Global Policy Forum

By Larry Elliott

We live in a world where bubbles are the norm. We've had bubbles in currencies, in property, government bonds, corporate junk bonds, bubbles in equities. The grandpappy of them all, however, is the bubble in optimism.

The optimism bubble works like this. When the economy looks good, growth will last for ever. When the price of an asset rises to an extent that all historical parallels are broken, it is because "it's different this time". When the market starts to come off the boil, it is a blip. When it comes down a bit further, there will be no impact on the real economy. When it goes into free fall, the recession will be short-lived because policymakers are on top of the situation. When the bad times go on longer than expected, there is merely a temporary obstacle to recovery, to be removed any time soon.

As such, you didn't need to be a genius to work out that the panglossian response to the dire US jobs figures released last Friday would be that the threat of war had deterred hiring. (The fact that markets had been expecting payrolls to rise in February was itself symptomatic of the optimism bubble).

The bubble interpretation of where the US economy stands is that conditions are in place for a broadly based upturn just as soon as Saddam Hussein gets his comeuppance. Have not all the macro-economic dials been set to go, with interest rates at 1.25%, the dollar falling and a big fiscal boost coming through, courtesy of the budget deficit? Isn't the US the home of a productivity miracle which has raised the trend rate of growth? Don't we have faith in the ability of Mr Greenspan to get this right?

Parts of the thesis hold water. Macro-economic policy does work, and without expansionary policies the US would have had a deep recession over the past couple of years. Yet, given the size of the stimulus and the explosion in the money supply, the upturn has been weak when set against previous recoveries. This is where Iraq comes in. Financial markets were bemused by the petering out of the economic upturn in the first half of 2002 but say recovery will resume as soon as the uncertainty in the Middle East is resolved. After all, the argument continues, once the shooting actually started in 1991 the world got back to normal immediately.

Some economists, to their credit, take a different view. They argue that the problems of the global economy will not disappear overnight and point to data which suggest there was a lag of at least two years between Operation Desert Storm in 1991 and sustained economic recovery.

Fundamentals

"In seeking to justify why growth has turned out to be lower than expected policymakers have tended to lay the blame on 'geopolitical risk'," says Ian Harwood of Dresdner Kleinwort. "We suspect, however, that the demand-depressant effect of uncertainty and high oil prices is by no means the whole story. Economic fundamentals - notably none-too-robust underlying corporate profits and over-leveraged balance sheets - are likely to be playing a critical role, too.

"Even if the US does win a quick victory in Iraq, with no damage to oil production facilities, we doubt that this will lead to any strong and sustained rebound in global demand and activity."

This seems a more realistic view of what is likely to happen in the US and the global economy over the coming months. The alternative interpretation looks at the effects of 20 years or so of financial deregulation on the demand for consumer and business credit, the size of the US trade deficit, the changing balance between investment in real assets as opposed to speculation, and the quality of corporate earnings. From this perspective, the US economy is in far worse shape now than it was in 1991, sustained only because a bubble in housing has taken the place of the bubble in stocks.

Consider the following nuggets culled from a newsletter produced by the former chief economist of Deutsche Bank, Kurt Richebacher. During the third quarter of last year, private households in the US added to their debts at an annual rate of $770bn, at a time when total consumer incomes increased by just under $300bn. To put the $770bn into some context, 1998 was the first year American households added more than $400bn to their debts.

While incomes were rising by a modest 2% last year, borrowing was going up by 9%, mainly because consumers were able to borrow on the back of house price increases. As one analyst puts it, you have to ask how sustainable an economy is when consumers are using their homes as cashpoint machines.

The splurge of borrowing explains why the US economy looks so lopsided and why the current account deficit has continued to explode despite the chunky fall in the value of the dollar. Imports have been rising far more quickly than exports, with the result that there is a leakage of income – and profits - from the US to overseas companies. Another way of looking at the same phenomenon is that the US lacks the capacity to satisfy its own domestic demand. Yet another is that the world's biggest economy has been relying on an inflow of foreign capital to cover the current account deficit. There is a limit to the willingness of global investors to subsidise another country – even one that is massive and boasts the world's reserve currency - and that limit was reached last year when a blind eye could no longer be turned to the scale of the current account deficit.

Why has US business not been able to expand sufficiently to cater for the excess demand created by the willingness of consumers to load up on debt? The received wisdom is that the US invested far too much in the boom of the late 90s and is now awash with spare capacity. If that is true, one might expect this spare capacity to be soaked up by rising consumer demand. Instead, the gap between demand and supply can only be met by imports, which means the current account is worsening.

'Goodwill'

The conclusion has to be that the real problem for the US has been over-speculation not over-investment. As Richebacher points out, between 1996 and 2001 there was a rise of $1,653bn in corporate tangible assets, dwarfed by a rise in financial assets of $3,603bn. Almost $3,000bn of this increase is accounted for by "goodwill" accrued in the dealmaking binge of the late 90s. For the most part, as the merger of AOL and Time Warner exemplified, the "goodwill" has proved worthless and symptomatic of a long-term trend in which organic growth of businesses was replaced by mergers and takeovers. The result has been a systematic undermining of corporate balance sheets.

Like US consumers, companies appear to be in denial about the extent of these structural problems. Sooner or later, they will have to be rectified. Expansionary macro-economic policies help, but only in the way that pain-killers help a struggling athlete; by temporarily deadening the pain.

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