A global game of dominoes

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A global game of dominoes Aug 23rd 2001 From The Economist print edition

The world economy is probably already in recession. How bad might it get?

ONE by one, economies around the world are stumbling. By cutting interest rates again this week—for the seventh time this year—the Federal Reserve hopes it can keep America out of recession. But in an increasing number of economies, from Japan and Taiwan to Mexico and Brazil, GDP is already shrinking. Global industrial production fell at an annual rate of 6% in the first half of 2001.

The picture may soon look even worse. Early estimates suggest that gross world product, as a whole, may have contracted in the second quarter, for possibly the first time in two decades. Welcome to the first global recession of the 21st century.

So far, America itself has escaped a technical recession, defined as two quarters of falling GDP. But on August 29th revised figures are expected to show that America's GDP growth in the second quarter was close to zero or even negative, rather than the 0.7% annual rate originally announced. With GDP growing well below trend for several quarters, profits tumbling and unemployment rising, it now smells horribly like a recession.

As yet there is no sign of a V-shaped bounce-back in America

America's index of leading economic indicators has risen for four consecutive months, suggesting that the worst may be over. But as yet there is no sign of the V-shaped bounce-back in the economy that most economists had promised earlier this year. The 32% fall in new orders for electronic goods in the year to June signals that capital spending will plunge further as firms respond to weak profits and excess capacity. The Fed's “beige book”, a monthly survey of economic activity, suggests that the manufacturing slump is now spreading to the rest of the economy.

So far, the consumer has kept the American economy ticking along—partly thanks to rising house prices, which have cushioned household wealth against the drop in share prices. But retail sales were flat in both June and July, down from an annual growth rate of 10% in early 2000; and consumer credit fell in June. Many commentators argue that America can still avoid recession, so long as consumer spending does not collapse. But 1982 suggests otherwise: America then had its deepest recession since the 1930s, yet consumer spending continued to grow, offset by plunging investment and exports.

Consumer spending may soon perk up as tax-rebate cheques drop through letterboxes. But worries about jobs could lead workers to save the money instead. The jobless rate has risen by 0.6 percentage points since last October, and recently announced huge layoffs imply that it will rise further. Goldman Sachs forecasts a rate of 5.2% in 2002, up from 3.9% last year. Unemployment has never previously risen by this much without there being a recession.

Nowhere is safe Earlier this year, when America first sneezed, the European Central Bank (along with most private-sector economists) argued that the euro area was insulated from America's slowdown and had little to worry about. This seems to have been wrong. In Germany there are fears about recession as business investment and retail sales tumble. The blame lies with weaker domestic spending rather than exports. New figures this week confirmed that Germany's GDP stagnated in the second quarter. But the Ifo survey of business confidence was better than expected in July, rising for the first time this year.

Italy's GDP fell in the second quarter, and although growth has held up better in France and Spain, most economists reckon that growth in the euro area as a whole was close to zero in the quarter. Nobody is forecasting an actual recession in the euro area this year, but it is no longer expected to provide an engine for world growth.

As for Japan, it is probably already in recession. Japan's GDP grew slightly in the first quarter, but only because consumer spending was boosted by the introduction of a new recycling law which encouraged households to bring forward purchases of fridges and televisions. Goldman Sachs reckons that figures due on September 7th could show that GDP fell at an annual rate of as much as 6% in the second quarter, and the contraction has almost certainly continued into the second half of the year.

In Japan, persistent deflation continues to weaken spending

Persistent deflation continues to weaken spending by increasing the real burden of debt and encouraging consumers to put off spending. A revised measure of Japan's consumer-price index, due to be published next week, is likely to show that deflation is worse than had been thought. The new index will include more up-to-date weights and new goods whose price has fallen sharply, such as personal computers and mobile-phone charges.

Worries about a deflationary spiral prompted the Bank of Japan to announce last week that it would pump more liquidity into the economy, increasing banks' reserves at the central bank and buying more government bonds. It was a step in the right direction, but probably not enough to drive away deflation. The government's plan to cut public spending is also likely to depress the economy.

