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February 04, 2003

Mutual Benefit
by Andrew Smithers

The weakness of the world's economy is neither unusual nor necessarily very serious. Recessions, and a speedy recovery from them, are normal. The worry today is that the policy response is inadequate.

World demand has been supported by low savings in the US and the UK and rising budget deficits. Despite this, growth has slowed to well below its trend rate, as rising unemployment and falling capacity utilisation show. Profits rise when growth is above trend and fall when it's below. We should therefore expect profits to fall this year. Profits drive economies. As they fall, companies cut back on investment and employment. If disappointment hits the stock market and unemployment weakens house prices, then households will increase their savings rate and add to economic problems. Below trend growth thus leads to decline, unless reversed by a change in economic policy.

With excess capacity and falling profits, investment is highly unlikely to increase. If, as seems likely, household savings in America and Britain now rise, and there is no compensating fall elsewhere, then budget deficits must rise again. They can, however, rise either deliberately in order to prevent a recession, or accidentally because there is one.

The opposition to higher budget deficits has mounted in Europe, Japan and America. This is unfortunate, but not entirely unreasonable. Japan provides a worrying example of the apparent failure of fiscal policy. A decade of stagnation since 1992 has accompanied a swing in the budget balance from a surplus of 0.8% of GDP to a deficit of 8%.

This failure may have been caused by the offsetting impact on external trade. The yen has strengthened and the trade surplus fallen from $125 bn. in 1992 to $ 70 bn. in 2001. This reaction is forecast by several economic models. They show that, in the absence of additional monetary stimulus, rising budget deficits push up the real exchange rate.

Therefore Japan's fiscal policy has not been ineffective. It has just failed to benefit Japan. Demand in the rest of the world has been aided by the fall in Japan's external trade surplus. We are left with a paradox, which may have been accentuated by globalisation. Rising fiscal deficits are just what the world needs, but they are a disinterested kindness, done for the benefit of others.

It is unlikely that America, Europe and Japan can be persuaded to increase budget deficits for their mutual benefit. It is more likely that the "Stupidity and Gloom Pact" will act to offset the small stimulus from tax cuts that President Bush is proposing; though the unselfish nature of his actions may have escaped his notice.

Monetary policy is thus the only way that world demand is likely to be boosted. Economic forecasting is so uncertain that it may not prove necessary. But policy must always be a matter of judgement and, although the case for greater monetary ease has long seemed overwhelming, it has been opposed by the ECB and the Bank of Japan.

Policies, however, change. The Bank of Japan will have a new governor soon and events will influence even the Europeans. Nonetheless, the chances of a double dip world recession must be high.

Once interest rates reach zero, they can be cut no further and monetary stimulus depends on less orthodox measures. Here lies the rub. Few are comfortable with heterodoxy. This inhibits vigorous action not only when rates reach zero, but also as they approach it. Monetary policy does not need to become ineffective when nominal interest rates are very low, but it tends to be weaker in practice.

Central banks, including the Fed, have been less aggressive in the post- bubble world than they should have been. It may therefore take time for monetary policy to catch up with today's needs and, even then, its impact will be delayed.

President Bush seeks re-election in November 2004. He should be pleading with the Fed to pull out all the stops now. A call for co-ordinated worldwide fiscal stimulus would also show statesmanship, even though its success is improbable.

Andrew Smithers
Smithers & Co.

Smithers & Co. Ltd. provides advice on international asset allocation to about 100 clients based mainly in Boston, London, New York and Tokyo. Our work is based on the fundamental belief that no one's judgement is better than their information. We believe that our clients' decisions will be helped if we can provide them with important information that is not otherwise available to them. We therefore concentrate on research which aims either to tackle issues in greater detail and thoroughness than is otherwise available or to tackle issues of importance which seem to have been generally overlooked. Examples of the former include our work on stock market valuation, the profit distortions arising from the use of employee stock options and the underlying secular problems of Japan's economy. Examples of research into areas which have otherwise been largely overlooked include our work on the Japanese life insurance industry.

Our approach to research is also different. The standard approach bases market projections on economic forecasts of major economic aggregates, such as GDP and inflation. Stock market, bond and currency forecasts are then derived from the way these estimates differ from the consensus. We consider this approach to be flawed in two ways. It places excessive reliance on the ability of any particular analyst to produce forecasts which are consistently better than average. It also ignores the evidence that stock markets tend to lead economies, rather than the other way around. In contrast, we put greater emphasis on "information arbitrage", in which we include identifying factors which have been overlooked, drawing on data and academic research which have not yet been exploited and pointing to inconsistencies in the implicit forecasts of different markets.

Andrew Smithers, founder of Smithers & Co., is also columnist for London's Evening Standard and the Tokyo Nikkei Kinnyu Shimbon's Market Eye, and is regularly quoted in the New York Times, Barron's, Forbes, The Economist, The Independent, and the Financial Times.

Copyright © 2002-2007 Andrew Smithers

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