Why? The factor most on everyone's mind at the moment is the approach of war. There can be little doubt now that U.S. President George W. Bush intends to attack Iraq and overthrow its repellent dictator, Saddam Hussein. American troops are gathering in the Gulf. And the attack now looks likely to take place in the first two months of 2003 before the heat of spring and summer begins to build in the desert. The question then is how the attack plays out, its consequences, political and economic, the harm (or, conceivably, good) that is done to international confidence.
Consider first the potential good. If Saddam is overthrown quickly and killed or imprisoned the Middle East the world will be rid of a ruthless and unpredictable man whose influence has long been malign. The terrorist threat which U.S. President George W. Bush ascribes to Saddam will be eliminated.
Other terrorists, the U.S. administration believes, if we judge by comments made by Defense Secretary Donald Rumsfeld, will be deterred. Moreover, there is little reason to doubt that the U.S. attack will be swift and effective. Hussein is an unpopular tyrant. His army may give way rapidly.
That is the potential good. But the consequences of war, even war as one-sided as this, are hard to predict. To spite the West, Saddam may destroy his own country's oil facilities and seek to destroy those of Kuwait and Saudi Arabia. Saddam has missiles, which may well fly towards Israel, too.
In Saudi Arabia unrest is possible. The Saudi royal family is unpopular. Sympathizers of al Qaida may react to a U.S. attack by destroying as much as possible of their own countries' oil production and export capacity. If they are at all successful the current rise in world oil prices to over $30 per barrel, a rise that reflects the prospect of war, would be just a beginning. Finally, there is a longer term question: would the terrorism the United States fears be quelled by an attack on Iraq or fanned by it?
Oil prices are the first main link between this war and the U.S. and international economy. Their rise means that a little more of Western consumers' disposable income is taken up by spending on oil, diesel and heating oil. Transport costs for goods also rise. But the impact with oil prices at their current level is not so severe. It is if the oil price goes still higher, to $40 per barrel or more, and stays there for a time, that the Western economy will be hit hard.
What should trouble investors is that the Western economy and, more than any other, the U.S. economy is already vulnerable. The U.S. economy, far from being ready, after two difficult years, to rebound, continues to live on borrowed time -- and borrowed money. The record trade deficit is a clear sign of excess consumption, a consumer boom that began in the late 1990s and has not yet corrected.
That the trade numbers are so bad in recent months, more than two years after U.S. economic growth began to turn down is itself a troubling sign, a reflection that the distortion of the U.S. economy in the stock bubble of the 1990s has been exacerbated by a second bubble -- in house prices.
Economic policy in the United States has gone badly wrong. The U.S. Federal Reserve has, to our mind, been aware that it has been dealing with an unusual recession, one that is the result of a burst asset price bubble. Fed Chairman Alan Greenspan has, we believe, been wary that a Japan style crisis would overtake the United States. Japan is generally criticized for having relaxed monetary policy too slowly after the bursting of the Japanese property bubble in the late 1980s. A similar criticism is made of monetary policy in the United States after the Wall Street Crash of 1929. Milton Friedman, the pre-eminent monetarist economist, studied this period and states firmly that it was after the crash, not before it, that U.S. monetary policy went awry.
We would judge that Greenspan has acted with these historical crises in mind. He has slashed interest rates in order to ensure that a downward spiral of falling asset prices and perhaps falling consumer prices (deflation) does not take a grip on the United States. But the result has been a new bout of asset price inflation, in homes, that may engender the sort of deflationary crisis that Greenspan has been trying so hard and so boldly to avert.
How so? The rise in the Nasdaq stock market to more than three times its current level and the rise, too, of many other blue chip stocks to inflated levels was a distortion. Companies now struggling to survive at all became some of the biggest by market capitalization in the United States. Vast amounts of portfolio investment flowed into them. They themselves invested heavily in new productive capacity.
Now in many cases that capacity cannot be used. The capital poured in has been squandered. After some investors made fortunes, many others have lost them. Now the same things risks happening with a still larger and more central market: the residential property market.
Ultra-low interest rates have fed a boom in house prices. Cheap mortgages have enabled home owners to refinance their homes and spend some of the freshly-borrowed money. Thus house price inflation has spurred consumption in the United States in just the way that stock price inflation did.
The result, too, will be the same. The inflation in house prices cannot persist. Eventually real forces, such as the relation between earnings and prices, will cause a correction in the market. Then home-owners will no longer be extracting equity from their homes and spending it. On the contrary, depressed house values and higher mortgages will leave home-owners tied to their homes and struggling with debt. Just as has been the case with the stock market bubble the house price bubble will eventually burst and act as a deterrent to consumer spending.
This is the threat which, more than any other, hangs over the U.S. economy in the months and years to come. Has Greenspan get it wrong? We suspect he has, but it should be said that the problems he is dealing with are largely unfamiliar and difficult: a journey into barely charted and hazardous waters.
The U.S. economy, to our mind, would be better poised to grow now if U.S. policy makers had been willing to recognize that the economy had been distorted by the stock market bubble, that not just stock prices and investment spending had been excessive but also U.S. consumer spending, and that a slowdown and even a recession was both inevitable and essential.
If interest rates had not been cut so swiftly and so far, the U.S. recession of 2001 would have been deeper and would probably have persisted into 2002. The stock market would be still lower than it is now. The housing market's boom would have been curbed sooner. And meanwhile U.S. imports and the trade deficit and house prices would have tended to fall back rather than spiraling upwards, so that the economy might be ready to grow again.
We doubt that the United States has needed the extreme monetary medicine Greenspan has fed it. The United States, though like Japan in having experienced an asset price bubble, is not Japan. The U.S. economy is more resilient because U.S. companies are much more ready to react to the world they find themselves in, make painful cuts, and then grow again.
But now we fear further damage is being done. More people own prices than stocks and the property price bubble could prove more damaging than the stock one, and cast a pall for longer. Greenspan may inadvertently create the slump he feared.
And what of Bush and the likely war? His desire to pursue Saddam at all odds seems to us dangerous -- even though we share Bush's loathing of the Iraqi dictator. Bush cannot be sure that an attack on Iraq will not inflame opposition to the United States in the Muslim world and possibly sow the seeds of an extreme Islamic revolution in Saudi Arabia.
If oil prices are pushed still higher and remain high, it is Bush himself that will suffer. The United States will head into recession and will be unlikely to emerge from it before Bush contests the presidency again in 2004. Bush might well go into that election defending an economic record of persistent low growth and recession.
Yet from our perspective Bush will not have been chiefly to blame for the mess the United States has found itself in so far during his term and, if we are correct, in 2003 and beyond. U.S. monetary policy got it wrong in the late 1990s, when the stock bubble bubbled, and is again getting it wrong now the bubble has burst.
Central bankers are going to learn a lesson from the fine mess the world economy now finds itself in. It is not just consumer price inflation that they must watch and counter, but also inflation in stocks and other assets.
We seem to be blaming Greenspan. But the world is difficult even for clever men and he was, as Stan Laurel used to say, "only trying to help."
(Global View is a weekly column in which our economics correspondent reflects on issues of importance for the global economy. Comments to firstname.lastname@example.org)
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