[OPE-L:7377] Recovery myths

From: Rakesh Bhandari (rakeshb@stanford.edu)
Date: Wed Jun 12 2002 - 18:25:34 EDT

Financial Times (London) June 12, 2002, Wednesday

Copyright 2002 The Financial Times Limited
Financial Times (London)

June 12, 2002, Wednesday London Edition 1


LENGTH: 1310 words

HEADLINE: The recovery myths: The view that the US has now led the world
through the worst of the post-boom trough is comforting but false. In truth,
the adjustment has barely begun, says Martin Wolf:


The world economy is coping with the aftermath of two huge asset-price
bubbles: the Japanese of the 1980s; and the US-led worldwide bubble of the
second half of the 1990s. Adjustment to the end of the first is not yet
over. Adjustment to the end of the second has, contrary to conventional
wisdom, hardly begun.

According to that wisdom, the world's largest economy is leading the rest of
the world into a durable, if restrained, recovery after a surprisingly brief
and shallow recession. Yet this may turn out to be no more than a fairy
story for frightened children. Recent falls in the stock market and the US
dollar suggest the children are unconvinced. At its closing price of 1,031
on Monday, the Standard & Poor's 500 was only 7 per cent above its
post-September 11 low and 33 per cent below the peak reached in March 2000.
Similarly, on a trade- weighted effective basis, the dollar had lost 6 per
cent of its value since its peak on January 25 2002. To understand the risks
ahead, it is necessary to analyse where the world economy now is in its
post-bubble adjustment. Between 1996 and 2000, the US economy generated 40
per cent of global incremental real demand (at market exchange rates). While
US real domestic demand rose 26 per cent over those years (a compound rate
of 4.7 per cent a year), output grew by 22 per cent (a compound rate of 4.1
per cent). The difference was the rise in the US current account deficit, to
4.5 per cent of gross domestic product in 2000.

This expansion was unsustainable and, last year, came to an end. Symptoms of
excess were, as Brian Reading of London-based Lombard Street Research
argues*, too much investment, too little saving and too big a current
account deficit. Behind these three phenomena was belief in the miracle of
the "new economy", as demonstrated by asoaring stock market, huge capital
inflows and a surging dollar.

Over the past year and a half, the US economy and, given the global role of
the US, the world economy, has begun its post-bubble adjustment. Yet what is
remarkable about this period is how modest that adjustment has been.

On June 7, the price/earnings ratio for the overall stock market was still
close to double its long-run average. Measures of underlying value suggest
that the market is still more generously valued than at any period in the
past hundred years, apart from the peak of the recent bubble and in 1929. On
a trade-weighted basis, the US dollar is 35 per cent higher than in May
1995. Estimates of the real exchange rate suggest the dollar remains almost
as high as in 1985.

Last year, business fixed investment in the US was only 3.2 per cent below
its level in 2000. This year, it is forecast by Goldman Sachs to be down
only another 7 per cent. The resilience of consumption has been astounding.
Supported by rising house prices and low interest rates, real consumer
expenditure rose 3.1 per cent last year and is forecast by Goldman Sachs to
grow another 3.2 per cent this year. The personal sector's financial deficit
is still close to 4 per cent of GDP, against a historic postwar surplus
averaging just under 2 per cent of GDP. The US current account has also
barely adjusted. Last year, it was 4.1 per cent of GDP.

Alan Greenspan's Federal Reserve has, in effect, restricted the post-bubble
adjustment almost entirely to the corporate sector. It has propped up asset
prices and supported household borrowing and spending. The big question
today is whether it has durably averted or temporarily postponed that

The answer is that, however unpredictable its timing and speed, it is highly
implausible that adjustment can be averted for ever. That would imply a
continuation of extraordinarily low household saving. It would also mean an
explosive rise in the current account deficit. If the US were to continue to
grow faster than most of the rest of the world, the deficit could reach 5
per cent of GDP next year. Under plausible assumptions, net claims by
foreigners on the US would also rise from 20 per cent of GDP to 50 per cent
of GDP, or more, five years from now.

This looks inconceivable. A more natural outcome would be a weakening
dollar, weak domestic demand and an improving external balance. That change
could, in turn, be triggered by a diminished willingness of foreigners to
purchase US assets. The vulnerability is evident. As a gigantic net borrower
from the rest of the world, the US depends on foreigners to sustain the
value of its corporate assets and its currency. As London-based Smithers &
Co says, domestic corporate cash flow is now weak and US households have
been persistent net sellers of the stock market. This is, in part, to
finance the purchase of other assets, especially houses. If foreigners fail
to fill the gap, stock prices, as well as the dollar, must fall.

Further asset price adjustment is thus likely. If it coincided with
weakening household demand and if the adjustments, particularly in the
dollar, were slow and limited, it would also be helpful for the US. If, for
example, the trend rate of economic growth were to be 3 1/4 per cent a year
and domestic demand were to grow at, say, 2 3/4 per cent, there could be a
steady contraction in the current account deficit at half a percentage point
of GDP a year.

Instead of adding demand to the rest of the world, the US would then be
subtracting from it. The question is where this would be offset. The
eurozone has, alas, generated growth in domestic demand of more than three
per cent in only two years - 1997 and 1998 - since 1993. Growth in demand
averaged only a little over 2 per cent between 1993 and 2001. Over these
years, Japanese growth in demand averaged 1.2 per cent.

With Japan's room for manoeuvre limited, much would depend on the ability of
the eurozone to generate faster growth in demand. Without aggressive action
by the European Central Bank, that seems depressingly unlikely. It is at
least as plausible that weaker export growth and a strengthening currency
would undermine investment and consumption in the eurozone.

One can therefore envisage three alternative scenarios for the medium term.

First, there may be no significant further adjustment in the behaviour of
the US consumer or in US asset prices. In that case, the US would generate
strong additional demand for the rest of the world and even more un-balanced
household and national balance sheets. This would be a Gadarene rush for the
cliff. But that cliff may only be reached years from now.

Second, there may be smooth adjustment in US household behaviour and the
dollar. The latter would help offset weak demand at home by forcing
adjustment on the rest of the world. This scenario would be most beneficial
for the US but decidedly problematic for the rest of the world.

Third, there may be brutal adjustment in the near future, with a vicious
downward spiral in US and world equity prices, higher long-term interest
rates, an exodus of capital and dollar weakness. This would force a strong
reduction in investment and consumption in the US and an unpleasant
adjustment on the rest of the world. This would be the world of the double

None of these alternatives can be ruled out. But the second is preferable,
for both the US and the world. If the dollar were now set on a gradual
decline, that would be altogether helpful. Unfortunately, this scenario is
too rosy to be plausible. The true choice may be between going over a high
cliff some years from now or going over a rather lower cliff quite soon.

The consensus view is not necessarily wrong. There may be a US-led recovery
in the next year or two. But it is too short-sighted. The post-bubble
adjustment can only have been postponed. It would be better if adjustment
continued at a moderate pace right now.

*Monthly International Review 115, April 2002

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