April 3, 2002

According to the latest forecasts by the International Monetary Fund (IMF), world economic activity may grow less than 1.5 percent in 2002.  Unlike individual countries, where a recession requires a decline in economic activity, most economists believe that a world recession occurs when economic activity is expanding by less than the growth in world population. 

World population is growing about 2 percent, although population growth appears to be slowing in virtually all countries except those garnering migration from other parts of the world.  Thus, the IMF forecast is one of global recession. 

Of course, economists are aware of the speculative excesses that led to consumers spending more rapidly than they were earning and corporations investing more aggressively than they could use the equipment they were acquiring.  Some of this excess was worldwide, especially in communications. 

However, a US recession became global because of the behavior of monetary authorities around the world.  And recovery is being delayed because most of those monetary authorities continue to hope that external factors, such as recovery in the US , will permit them to continue anti-growth programs. 

(Actually, I believe the IMF forecasts are too pessimistic and that world growth will be closer to 2.2 percent, but this does not alter my criticism of world monetary activity). 

I already have criticized two policy flaws in our own monetary activity that have not yet been eliminated.  First, our Federal Reserve appears to begin a change in monetary policy with timidity and then become bolder.  Thus, the most aggressive policy usually is at the end of a policy shift, when policy overshoots the target. 

Second, our Federal Reserve does not re-establish normality in the credit markets after a policy shift is completed.  The interest rate cuts that protected the U.S. against the Asian crisis were not reversed when the crisis was over.  High interest rates that pricked the speculative bubble remained in place until a recession was on the horizon. 

These clearly are areas that require improvement if non-inflationary sustainable growth at high levels of resource utilization are to be sustained.  Nevertheless, our Federal Reserve has attacked problems and generally repelled the worst outcomes that those problems could create. 

Kudos also are deserving for the central bank in Great Britain .  Indeed, they also were aggressive at supporting growth during the world recession.  Even without a strong currency, inflation has been restrained while growth has been sustained. 

The British pound has made their task more difficult.  Instead of being rewarded with a strong currency for preserving growth, the pound has been acting as if it is tied to the euro.  As a result, currency related inflation has created an added challenge for England . 

Frankly, Britain either must declare the pound will be converted to the euro or that no such union will ever occur.  Being punished for a euro connection while pursuing monetary policies that are far superior to those in euro-land should not be allowed to continue. 

Of course, the European central bank has been fighting an inflation that was caused by rising oil prices and a falling currency while unemployment rose on the continent.  The recessions that spread throughout most of Europe would not have occurred if a more aggressive monetary expansion had occurred.  Now euro-land is waiting for the US to provide them with growth rather than generating it from their own policies. 

The fallacy that restrictive monetary policy will support currency values also is restraining the Japanese central bank from aggressively fighting the deflation that continues to threaten the lending capacity of its banks. 

This fallacy arises because our basic economic textbooks teach that tight monetary policies raise interest rates while restricting inflation domestically.  As a result, world savings flow to this happy state of higher inflation adjusted returns.  This increased demand for domestic assets raises the value of the currency a rewards astute international investors. 

What is missing from this reasoning is what such a monetary policy is doing to the earning capacity of assets in the domestic economy.  Who wants to buy equities in a country where earnings are falling?  How much can interest rates rise when no capital is needed?

What the textbooks do not emphasize is the separate impact that earnings from capital creates in attracting international savings.  In fact, the no growth policies in euro-land and in Japan are causing savings to flee from such unhappy economies.  The result is currency weakness. 

Indeed, Japan would have a stronger currency after it defeated deflation than it has from restricting money growth.  Unfortunately, its central banker does not understand that and the Japanese recession continues. 

Hopefully, these central bankers will learn from past misdeeds and stop waiting for external forces to support their economies.  If not, more frequent world recessions are likely in the years ahead. 




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