If one assumes that growth in the second quarter was close to zero in America and the euro area, and that Japan contracted sharply, the combined GDPs of the rich economies will have contracted for the first time since late 1990. But, unlike 1990, a growing number of emerging economies are also sliding into recession.

United we fall Some of the numbers coming out of East Asia are truly scary. Singapore and Taiwan have both seen two quarters of shrinking GDP. Singapore's fell at an annual rate of 11% in the first half of the year, Taiwan's at a rate of 6%. South Korea's economy has slowed sharply, and second-quarter figures are likely to show that Malaysia and Thailand are also dangerously close to recession. J.P. Morgan estimates that emerging East Asia, excluding China, contracted in the second quarter and will do so again in the third quarter.

East Asia's problem is that the region had been over-reliant on exports of information technology (IT) equipment to the United States. America's IT investment boom allowed the Asian economies to recover much faster than expected from their financial crisis in 1997-98, but as the boom has turned to bust they are now being dragged down. Taiwan's total exports fell by 28% in the year to July. As well as a collapse in exports, Asia also faces a huge overhang of capacity and hence the risk of a sharp plunge in investment.

Although America's slump may be the main culprit, the former East Asian tigers also have themselves partly to blame. The strength of their rebound bred complacency about the need for structural reforms, such as cleaning up banks and cutting corporate debts. As a result, the growth in domestic demand has been relatively weak, making economies even more dependent on exports. South Korea's exports of goods and services jumped from 30% of GDP in 1996 to 45% last year; Thailand's from 39% to 66%. Asia is thus more exposed to a global slump than ever.

In Latin America, Argentina and Mexico are already in recession and Brazil looks likely to follow after its GDP fell at an annual rate of 4% in the second quarter. Argentina's problems stem from the peso's rigid link to the dollar, which has eroded competitiveness and forced up interest rates on its massive debts. Brazil has been hurt by financial contagion from its neighbour; Mexico's headache is that its exports to America amount to 25% of its GDP. Mexico's GDP has now fallen for three quarters in a row.

There are some exceptions around the world of economies that seem relatively untouched by the global downturn. For example, although China's growth slowed to an annualised 5% in the second quarter, it is still tipped to grow by almost 8% for the year as a whole, and India by 5%. But with output flat or falling in the second quarter in economies that among them account for two-thirds of world output, the world may already be in recession (see chart 1).

The most striking aspect of the current slowdown is that it is more widespread than in previous world slumps in 1975, 1982 or 1991. Those three years were all officially designated as world recessions, yet global GDP growth ranged between 1.2% and 1.9%, as recession in some parts of the world was offset by growth elsewhere. (This is why growth of 2% or less is generally considered to be a world recession.) In 1975, even as the jump in oil prices pushed rich economies into recession, Latin America and Asia remained relatively strong. In 1990-91 America went into recession, but Japan, Germany and most emerging economies continued to boom.

The world economy grew by 4.8% in 2000, its fastest since 1984, and most economists had expected 2001 to be another bumper year. Even those who predicted a hard landing for America's economy did not expect the whole world to slump with it. The downward revisions to 2001 growth forecasts have been unusually abrupt (see chart 2)—and they are probably still too rosy. What went wrong?

At least four negative forces have driven the global slowdown:

• First, and most important, the global IT boom has turned to bust. It was obvious last year that America's IT bubble was bursting as the Nasdaq collapsed and dotcoms went bust, but it was not widely appreciated that this was much more than just a narrow bubble in Internet stocks. Instead, “new economy” hype had distorted the global tech sector and unbalanced the entire American economy.

Over-exuberance about future profits and cheap capital had encouraged a lot of overinvestment, especially in IT. The consequent collapse in capital spending this year has hammered IT manufacturers at home and abroad. In the second quarter, business investment fell by an annualised 15% in America and by an estimated 18% in Japan, according to Morgan Stanley.

