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ECONOMIC ANALYSIS – What we learned by building hotels on Mayfair.

When a player accumulates properties on the Monopoly board, everything looks good. As he builds houses and hotels, the situation looks better. Yet if he doesn’t keep enough cash in hand, he will be in trouble as soon as he lands on someone else’s property, because in Monopoly you have to pay your bills, and you have to sell houses and hotels at half the price you paid for them to do so (these “fire sales” are a feature of real life, as events in Asia have demonstrated). Liquidity is the key to this lesson. It allows you to weather bad times. In economic downturns, liquid companies are less likely to go bust. Recent economic indicators are pessimistic and surveys suggest the UK is in recession. But where previous UK economic cycles have run into either an inflation or a trade problem, this time, things have been different: interest rates have fallen and the pound has remained stable. While a slowdown is inevitable, two important factors may prevent recession. First, low inflation will allow scope for UK interest rates to fall. Initially, the Bank of England will push rates down to a neutral level, probably around 5% by the spring, with further easing to follow. If this does not happen, the economy will be in recession. Secondly, the UK private sector’s balance sheet is not in bad shape. This is in contrast to previous downturns, when British companies and consumers have nursed big debts. So that’s one Monopoly lesson we’ve learned. Yet the UK is vulnerable to problems overseas. As a medium-sized open economy, heavily dependent on trade, Britain was badly affected by global economic events last year, as Asia’s crisis spread. Now, the world’s two largest economies face problems. The Japanese economy is not looking good. This year has been its worst since the Second World War. All is not lost. Rising government debt and unemployment are the price Japan is paying to overcome its difficulties. In recent years there have been significant increases in both, and there is more to come as the Japanese economy heads towards eventual recovery. However, Japanese consumers are able to survive bad times. The poorest 20% of Japanese households have savings five times their annual income. By contrast, the US is booming and acting as a locomotive for world growth. US demand is strong, lending and monetary growth are rising, and unemployment is low. On the face of it, the US is in great shape, but this is deceptive. The US economy is imbalanced. People are spending all their income and more. For the first time since 1936 the US savings ratio is negative. This is not sustainable, but it may continue for some time if a rising US stock market feeds consumer confidence. The situation is rather like a player buying up everything on the Monopoly board. It works fine until the hard times begin. The world economy needs the Americans and Japanese to reverse what they are doing. Japanese consumers need to save less and spend more. US consumers need to spend less and save more, but they need to adjust gradually so the economy enjoys a soft landing. Unfortunately, the likelihood of either population changing their habits is small. But a continuation of current trends could drag Japan from recession into depression and pull the rest of Asia down, while a continued US boom will eventually be followed by a US bust. The reaction of financial markets to the recent crisis in Iraq was telling. In the past, such serious global problems would have triggered a flight to quality, boosting the dollar. This is no longer the case. A flight to quality now means Europeans are likely to keep their money at home, boosting the deutschemark. Japanese investors follow suit, helping the yen. One reason why Asia’s problems were overlooked by financial markets in 1997 is that too much attention was paid to low inflation and healthy government surpluses. Trade deficits and deteriorating private sector balance sheets were ignored. In the US, the deteriorating trade deficit and negative savings ratio should not be overlooked. As they become of more concern to investors, money may not flow so readily into US financial markets and the US stock market and dollar may fall. Previous US recessions have been preceded by inflation, high interest rates and slowing monetary growth. This time all three are absent. This feeds the view that the US will not head into a sharp downturn. But this cycle is different. This was most evident last year when events in the rest of the world led developments in the US, rather than the other way. And, as if to highlight how different the present cycle is, there is excess capacity around the globe. After the inflationary problems of the 1970s and 1980s, inflation is no longer a problem. Witness the collapse in oil and commodity prices. The absence of inflation also explains why global interest rates have fallen. The euro will also be key. This is not Europe’s first attempt at a single currency. A century ago, Europe had three coexisting monetary unions: the German monetary union, a Latin monetary union of five countries centred on France, and a Scandinavian monetary union. All survived for a long time, but all eventually collapsed. History shows that monetary unions of large sovereign nations eventually fail unless the nations become politically united. So in 1999, European policy makers will have to pull out all the stops. The European repo rate will be down to 1.5% by year-end and fiscal policy will be relaxed. Weak, below trend growth, high unemployment and low inflation in the core EMU economies will justify such a policy. There may be a temptation to believe the UK is isolated, exposed to speculators outside the European fortress. This is wrong. Euroland is not a fortress but a prison. Outside it, the UK will be free and safe. As Monopoly teaches us, the worst place to be is inside the jail. Gerard Lyons is Chief Economist at DKB International, London subsidiary of Japan’s Dai-Ichi Kangyo Bank.

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