Market Advisory Features
Breaking the Deflationary Spell
Economic and Financial Indicators
Investment Banking - A Spring in their Step
The Economy: Poised for Growth?
Financial Markets: Short memories, Deep Pockets
Mending Fences, Mending Economies
China: On a
Confronting the Enemies of Peace
A Bloodstained Road Map
On a roll
Last year, China’s imports and exports had a combined value of about $620 billion and accounted for 4.7% of world trade—nearly double the country’s share of 2.7% as recently as 1995 (see chart). Such is the speed with which China’s industries are growing that the share is expected to jump again over the next few years.
Take the steel industry. China's steel producers are developing so fast that the country is likely soon to overtake Japan as the world's largest importer of iron ore, a crucial ingredient in the production of steel. Before long, China could turn itself from being a big importer into a net exporter of steel. In recent years, the country's steelmakers have invested heavily in new factories and in modernising existing ones. That investment is beginning to pay off. A decade ago, Asia as a whole accounted for about a third of the world's production and consumption of steel. Today, the figure is closer to half on both counts, with China alone accounting for a quarter of the world's output and demand.
China also boasts one of the world's most competitive steel industries. And the quality of its output is high. World Steel Dynamics, a consultancy, reckons that the cost of building steel plants in China may be up to 60% lower than most other big steel-producing countries. This gives the country's steelmakers a big advantage which, in turn, could help to boost the competitiveness of their customers.
One reason for the rising consumption of steel in China has been the insatiable demand for cars. They have been rolling off assembly lines in unprecedented numbers since the country's accession to the WTO pushed down prices of imports and so helped to stimulate the market as a whole. Last year, sales of new cars in China jumped by 56% to a record total of 1.13m units. Sales of new cars are likely to suffer from the travel restrictions imposed on China's population in order to defeat SARS, but the medium-term outlook for carmakers remains rosy.
Steel is not the only industry where China is starting to have an impact internationally. Energy is another. The growing need for cheap fuel with which to generate electricity to feed the country's economic boom is stoking demand for oil and liquefied natural gas (LNG). China is already the world's third-largest consumer of oil after the United States and Japan. The US Energy Information Administration reckons that, if China's demand for oil grows by a modest 3.3% a year, the country will be importing nearly 11m barrels per day by 2025. Poten & Partners, an American shipping broker, estimates that, by 2012, owners will need another 70 very large tankers just to supply China's imports of oil.
Energy is only one area where the rapid growth of China's economy is having an effect on shipping and cargo rates. Because of rising demand for capacity, the cost of moving a 40ft box container from Asia to markets in the West has jumped from around $1,000 a year ago to nearly double that today. Rates for chartering container ships have also shot up. Indeed, demand for cargo space is so strong that container lines can barely keep up. The reason? Mainly the rapid growth in China's foreign trade.
Even taking SARS into account, the number of containers needed to shift goods from one place to another is likely to continue growing fast. In the past, says Drewry Shipping Consultants, the container trade has increased by between two-and-a-half and three times the rate of GDP growth. The trade could grow even more quickly than that over the next few years, thanks partly to the pace at which China's foreign trade is growing, and partly to the speed with which its companies are switching to containers and learning to manage their supply chains more efficiently.
This is likely to put severe pressure on China’s fast-growing ports, says a joint study by Drewry and APL, a shipping line. On Wednesday June 25th, the southern Chinese city of Shenzhen said it had overtaken Kaohsiung in Taiwan to become the world’s fifth-largest container port. In the five months to May, container traffic in Shenzhen was 43% up on the year before. The Chinese city of Shanghai, which last year overtook Kaohsiung as the world's fourth-largest port (after Hong Kong, Singapore and South Korea’s Pusan), saw traffic rise by an almost-as-impressive 35.6%. Thanks to a surge in exports from southern China, throughput at Hong Kong's container terminals is soaring. Traffic at the Kwai Chung terminal, for instance, was up by 12.8% in the first quarter compared with the same period in 2002, according to the territory's Port and Maritime Board.
Freight costs for dry cargo—bulk commodities like grains, coal and steel—have also jumped of late. Again, this is mainly the result of increasing demand from China. Not only is the country shipping in more commodities like iron ore; it is also having to go further afield for it, with the result that more vessels are being chartered for longer periods of time. Unable to secure all the iron ore they need from Australia, a traditional source, traders in China have recently started to import from such places as Brazil.
Is the resulting bonanza for ship owners likely to last? It is hard to tell. The more that China's economy relies on the private sector and the less on pump-priming by the state, the faster it is likely to grow. Standard & Poor's, a credit-rating agency, reckons the private sector accounted for about 40% of the country's industrial output in 2000. The effect on the economy once that proportion rises above 50% is anybody’s guess.
WITH a masterful flick of his wand, our bespectacled hero vanquishes the evil forces that threaten the world. Not Harry Potter, but Alan Greenspan, the owlish chairman of America's Federal Reserve, whom many on Wall Street believe to be an even more powerful wizard. On June 25th the Fed, seeking to ward off deflation, cut interest rates by a quarter-point to 1.0%, their lowest level in 45 years. In anticipation of such wizardry, investors had already pushed American share prices up by more than 20% above their mid-March lows. Share prices dipped after the rate cut as some investors, hoping for a half-point cut, were disappointed. But the markets still seem to believe that the Fed can not only see off deflation, but also return America to a path of robust economic growth. Unfortunately, this hope is more hogwash than Hogwarts.
