TCS Daily

A Tolstoy Economy

By Desmond Lachman - September 6, 2006 12:00 AM

Leo Tolstoy wrote that while happy families are all alike, every unhappy family is unhappy in its own way. The same might perhaps be said of the unwinding of major global economic imbalances at different times. For while the serious imbalances characterizing today's global economy bear a certain resemblance to those of 1973, there would also seem to be important differences. Those differences make it most likely that today's global economic imbalances will unwind in a very different way from those in the past, even though the end-result might be no happier.

Looking at the way in which today's markets are choosing not to price economic or political risk, one might be forgiven for thinking that all was well with the global economy and that peace was about to break out in the Middle East. For seldom have we had a situation where global equity volatility has been so low or where the major global currencies have traded in quite so narrow a range. Similarly we would have to go back to the period before the 1997 Asian crisis to find emerging market and corporate high yield-debt trading so favorably.

Yet when one reflects upon the present state of the global economy, one has to be struck by the unusually large number of economic and political risks that now threaten the global economic recovery. One also has be taken aback by the very seriousness of those risks should they ever be triggered.

Leaving aside the ever-present geopolitical risks, especially in the Middle East, there are today at least three main risks to the global economic recovery: First, there is an unprecedented large United States trade imbalance, which could be the precursor to a real dollar crisis. Second, there is an unusually low level of spare capacity in global crude oil and refining production, which exposes the global economy to the risk of yet another oil price shock emanating from the Middle East, Nigeria or Venezuela. And last, but by no means least, we are in the midst of a historically unprecedented US housing price bubble, whose bursting could be a major drag on US and global economic growth.

Niall Ferguson, the Harvard economic historian, has noted the many similarities between today's global economy and that which prevailed in 1914 immediately before the First World War. Most tellingly, he reminds us that then, as today, markets were simply not prepared for the possibility that globalization could come to an end. Indeed, it was not until the last week of July 1914 that market participants began scrambling for liquidity to protect against the possibility that war might break out. The panic selling that ensued necessitated the closing of the world's major stock markets for the rest of that year.

While there are certain parallels between today's economic situation and that in 1914, today's situation would seem to be a lot closer to that which prevailed immediately before the onset of the serious recession and the prolonged equity bear market of the mid-1970s. At the political level, then, as now, the US was engaged in an unsuccessful foreign war, albeit in Vietnam rather than in Iraq, while it also had a president whose popularity kept declining. At an economic level, then, as now, the world economy was forced to cope with ever-higher international oil prices, while the unraveling of the Bretton Woods system and a large US external deficit resulted in an ever-weakening US dollar.

There are, however, at least two basic differences between today's situation and that of 1973, which would make it highly unlikely that we will again suffer from the sort of stagflation that plagued the mid-1970s.In the first instance, the Fed is starting from a relatively low level of inflation and it has a better understanding today than it did in the 1970s of how it should respond to an oil price shock.

The more important difference is that, unlike in the mid-1970s, today we would seem to be at the peak of an unprecedented US housing price bubble. As that bubble begins to deflate, we must expect US households to tighten their belts and to increase their savings. This is bound to constitute a major drag on the economy and is likely to be deflationary in its effect in much the same way as was the bursting of the equity price bubble beginning in March 2000.

The net upshot is that despite the apparent complacency of today's financial markets there is the very real risk that the global economy is in for a hard-landing. However, in keeping with Tolstoy's view that unhappy families are unhappy in their own way this hard-landing is most likely to end in deflation rather than in the inflationary burst of the mid-1970s.

Desmond Lachman is a Resident Fellow of the American Enterprise Institute.



One Similarity to 1973
"we must expect US households to tighten their belts and to increase their savings. This is bound to constitute a major drag on the economy"

apparently we are still all Keynesians, now.

no reason to expect a hard landing
Hold on. In the 1970s, there was a big productivity slowdown. This was an important part of the reason for the decline. The US has had strong productivity growth in recent years, and I don't see why that shouldn't continue. At any rate, Lachman hasn't offered one.

Second of all, strong growth in the rest of the world means that the US as economic locomotive is not needed as much as it used to be. If growth in the US slows down, demand from East Asia and even to some extent the EU can take up the slack.

But would a deflation of the housing bubble-- if it is a bubble-- really cause the US economy to slow down? If people have a certain desired net wealth position, a decrease in their wealth due to a weaker housing market should make them want to work MORE, not less. And if the dollar falls, that should make it easier to work more, because it will boost US exports in the medium run. If the dollar CRASHES, that's a big problem, but there's no reason to worry a lot about a SLIDE in the dollar.

Lachman should cheer up. We'll be all right.

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