The week that showed us the future

t was the week of the double whammy, wasn't it? Blow number one came from Dr Alan Greenspan, who said in testimony to Congress on Wednesday that the fall in unem- ployment in the US "suggests the economy has been on an unsustainable track". Blow number two came from the Bundesbank, which jacked up interest rates on Thursday, prompting follow-my-leader increases from other European central banks.

The markets, understandably enough, were perturbed by the juxtaposition. This year has seen the strongest growth in the world economy for more than a decade. But it has also seen the economies of the East Asian time zone struck by currency instability and what looks like a sharp fall in demand. Now we are warned that the present rate of US growth cannot continue, and we have a signal that the continental European interest-rate cycle has turned up at last.

It is time to stand back and take stock. We have had a middling-sized shock with the East Asian problems, similar probably to the Latin American debt crisis of the early 1980s but not as serious as either of the oil shocks of the 1970s. We have had a statement from the head of the Federal Reserve, but only a state- ment. And it looks as though we have had the inevitable turn in the European interest-rate cycle, but this does not necessarily herald a dramatic climb.

Not much new can be said at this stage about the East Asian shock, because it will be several months before anyone will know whether the financial ructions will translate into serious economic damage. There will of course be some economic damage, but that may not extend far beyond the region. There are, however, some new things to be said about America and Europe - America first.

The dilemma facing the US authorities is shown in the graph on the left. Consumer confidence has been whizzing up, reflecting the scale of the boom; the price of consumer durables, on the other hand, is actually falling. You may have noticed that the new car ranges in the US this season are priced below those of last season - something that has not happened for a generation. It is the low-inflation boom.

The dilemma is this: the Federal Reserve needs somehow to try and take the steam out of the US economy, but it has no obvious mandate while inflation is so low. Or rather while inflation of current goods and services is so low; asset-price inflation is very high if you take securities prices as a measure. The result is that Dr Greenspan has, at this stage at least, to use words rather than deeds. The deeds can come later.

The Bundesbank has a different dilemma. The German economy has managed a decent, export-led recovery this year. But it is jobless recovery, with the economy still losing employment in a country with 4.5 million people out of work. There were two possible reasons why it felt it had to move rates last week. The obvious one was the upward nudge in producer prices (see right-hand chart), which was threatening to push up consumer prices. The other - suggested by many people in the financial markets but not necessarily correct - was the need to work towards an interest rate suitable for the rest of continental Europe. If exchange rates for conversion into the euro are indeed to be fixed next spring, and the political pressures to keep this timetable are very considerable, then interest rates will have to be harmonised ahead of that date. Maybe the Bundesbank is letting general European interests influence its judgement, rather than specific German ones.

So both the American and the European blows are modest and rational, easily explained in the context of current issues. Why the shock? I think the answer is that they have reminded people who should not have needed reminding that there is rougher water ahead.

At some stage, the US economy has to come off the curve. It has somehow to make the transition from rapid growth to ordinary growth, and as a consequence at some stage in the next 18 months the unemployment figures will be going up instead of down. That will affect consumer confidence and domestic demand, which in turn will affect corporate profits. At the moment, this simple reality - however obvious it might seem - is not at the front of people's minds.

As for the continental European economy, it will continue to fight into a head-wind of tighter fiscal policy, (slightly) rising interest rates, and stagnant domestic demand through next year. Optimists believe that exports will continue to pull it along. But who is going to buy those exports? The US? Not if growth slows down. Japan and East Asia? Not a hope. Fringe Europe, countries such as the UK and Sweden? To some extent, but they are not big enough.

Add to this the possibility, as my colleague Peter Koenig discusses on page 2, of a break in US share prices and suddenly the balance of probabilities for the world economy over the next 18 months seems chillier. The financial world always divides into bulls and bears, optimists and pessimists, but until a few days ago the tide of enthusiasm - what Dr Greenspan described nearly a year ago as "irrational exuberance" - dominated all. Now the balance is more even.

So how then should the rational (we'll leave the irrational variety aside) optimists take the week's news? I think they would argue that the private sector in both North America and Europe has really lifted its game in the last three or four years; that the companies really are better managed than before and are applying new technologies to im- prove customer service in a dramatic way; they would also point to the continuing downward pressure on world prices that is forcing them to do this. They would welcome a pause for breath at this stage of the expansionary cycle, and would expect a sustained growth path both in North America and particularly in Europe next year.

The rational pessimist, on the other hand, would focus on the threat of global deflation. Even if the US manages to adjust to slightly slower growth, and even if the European economies are sensibly managed through the next 18 months, 1998 is going to be a much tougher year than 1997. True, momentum for the world economy is exceptionally strong and momentum matters. But that may simply roll back the downturn into 1999 or 2000.

It is quite hard to appreciate that we are only just a couple of years off the Millennium; quite hard to accept that the rules of the financial game in the new century may be very different from those of the second half of the present one. Most crucially, I think markets, companies and certainly governments, will find it hard to accept that we may be facing a long period of falling prices - as occurred in the last century. Unease about the magnitude of change has been missing from the financial scene in recent months, and that was why last week came as a surprise. I may be wrong, but I think that this was an important week.

Copyright: IOS & Bloomberg

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