John Rapley - Foreign Focus THE WORRIES expressed earlier this year by the monetary authorities of the major economic powers and international financial institutions, that the world economy might sink into deflation, have given way to a renewed if cautious optimism.
The US economy looks poised for a rebound, western Europe seems past the worst and even in Japan, the stock market is rallying.
The big question now is whether this is a sustainable recovery, or merely a bounce before the world economy slides back towards recession. Faced with an economic slump, the US Federal Reserve Board flooded the American economy with money in a way never before seen. Using its leverage over financial markets to drive interest rates to lows not seen in two generations, the Fed both diminished the cost of borrowing and drove down returns on saving. In other words, it encouraged Americans to spend like never before.
But the policy did more than that. Low US interest rates brought down the returns paid to investors holding US Treasury securities. As a result, foreign investors began pulling out of the US and parking their money where returns were higher, particularly in Europe. For its part, the European Central Bank (ECB) remained conservative on the threat of inflation and did not want to lower interest rates. So the Fed forced its hand.
The move of investors from the US to Europe caused demand for the euro to rise, driving up its cost, and thereby devaluing the dollar. This threatened the European economic recovery, since a rising euro raised the cost of European exports. Eventually, the ECB had to join the monetary bandwagon, and started cutting its own interest rates. As a result, the world's major stock markets, which had started their fourth consecutive year of implosion, began rebounding.
If current trends persist, 2003 will be the first positive year for stocks since 1999. Rising stock prices and with them rising house prices and near-zero interest rates have bolstered consumer confidence. As consumer spending has picked up, the bottom lines of businesses have improved. This, along with the influx of fresh cash in the US due to a sweeping programme of tax cuts, appears to have shored up the recovery. Yet the Western economies are hardly out of the woods.
On the one hand, the spectre of global deflation appears to have been beaten back, at least for the time being, by the depressed value of money. However, the conditions underpinning the recovery belie its strength. Stock prices are where they are simply because of the ultra-loose money supply. Corporate earnings are actually not strong, and the productivity gains that might justify their future take-off are not likely to materialise.
It is accepted that consumer spending alone cannot sustain a recovery. At some point, business investment will need to take up the baton. So far, there is little sign of a resumption in investment, for the simple reason that the global economy is still beset by excess capacity: there was so much investment during the 1990s boom that more plant was built than needed.
The tax cuts promoted by the Bush administration favour the rich on the ground that they will invest their new-found money. But if consumer spending does not absorb this excess capacity, it is a safe bet the rich will sit on their money. Now, there is the added problem that the cost of the war on terror is worsening the US's fiscal position. The need to borrow money to plug the budgetary gap is driving interest rates back up once again. If this continues and the mediu-term trend, I suspect, is towards rising interest rates then both the stock-market rallies and the spending boom in the industrial countries will likely be reined in.
While the real estate markets of the major economies may not be in a new bubble, the stock markets probably are. If a recovery takes hold, interest rates will continue rising and stock prices will plummet. If the recovery fails to take hold, interest rates will remain low but pessimism about corporate earnings will likely bring stock prices tumbling.
Either way, it looks like the global economic recovery is built on a foundation of sand. The simple fact is that it depends on pumping the world economy with cheap money. But we in Jamaica know all too well what happens
when money chases money. It is no way to run an economy.
John Rapley is a Senior Lecturer in the Department of Government, UWI, Mona.
