The Nikkei Financial Daily (Market Eye Column). , 19th May 2006
The Managing Director of the IMF recently expressed the view that the world economy seemed well set for good growth this year, but that the underlying imbalances in the world economy had seldom been greater. Both these views seem, as can be expected from such an authoritative source, to be soundly based.
When the US stock market bubble came to an end in 2000, the subsequent fall in share prices could easily have been both the start and the cause of a severe recession. This was happily avoided by the response of governments and central banks, which gave a large stimulus to the world economy through a combination of easy fiscal and monetary policies. Taxes and interest rates were both cut.
These policies have been successful in their short-term aims, but they have aggravated rather than cured the underlying imbalances. As seems invariably to happen in bubbles, there was a huge expansion of debt in the latter years of the 20th Century and the subsequent policies have encouraged an even greater build up. But while, in 2000, the overvaluation of assets was largely confined to the stock markets of the US and Europe, it now includes almost all financial assets, including bonds, houses, property and gold, as well as shares.
Nearly all asset prices everywhere are extremely high relative to peoples’ income. To return to a more normal relationship, either asset prices must fall or inflation must return to give a boost to incomes. So, if inflation is to be avoided, there must be some sharp falls in asset prices. The problem is that whenever asset prices have had large falls in the past, this has been followed by a severe recession or a prolonged period of economic stagnation, such as Japan has suffered since 1990.
The policies of easy money and large budget deficits, which were introduced when the 2000 stock market bubble ended, were designed to avoid such economic malaise and they were successful. The risk is that the medicine, which has left the underlying problems unresolved, will become less effective over time.
Central banks have been happy to allow inflation to accelerate a bit in recent months, but it seems unlikely that they will allow this process to continue for much longer; they are already responding by raising interest rates. Unless enough has already been done, further increases must occur. In either event there must be some slowdown in world growth.
Even before the economy has slowed it is likely that asset prices, which tend to foresee troubles ahead, will have started to fall. As they do, we will probably have a sharp rise in household savings in the US. Over the medium- term this is both necessary and desirable, as such savings have fallen to near zero and, as they rise, a much needed improvement in the US current account deficit will become possible.
A rise in US savings will, however, cause world demand to fall. Unless this decline is matched by an increase in demand elsewhere the result must be general economic weakness worldwide. Such weakness will produce, as usual, a policy response and this can only be the same as the one we witnessed after the sharp falls in US shares that began in 2000. Governments will, presumably, increase their budget deficits and central banks will cut interest rates.
The key questions are first, whether the repeated dose will prove just as effective as it did last time and second, whether governments will be quite as willing to cut taxes as they were. In 2000 the US was running a budget surplus; today it has a large deficit, which is the subject of frequently expressed concerns by US politicians. It seems likely that these worries will make it much more difficult to implement tax cuts in response to the next downturn than it did last time.
It is of course possible that the world economy can be brought back into better balance without either a severe recession or a prolonged period of stagnation. Such a benign adjustment will require a fall in asset prices, which will hurt the rich and the elderly, who have been the major beneficiaries of the past rises, rather than the poor or the relatively young.