Delayed, but there is a day of reckoning

Knock-on effects of slower US growth will be felt in every corner of the globe

Larry Elliott, economics editor
Monday June 26, 2006
The Guardian

No prizes for guessing what's going to be the focus of attention in the financial markets this week. At around 2.15pm Washington time on Thursday, the Federal Reserve will announce its latest decision on interest rates. The almost universal belief is that the US central bank will increase interest rates for the 17th successive time to 5.25%. But of greater interest will be the hints dropped by the Fed about its future intentions.

Will 5.25% be it? Or is Barclays Capital right when it says the figure could go as high as 6%? At the same time as the Fed announces its decision, trade ministers from 40 countries will be gathering in Geneva for the latest make-or-break meeting to save the Doha round of negotiations from collapse. This will be a much lengthier affair; the World Trade Organisation thinks the haggling could go on into the weekend and even beyond.

Both meetings are important. The optimistic scenario is that the Fed finesses a soft landing for the US economy, calibrating the level of interest rates so that growth eases enough to temper inflationary pressure, but without causing a recession. A strong US economy helps tug the rest of the world along, keeping demand high in Asia and Europe.

Meanwhile, a successful conclusion to the trade talks removes protective barriers and helps extend the longest period of sustained growth seen in the global economy since the early 1970s. As Peter Mandelson said last Friday, the multilateral trading system is the "engine room of the global economy".

It is not going to be easy on either front. In Washington, the Fed now has the task of clearing up the mistakes made in Alan Greenspan's last years. The fact that inflation is picking up even as the economy is slowing down, is testimony to an over-lax monetary policy two or three years ago.

Interest rates were left too low for too long, and when Greenspan did start to tighten the screw it was too little, too late. The US needed to work off the excesses of its debt binge in the 1990s but never had the chance to do so because the Fed pumped the economy full of cheap money. In previous eras, the speculation, and over-investment seen at the end of the 1990s, would have led to a recession as the excess capacity was worked off. Greenspan ensured that even the bursting of one of the biggest stock market bubbles in history did not have much of an impact on growth by fuelling a colossal boom in housing.

What is becoming clear is that the day of reckoning has been delayed, rather than avoided altogether.

A period of slower growth in the US is now inevitable. Interest rates at their current level are more than sufficient to kill off the housing bubble; indeed, the signs are that the property market is cooling rapidly. The Fed, though, is unlikely to stop raising rates yet, given that inflation is still rising.

Unless there is some exceptionally weak data over the coming month, the Fed is likely to push rates up to 5.5% in August and leave them there for some time. That will represent monetary overkill, increasing the risk of a hard landing and making deflation more of a threat than inflation. Bond prices are likely to soar, and equity prices are likely to suffer as the 2002-04 stock market recovery is seen as a cyclical bull phase in a secular bear market. The knock-on effects of slower US growth will be felt in every other corner of the globe and, no doubt, lead to redoubled calls for the trade talks to be completed quickly and successfully. That will be easier said than done, despite the more positive noises coming out of Brussels and Washington last week, since history shows that countries tend to be even more risk averse when growth is slow than when everything is ticking along nicely.

Governments tend to pay lip-service to the doctrine of free trade at the best of times; protectionism starts to look far more attractive as the unemployment lines lengthen. That's especially so when there are elections in the offing: there are mid-term elections in the US in November and a presidential election in France next year.

It is, then, conceivable that we could be in for a period in which a synchronised upswing in the global economy turns into a synchronised downturn, as weaker demand from the US ripples out to the export-driven economies of Asia and the Eurozone. Protectionism will then exacerbate the recession. To which the response might be: a good thing, too. If, as Al Gore was arguing during his visit to London last week, the world is on the brink of ecological catastrophe, we ought to lose our fixation with growth and concentrate on self-sufficiency and sustainability instead. The dystopian vision presented by the former vice-president is certainly alarming; the thawing of the Siberian permafrost, the irrevocable changes to marine life, the icequakes caused by the breaking up of the Greenland ice fields all point to the need for a root-and-branch rethink of the way we live our lives. From this standpoint, anything that throws sand in the wheels of the globalisation juggernaut is welcome. What we need is a full-scale cathartic crisis that will enable a new and better world to emerge.

It might not be that easy. True, a collapse of the Doha round, and a sharp contraction in global growth, could provide two of the elements that brought about change in the mid-20th century. But in the 1930s, the progression of events did not go stock market crash, recession, new world order. It went stock market crash, financial collapse, beggar-my-neighbour devaluation, protectionism, fascism, world war, new world order.

Clearly, the solution to Gore's looming environmental Armageddon has to be collective, rather than unilateral. There is no way that the US, for example, is going to take action to cut carbon emissions unless it is sure every other country is doing likewise.

Yet the chances of multilateral action will be diminished in a climate of fear generated by economic weakness. The report on the economics of climate change currently being undertaken by Nick Stern at the UK Treasury is likely to conclude that the costs associated with a reduction in the emissions to the levels deemed safe by scientists are relatively modest. Gore himself believes that tackling climate change will be good for business, opening up plenty of new opportunities to make money.

That's as may be. Multilateralism is a delicate plant; it does not thrive in harsh climates and the same impulses that drive countries to put up trade barriers when times get tough will persuade policymakers to listen to the special interest groups arguing that the price of tackling climate change is too high. The growth-at-all-costs lobby will be strengthened.

So it's potentially a bleak outlook. The Gore thesis suggests the current economic paradigm is leading us up an environmental blind alley, but if, and when, there is a crisis in globalisation it will set off a train of political events that will make the prospects for salvation far more difficult to achieve.

Gordon Brown says that it is no longer enough for progressives to marry economic growth with social justice; the challenge now is to add a third element - care for the environment. He's right: it is a challenge. As John Lennon once said, we'd all love to see the plan.

Source: The Guardian