A chasm opens Falling stock markets in the US and weak Japanese domestic demand could generate a dangerous global recession, says Martin Wolf Published: March 27 2001 19:41GMT | Last Updated: March 27 2001 20:00GMT

Let us, for a moment, peer into the abyss. How deep could the fall of the world economy turn out to be if my moderately optimistic analysis of three weeks ago (America's return to normality) proves to be wrong? What, in other words, is the worst that a reasonable person might fear? The answer, alas, is disturbing. Big shifts in the desired balance between savings and investment in the US and Japan could conceivably generate a global slump.

The starting point for such a worst-case scenario has to be two propositions about the US: first, the stock market remains overvalued; second, the private sector is running a historically unprecedented financial deficit.

There is a huge interest in denying the first of these propositions. But it remains unconvincing. James Tobin's "Q" - the valuation ratio that relates the stock market's valuation of companies to the replacement cost of their net assets - has moved from being three times above its historic average to merely twice. Only now is it back to the levels of 1929 and 1967, the two 20th-century peaks.

A similar point can be made about the ratio of stock prices to earnings. Datastream's latest estimate of the price/earnings ratio for the US is 22, down from a monthly peak of 33 last August but still above the historic average of 15. Moreover, as output growth slows, earnings are likely to shrink, further undermining current valuations. Because of overshooting, a loss of two-thirds from valuations would be within the bounds of experience.

Many argue, against this, that the market is undervalued. Among the arguments is the so-called "yield ratio", the ratio of bond yields to earnings and dividend yields. This ratio is conveniently low - almost half of its peak in 1999.

Unfortunately, this relationship is theoretically nonsensical and empirically useless. If the nominal bond yield has gone down because inflation expectations have subsided, why should desired real returns alter? But if real yields on bonds have subsided, because of lower expected growth, there should also be a decline in expected real returns.

As Andrew Smithers of London-based Smithers & Co has noted, there has been no correlation between yields on bonds and stocks over the history of the US stock market. Correlations are identified only by examining chosen sub-periods. Believers should also take a look at Japan, where the decline in bond yields has failed to boost the market.

The proposition about the US private sector financial deficit is still more compelling. It has been running at close to 6 per cent of gross domestic product. This is roughly 11 percentage points below where it was in the last recession and 8 percentage points below its long-run average. It is hard to believe that this huge shift from surplus to deficit has not been driven, in part, by the stock market.

That investment is being cut is common knowledge. But the crucial question concerns the consumer. The logical wealth target for any individual is net worth: the real value of assets, less liabilities. When asset values soar, so does borrowing - and vice versa. Federal Reserve flow of funds data show that the net worth of US consumers declined last year. Over the past half century, there have only been two previous examples of significant declines, the most recent being 1974. It is probable that households will respond to this by cutting borrowing and spending.

Suppose then that a vicious circle of tumbling wealth, declining investment and increased household saving were to push a dis-illusioned US private sector back to the spending and saving patterns of the early 1990s. T hat could cut net demand by some 10 percentage points of US GDP. If it were to occur swiftly, the impact would be devastating.

Unfortunately, these big risks coincide with renewed weakness in the world's second-largest economy. In response, the Bank of Japan has announced what seem to be significant changes in policy. It now has a quantitative target for the monetary base. It is also committed to limited purchase of Japanese government bonds. Last, but perhaps not least, the Bank indicated that it would stick to these policies until the rate of consumer price inflation reached zero.

Behind this apparent monetary loosening lies Japan's huge private sector financial surplus, which has been between 10 and 13 per cent of GDP over the past three years. Hitherto, this has been largely absorbed by the fiscal deficit, with a relatively small amount left over for lending abroad, via a current account surplus of just under 3 per cent of GDP. If the Japanese conclude that their fiscal deficit must be cut, the surplus available for foreign lending is certain to rise. It would be further increased if total private investment were to fall from extraordinarily high levels of about 19 per cent of GDP.

Suppose then that the Bank of Japan moved to large-scale quantitative easing. In the short run, the impact would largely come via exchange rate depreciation. The current account surplus would rise. The external absorption of excess Japanese private savings could require a surplus of 10 per cent of GDP.

This then is the nightmare: a huge simultaneous shift in the balance between desired savings and investment of the US and Japan. Since these two economies generate almost 45 per cent of global GDP at market prices, the impact would be a large net reduction in demand for the rest of the world. There would also be a further increase in risk aversion. This would dry up finance for emerging market economies, making it more difficult for these countries to cope with the external adjustments emanating from the US and Japan.

Is this scenario likely? The honest answer is that nobody knows. Is it conceivable? The answer to that is: yes. How then are these risks to be minimised?

The obvious answer is for the US Federal Reserve to pursue an aggressively expansionary monetary policy. If US short-term interest rates were close to zero, there should be no difficulty in persuading households to keep on spending. Yet such an extreme cheap money policy would have two significant drawbacks. The first is that it could ultimately trigger a run on the dollar. The second is that it would work by encouraging a continuing deterioration in private sector balance sheets. While that might halt a downturn now, it could lead to a still more serious crisis a few years hence.

US monetary easing should not be so aggressive as to generate no adjustment for the private sector at all. For this reason the public sector has an offsetting role to play. A large temporary tax cut could make more sense than the permanent one now planned.

Yet some adjustment of the US external balance is desirable. For this reason, Japan should not pursue the extreme cheap yen policy right now. But modest and progressive deficit reductions, combined with increasingly dynamic monetary expansion, the writing off of bad loans and full recapitalisation of banks may do the trick.

If the US did cut its current account deficit (now 4.5 per cent of GDP), while Japan increased its surplus, other countries must make offsetting adjustments. Once the world economy is blooming again, the resources no longer being absorbed by the US private sector ought ideally to go to emerging economies.

In the short term, however, Europe is in the best position to take the strain, since it accounts for half of the rest of the world economy (with the US and Japan taken out). The European Central Bank should plan to adjust to any changes in the US and Japanese external balances by expanding demand in the euro-zone rather than allowing output to shrink.

The right policy for individuals is to be aware of the risks. But policymakers must respond. It may prove impossible to avoid the abyss. It should still be possible to stop before the bottom.

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-- Carl Jenkins (somewherepress@aol.com), March 28, 2001