The Asian clouds have a silver lining

There was a sudden shiver last week, the gust of wind that knocks the temperature and hints of further chill to come. You can measure the shift of perception by looking at the falls on the stock markets at the end of the week, particularly the sudden fall in Japan. But day-to-day share price changes are just one crude indicator of mood, worth watching (especially if you own shares) but not in themselves much help in understanding what is going on. They reflect the mood rather than explain it.

So a better starting point is what seems likely to be happening to the world economy in the near future. All forecasts should be taken with the usual pinch of salt, but those in the left-hand chart do give an indication of the way in which things seem to be deteriorating. They come from Kleinworts and show how the very sharp cut in Asian growth, including that of Japan, seems likely to hit the United States. Europe is least affected, though the middle graph showing how Germany's export competitiveness has declined vis-a-vis Asia suggests that the great engine of the German economy, exports, may find things tougher in the future.

The cyclical position of both the US and Europe has become more positive - the OECD lead indicator for growth of industrial production (right-hand graph) rose steadily through the year. But that is based on historical data and does not pick up the shock from Asia, because the shock has yet to hit the figures in the US and Europe. Meanwhile, the shock hits an already weakening Japan.

But this data is just a starting point. Here are some more intuitive comments on the likely pattern of growth next year for the three mature developed regions - the US, Europe and Japan - picking up this new cooler climate.

Start with East Asia. The fear a few weeks ago was that the fall-off in demand in the "tiger" economies might destabilise Japan. Provided that did not happen, the East Asian crisis was not a global systemic threat, but would merely be a very disagreeable two or three years for the over- borrowed countries like Korea. The balance of opinion was that provided it pushed though appropriate reforms, in particular securing its banking system, Japan would be okay.

Well, last week Japan did produce its latest package, which surprised because it included a one-off income tax cut. But within 24 hours the benefit from this surprise had been eroded and Japan was plunged back into gloom. I don't think yet that the contagion from the rest of East Asia will necessarily lead to actual recession in Japan next year, but the odds have undoubtedly shifted the wrong way.

Because Japan retains its cohesive society, the country will - in social terms - ride through the difficulty. Its exporters will be helped by the fall in the yen against the dollar, so at the price of an even-larger trade surplus with the US, there will be one cylinder of the growth engine firing. But that will not be enough. So there is now a very real possibility that Japan will suffer another recession next year, something that the official forecasts are not yet picking up at all.

The profile of Japan's economy next year? I am less worried about the first half of the year, when the tax cuts will pump a bit of demand into the economy, than the second half, when things really might go wrong in a big way.

As for the rest of East Asia, 1998 is going to be a very difficult year, and one made particularly difficult because young people in the region have little or no memory of hard times. It is perfectly possible to believe that the region will remain the most vibrant of the world economies - it has been contributing roughly two-thirds of all world growth this decade and may well be performing in the same manner in another five years' time - yet also believe that the next three years will see a serious regional recession.

And what of the US? So far the downgrades that have been published have been based largely on the first-order impact of East Asia: the extent to which a decline in export orders and a rise in import competition will hit US growth. What have not been factored in, because they are really guesswork, are the second- and third-order effects. For example, we have seen several US companies give profit warnings for next year as a result of the loss of exports. What we have not seen is much of a wider reassessment of a slowdown in US profit growth on share prices, and then the next-order impact of that on US confidence and hence growth. There was a hint of this at the end of last week, but only a hint.

As for Europe, we are the least-affected region. Sure, expect Korean firms in the UK to cut back a bit on investment, but that is not material to the economy. Expect, too, the vigorous continental export growth of the last year - the main thing stimulating the French and German economies - to fade somewhat. If that means unemployment in continental Europe fails to decline next year, so be it, but from the perspective of the UK you could almost argue that it might be a benefit. We have been expanding at above-trend growth, and externally generated vigorous deflation will help cut us back to trend.

And not just us. There is an interesting argument to be made that the chill wind from the east is what America needs too. The astounding thing about the US economy (and to a lesser extent our own) is the way in which several years of strong growth have not lead to much inflation.

An inflationary shock, like for example the two oil shocks of the 1970s, would come at just the wrong time - as did the first oil shock at the top of the Heath boom. Now we are about to experience an external deflationary shock, coming at just the right time. Commodity prices will be weak, the oil price will remain flat.

Maybe this deflation enables the booming economies of the US and UK to come off their growth curve in a benign way. We do not need to deflate so hard ourselves because someone else is doing it for us.

If this is right, what is bad news for Japan is good news for the US and UK. For the US, reluctant to face the pain of higher interest rates, downward external pressure on prices is certainly helpful. Here, unlike the US, we have increased our interest rates, so it is at least possible that if things slow very fast next year we will see rapid interest-rate disarmament.

None of this is to suggest that the meltdown in East Asia should be welcomed. To say that is not just to acknowledge that in human terms recession is always miserable; it is also to recognise that when things start heading downwards in one part of the world, they can cause a lot of collateral damage in another.

The world will have to live with powerful deflationary forces through into the next millennium, perhaps setting a tone for the century. We have had a century of great inflation by any historical standards. We start the next batting into a strong deflationary head-wind and, as far as the present boom economies are concerned, this happens to come at the least damaging point in the cycle.

If this is right, there are two messages in the air. One is that things will be cooler next year than this; the other is that while it will be unpleasant for some, there will be some silver lining for others.