US consumers keep the world out of recession

Gavyn Davies on the threats to global growth

Freddie Couples, a laid-back genius of an American golfer, recently played an important tournament in Japan. Leaving the 18th green, he was asked by a local reporter whether he enjoyed playing golf in Asia. "Asia?" said a puzzled Freddie. "I have never been there."

Sadly for the Japanese, Freddie's view of their geographical location is not shared by more more orthodox scholars. Quite clearly, the chronic long-term problems of the Japanese economy are being made much worse by its close proximity to the Asian meltdown. The key question now is whether the Asians will suck the rest of the world into recession with them.

A previous column in this series argued that the emerging market and Japanese domestic shocks might reduce GDP in the developed economies by about 0.6 per cent next year, and might reduce global GDP by about twice that amount. These are significant numbers, and are much higher than the rather complacent estimate of 0.2-0.3 per cent of GDP published last week by the OECD. But these Asian shocks need to be set against the context of a strong US consumer, with surging investment activity in America, and tentative signs of life in domestic demand in continental Europe.

One figure is telling in this regard: US domestic demand on its own accounts for 28 per cent of global GDP, whereas the combined GDP of Asia (ex Japan) and Latin America accounts for only 16 per cent. California alone is about the size of China and India combined. (All these figures are estimated at actual exchange rates. At exchange rates which more correctly reflected purchasing power parity, the emerging economies would appear larger than these figures imply, since several important currencies, including the Chinese yuan, are severely undervalued according to official statistical sources.)

The world may be moving into an era where the emerging economies are becoming increasingly important, but we should not go prematurely overboard on this. The motor for world growth is still located primarily in a handful of developed economies, though to a smaller extent than a decade ago. For example, if projections for domestic demand in the US and the EU are raised by 1 per cent next year, while the entire GDP of Latin America and Asia (ex Japan) is reduced by 3 per cent, then world GDP would be exactly unchanged.

In the past few months, this is broadly the pattern of the revisions to forecasts which has taken place. For example, since the onset of the Asian crisis in the summer, the Goldman Sachs forecast for domestic demand in the US next year has been revised up by about 1.2 per cent, while GDP in the Asian economies (ex China, India and Japan) has been revised down by 3.3 per cent, and Latin America has been revised down by 1.3 per cent. In addition, domestic demand in Japan has been revised down by a phenomenal 4.2 per cent. Consequently, weaker growth throughout the emerging economies and Japan has been partly offset by stronger domestic demand in the US.

Overall, the combined effect of these three revisions has been to reduce the level of OECD real GDP next year by only 0.3 per cent compared to Goldman Sachs' July projections, and to reduce world GDP by only 0.6 per cent.

However, while there should be no recession next year, the shocks which have hit the global economy in the past few months have genuinely increased the risks in the system, since it is increasingly apparent that domestic demand in the US remains too strong, while domestic demand in much of the rest of the world remains too weak. In the short term, the benign way out of this dilemma would be for the dollar's trade-weighted index to rise, simultaneously reducing inflation pressures inside the US and redistributing global demand to the areas that need it most (ie Asia and Europe). By holding down US inflation pressures, this might prevent a tightening in US monetary policy that would otherwise spell the end of the equity bull market.

The problem is that this benign process can only continue for as long as the strong dollar does not lead to excessive imbalances in the current account positions of the major economies. So far, this has not happened. Although there have been signs of a widening trade imbalance between the US and Japan, this has been more than offset by capital outflows from Japan, so the dollar has been trading at its 1997 highs against the yen. Furthermore, though the dollar has adjusted downwards against the European currencies, it has simultaneously moved sharply higher against emerging currencies, so the trade-weighted index for the US currency has also been trading at recent highs.

But trade imbalances between the US, Japan and the EU now look set to rise quite rapidly in coming quarters. It is possible that the threat of this will bring down the dollar quite quickly, in which case the dilemma facing Alan Greenspan's Federal Reserve will markedly worsen - they will either have to watch US inflation rise or tighten US monetary policy in an environment of great financial market turbulence. That will spell trouble for global markets.

Perhaps more likely, the dollar's trade-weighted index will continue firm for a while as emerging currencies and (possibly) the yen fall further against the US unit. On this scenario, the Fed may stay on the sidelines for a few more months, while they assess the damage done to the US economy from the emerging market shock. Growth in global GDP would probably stay close to trend, while global inflation would remain around its "optimal" 2 per cent rate. Things would then look quite good for a time.

But beneath the surface, trouble may be brewing. It would hardly be a new event if a rising exchange rate temporarily suppressed domestic inflation pressures, but later led to trade imbalances which triggered instability. A firm dollar/weak yen scenario, which may seem beneficial to markets in the near term, would probably carry the seeds of its own eventual destruction, in that it would lead to a dangerous widening in trade imbalances and - much later - to a collapse in the dollar. This dollar collapse would then unleash pent-up American inflation pressures which have been suppressed so far by the strong currency. All this would obviously increase the risk of a hard landing in 12-24 months time.

In summary, the series of different shocks and "news" in recent weeks have weakened activity in Japan, Asia and Latin America; strengthened domestic activity in the US; and increased the risks of wage pressures emanating from a tight US labour market. Taken together, these three factors are most unlikely to lead to global recession, but have clearly increased the scale of global trade imbalances, and made the task of the Fed much more complicated.

Those who see a stronger dollar as a benign way out of this problem may well be proved right for a while, but this would only exacerbate trade problems later, and raise the spectre of an eventual hard landing for the US economy. It is premature to fear that this extreme outcome will happen soon, but it has certainly been brought a few steps closer by the events of the past few weeks.