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ECONOMIC PERSPECTIVE
Prepared by Merrill Lynch & Co.
Global Securities Research & Economics Group
Recently, several officials, including Greenspan have characterized the Asian crisis as having a limited impact on the U.S. While most private forecasters have assumed that the crisis would at least keep the U.S. from raising rates when it otherwise might, it is clear that the G7 in general has not yet felt the crisis precludes interest rate adjustments to the upside and, in contrast to the Fed which held rates steady at its November 12 meeting. The Bank of England raised its base rate by 25 basis points a week after world equity markets had been shaken by the near collapse of the Hong Kong stock market.
While we agree with the prudent move (or in this case “non-move”) by the Fed until it has a better chance to assess the impact of the Asian situation, we are not so supportive of some policies elsewhere. For example, with interest rates already near rock bottom in Japan, the government not only raised the consumption tax earlier in the year, but is considering other measures to consolidate government spending going forward. Japan has only limited means to get out of its present slow to no growth situation. Either they have to stimulate domestic growth or, alternatively, export growth. The latter has the negative consequence of “stealing” growth from other countries and thus could actually exacerbate the current situation as growth slows rapidly elsewhere in Asia.
We think that the Japanese must show leadership in the present situation and first and foremost this means supporting a stabilization of the yen against the dollar. Indeed, it was the dramatic fall in the yen that hurt the terms of trade in those countries whose currencies were or are tied to the dollar. This shift in competitiveness came at a time when Japan and other countries have been investing heavily in China and Southeast Asia, and as facilities come on stream, these countries are finding it increasingly hard to preserve their export markets.
While Japan has been able to thrive in the past on exporting its way to healthy growth, the time for that is now past. As a reasonably mature economy it must provide as much demand to the world as it gets, and the failure to do so will allow its misguided policies to adversely affect the economies of its trading partners. Specifically, the Japanese must create additional domestic demand either by cutting taxes, lowering rates even further or increasing government spending. The risks of failure are increasingly onerous.
Keynesian economics went out of vogue in the 1970's because developed countries had learned to invoke Keynes's ideas to justify government spending increases long after the circumstances which call for his ideas were overcome. Far from being a “general” theory, Keynes's prescription of government spending when there was no other means of sparking growth in a depressed economy were very specific to economies in which interest rates were so low that they could either not go any lower or where, because of price decreases, real rates were rising and thus choking the economy.
Japan is, today, in a kind of “liquidity trap” which Keynes spoke of. Rapid increases in money supply have not been useful in creating demand, nor has the Japanese stock market rallied and allowed households to feel wealthier. If Japan insists on creating demand though net exports, it will simply force its trading partners into a similar situation, having to choose between lowering rates to boost their own demand, but cheapening their currencies, or alternatively, raising rates to preserve their currencies (Hong Kong) but insuring a loss of competitiveness.
The U.S. seems far removed from the problem and, indeed, Greenspan could barely restrain his pleasure that recent events in Asia and their impact on the U.S. stock market have the potential to keep the U.S. economy from becoming overheated and to hold inflation down by putting downward pressure on import prices. However, that pleasure could quickly turn to concern, if the financial dislocations caused by the Asian situation begins to impact the credit-worthiness of U.S. corporations as it already has for Asian corporations.
Consider what would happen if U.S. growth slows to, say, one percent. Given the sensitivity of U.S. import demand to growth and the fact that imports exceed exports by quite a bit, the drop in U.S. demand for overseas goods could occur just as Asian nations are increasingly relying on the growth in exports to stabilize their economies. By not adopting stimulative policies now, Asia will be ill prepared for a collective drop in export demand.
Investment is a wonderful thing in that it provides additional capital which can be used to provide more goods and services for everyone. However, as Keynes so elegantly argued, if savings are too high (leaving demand too low to absorb the goods produced and leading to unemployment as resources can not be fully used), what is normally thought of a virtue can quickly become an albatross as countries try to export their way to the full use of productive resources. Fortunately for the rest of the world, the U.S. has, since World War 2 and due to its richness been willing to spend (consume) what other nations saved. Going forward, the U.S. is likely to save more and the result will be lower rates and potentially inadequate demand. The latter could be devastating. Just as the Central Banks of the world kept rates too high in the early 1930's thinking it was prudent to do so, now fiscal conservatism could lead to a similar situation. Unemployment is 3.4% in Japan and rising, 11.2% in Germany and rising, and rampant elsewhere although sometimes masked by the continuing existence of state owned, but non- productive enterprises. Both effective leadership and an understanding of economic principles are sorely need and, apparently, in short supply.
(Reprinted by permission. Copyright © 1997, Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
November 13, 1997David Horner
Merrill Lynch & Co.
Global Securities Research & Economics Group
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