Wednesday, September 01, 2004
Will the world slow down next year?
Posted by David Smith at 08:27 PM
Category: David Smith' s magazine articles

The approach of autumn is a good time to be looking forward. Many of the trends for next year are already in place. By the time autumn turns to winter they will be rock solid. So how is 2005 looking?

The starting point for looking into our crystal ball has to be the fact that 2004 has turned out to be a pretty good year for the world economy, easily the best since 2000. Between 2000 and now, of course, plenty of water has flowed under the bridge – the bursting of the stock market bubble, the 9/11 attacks on America, a US (and global) recession, the Iraq war and the return of high oil prices.

World economic growth will be around 4.2 per cent this year, up from 2.9 per cent last year and 2.1 per cent in 2002. America is leading the way, with a likely growth rate of nearly 4.5 per cent for the year. Next among the G7 countries, perhaps surprisingly, is Japan, where growth should top 4 per cent. For an economy not long ago apparently condemned to permanent stagnation, Japan’s revival this year has been quite a story. I’ll come on in a moment to the question of whether it can be sustained.

Britain can hold her head up high, with likely growth of 3.5 per cent this year – in line with the upper end of Gordon Brown’s forecast range – up from 1.7 and 2.2 per cent in 2002 and 2003 respectively. That ranks as a stellar performance among Europe’s bigger economies. Germany and Italy will grow by less than 1.5 per cent; France by around 2 per cent. Euroland, which has been crawling along at growth rates of below 1 per cent a year for the past 2-3 years is doing better though not dramatically so. This year’s expansion will be about 1.75 per cent.

The story of 2004 has thus been one of good growth, although it has been unbalanced, with the euro countries lagging behind, Britain doing very well but the real growth action being in America and Asia. I have not mentioned China, which should grow by 8 per cent this year or India, not far behind on about 7 per cent. So what about 2005?

Let me start by listing what economists describe as the “headwinds” facing the global economy. The first is monetary policy. Central banks, particularly in the wake of 9/11, decided that their economies needed a substantial tailwind in the form of very low interest rates. Now they are in the process of removing that stimulus, for fearing of allowing inflation back into the system.

The Bank of England started the ball rolling in November last year and has continued raising rates in a steady way since. It was followed by the Federal Reserve in June, which also seems set on a course of raising rates steadily, admittedly from the very low level of 1 per cent. In China the authorities have also taken action, by squeezing bank lending and liquidity in an attempt to cool an overheated economy. Higher rates in Europe and Japan will come, though perhaps not for a while.

If the monetary stimulus is being removed, so is that provided by fiscal policy. Most countries have larger budget deficits than they would like. In the case of Britain and some of the bigger Euroland economies, the fiscal rules have either already been broken or under threat. A tightening is therefore in progress. Whoever wins the November presidential election in America, it is hard to see them not taking action to cut the deficit.

A third headwind is provided by high oil prices. One of the surprises this year has been the failure of oil prices to lie down. The ingredients are familiar – high levels of demand from a strong global economy (boosted by the China effect), supply worries directly and indirectly resulting from the Iraq war, more general Middle East tension, worries over Russian production, and so on. Most analysts now expect oil to settle in the mid-$30s a barrel, $10 more than they expected a few months ago. Even that may be too optimistic. In real terms oil is well below previous peaks but even at $40 a barrel or more it has the capacity to do damage, effectively acting as a tax on growth.

A fourth possible constraint is China itself. Such has been the consistency of Chinese growth that it is tempting to think of it as a kind of economic perpetual motion machine. But the authorities have taken action against overheating for good reason – the risk of rapid inflation. Some see a risk of a significant Chinese slowdown.

Finally, and this almost goes without saying, the terrorist risk now seems to be an almost permanent economic headwind. Even the White House has warned of taking emergency measures should the presidential election be disrupted by terrorism.

Adding all this up, most economists think the world economy will come off this year’s pace next year. There are already some signs of that in America, with second quarter growth slowing to an annualised rate of just per cent, from 4.5 per cent in the first. That may have been a temporary effect or a sign that, even before the Fed has really started raising rates, momentum is fading.
Broadly speaking, though, the expectation is of an easing of the pace of growth, not a sudden halt. America will grow a little slower; perhaps 3.5 rather than 4.5 per cent, and Japan will come back down to earth, growing by about 2 per cent. Britain should manage 3 per cent, while Euroland will again struggle to hit 2 per cent.

Where do the risks lie to this consensus? Probably on the downside. According to economists at Schroders, a Chinese “hard landing” and an abrupt post-election slowdown in America could make next year feel distinctly cool, with growth sharply lower. Economists at Dresdner Kleinwort Wasserstein have similar fears.

What about the risks on the other side? There is, as Schroders acknowledges, also a realistic “no landing” scenario, in which the US economy powers ahead through the election period, and China shrugs off the attempts by the authorities to slow it down. If we wanted to think of a “no landing” in Britain, it would be that the housing market – against all predictions – continues to rise by 20 per cent a year.

Which will it be? I’ll go for the modest slowdown, while acknowledging that this is also the safe option. Not for the first time, we’re left hoping for a Goldilocks world economy, not too hot and, most definitely, not too cold either.

From Business Voice, September 2004

Comments

From USA Today, "Companies in the Standard & Poor's 500 are expected to boost capital spending 5.5% this year, reversing two years of cutbacks, says Howard Silverblatt, strategist at Standard & Poor's. They boosted spending 5.7% in the second quarter after a first-quarter increase of 5.5% - the first back-to-back quarterly increases since the end of 2001, S&P says."

Capital spending is the mother's milk of economic growth. I'm optomistic about the economy's prospects if central banks don't overreact and crash the money supply. If only the central banks would get out of the business of economic management and concentrate on moderate and steady growth of the money supply, we would all be better off.

Capital spending, competition, low marginal tax rates on income and capital will promote long term steady growth which will erase deficits if government spending simply slows. It always works.

Posted by: Gary B at September 5, 2004 06:58 PM