• A second and related dampener on growth has been the collapse in stockmarkets everywhere, which has eroded households' wealth and hence their desire to continue spending at the pace of last year. The 28% average fall in share prices since early 2000 has wiped $10 trillion off global wealth. Stockmarkets have fallen by even more in Europe and Asia than in America. Households in Europe hold fewer shares than their American counterparts, so the wealth effect on consumers is smaller. However, the plunge in share prices has seriously dented business confidence and investment plans.

A recent study by the IMF found that, whereas changes in the value of non-tech shares have little impact on consumer spending or investment in Europe, each dollar increase or fall in the value of tech shares has as big an impact on investment and spending as in America. This may explain why the bursting of America's tech bubble has dented Europe's growth by more than expected.

• The jump in energy prices last year reduced real incomes in oil-consuming economies and squeezed firms' profits. The economic impact of higher oil prices has been smaller than in the 1970s, because rich economies today use only half as much oil per dollar of GDP as they did. Nevertheless, higher oil prices have clearly reduced global growth.

• Last, but by no means least, the spillover from America's downturn to the rest of the world has been more powerful than in the past. As the world economy has become more integrated, a downturn in one economy spreads faster to another. During the past few years the world was hugely dependent on America as an engine of growth. Stephen Roach, at Morgan Stanley, reckons that the United States accounted for two-fifths of world GDP growth over the past five years, either directly or indirectly by sucking in imports from other countries. That dependence left the world more vulnerable to an American slump.

Economies have become more closely connected to America through trade, global supply chains and multinationals. Over the past decade world trade has grown 2.3 times as fast as world GDP, compared with only 1.4 times in the previous two decades. American imports now amount to 6% of the GDP of the rest of the world, twice as large as in 1990. But in the first half of this year, American imports fell at an annual rate of 13%; imports of IT equipment fell at a rate of almost 50%.

Industrial supply chains have become increasingly globalised as firms in rich economies outsource production to cheaper places, such as East Asia. Two-fifths of the growth of non-Japan Asia in 2000 was due to an increase in IT exports to America. But conventional trade statistics understate the increase in business linkages, because multinationals are playing a growing role. In 1998 the local sales of American affiliates of German firms were nearly four times their exports to America. So the slump in America has squeezed parent companies' profits. American multinationals have also responded to the slump at home by trimming output and jobs in Europe and Asia, transferring the blight from one region to another. Similarly, Fujitsu, a troubled Japanese electronics firm, has just announced that it will slash 16,400 jobs, 10% of its global workforce. Most of the cuts will be outside Japan.

During the good times, the increased interconnections of economies allowed other countries to share in America's boom. Now, however, America is exporting some of its recession abroad by importing less. In turn, economies hurt by America's downturn buy less from the United States and the rest of the world, which depresses demand further. In the first half of this year, Asia's exports and imports both fell by around 20% at an annual rate (see chart 3). Indeed, global trade is screeching to a halt. The Economist Intelligence Unit, a sister company of The Economist, forecasts that growth in the volume of world trade will drop to only 3% this year, from 13% in 2000. That would be the sharpest slowdown since 1975.

The long and the short of it How long will the world economic downturn last? Most economists still expect both the American economy and the world economy to bounce back by the end of this year. Goldman Sachs, for instance, reckons that global economic activity will reach a trough in the present quarter. However, it expects a sluggish recovery.

There are two reasons for optimism. First, largely thanks to the cut in American short-term interest rates from 6.5% to 3.5%, the money supply in rich economies has accelerated sharply. If monetary policy worked with the same lags as in the past, the world could look forward to a strong rebound next year. Second, oil prices have fallen, pulling down inflation and pushing up real incomes and profits.

This downturn is part of an investment boom-bust cycle, different from other economic cycles since the second world war

But unfortunately, the balance of risks lies on the downside. Top of the list is the risk that America may go into recession as rising unemployment curbs consumer spending. Were the dollar to go into freefall, as opposed to a measured decline, that too could cause a collapse in economic confidence. America's economic downturn is also likely to last a lot longer than had once been expected. It is different from other economic cycles since the second world war. Typically, recessions have been caused by high interest rates imposed to fight excess demand and inflation. Instead, this has been an investment boom-bust cycle, more like recessions before the war. In investment-led cycles, interest-rate cuts tend to be less effective in spurring demand until excess capacity and debts have been reduced.

