The pessimists and the optimists on global recession

By John Llewellyn

LONDON: The mood among many economic commentators is dire. And it is easy to see why. Economic activity is slowing in each of the three largest economies -- the United States, the European Union, and Japan -- which together account for some three quarters of Organization of Economic Cooperation and Development (OECD) GDP and nearly half of the output of the entire world economy. Take that slowdown in conjunction with the fact that most projections for the near term are made by extrapolation, and it is easy to see why there is a widespread assumption that the global economy will inevitably slide gracelessly into recession.

But the pessimism is overdone. Momentum can always be countered by a force sufficiently strong, and right now some truly heavyweight forces are starting to bear on the world economy.

To start with, there is oil. When its price is rising, as it was until around the start of this year, oil eats away at real incomes and thereby demand. Every major run-up in prices -- 1973- 1974, 1978-1979, 1990-1991 and 1999-2000 -- has eaten into the incomes of oil consumers and slowed world demand substantially.

Ultimately, the oil-producing countries spend their new income and world demand rises again. But this takes time: there is inevitably a world slowdown first, and that is one of the major factors that have been afflicting the world economy of late.

But the process also works in reverse. When energy prices fall, energy producers continue to spend their new-found accumulated income reserves, while energy consumers, seeing petrol, gas and coal prices eating less into their incomes, spend more. If world oil prices merely stabilize over the next 12 months -- and they could well fall significantly -- this will represent the end of a negative drag of some 1 percent on OECD countries' income.

Then there are important positive policy forces, most notably in the United States. That economy, which has seen the largest deceleration in domestic demand growth, also stands to see the largest contribution from policy. First is the reduction in official interest rates that Federal Reserve chairman Greenspan has been delivering since the start of the year. In the past, each 100 basis point cut in official interest rates has added, after a multi-month lag, something like 0.8 percentage points to GDP growth. On that basis the 275 basis points cut seen so far should add more than 2 percentage points to GDP growth, starting in the second half of this year.

Then there is the U.S. tax rebate. In the past, U.S. consumers have spent around half of any such cut. If they react true to form this time, their additional expenditure should add about 1 percentage point to domestic demand growth, again in the second half of the year.

Of course, history never repeats itself precisely, if only because circumstances are never exactly the same. And certainly the "tech wreck" makes this occasion different from earlier episodes, even if the true extent of the excess investment -- which we put at US$50 billion-odd -- is overstated by some commentators.

But also fundamentally different this time is the fact that inflation is no constraint on policy. In contrast to previous end-of-expansion episodes, this time around the Fed can cut as much as is required to get the job done. Dr. Greenspan has many more rate-cut pills in his bottle, and he evidently is determined that the United States take its course of antibiotics right to the end. If more rate cuts are required, he will not hesitate to prescribe them.

So much for the United States. What of the euro area? Certainly, euro pessimism is the current vogue, and much play is made -- rightly -- of the size and importance of Europe's supply- side structural problems. These matter, and considerably, for the medium performance of the European economy. But the real issue is demand, not supply. And here there is some reason to be optimistic.

Particularly instructive was the way that euro-area domestic demand growth jumped in 1998, immediately the six-year episode of Maastricht fiscal tightening concluded. This suggests that underlying "animal spirits" in Europe, even if less vibrant than in the United States, are not easily killed off. Turning to the present, the oil price effect is likely to be bolstered in Europe by an easing of food prices, which in the past six months alone have subtracted more than half a percentage point from consumers' real incomes.

Taking the United States and Europe together, therefore, there are several good reasons to expect that incomes, particularly of consumers, which together account for more than 60 percent of all expenditure in the economy, will shortly receive a fillip. Although guessing at timing is always hazardous, it could well be that the second quarter will prove to have been the slowest of the year.

Unfortunately, this potential good news seems most unlikely to extend to Japan. While the export sector is in good overall health, domestic "animal spirits" are severely depressed. Domestic demand in Japan has performed miserably for over a decade:

And there is worse. Japan's banking system, saddled with monumental bad loans as a result of the collapsed property price bubble, is for all practical purposes bankrupt. And the insurance industry seems increasingly unable to meet its legal obligations.

Furthermore, as if all that is not enough, the domestic price level is falling, at several percent per year, something not seen in any major economy since the Great Depression of the Thirties.

This encourages consumers to postpone their purchases, which stand to be cheaper tomorrow than they are today. It means that interest rates stand considerably higher than the rate of inflation, preventing conventional monetary policy from providing sufficient stimulus to the economy. And, as the numerator escalates and the denominator diminishes, it causes the already- high national debt to balloon as a proportion of GDP.

There is a real risk that, if Prime Minister Koizumi does not soon bring forth a complete and convincing package of reform measures, and if the Bank of Japan is not thereby induced to monetize and adopt at least a zero inflation target, there will be a crisis in Japan in the autumn.

Other parts of Asia, too, are problematic, although the gravity of the situation should not be overstated. To begin with, some economies, most notably China's, are doing well, and Hong Kong is recovering. It is a number of the smaller countries that are suffering. But many of Asia's problems derive from the slowdown in the world's major economies, and are not an independent source of weakness.

How does all this add up? Our best judgment is that the sum of the positive forces of energy (all energy-consuming nations), fiscal and monetary policy (the United States), and food prices (Europe) will serve to reverse the current negative domestic demand momentum in the United States and Europe before the end of the year.

But Japan, unfortunately, remains the exception. Somehow the international authorities -- the G-7, the IMF, and the OECD -- have to convince the Japanese of the gravity of their situation. They have to persuade Koizumi to take bold and complete action, lest Japan turn from being a potential to an actual source of damage to confidence worldwide.

The writer is global chief economist at Lehman Brothers. Prior to that, posts included chief economic forecaster at the OECD in Paris.

-- Observer News Service