IMF, April 1999:

Fears of a hard landing in the US have been fuelled in part by the experiences of Japan, Finland, Sweden and the UK following similar periods of falling net savings in the 1980s. To assess the possible impact, the IMF examines a scenario in which the household saving rate rises in response to a 30 per cent fall in share prices, with markets overseas dropping by 15 per cent as a result.

PRESS CONFERENCE OF MICHAEL MUSSA,
ECONOMIC COUNSELLOR AND DIRECTOR, IMF RESEARCH DEPARTMENT,
ON THE WORLD ECONOMIC OUTLOOK, April 20, 1999

Wall Street correction. Well, we have been talking about this for more than two years now. The market's up 60 percent since "irrational exuberance" was coined into the English language. Maybe there is something that has changed fundamentally the relative valuation of stocks in comparison with earnings.

A variety of factors have been suggested by analysts. Nevertheless, to virtually all economists whom I know, the market looks to be very handsomely priced at present. And bringing prices down to more normal relationship to earnings could easily suggest a 20 percent correction, or perhaps larger.

I emphasize we have been talking about that for the last two and a half years or so, and it hasn't happened yet; so it is by no means a sure bet. But I think we have to regard the very high level of stock market valuations, and what might happen if they were to correct either exogenously or as a consequence of a needed change in monetary policy stance, as one of the risks to the outlook for the U.S. economy and to the global outlook going forward. We have so characterized it in the World Economic Outlook.

Transcript http://www.imf.org/external/np/tr/1999/TR990420.HTM

FT April 21 1999

IMF: US slowdown now inevitable

By Robert Chote, Economics Editor, in Washington

The 1990s have been a disappointing decade for the World economy. Thanks to two significant global slowdowns, growth in world output is likely to have averaged just 3.1 per cent a year, the IMF said yesterday, weaker than either the 1970s or the 1980s.

During this period, Japan has experienced a decline in economic activity unprecedented among major industrial countries in the post-war era. Much of Europe has suffered stubbornly high unemployment and persistently weak growth. And a succession of emerging market economies have fallen victim to painful financial crises.

"Although financial fragilities and policy shortcomings played important roles in the build-up to the recent emerging market crises, the unsatisfactory performance of Japan and much of western Europe since the early 1990s also contributed," the Fund said in its World Economic Outlook - http://www.imf.org/external/pubs/ft/weo/1999/01/index.htm

"Japan's and Europe's large and growing surpluses of domestic saving over domestic investment not only meant that they were able to finance the persistent balance of payments deficit of the US, they also enabled global financial markets to channel large net capital flows into emerging markets."

These capital flows fuelled domestic overheating and widening current account deficits. They made emerging market economies increasingly vulnerable to adverse external developments, including changes in cyclical conditions among the big industrial countries, fluctuations in the world's main exchange rates and shifts in investors' perceptions of and aversion to risk.

"Alone among the major countries and regions, only the US may be considered to have achieved a fully satisfactory economic performance in the 1990s, with a relatively shallow recession in 1990-91 having been followed by an unusually long economic expansion," the outlook said.

The Fund believes that some slowdown in the US economy is now inevitable. The outlook for the world economy depends on whether this deceleration is gradual and orderly or abrupt and disruptive. It also depends on the response of policymakers and economic agents elsewhere.

"If the US economy were to slow significantly, which seems both likely and desirable at a relatively early stage, the European Union may be the only region of the world with both the scope to offset the consequences of the adverse external environment for its domestic economy and the potential to help the world avert a further broadening and deepening of the current slowdown," the Fund said.

With domestic demand growing by 5 per cent in 1998, US consumers and investors were responsible for almost half the growth in world demand last year.

Private sector optimism in the US has been fuelled by an exceptionally encouraging combination of economic conditions - including near price stability, low interest rates, low unemployment and a rising government budget surplus. This confidence effect has been reinforced and reflected by a buoyant stock market.

But with US unemployment at a 29-year low of 4.2 per cent, the expansion is increasingly constrained by trends in underlying productivity and the labour force, which together point to a sustainable growth rate of 2.25 to 2.75 per cent a year. In addition, higher long-term interest rates will weaken demand, while consumer spending cannot outstrip personal incomes for ever.

"Given the absence of inflationary pressures that might lead to a tightening of financial conditions, however, it seems quite likely that the slowdown in demand will be gradual and moderate: in short, a soft landing is possible," the outlook argues.

