May 21, 2000
There must be nothing more deflating for an Olympic relay runner than being miles ahead, with victory and a possible world record in sight, only to drop the baton. How many times have we seen brilliant performances stumble and collapse at the changeover?
The simplest thing, practised hundreds of times in training, fails to come off. Despairing teammates, heads in hands, can only look on as glory races off into the distance and the useless baton lies discarded on the grass. It doesn’t matter how good the coach, how fast the final sprinter or how many records have been smashed in the past, these athletes will henceforth be remembered as the team who blew it.
The world economy can be regarded as a similarly interdependent relay team. Certain regions and areas make the running for a few years and when these run out of steam, the baton is passed to another region.
If we look back at the 20-year period from 1980 to now, we can see this relay process between the US, Japan and Europe quite clearly. In the early to mid 1980s, the US recovered and then began to motor. By 1986/87 it was the turn of booming Japan to take over and the baton was passed smoothly until around 1990. By 1990, following its late 1980s sprint, Japan started to suck air.
The US’s mini recession of the early 1990s suggested overexertion during the Reagan years but luckily post-unification Germany was on hand. Having been limbering up during the previous three years, unification put Germany on steroids. When this short-term boost wore off, the US in 1993/4 was ready again to take the baton and has been sprinting ever since.
Now there are emerging signs that the US economy is finally showing the strain. In recent quarters the growth rate has been driven by the consumer as a combination of historically low unemployment and unprecedented wealth increases from the stock market are underpinning a spending binge.
With the national savings rate now in negative territory, US punters have already spent their own savings and – as evidenced by the burgeoning current account deficit – are now spending the rest of the world’s. Many argue this effervescent cocktail has been spiked by interest rates that have been far too low for far too long.
Alan Greenspan, aware of the danger in an abrupt puncturing of the stock market bubble, has been raising rates gently for over a year now. However, this week he seemed to change gear with a 0.5 per cent increase and the indication from the Delphic Fed chairman that more may follow. These events, together with three months of financial market jitters, suggest it may be time for the US to pass on the global growth baton.
In finance as well as athletics, pace and synchronicity are all important. In a relay race it is essential that the receiving runner has already built up a decent pace when he takes the baton.
Otherwise, the incoming sprinter will crash into his teammate or will be forced to ratchet down too many gears too quickly, thus increasing dramatically the chances of a fumble. Precisely the same dynamic pertains in the global economy.
For the US to pass the baton smoothly, either Germany/Europe or Japan needs to be travelling quite quickly. This implies that global interest rates need to be rising at the time when Europe or Japan takes up the challenge. In the past, this has always been the case.
In 1986 Japanese and US rates were rising, likewise German rates in 1990 and similarly, US and German rates again in 1993/94. However, given Japan’s almost decade long recession, we can probably rule it out as a global saviour. Therefore, the spotlight falls on Europe.
Is Europe travelling quickly enough? My guess is not yet. Luckily, we don’t have to rely on guesswork. The relative position of the dollar/euro exchange rate clarifies things for us. Because this exchange rate is a reflection of future growth and investment opportunities in both regions, a fully warmed up, primed European sprinter would be signalled by the dollar falling sharply against the euro. Unfortunately, the opposite is the case, implying Europe isn’t ready and only when both the euro and our interest rates are significantly higher can we have the confidence that the baton will not be dropped.
A fumbled baton is the sporting equivalent of a financial market crash in the US extending into our markets. Like the sprinter crashing into his teammate, if Europe cannot match the US’s locomotive powers, global growth prospects could evaporate with the US slowdown.
Consequently, the ability of the rest of the world to inflate US companies’ earnings will be undermined, causing a re-rating downwards of ‘old economy’ stocks in particular. Such a development, taken together with the higher US interest rates, will draw liquidity out of the stock market at precisely the time when liquidity is most needed.
With poor earnings prospects and even poorer liquidity, the markets could well take fright, producing the financial equivalent of a baton fumble. In these circumstances, instead of the dollar gradually easing back ahead of a changeover, the dollar would drop like a stone on the realisation that the changeover might be difficult.
This week’s events in the US suggest that the global economy is at a critical juncture, precisely like a relay team coming up to a baton change.
Unfortunately for the sprinting coach, Alan Greenspan, there is not a lot he can do but hope that the receiver is on song.
But even from the grandstand the crowd can see that the sprinter is hurtling far too quickly. Will he slow down while the recipient takes off? Is a fumble on the cards?
Let’s hope not, because we’ve all paid to see the event and dropping the baton would be too much to bear.