A miraculous error
Martin Wolf, FT, September 29 1999

The Federal Reserve inadvertently allowed unsustainable growth in the US, but this helped to offset the collapse of demand elsewhere and avoid deep world recession

A year ago, President Bill Clinton told annual meetings of the World Bank and International Monetary Fund that the world faced the greatest economic crisis since the second world war.

Yet now the IMF, in its latest World Economic Outlook, remarks that it will turn out, instead, to be the "mildest of the four slowdowns in the world economy in the past three decades". If the IMF proves right, at least two questions arise: first, why did what many feared would be a devastating hurricane turn out to be no more than a minor storm? And, second, has it passed?

The worries were pardonable. Between the devaluation of the Thai baht in June 1997 and that of the Brazilian Real in January of this year, virtually everything that could go wrong did so. Then, suddenly, the storm passed. The IMF now forecasts global growth this year at about 3 per cent, three-quarters of a percentage point higher than in its WEO of last May. This means that growth never fell below the 2.5 per cent of 1998.

The worst impact was on Japan and on emerging market economies unlucky enough to have become dependent on imports of private, debt-creating capital and foolish enough to defend pegged exchange rates. There was little discernible impact on Africa and on China or India. It did not prevent growth in the euro-zone from accelerating from 2.4 per cent in 1997 to 2.8 per cent in 1998.

Above all, as Michael Mussa, the IMF's director of research, noted last week: "The US economy has supplied, over the past 18 months or so, roughly half of the total demand growth in the global economy."

Year-on-year growth in US domestic demand rose, remarkably, from 3.6 per cent in 1996 to 4.2 per cent in 1997 and then 5.2 per cent in 1998. It remained at more than 5 per cent in the first two quarters of this year.

The swift return to relative economic health in the crisis-hit economies cannot be ascribed to strong US demand alone. But US buoyancy provided the protection needed for domestic measures of financial restructuring, fiscal stimulus and interest-rate reductions to bear fruit. Above all, it allowed the needed external adjustment to occur in a context of global expansion, rather than contraction.

The IMF revisions since May reveal the extent of the turnround. Japan's output this year is now forecast to grow by 1 per cent, instead of the decline of 1.4 per cent then forecast. The four most afflicted members of Asean are outperforming expectations to an almost identical extent. The improvement in the Asian newly industrialising countries is bigger still, with growth at 5.2 per cent, against the earlier forecast of 2.1 per cent.

Virtually the only significant area not expected to do much better than last May is the euro-zone, principally because of disappointing performance by Italy and Germany.

Behind this return to growth is a successful shift in external balances. Newly industrialising and developing Asian economies together moved their combined current accounts from a deficit of $37bn in 1996 to a surplus of $113bn last year.

Over the same period, Japan increased its current account surplus from $66bn to $121bn. The principal counterpart to this huge combined shift was a deterioration of $92bn in the US current account deficit - one forecast to reach $187bn by this year.

Intriguingly, the US had started to record annualised growth rates of 5 per cent in domestic demand at the beginning of 1997, before the Asian storm was even a cloud on the horizon. New economy or not, the US is demonstrably unable to sustain growth at this rate. Yet, as it happens, this was a miraculously benign error by the Federal Reserve, one that offset the still more unexpected collapse of demand elsewhere.

If the US was the bulwark, is the protection it provides secure? This breaks down into two further questions: how likely is a sharp reversal in US performance and how well could the rest of the world cope?

Unhappily, behind the growth of US domestic demand lies behaviour that would, in any other economy, provoke serious concern. Even after their recent correction, equities are, in aggregate, extraordinarily highly valued. Ratios of private sector debt to gross domestic product are also higher than during the last recession. The private sector's financial deficit is expected to be more than 5 per cent of GDP this year (see chart), a level that preceded deep recessions in the UK and the Scandinavian countries at the end of the 1980s.

Monetary growth also continues to be strong, with broad money expanding 8 per cent over the year to August.