Then there is the risk that Argentina might yet default on its debt. This week the IMF agreed to a new $8 billion loan for Argentina. But it is only a stopgap. The fiscal austerity required to meet the IMF‘s conditions are likely to prolong Argentina's recession. The good news is that the risk of widespread contagion from Argentina to other emerging economies may be smaller than a few years ago. Most emerging economies have larger foreign-exchange reserves, less short-term debt and floating exchange rates. Investors also seem to discriminate more among borrowers. However, if Argentina does eventually default, other emerging economies would surely suffer.

Perhaps the biggest downside risk is that American share prices still look overvalued. Indeed, the recent downward revisions to both productivity growth and total profits as measured in the national accounts has increased the likely extent of that overvaluation. One of the success stories of the new economy was supposedly the surge in productivity and profits in the late 1990s. But official number crunchers have recently rewritten history. It turns out that productivity growth was a bit less miraculous than first thought, while the profits boom of the late 1990s was mostly an illusion.

The new figures, which take account of the true cost of stock options, show that profits have been falling as a share of national income since 1997. The reductions in productivity growth make analysts' forecasts of long-term profits growth—and hence share prices—look even more ridiculous. They also suggest that America's sustainable rate of GDP growth is well below what it has enjoyed in recent years.

The risks of a deeper global slump remain high. But even if America avoids a recession this year, it is unlikely to return soon to the go-go days of recent years. Many American investors and consumers have yet to wake up to this fact.

http://www.economist.com/finance/PrinterFriendly.cfm?Story_ID=748689

-- Martin Thompson (mthom1927@aol.com), August 23, 2001

Answers

From the same magazine, The Economist:

World economy: Get a parachute

Aug 23rd 2001

From The Economist print edition Copyright, Fair Use for Education and Research Only

The world economy may be in a recession already Ronald Grant FOR the seventh time this year, America's Federal Reserve has cut interest rates, this time by a quarter-point to 3.5%, leaving the federal-funds rate a full three percentage points lower than at the start of 2001. Americans hope that Alan Greenspan, the Fed's chairman, is doing enough to prevent a recession. But for some it is too late. The sharp slowdown in America has already caused a recession, maybe not at home, but in Mexico, Singapore, Taiwan and elsewhere. In more and more countries around the world output is now stalling, if not falling. Total world output probably fell in the second quarter for the first time in two decades (see article).

America's GDP growth in the second quarter is widely expected to be revised down next week to zero or even negative, and although there are signs that the economy may be close to a trough there is little sign of a rebound. Meanwhile, the news from around the rest of the world is getting gloomier. In the second quarter, Germany's economy stagnated, and growth in the euro area as a whole was probably not much above zero; Japan's economy saw a steep decline; and many economies in East Asia and Latin America are slumping alarmingly.

The current global slowdown differs from others in the past half- century in three ways that may determine its outcome. The most striking is that economic weakness is more widespread than in previous downturns. In the 1991 “world recession”, for instance, the American economy sank, but Japan, Germany and emerging East Asia continued to boom, helping to cushion world demand. So far this downturn is not deep, but it could be the most synchronised since the 1930s.

Therein lies the biggest risk. Economies have become increasingly integrated through trade and investment in recent years, to their great benefit. But the downside to this globalisation is that the economic slowdown around the world is now proving self-reinforcing, magnifying the initial fall in demand. As investment has collapsed in America and Japan, those countries have slashed their imports from East Asian producers. But weaker demand in Asian countries is causing them in turn to trim their imports, not just from America and Japan, but also from Europe. The chances of a prolonged American (and global) downturn have thereby increased considerably.

