On Tuesday, Martin Wolf , the chief economics commentator at the Financial Times of London, published a startling article about the prospects for the world economy in 2006.  --  In Wolf's view, "the risks of [what could go wrong's] doing so are [not] adequately priced" at present, and as a result, the sense that "a happy new year is now expected" for the world economy is unjustified.  --  "Large dangers of disruption exist," he writes.  "But markets are ignoring them.  So we must recognize the danger not only that something will go wrong, but that markets will then multiply the needed corrections." ...

Comment & analysis


By Martin Wolf

Financial Times (UK)
January 3, 2006

http://news.ft.com/cms/s/940454f6-7c8c-11da-936a-0000779e2340.html (subscribers only)

For the world economy, a happy new year is now expected. But forecasters usually assume that recent trends will continue, modified where appropriate by reversion to a longer term mean. It is more useful, however, to ask what might change. When everything is going quite well, as now, that mostly means asking what could go wrong and, more important, whether the risks of its doing so are adequately priced. The answer is: they are not.

Start with the expectations. According to December's Consensus Economics, the average growth forecasts for this year are: 3.4 per cent for the U.S.; 1.9 per cent for the eurozone (with France on 1.9 per cent, Germany on 1.5 per cent, and Italy on 1.3 per cent); 2.1 per cent for the U.K.; 2.0 per cent for Japan; 4.0 per cent for Latin America (with Brazil on 3.4 per cent); 5.3 per cent for eastern Europe (with Russia on 5.7 per cent); 8.5 per cent for China; and 7 per cent for India (in fiscal year 2006). The story is clear: the upswing broadens; the U.S. continues to outperform other big developed countries; Germany and Italy remain laggards; Latin America disappoints; and the Asian giants grow fastest.

So what might go wrong? The dangers fall into three categories: non-economic, economic and, in the case of energy, a blend of the two.

The biggest non-economic risks are those relating to security, as Harvard's Ken Rogoff pointed out in yesterday's FT. Consider the possibility of a nuclear device found -- or even let off -- in a container in an important port. But a nuclear device in the Saudi oil fields would be as devastating. The four horsemen of the apocalypse (war, famine, disease, and death) are always with us. A century ago, nobody expected the First World War, which ushered in an era of conflict, chaos, and economic calamity.

The risk at the cusp of the non-economic and the economic is our insatiable demand for energy. The economic progress of the past two centuries is built on growing consumption of fossil fuels. According to the U.S. Energy Information Administration, the total energy supplied by oil, natural gas, and coal will need to grow by about three-fifths between 2002 and 2025. Its forecast increase in the demand for oil is equivalent to adding four new Saudi Arabias. The energy demands of global growth are, at the least, a series of small accidents waiting to happen. They could be a big accident waiting to happen, instead.

The economic risks are most evident in today's "imbalances." If the world economy is to continue on its present path, markets must remain open to exports from developing countries. Finance must also flow smoothly from countries with excess savings and large current account surpluses to countries both able and willing to absorb the resulting capital outflows. The debtors must be willing to go on borrowing. Interest rates must remain low (in both real and nominal terms). This, in turn, will demand continued low inflation and sustainable public finances.

Many are the risks of disruption. To take one salient example, the principal domestic counterpart to the huge U.S. current account deficit is the financial deficit of U.S. households, currently running at an all-time record of more than 7 per cent of gross domestic product. As Wynne Godley, the Cambridge economist, has pointed out, with such a financial deficit, the indebtedness of the household sector must rise continuously. And indeed it has, from 92 per cent of disposable income in the first quarter of 1998 to 126 per cent in the third quarter of last year. That rise in indebtedness has pushed household debt services payments to an all-time high of 14 per cent of disposable incomes, despite today's modest interest rates. What would happen if house prices ceased to rise or interest rates increased? Households would cut back on their borrowing. If they did, how would a sharp U.S. slowdown be avoided?

The big question, however, is whether these risks are correctly priced. The reason to believe they might not be is our natural tendency to ignore the likelihood of low probability events, however calamitous. Nassim Taleb made this point in his brilliant book, Fooled by Randomness.+ In a "Taleb distribution," catastrophic loss follows a long history of small gains. Lulled into a sense of security, people greatly overestimate the probability of winning in the long run.

After such a long period of stable growth and low inflation, precisely this mistake seems evident in almost every asset market. On a cyclically adjusted basis, the U.S. stock market is as highly valued as in any period of the past 120 years, except the late 1920s and the late 1990s (see chart). What is needed to justify this condition is the bold assumption that current exceptional profitability will endure forever. Similarly, house prices are high, on most measures of value, almost everywhere. The justification could well be that interest rates are so low, in real and nominal terms. But continuation of low real interest rates is possible only if one assumes an enduring savings glut in much of the world, while continuation of modest nominal rates requires low inflation forever, as well. Finally, spreads on risky assets are also very low (see chart). But present conditions of easy monetary policy and weak demand for investment are unlikely to persist. When they change, credit spreads are likely to widen again.

I am neither clever enough nor foolhardy enough to make forecasts. It may be more likely than not that this year will be very like 2005. But it may well not be. Large dangers of disruption exist. But markets are ignoring them. So we must recognize the danger not only that something will go wrong, but that markets will then multiply the needed corrections.

Today, alas, the world is priced almost for perfection. Something close to perfection may indeed be with us in any year. But disappointment is ultimately certain. The question everybody should ask is not what will happen this year. The question is, instead, whether we are making a good assessment at least of what Donald Rumsfeld would call "the known unknowns." We are not.

Hamlet told us everything we can know: "we defy augury. There is a special providence in the fall of a sparrow. If it be now, 'tis not to come; if it be not to come, it will be now; if it be not now, yet it will come -- the readiness is all." Hamlet was talking about life, which is the ultimate Taleb distribution. Are you prepared for the fall of the sparrow? I do hope so. Anything else would be foolish.

Happy new year.

+Texere Publishing, 2001

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