JUST OVER a year ago the world economy found itself standing at the edge of an abyss. The Russian crash of August 1998, coming in the wake of the Asian economic crisis, sent global financial markets into panic.
That seems far behind us today. According to mainstream pundits and politicians the sheer economic strength of the United States saved the world from falling over the brink. Shrewdly timed interest rate cuts reassured finance markets. And the booming US economy helped to sustain world growth by providing a market for other countries. The boom apparently goes on. 'From coast to coast the US economy is humming as it has not done for decades,' the Financial Times reported not long ago. US unemployment has just fallen to 4.1 percent, the lowest level since 1970.
The resulting mood of optimism was reflected in Monday's Guardian, which was largely devoted to celebrating 'The American Century'. But two British economists argue that the US boom rests on very fragile foundations indeed. Last December Bill Martin and Wynne Godley produced a research paper for stockbrokers Philips and Drew.
They argued that at the heart of the boom were soaring share prices on the Wall Street stock market. The spectacular rise in share prices during the 1990s encouraged prosperous middle class households to speculate on the stock market. These households felt richer as their shares prospered, so they spent more. This was good for the economy, since it meant that demand for goods and services rose. But the US middle class borrowed more in order to finance their higher spending. The spending of the private sector rose above its disposable income to a historically unprecedented degree.
This situation was, Mar tin and Godley argued, unsustainable. It depended on share prices continuing to rise at an unbelievable rate. And it was producing a soaring US balance of payments deficit, as consumer spending sucked in imports from the rest of the world. Sooner or later the US middle class would have to cut down spending and start saving again. The resulting fall in demand would not simply produce a recession in the US. Given the country's role as 'consumer of last resort' on a world scale, the likely consequence would be a global slump.
Godley and Martin have now updated their analysis. In a new paper, they defy the official euphoria, declaring that 'our previous paper rather understated the risks facing an unsuspecting America'. They show that Wall Street share prices are way out of line with the underlying profits of US companies and point to the disproportionate impact that well off households have on consumer spending. The top 20 percent of households account for nearly 40 percent of total expenditure.
The paper also looks at the experience of other stock market bubbles such as those in Japan and Britain during the late 1980s. The consequences are devastating when the bubble of financial speculation finally bursts. Individuals and companies find themselves stuck with debt that was backed by shares whose value has been more or less wiped out. They have to cut back on spending in order to pay back the debt. The effect is to drive the economy into recession.
As Martin and Godley put it, 'Once growth falters, the self reinforcing process which has fostered an enviable expansion is liable to go into a powerful reverse.' Lower spending reduces demand for goods and services and therefore the incomes of those producing these goods and services. 'Despite attempts of debtors to curb borrowing, the initial effect of their collective action is to reduce their ability to service debt thanks to the sharp contraction of incomes,' the paper says. And people can spend even less as they become poorer. The economy is driven into a vicious downward spiral.
Martin and Godley argue that in theory this process could be halted if the US government was willing either to spend more itself or to cut taxes to encourage private spending. But, given the present free market ideological consensus, establishment politicians are unlikely to back the huge stimulus that would be needed. 'We would regard it as nothing short of miraculous were America to succeed in warding off the depressive forces of a huge bursting bubble when others, in similar circumstances, have all failed,' they conclude.
This analysis should be taken seriously. Godley was one of the very few economists to have predicted the scale of the Thatcher recession of the early 1980s and to have warned that the Lawson boom at the end of the same decade would produce another great slump. If he and Martin are right, there are stormy times ahead for the US and the world economy.