Financial Times (London) June 12, 2002, Wednesday Copyright 2002 The Financial Times Limited Financial Times (London) June 12, 2002, Wednesday London Edition 1 SECTION: COMMENT & ANALYSIS; Pg. 18 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: BYLINE: By MARTIN WOLF BODY: 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 adjustment. 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 dip. 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 LOAD-DATE: June 11, 2002
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