1998 demonstrated that the British economy is not immune to events in the rest of the world. As a medium-sized open economy, heavily dependent on trade, the UK can be greatly affected by global economic events. So it proved in 1998, as problems from Asia spread. Yet, it was not just external events that affected the UK. Domestic factors played an important role in the UK’s slowdown. At the start of 1998 misplaced inflationary worries prompted the Bank of England to tighten monetary policy, compounding problems for the manufacturing sector. The economy slowed so much that by year-end the Bank of England was cutting rates aggressively, with further easing likely in 1999. The biggest surprise last year was that the impact of problems in Asia caught so many people by surprise. A year ago it always looked likely that the fall-out from Asia’s problems would be great. What about 1999? While debate about the euro has dominated the start of the year, there are two other key international developments that need monitoring. Both will have a key bearing on events in the UK. First, a big change has been affecting the world economy through the 1990s. After the inflationary problems of the 1970s and 1980s, the 1990s have been different, with inflation not a worry. A clear example of this has been the slump in the oil price. There are many reasons for the easing in global inflation pressures. Economic policies around the world have been anti-inflationary for most of the last two decades. As inflation was seen as the main economic problem, political parties of the left and the right, particularly in the industrialised world, adopted similar, anti-inflationary policies. Central banks have become more influential, with many of them being made independent, allowing them to pursue anti-inflationary policies successfully. Yet policy has not been the only factor keeping inflation down. Globalisation has become a key contributing influence. The production of low-cost, high-quality goods in emerging markets has added to competitive pressures in the industrialised world. This explains why problems in Asia have had a big impact elsewhere. Intense global competition and the lessons of recent economic cycles, when some companies overextending themselves, have forced firms to keep costs down. The flip side of this has been that people have become more price sensitive, looking for value for money when they spend. When similar developments are happening around the world, the net effect is reinforced. As a result, the world economy is in a disinflationary environment but in Japan it is deflation that is gripping the economy. This may not sound too different, but it is. Whereas disinflation means modest growth and low inflation, deflation is negative growth and falling prices. Deflation is bad news. A rebound in Japan is essential for prospects in Asia to improve. If not, Asia’s problems will continue, exacerbating global competitive pressures. The absence of inflation explains why official interest rates and bond yields have fallen around the world. So the first key issue is whether the global disinflationary trend continues or if the deflation problem gripping Japan spreads? As Japan continues to pull out all the stops to make sure its problems do not get any worse, and in order to stimulate growth, all eyes will turn to the world’s other major economy, the USA. The second big issue is what happens in the USA, the locomotive of world growth. The US economy has performed incredibly well in recent years, with strong growth, high consumer confidence and a surging stockmarket. Yet growth is imbalanced. In particular, the US savings ratio is negative, as Americans are not only spending all their income but are also dipping into their savings. This situation is not sustainable. But this behaviour may continue for some time, particularly if the US stockmarket continues to rise, feeding consumer confidence. In recent months, US interest rates have fallen. Despite the buoyant stockmarket the US Federal Reserve Board has cut rates in response to a slowing economy and tough financial conditions as global problems have hit Wall Street firms. With inflation low the Fed has scope to ease, but lower rates may boost the stockmarket. Therein lies a worry for the whole world. If the US stockmarket continues to discount too much good economic news, it will be vulnerable and eventually fall. If the stockmarket fell sharply it could force the US economy into a hard landing. Yet as long as interest rates are falling this will give a new lease of life to the stockmarket, pushing it up to levels it will not be able to sustain if the US economy slows. Some might argue there is little sign the US is about to slow: monetary growth, bank lending, and the stockmarket are all rising, jobs are plentiful and consumers are confident. If growth is imbalanced then the answer on this basis would be for the Fed to tighten policy, not to ease! It seems unlikely the Fed will do this, but it highlights how imbalanced the US economy’s growth is. There are similarities between the US economy and the emerging Asian economies, which got into trouble in 1997. On many comparisons, the US has all the characteristics of an emerging economy. One of the reasons why problems in Asia were overlooked by the financial markets in 1997 is too much attention was paid to the low inflation rates and healthy government surpluses which were seen across the region. Trade deficits and deteriorating private sector balance sheets were overlooked. In the US, the deteriorating trade deficit and the private sector’s poor balance sheet, as seen in its negative savings ratio, are problems that should not be overlooked. As they become of more concern to international investors, money may not flow so readily into US financial markets and the dollar could head for a big fall. Dr Gerard Lyons is Chief Economist at DKB International, London based subsidiary of Japan’s Dai-Ichi Kangyo Bank.
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