THE world economy is slowing and pretty soon the dreaded word “recession” will reappear in media headlines, especially in the American and German press. This may seem a strange prediction. After all, America has just reported a 4.8 per cent annualised growth rate, German business confidence is at its highest level since unification, stock markets everywhere are near record highs and prices of economically sensitive commodities such as copper have doubled this year.
Why, then, do I say that the world economy will soon seem to be on the brink of recession? Let me begin by emphasising that weasel-word “seem”. I am not suggesting that a recession will actually happen, but I do believe that perceptions of economic performance will shift abruptly downwards, especially in Germany and the United States. And given the extreme bullish sentiment now prevalent among businessmen, investors and central bankers, even a modest slowdown will come as a rude shock. This shock will probably be big enough to cause some financial mayhem and swing the pendulum of financial and media sentiment abruptly from today’s over-optimism to a pessimistic extreme.
Now let me turn from sentiment to substance. Why am I so convinced that the world economy is actually slowing, even though financial markets and business sentiment are pointing to faster growth? Because, while the markets generally have to be respected, there are times when they get things spectacularly wrong.
Recall the insane over-optimism of investors in technology shares in the late 1990s, or the equally misguided pessimism of bond investors, who believed that the world was heading for a long depression in 2003. In both these cases, financial market had a very clear view about the economic outlook and it turned out to be wrong. This was obvious at the time to anyone who looked dispassionately at the underlying economics — the impossible growth expectations for technology stocks in 1999 or the ultra-stimulative monetary conditions created in 2003, which virtually guaranteed a strong recovery by 2004. Yet the markets’ exaggerated sentiment distorted official forecasts and, in turn, these distorted forecasts seemed to justify investors’ misguided views.
Those two bizarre episodes were perfect examples of the self-reinforcing process called “reflexivity” described 20 years ago by George Soros in The Alchemy of Finance, his classic analysis of financial speculation and its surprisingly pervasive effects on the real world. Reflexivity magnifies errors in financial markets by transferring the erroneous perceptions of investors into the real economy and then reflecting them back into market prices in an exaggerated form.
This feedback process, according to Soros, is the root cause of all boom-bust cycles — and looking at the world today he certainly seems to have a point.
There are two great reflexive divergences between reality and market perceptions today — the idea that Europe is enjoying a strong economic recovery and the belief that America is somehow immune to rising interest rates and the soaring price of oil.
Last Thursday, European politicians and central bankers boasted of the dynamism of the eurozone economy after Eurostat, the European Union statistics office, announced that its preliminary estimate of GDP in the first quarter showed growth of 0.6 per cent. But closer inspection of the statistics showed that the eurozone’s apparent acceleration from
0.3 per cent growth in the fourth quarter of last year was a statistical mirage. Most European countries actually weakened and the whole improvement was due to a “dead-cat bounce” in Germany and Italy, both of which had zero growth in Q4. Averaging over two quarters, in order to eliminate the volatility of recent statistics — due partly to weather and partly to political upheavals in Italy, Germany and France — shows that the trend in nearly every European country, and most emphatically in Germany, is actually down.
These smoothed statistics show that a slight improvement in European economic conditions last summer had fizzled out by the autumn. They also reveal that the divergence between business optimism and economic reality, especially in Germany, has now reached ridiculous proportions. As a result, the interest-rate policy of the European Central Bank, which is based largely on business expectations, could push the eurozone into recession unless the central bankers quickly refocus on economic reality, instead of the fantasies of German businessmen, which in turn are inspired by the apparent confidence of the ECB.
The problem in America is the other way round. The Federal Reserve understands economic reality but the markets refuse to believe it. There is a widespread view on Wall Street that the US economy is growing strongly and has shaken off the effects of 5 per cent interest rates and the soaring oil price. It is now clear, however, that the post-Katrina rebound that boosted first-quarter growth figures was just that — a one-off bounce lasting a month or two. Last Friday, the University of Michigan consumer confidence survery revealed the biggest decline in consumer expectations in its 30-year record, the US trade figures showed an abrupt slowdown in imports and retail sales figures suggested that higher petrol prices were now crowding out virtually all consumption growth.
Between them, these statistics paint a clear picture of the US economy slowing down. This slowdown should not lead to outright recession because the Federal Reserve Board will eventually cut interest rates to support the US housing market and revive consumer demand. For the time being, however, the bias in US monetary policy must remain towards monetary tightening, since inflation is creeping upwards, commodity prices are flying and the markets refuse to believe that a slowdown is on the way.
Once investors accept the slowdown story, commodity prices will collapse, inflation will stabilise and the Fed will be free to consider a policy of stimulating US demand. But this will be impossible as long as the world puts its faith in ebullient stock markets and metal prices, rather than the sober message from economic statistics. In the end, reality will prevail over expectations. But first investors and businesses should prepare to ride a psychological roller-coaster from over-optimism to pessimism and then back again.
