Why fear of recession stalks the markets
Sunday 02 March 1997
You could catch it in the warnings from the world's two most important central bankers. Alan Greenspan, chairman of the United States Federal Reserve Board, told the Senate that he was concerned about "bubbles": a reference to the level of US share prices. And Hans Tietmeyer, president of the German Bundesbank, warned that European monetary union could spawn "dangerous" wage conflicts and higher unemployment if governments did not correct their fiscal deficits: a reference to Italian and Spanish membership of European Monetary Union.
The immediate market effect of Dr Greenspan's comments was the sharp response on Wall Street, concerned that there might be an early rise in interest rates. The immediate effect of Mr Tietmeyer's speech was a plunge in the Italian and Spanish currencies and bonds on the grounds that they would not be in the first round of EMU membership, if indeed EMU were to go ahead at all.
But while the world's markets are accustomed to hanging on the words of central bankers, all Dr Greenspan and Mr Tietmeyer were doing was to articulate what many others have been thinking for several months. In any case, the fear is something deeper than just a worry about US share prices or Europe's plans for a single currency. It is about the next recession.
I caught this fear in two conversations in London last week. One was with the economics team at Tokai Bank, a medium-sized Japanese bank best known for its links with Toyota. We found ourselves agreeing that there may have been a downward lurch in global inflation in the past six months, and that this could lead to recession in 1999 if policies were not sensitive to the danger.
The other conversation was with a friend who works for a London-based fund management group. "What is happening in Germany?" he asked. He, like many others, had become increasingly alarmed not just at the country's rising unemployment, but the difficulty Germany will have in making the big structural changes to its economy it must over the next 10 to 15 years. The point of the question was that he felt that, quite suddenly, things in Germany could go very wrong.
Are these fears justified? Has anything really changed in the past three or four months, or is it simply that towards the end of any long period of expansion, people naturally and properly begin to ask how it might end?
Some of the causes for concern are shown in the charts. On the left, you can see two examples of deflation, or "price destruction" as they call it in Japan. Both display the prices of consumer durables - cars, washing *machines, televisions and the like. As you can see, Japan has been accustomed for three years to the idea that prices of consumer goods fall, and that is one of the reasons the Japanese economy has found it so hard to recover from recession. But in the past year the same things seems to be happening in the US: there, instead of prices creeping up by a couple of percentage points a year, they have come down by a similar margin. The same sort of thing is happening in capital goods - things like business equipment and electrical machinery.
In several countries, falling prices have pushed the economy into stagnation. Switzerland is a good example. The problem there, as in Japan, is that even very low nominal interest rates do not stimulate the economy if falling prices mean that rates remain high in real terms. Comparisons with the 1930s are inevitable, for falling prices holding up real interest rates create the "liquidity trap" described by Keynes. For the moment this has not happened in the US or Europe, but the danger exists.
In continental Europe, the danger is compounded by the rapid tightening of fiscal policy needed to meet the Maastricht criteria. There are very good reasons why European countries, maybe even including the UK, need to cut their budget deficits, but you should do this in a period of strong growth, not weakness.
The centre graph shows how worried the German retail trade is about the business outlook, plunging back to the deepest gloom levels of the last recession. In the face of weak consumer sales and rising unemployment, the German fiscal position has suddenly deteriorated, as the monthly running deficit total shows.
There is an immediate political effect of all this, in that neither France nor Germany seem likely to meet the 3 per cent fiscal deficit limit this year. It is still guesswork, but something around 4 per cent for both countries seems more likely. If this happens, German public debt starts rising not just a little above the 60 per cent total debt limit, but towards 70 per cent. Tokai Bank forecasts a German debt-to-GDP ratio of 69 per cent by 1998.
There is an amusing side effect of all this, which is that Britain's annual fiscal deficit may well squeak under the 3 per cent figure and thereby make the UK the only large European economy to qualify for EMU. But we should temper our mirth with the realisation that stagnation in the continental European economies is bad news for UK exporters and hence for our economy as a whole.
But this political fall-out is small stuff beside the potential economic fall-out. It becomes uncomfortably easy to paint a really gloomy scenario. It goes like this.
One. At some stage there is a sudden break in the US stock market, presumably following a rise in interest rates. Since many people in the US use mutual funds as bank accounts, the wealth effect knocks demand and triggers a (maybe mild) recession.
Two. This also triggers another downward ratchet in Japanese share prices, which undermines the financial position of the Japanese banking sector. The Japanese authorities step in and bail out the banks but pile on yet more public sector debt. This in turn undermines confidence and Japan dips back into recession.
Three. The large continental European countries tighten fiscal policy in a vain attempt to meet the Maastricht criteria and thereby push German and French growth down to about 1.5 per cent this year. Growth in the UK is fine through this year but tails off quite quickly in 1998.
Four. By the end of this year it is clear that 1998 is going to be difficult for the world economy as a whole, but the next global recession really bites in 1999. There is a recovery - there is always a recovery - but it does not get under way until 2001 and the early years of the next century are blighted by fairly slow growth.
Of course, that will turn out to be wrong. Things don't ever happen quite the way the scenario-painters predict. But official forecasters get things wrong too: disagreeable facts of economic life, like recessions, are hardly ever predicted by mainstream economists.
The purpose of this sort of scaremongering is to remind people of two things. The first is that the economic cycle does still exist and that therefore at some stage in the next four or five years there is likely to be another recession. The second is to point out that this recession will take place in a very different global economic environment than any downturn since the Second World War. It will take place in a world of stable or maybe even declining prices.
Does that mean we are facing a 1929-type crash and depression? Not really, for that period really was exceptional. The outlook is much more akin to the economic downturns of the last century when, in the long term, economic progress continued but was interrupted from time to time by sudden downswings. Just as it took a generation after the last war for people and companies to learn to adjust their economic behaviour to a world of rising inflation, so we will take years to adjust to a world of stable prices. Stable prices are fine, for they ultimately help to establish a base for more stable growth. But the transition is difficult; and it is that transition we are making now.
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