It just gets curiouser and curiouser

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The Independent Online
WHAT a long, strange trip it's been. World equity markets fell between 20 per cent and 50 per cent during the course of this year, down from record highs, amid fears of a global credit crunch and a global recession. Since 15 October, markets have rebounded vigorously. The Dow Jones achieved a new record high on 23 November and ends this week almost 6 per cent away. The Korean market, which fell by 50 per cent between March and the summer, is now 3 per cent away from its all-time high. Elsewhere, the picture is less good, but the FT-SE is only 10 per cent off its July high. Other European markets have fared less well, closing the week about 15 per cent to 20 per cent off their highs, but comfortably above the October lows.

The key date is 15 October, for it was on that day that Alan Greenspan, the Federal Reserve chairman, marshalled his colleagues on the Federal Open Market Committee (FOMC) into an atypical inter-meeting interest rate cut and, in so doing, successfully administered shock therapy to the world's ailing financial markets. Since then the Fed has cut rates for the third time, and the European Central Bank (ECB) has picked up the same hymn book and reduced European interest rates. And, of course, the Bank of England this week cut rates for the third time, taking base rates down to 6.25 per cent. All of this has prompted many people to ask nervously whether or not the Asian-cum-emerging-cum-global crisis is now over.

Sad to say - and at the risk of being unfestive - it isn't over. It's not that some of us economists are genetically programmed to be bears, but rather that the world economy and global stock markets have again become dysfunctional. We needed the equity market correction in late summer and we need it again. For the truth is that the fabric of the world economy remains unsustainably stretched, and world trade is falling fast. The risk of a global credit crunch (such as it was) triggering a global recession in 1999 has diminished significantly, but it is far too early to sound the all-clear.

To appreciate why, we have to keep reminding ourselves what this crisis is all about. It is about some combination of global excess capacity in a large number of sectors and industries and inadequate aggregate demand; it is about insolvency; and it is about a debt overhang. All of this is made worse by the fact that these conditions exist in a world that has a strong deflationary bias.

Japan has already succumbed to a nasty deflation and Europe is by no means immune. Producer prices have been falling for the past six months almost everywhere, and in the major European countries consumer price inflation is around 0.5 per cent on normal measurement and without the suspected overstatement. Even the higher headline inflation of 3.1 per cent in October in the UK is "old news" and is expected to plunge to less than 1 per cent by this time next year.

In the US, producer price changes have been negative on an annual basis for over a year, while consumer prices are running about 1.5 per cent higher than a year ago. And this is the starting point before the US and European economies slow down significantly over the coming year.

In Australasia recently, I detected signs that the Asian slump is bottoming out, but meaningful recovery is probably over a year away and even then at about half the growth rate of the pre-crisis years. The good news, such as it is, is that the region's balance of payments position has swung around sharply into a surplus of some $40bn (pounds 24bn) over the past 12 months.

There has been some pick-up in output growth in some countries - albeit from slump levels - while in South Korea, for example, the inventory cupboard is bare. Local interest rates have been falling since the US dollar fell sharply against the yen in October. However, there is no indication that domestic demand is going to recover significantly and the trade improvements really reflect the collapse in import demand. The turn in Asia will come only when governments seek more aggressively to stimulate domestic demand and when economic reforms, especially in the banking sector, become more real than rhetoric.

The perspective on Japan is as above, but writ large. The only economic data that are not falling are bankruptcies and unemployment. Despite the fact that Japan's general government budget deficit is close to 10 per cent GDP and that the Bank of Japan has reduced interest rates to the bone (0.25 per cent), Japan's lost growth decade isn't about to end. Next year, we forecast a contraction of 2 per cent after a decline of 3 per cent in 1998. Eventually, Japan is going to resort to the printing presses, but the worry is that she may have to be shocked into so doing. One such shock could be a further and perverse strengthening in the yen; another might be a further tumble in the Nikkei.

But what of the main industrial countries: the US and Europe? First, falling interest rates are an essential part of the adjustment process but it appears that we may need more rate cuts for less incremental growth for a while. The reason for this is because "this time, things are different". In all previous cycles since 1945, excess demand growth and inflation were the villains causing rates to rise. When they eventually came down, they stimulated leverage again and boosted the supply side of the economy and the cycle got underway again. This time, rates are falling as a reflection of chronic weaknesses and deflation in the world economy. Moreover, the world is deleveraging - a process that could take a couple of years - and there is no need for a new round of capital investment when we are awash with capacity.

Second, US monetary policy has as its principal focus the local capital markets, which in effect shut down for business in the early autumn. American corporations raise about 50 per cent of their credit via the capital markets and a seizure here could have easily precipitated a more serious economic accident. But the unintended beneficiary of this policy agenda has been the equity market - and this could continue for a while, even though the last few days' trading performance has been disappointing. But whatever it is, people are buying in US equities; it isn't valuation and it certainly isn't earnings prospects. The driver in this latest rally has been rate cutting and liquidity taking price-earnings ratios into bubble territory. Joining this bubble are two other inter-related bubbles: household spending that is being sustained by a negative savings rate, the stock market and a rising debt-to-income ratio; and a balance of payments deficit bubble on target for nearly 4 per cent GDP. Letting these bubbles down gently will not be an easy task. We should dread the day that a US recession causes these bubbles to deflate, but the crucial issues relate to how and when, not if.

Meanwhile, one of the agents for a change could quite easily be a surprise lurch down in the US dollar in the new year, coinciding maybe with Japanese monetary policy stubbornness and the birth of the euro. On the latter subject, let us note that while a strong euro will bring smiles to faces in Brussels, it could not come at a worse time for European companies and for the economy.

Third and last but not least, even if, as I hope and expect, we can avoid a global recession, there's enough economic damage already in the pipeline. Commodity prices, as noted above, are touching new lows and deflationary headwinds in the world are blowing strong. This week, oil prices fell back into single figures, the real oil price is as low as it has been since 1949 and commodity price indices are at 26-year lows. Manufacturing is already in recession and a profits recession is likely in the US, while Europe would do well to settle for severe compression. The profit warnings are starting to come through fast and furious on both sides of the Atlantic, most recently in two hitherto buoyant sectors: telecommunications and internet stocks. None of this is surprising in a world where we may still get some positive real GDP growth but where money GDP growth is continuing to grind down. In a low or non-inflationary world, low or falling nominal rates of activity make for tough trading conditions and cast a shadow over employment.

This isn't a particularly festive note on which to conclude. The long, strange trip is set to continue with two sets of additional uncertainties, namely the introduction of the euro on 1 January 1999 and the impact of the year 2000 problem on economic activity and financial markets. George Magnus is chief economist at Warburg Dillon Read.