and one of the most useful things the BIS report does is to explain why things are not what they might have been. In particular it hints at the unsustainable nature of the US and UK expansions, where inflationary pressures have only been held down by rises in the dollar and the pound, and where the current accounts have accordingly deteriorated.
However, the BIS also points out an aspect of the US expansion which I had not fully grasped: the extent to which investment in information technology might have increased the potential for growth. The chart on the left is derived from some statistics the BIS dug out on IT investment, which last year took 20 per cent of total investment in the States. The information industry now accounts for 4 per cent of US output, against only 0.8 per cent in 1992. If you exclude the information industry, real GDP would have only grown at an average of 2.2 per cent over that period. As it was, real output rose by 2.9 per cent a year. In addition, the growth of the information industry helped hold down inflation: strip out information and inflation would have averaged 3 per cent over the period. In fact, inflation was only 2.4 per cent. If one wants a single example of American exceptionalism, this is perhaps the best.
To some extent it must also apply to the UK, where the information industry is also expanding very fast, but it would be nice to see some figures to confirm this. Worryingly, the BIS does note that continental European investment in general has been rather low, and accordingly the spare capacity there is less than might be expected. This is bad news for the continent's unemployed, for it suggests that there might be high residual unemployment, even when the economies are at full capacity.
An even bigger surprise than the divergent performance of the main developed countries last year was of course the abysmal performance of what had been the fastest-growing region, East Asia. It would not have been a complete surprise to anyone who read the previous year's BIS report, which did warn of the excessive investment that was taking place, and the price bubbles that were a-brewing in the property markets. The region was clearly vulnerable to any sharp fall-off in demand, but what everyone had failed to spot was the way in which the decline in demand would interact with a fragile financial system and companies heavily burdened with debt.
What no-one really saw was the way in which the short-term response to the financial crisis, sharp devaluations, would hit growth prospects and thereby put even more pressure on the region's banks and companies. The right-hand graph shows how estimates for the 1998 growth of the crisis- hit four (Indonesia, South Korea, Malaysia and Thailand) were cut during the second half of 1997, as their currencies simultaneously collapsed.
Normally you might expect a devaluation to boost growth by encouraging exports and leading to import substitution. In this case, because one country's exports were another country in the region's imports, the devaluations had the effect of depressing the whole region.
What happens next? The BIS believes that asset prices have not been inflated by the global fund management industry to any substantial extent, but there is an implicit warning here that the present high asset prices are not sustainable. The BIS is not predicting a stockmarket crash later this year; but if there is one, it would be able to say that such an outcome was consistent with what it wrote.
The most interesting part of the report is, as usual, the final few pages of commentary at the end. It starts by pointing out the dangers of fashion. It is fashionable at the moment to take a generally positive view of the future, despite the trauma of Asia. It suggests that there is a danger of over-optimism at the moment. Just as the Asian economies were admired for their high savings and high investment, no-one focused on the fact that a lot of this investment was going into unprofitable projects. With that warning, it looks at the potential weak spots in the world economy now.
One is the imbalances among developed countries and, in particular, the rising current account deficit of the US. It sketches a scenario (not, it notes, a forecast) where US growth slows, confidence ebbs and foreign funds are suddenly withdrawn from the dollar.
Two, banking systems throughout East Asia and Japan need to be rebuilt. The weakest banks will have to be closed and the rest recapitalised.
Third, there are imbalances within the rest of the developed world. The new European Central Bank will find it difficult to set a single interest rate for the entire region, given the different cyclical position of the large and small economies; and the US and UK will have to tackle tightening labour markets, worsening trade balances and rising inflation.
Finally, the BIS asks: can we learn to cope with crises better? It concludes that crises will undoubtedly continue - we cannot hope to prevent them - so we will just have to learn to manage them as well as possible, but "it is simply not prudent to assume that everything will turn out for the best".
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