But a harder landing is easy to imagine, especially if growth fails to slow and domestic inflation picks up. The likely response of the Federal Reserve and the bond market might well trigger a sharp fall in share prices, which are high in relation to historical experience as well as current and prospective corporate earnings.

This could slow domestic spending quite abruptly, especially in the light of the deteriorating balance between private saving and investment in the US that has accompanied the recent expansion.

Fears of a hard landing in the US have been fuelled in part by the experiences of Japan, Finland, Sweden and the UK following similar periods of falling net savings in the 1980s. To assess the possible impact, the IMF examines a scenario in which the household saving rate rises in response to a 30 per cent fall in share prices, with markets overseas dropping by 15 per cent as a result.

At the same time it is assumed that the dollar falls 10 per cent as foreign investors become less willing to finance the burgeoning US current account deficit.

Comparing this with the Fund's central forecast of a soft landing, output growth in 2000 could fall from 2 to 0.1 per cent in the US, from 2.9 to 1.7 per cent in the euro-zone, from 0.3 to minus 0.8 per cent in Japan and from 4.9 to 4.1 per cent in the developing economies, with the impact declining subsequently.

After five years the US current account deficit would have dropped by more than $280bn, while the current account surpluses in the euro-zone and Japan would have shrunk by $111bn and $90bn respectively.

Current account imbalances between the world's three main economic blocks have widened in recent years, reflecting stronger growth in the US economy than in Japan and Europe. According to the Fund, this has created "significant risks for the world economy through a potential rise in protectionist pressures, or excessive and potentially destabilising movements in exchange rates among the major currencies".

The Fund's best guess is a warily optimistic one. It assumes that financial market conditions continue to improve for emerging markets, that the US experiences a soft landing, that growth in the euro-zone remains relatively resilient and that the Japanese recession bottoms out this year. If so, world growth should pick up again in 2000.

But what if there is a hard landing in the US, emerging market economies remain starved of finance, the recent weakness in the euro-zone economy persists and Japan's economic problems drag on? "If these risks materialise, the global slowdown could widen and deepen in 1999 and 2000 with recovery being delayed until 2001 at the earliest."

In which case the disappointing decade would come to a truly dismal end.

Editorial Comment, FT, April 21 1999

The world economy turns

Financial markets have calmed; Asia is showing signs of improvement; and the US economy continues to speed away. The International Monetary Fund, in its latest assessment of the world economy, believes that despite Latin America's troubles, these positive developments are the beginnings of a global economic revival. But the road to recovery may not be a smooth one.

The IMF forecasts that world output growth this year will be much the same as last year, at 2.3 per cent. But as the recovery gathers speed, next year's growth should reach 3.4 per cent, equal to the 1980s average.

What could interrupt this process? The IMF identifies two risks. The first is further problems in the emerging markets. Confidence has been returning, but there are still plenty of troublespots which could send investors running scared. The Chinese economy is slowing, and fears of a devaluation have not gone away; Brazil remains vulnerable; and Russia continues its plunge into economic chaos.

The second risk stems from the external imbalances that are building up in the world's three major economic blocs - the European Union, Japan, and the US. Growth in the three has been very uneven, partly reflecting the varying boldness of their policymakers, partly their stage in the economic cycle.

The consequence is that the US has played a dominant role in keeping the world economy moving.

Growth in US domestic demand, fuelled partly by a drop in private savings, accounted for almost half the total growth in world demand and output last year. The US absorbed most of the trade shock from the Asian crisis; this year, it is expected to do the same for Latin America. The result: a current account deficit which the IMF expects to reach $310bn (3½ per cent of gross domestic product) this year, accompanied by virtually unprecedented levels of net private-sector dissaving.

Meanwhile, the euro-zone and Japan are running large current account surpluses. This, as the IMF hints, is not sustainable.

The question is how, and when, these imbalances will be resolved.

The IMF believes that adjustment will be gradual. But experience shows that the such corrections have often been much more rapid, and painful. A knock to equity prices, perhaps combined with a falling dollar, would resolve the imbalances - but at great cost to global stability and US economic growth.

To limit the damage of such a rapid correction, two things would be critical. One is the response of US monetary and fiscal policy. The other is the ability of the EU to take over as the motor of global demand.

The message is that in today's unbalanced world economy, policymakers must be prepared to react quickly to protect global growth.

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