The second big difference has, at least superficially, more positive implications. In contrast to previous world recessions in the past three decades, inflation is low. This means that there is plenty of room to ease monetary policy. Furthermore, America entered this downturn with a large budget surplus, for the first time since the 1970s. That surplus has made possible the tax cuts which—with lucky timing—are now going out to households and may yet help to prop up consumer spending. The scope for monetary and fiscal easing offers one reason to hope that America can avoid a deep recession.

The snag is that the money-transmission mechanism, through which interest-rate cuts affect the economy, seems to be partly blocked. There is always a lag of 6-12 months before monetary policy has its main impact, but it traditionally works through lower long-term bond yields, higher share prices and a weaker dollar. Yet since the Fed started to cut interest rates, long-term rates have fallen only slightly, share prices have declined and the dollar, despite its recent drop, is still stronger than it was at the start of the year. The awkward truth is that monetary conditions have hardly eased.

Where interest-rate cuts have helped to sustain demand is through the housing market. House prices in America are rising at their fastest pace for more than a decade. This has cushioned consumer wealth from the fall in share prices and encouraged households to refinance mortgages, allowing them to keep up their spending. But how long can house prices remain buoyant if company layoffs continue at their current pace? If house prices crumble, so surely will consumers.

At least the Fed is doing everything it can to prevent a recession. Sadly, the same is not true of policymakers in the euro area and Japan. The European Central Bank has cut interest rates only once this year, to 4.5%. Falling inflation and a strengthening euro mean that it no longer has any excuse: the ECB should cut rates again at its meeting on August 30th. Another problem is fiscal policy, as slower growth is swelling governments' budget deficits. This is right and proper during a downturn, but it risks pushing deficits above the ceiling laid down in Europe's “stability pact”. The pact should be scrapped (see article).

Japan, too, risks exacerbating its deflationary slump if the government goes ahead with its plan to cut public spending. Budget cuts can wait until the economy perks up. The Bank of Japan, on the other hand, needs to act now to halt deflation, by pursuing a far more aggressive monetary easing. Sadly, since 1990 it has offered a useful lesson to other central banks around the world on how not to handle the bursting of an investment bubble.

Vicious cycle

The third way in which this downturn may differ from previous ones is that it has not been caused by a collapse in demand after central banks have raised interest rates to fight inflation. Instead, it is an investment-led downturn. America's long expansion in the 1990s encouraged rosy expectations about future growth and profits, encouraging over-investment financed by heavy borrowing. When there is excess capacity and an overhang of debt, interest-rate cuts tend to be less effective in reviving demand. Investment-led recessions, which were common before the second world war, tend to be deeper and to last longer because it takes longer to purge financial excesses and over-capacity than it does to tame inflation.

Worries that America's downturn may be more protracted than originally expected are largely to blame for the recent slide in the dollar. Some commentators are even calling for policymakers to push the dollar lower to help America's shaky economy. A modest further fall in the dollar against the euro alone might be beneficial. It would support American demand and, by helping to reduce inflation in the euro area, also make it easier for the ECB to cut interest rates.

However, a plunge in the dollar against all the main currencies would be dangerous. To the extent that a sharp fall in the dollar reflected fading faith in America's economic prospects it would further undermine confidence and knock share prices, which could weaken consumer spending. A free-falling dollar would also make America's huge current-account deficit harder to finance, and might thereby limit the Fed's room to cut interest rates again. Meanwhile, an abrupt rise in the euro and the yen would squeeze their economies, as America exported its recession. Japan desperately needs a weaker, not a stronger yen. With interest rates in Japan already at zero, the exchange rate is one of the few channels through which monetary easing can still work.

No investment bubble has ever burst without causing a serious economic downturn. Even if America avoids an outright recession, its slowdown is likely to be prolonged. The crude manipulation of exchange rates cannot prevent global recession. Instead, and until economies look rosier, central banks should keep easing monetary policy and governments should be more flexible over their fiscal policies—and all should keep their fingers firmly crossed.

-- Robert Riggs (rxr.999@worldnet.att.net), August 24, 2001.


Yup, when you want the straight scoop on the world ecoonomy it's hard to beat The Economist.

-- Chance (fruitloops@hotmail.com), August 24, 2001.

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