Unemployment, at 4.2 per cent of the labour force, is below rates that would have been considered consistent with stable inflation, until very recently. Inflation has been kept down, temporarily, by weak commodity prices, by global excess capacity for many manufactured goods and by a high real exchange rate.

Growth of domestic demand has also spilled over into the current account, which has deteriorated from a deficit of less than 2 per cent of GDP in 1997 to a forecast of 3.5 per cent this year, virtually the same as in the mid-1980s.

Economics is no exact science. But, taken together, these facts spell trouble. Each and every one can be explained away. But the vulnerabilities - to a rise in inflation, to a fall in the dollar, to a collapse in equity markets - are also self-evident.

Demand growth will certainly have to slow. The question is whether this will be a smooth slowdown, as the WEO forecasts, with the rates of economic growth and domestic demand down to about 2.6 per cent next year, or will it be more abrupt and painful.

The private sector imbalances strongly suggest the latter. The strength of the public sector finances and the level of short-term interest rates suggest, however, that strong policy action could yet ensure the former.

The least that can be said is that a big slowdown in demand, a weak dollar and a sharp turnround in the external balance are far from negligible possibilities. Outright recession cannot be ruled out. For a country on the verge of achieving, at the beginning of the next millennium, the longest sustained expansion in its recorded history, this would be quite a shock.

How much of a shock would it also be for the rest of the world? A significant one seems to be the answer. The WEO's "harder landing" scenario has US domestic demand running at more than 3 per cent of GDP below its "baseline scenario" for three years. This generates a 1.9 per cent shortfall in US GDP in the first year, a 1.5 per cent shortfall in the second year and a 0.8 per cent shortfall in the third.

In the euro-zone, the impact is a shortfall of 1.2 per cent, 0.6 per cent and 0.4 per cent, respectively. In Japan, it is 1.1 per cent, 0.8 per cent and 0.5 per cent. For the world as a whole, it is 1.2 per cent, 0.8 per cent and 0.6 per cent.

Such numbers are less revealing than the underlying economics of the adjustment. A slowdown in US domestic demand and consequent turnaround in its current account deficit would need to be accommodated elsewhere.

In the rest of the world, demand would need to rise, relative to output. If demand were not to adjust upwards, output would necessarily adjust downwards. Yet demand is unlikely to adjust upwards spontaneously. There would have to be action. Where it would come from?

Emerging market economies should be able to reduce external surpluses or, at least, stop shrinking deficits in coming years. That is what the IMF expects. But these countries are unlikely to be able to finance big expansions in current account deficits in the near term.

As for Japan, despite the recovery in its economy in the first half of this year, the sources of domestic demand are weak. This makes it unfeasible for Japan to combine reasonable growth with a big reduction in the current account surplus, now forecast at 3.4 per cent of GDP this year and 3.1 per cent in 2000.

The yen appreciation of autumn 1998, and again over the summer and early autumn of this year, has been helpful to recovery in Asia's emerging market economies. It is also likely to shrink the Japanese external surplus. Unfortunately, it will do so by squeezing output, possibly reversing the fragile return to growth.

This leaves the euro-zone, with its current account surplus forecast at 1.2 per cent of GDP in 1999 and 1.4 per cent next year. If the balance between the growth in US demand and output were to shift sharply, the euro-zone is certainly in the best position to offset it. But an appreciation of the euro against the dollar would have a negative impact on euro-zone output.

Happily, there is room for offsetting monetary and fiscal action, with the structural fiscal deficit in the euro-zone down to about 1 per cent of GDP this year and inflation modest. Whether either would be taken with sufficient speed to offset a big negative shock emanating from the US is an open question.

Today, the world economy is indeed in an encouragingly widespread recovery. But threats remain. The biggest emanates from the very economy whose outstanding performance did so much to protect the world from the worst. The US and the euro-zone appear together to be in a good position to take any action needed to offset a big collapse in US private spending. The comforting official hypothesis is that they will succeed. Whether the recent global storm is gone for good will, in all probability, depend on whether the hypothesis turns out to be true.

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