Tuesday, March 22, 2011

Japan + the markets + higher oil prices = another (mild) recession?

OK, I know it's been a considerable amount of time since my last posting, but I've been busy interviewing and doing conference presentations, but also a little blown over by world events in the last 6 weeks.  Each time I've sat down to write about one event, another seems to happen!  The events in the Middle East, and particularly the fall of Mubarak in Egypt and the uprising in Libya, have been astonishing, while the earthquake, Tsunami and nuclear fallout in Japan have been heartwrenching to watch unfurl, and the market reaction has been knee-jerk to say the least. All these bits of the jigsaw might be relatively easy to analyze by themselves, but the interactions between them all have been difficult to piece together and understand in the context of the world economy. 

So let's start with the fallout (literally) from Japan's tsunami, earthquake and tsunami.  Japan's economy was beginning to show some feeble signs of recovery prior to the earthquake, tsunami and nuclear fallout, but this disaster changes everything.  The fall in Japanese stock prices, as Warren E. Buffett, the billionaire investor recently stated, thinks the disaster in Japan doesn’t change the economic future of the country, but with the market turmoil creates a buying opportunity for investors (see http://www.businessworld.in/bw/2011_03_21_Buffett_Japan_A_Buying_Opportunity.html).  I would go one step further, and say that it does substantially change the economic future of the country, and for one simple reason - the stimulus that the rebuilding must bring to the Japanese economy.  As any undergraduate principles of economics student knows, a disaster, as long as it happens in a country, region or state that has the resources to rebuild ( - and despite it's massive public debt, Japan certainly has the capacity to rebuild through issue of either savings bonds to the thrifty Japanese general public or by special financing bonds for public infrastructure), will lead to higher GDP than before and often higher sustainable growth rates than before if this better quality infrastructure.  Think New Orleans and contrast this with Haiti and hopefully you'll get my point.  The key here is that this rebuilding effort may begin to utilize resources that have been idle, or largely idle over the past 18 years, allowing Japan to break out of it's deflationary liquidity trap.  In economics jargon, I see the disaster in Japan as a shock that might allow Japanese GDP to start growing in a more normal way again.  That can only be good news for the rest of the world.

What about the impact on other countries and therefore the global stockmarket reaction to this?  Well Japan had a housing meltdown in the early 1990s with no apparent impact on the rest of the world, so why would the destruction of wealth this time around have a sizeable economic impact on the rest of the world?  Hence my reaction to the skittishness in the stockmarkets about the Japanese situation is that myopia will soon overcome any nervousness about the global fallout from the Japanese situation.

Now to the situation in the Middle East.  The main threat here is continuing instability and that clearly affects the oil price.  There are 2 possible scenarios that I see playing out - either a) the "low-hanging" fruit has already been picked (i.e. countries that could have a relatively stable transition of power) and populist uprisings in the "high-hanging" fruit will cause massive instability if (and that's a big "if") this wave of popular protest continues or b) the action over the Libyan situation causes a "domino" effect to occur i.e.the wave of popular protest against unpopular autocracies gathers steam and becomes unstoppable.  Clearly scenario a) is the most worrisome for the rest of the World, and would entail much higher oil prices than where we're at, whereas presumably scenario b) would imply only temporary disruptions and a much better long term future for the region.

So if much higher oil prices occur, would this give us a "double-dip" recession?  I think the risks are certainly there in certain countries, and it would be a similar set of recessions to those that occurred in the 1970s with oil prices the catalyst, but I don't think the natural international business cycle points in this direction right now.  I think though on balance this has a much lower risk than continued growth, particularly in the developed world, as countries that have significant long term stimulus efforts in place (such as the US) will not be completely knocked off course by significantly higher oil prices. The major risks are to countries such as the UK and clearly higher oil prices would cause a further slowdown in countries such as China and India.  Countries like Brazil and Canada could benefit from such a scenario though, although obviously the benefits would not be evenly spread throughout the economy.
Certainly, once again, we live in interesting times!!

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