- In October 1929, then United States President Herbert
Hoover tried to cheer his country with the words: 'The fundamental business
of the country, that is production and distribution of commodities, is
on a sound and prosperous basis.'
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- On Monday, as the stock market tumbled, President George
W. Bush echoed: 'I want you to know the economy, our economy, is fundamentally
strong.'
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- Unfortunately for Mr Bush, nobody is likely to listen.
Yet the reason for his hitherto futile interventions is evident: The fall
in stock markets threatens both the US and wider world economies - and
so his political future.
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- The fear must be that a continued decline would undermine
the recovery hailed so warmly by Federal Reserve chairman Alan Greenspan
in his testimony to Congress on Tuesday. Any break in the US recovery would
create big dangers for the whole world.
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- Market corrections are now substantial. By Monday evening,
the Nasdaq composite index was down 73 per cent from its peak in March
2000. Standard & Poor's 500 (S&P) had lost 40 per cent of its peak
value, also in March 2000; in London, the FTSE 100 closed down 42 per cent
from its December 1999 peak; and the FTSE Eurotop 300 closed down 45 per
cent from its September 2000 peak.
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- Yet these falls may not be over, for three reasons.
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- EXAGGERATED EARNINGS
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- FIRST, markets are far from cheap. The point is made
in the annual report of the Bank for International Settlements (BIS), out
last week. The latest price/earnings ratio on the S&P is, after all,
almost three times its long-run average.
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- Second, to the obvious response - that these high price/earnings
ratios reflect exceptional write-offs and an unexpectedly deep earnings
recession in the high-technology sector - one must reply 'precisely'. Such
write-offs mean earnings in the years before last were exaggerated. Prudent
investors will ask how much wasteful investment, massaging of earnings,
undisclosed risks and fraud are behind today's reported earnings. The equity
risk premium has probably shot up.
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- Third, markets overshoot in both directions. They were
too expensive. They are likely to become too cheap.
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- Suppose there were further falls - or merely that stocks
languished at current levels. What might be the impact on the US-led recovery?
To answer this, one must look at what the bubble did.
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- Again, the broad outlines of this story are admirably
recounted in the BIS report. Because the credibility of central banks is
high and inflation expectations stable, misalignments between demand and
supply can take a long time to show up in inflation. A runaway boom can
occur instead.
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- As investment rises, productivity growth surges and inflation
falls. An inflation-targeting central bank then has good reason to relax
monetary policy. This leads to further rises in asset prices, faster credit
growth, soaring investment and consumption, still faster productivity growth
and so back to low inflation.
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- This is what happened in the US in the exceptionally
long expansion of the 1990s. Households and corporations moved into huge
net financial deficits. Similar shifts occurred in other English-speaking
countries, notably Britain.
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- No analyst has done more to explain the ultimately unsustainable
behaviour that resulted than Professor Wynne Godley, now at the University
of Cambridge.
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- In April, he noted that the US corporate sector had already
largely eliminated its financial deficit: It had had no choice but to do
so. But households, buoyed by rising house prices and Mr Greenspan's easy
money, have continued to borrow. The result is record levels of the ratio
of personal debt to personal disposable income.
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- There are reasons to believe this behaviour cannot continue.
One is that it is abnormal. Usually, households are lenders, not borrowers.
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- Another is that big reductions in wealth have already
occurred. Datastream's estimate of the market capitalisation of the US
market has now fallen by US$5.7 trillion (S$9.9 trillion) - a reduction
of 37 per cent from its peak.
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- As Prof Godley notes, the ratio of net worth to disposable
income has already fallen from an exceptional level of 6.2 in 2000 to about
4.8, which is its long-run average. The depressing effect will not be restricted
to the US alone. The world's market capitalisation has fallen by US$11.3
trillion (35 per cent) since its peak in April 2000.
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- The two big elements of risk, then, are further falls
in stock markets that drive additional correction in US and European private
sector spending. There may even be a 'double dip' recession.
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- It is not easy to see where the offsets to weaker US
demand might come from. Japan is dependent on exports for recovery. The
eurozone is also affected by the stock market fall. Household spending
has long been chronically weak in important eurozone countries.
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- In an environment of greater risk aversion and weaker
recovery, there is also likely to be a reduced willingness to fund non-investment-grade
borrowers. Foreign direct investment - the most important single source
of emerging market finance - is also likely to be affected adversely by
pressure on corporate profits and greater risk aversion. Argentina's malfeasance
will also discourage investors, at least in Latin America.
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- The risks are evident. What is needed from policy makers
in the world's most important countries is realism and determination. They
should focus their effort in three directions.
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- First, monetary policy must be directed everywhere at
supporting demand. Monetary policy is tricky in such times, as there is
a danger central banks will create panic. Equally, it is possible they
will overdo the easing. But these risks look modest.
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- Secondly, governments with low debt ratios and good credit
ratings should accept bigger fiscal deficits if they emerge. There is little
reason to fear much crowding out of the private sector, provided deficits
are credibly temporary. A good test is what happens to long-term interest
rates as deficits expand.
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- Last, a global downturn is the situation in which a lender
concerned with systemic threats should intervene. If Turkey and Brazil
need help, the International Monetary Fund should be willing to offer it.
That is what it is for.
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- None of the above represents a forecast. It is merely
an evaluation of risks. A downward spiral in stock markets triggering a
sizeable reduction in spending is an obvious danger. It is right to be
prepared. Realism, not Mr Bush's bromide, is what the world needs today.
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- Copyright 2002 Singapore Press Holdings. All rights reserved.
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