The market rally is built on fragile foundations. Indeed, the price/earnings ratio for the S&P 500 is now 33 (based on past profits), higher than at the market's peak in March 2000. Over the past three years America's economy has received perhaps its biggest monetary and fiscal stimulus in history. A budget surplus of 1.4% of GDP in 2000 has turned into an estimated deficit of 4.6% of GDP this year. Short-term interest rates have been cut 13 times, from 6.5% at the start of 2001. Long-term bond yields have also tumbled. Given all this, the economy's below-trend growth for the third year running suggests that policy weapons may have lost some of their power. Will this week's rate cut make a difference?
In the first half of 2003, America's GDP grew at an annual average rate of about 1.5%. Many economists predict that growth will rebound to 3.5-4% in the second half. The Fed's latest cut is simply insurance against the risk of deflation. America's core inflation rate (excluding food and energy) has fallen from 2.6% in January 2002 to 1.6% in May. On the surface, May's figures suggested that the risk of deflation was fading: core inflation edged up. But the proportion of individual prices in the consumer-price index that fell over the past 12 months rose to a new high. According to Dresdner Kleinwort Wasserstein, the 12-month rise in the underlying consumer-price index, excluding non-discretionary housing and health-care costs, fell to an all-time low of under 0.4%. A similar measure gave early warning of deflation in Japan.
Some economists argue that America is sure to escape deflation so long as it avoids another recession. They may be wrong. Inflation depends not on the rate of growth but on the level of output relative to potential, ie, the output gap. Historically there has been a close relationship between the output gap and the direction of change in inflation. If, as now, the output gap is negative (ie, actual output is below potential) inflation falls; if the gap is positive, inflation rises (see chart 1). Even if America's growth returns to its trend rate of just over 3% a year, the output gap (now about 2% of GDP) will remain large for a couple more years; so inflation will keep falling. To be sure of preventing deflation, America needs to grow faster than trend.
Forecasters have been consistently over-optimistic. In March 2002 The Economist's poll of forecasters offered an average prediction for America's GDP growth this year of 3.6%; that has since been trimmed to 2.2%. That shortfall is popularly blamed on the war in Iraq, which dented business and consumer confidence. The Conference Board's index of consumer confidence has improved since the war ended in April, albeit by less than had been hoped. Consumers are fretful about other things besides war and terrorism, notably the dire state of America's jobs market.
The consensus view that America's growth will now rebound to above trend for a few years is based on the belief that America's economy is fundamentally sound, so that the recent massive monetary and fiscal stimulus will spur it to grow faster. Yet “sound” is an odd word to choose to describe an economy with too much debt, too little saving and an unsustainable current-account deficit.
America's bubble in the late 1990s created excesses that still need to be purged before the economy can resume sustained vigorous growth. The best measure of those excesses is the private-sector financial balance (see chart 2). In the 40 years up to 1997 America's private sector was always a net saver, meaning that total income of households and firms was greater than their spending. Net private saving averaged 2.6% of GDP. But the bubble encouraged a massive boom in borrowing and spending, pushing the private sector into a net deficit of 5% of GDP in 2000. That has since been trimmed. Even so, in the first quarter of 2003 the private sector was running a deficit of more than 1% of GDP. That means it still has a long way to go to restore its financial health.
Households have done much less than firms to repair their balance sheets. The main reason why they could delay this adjustment is that they have been able to borrow against the rising value of their homes. According to Merrill Lynch, over the past six months household debt has increased at its fastest pace for 17 years. The ratio of debt to household income has risen to 111%, up from 102% in 2001.
House prices now look overvalued by past standards. Most economists, including Mr Greenspan, dismiss talk of a housing bubble. But suppose house prices were to stabilise at their current level, rather than actually to fall: even if interest rates stayed low, the scope for further home-equity withdrawal would diminish sharply. So long as interest rates are falling, households can increase debt without any rise in debt service. But once rates hit bottom—and they must be near that in America—the pace of borrowing needs to slow if debt-servicing costs are not to explode. Even with today's historically low interest rates, household debt service is close to a record high as a percentage of disposable income. If new borrowing slows sharply, so will consumer spending, dragging GDP growth back below trend.
Jan Hatzius, an economist at Goldman Sachs, reckons that the recent decline in short- and long-term interest rates, along with the boost to wealth from rising share prices, will again postpone the necessary adjustment of household balance sheets. But it has to occur eventually. At some point households need to save more and spend less. Mr Hatzius concludes that GDP growth will falter again by around the middle of next year.
Companies have done more than households to cut costs and reduce new borrowing. But their outstanding debts still loom large, and capacity utilisation remains low, so there is unlikely to be another investment boom in the near future. Weak pricing power is also holding back profits. Total profits across the economy, as measured in the national accounts, rose at an annual rate of only 4% in the first quarter. The recent surge in share prices appears to assume that profits will grow at a strapping double-digit pace over the next year, but that will be hard if inflation continues to slide.
One reason for hoping that America will avoid deflation is a weaker dollar, which will support exports and boost import prices. But devaluation will merely serve to export deflationary pressure to economies that already look vulnerable. Deflation is a global concern. Nominal GDP growth in the G7 rich economies has increased at an annual pace of only 2% over the past two quarters.
Since its bubble burst in 2000, America's real GDP growth has remained faster than that in the euro area and Japan. American consumer spending has outpaced the rest by an even bigger margin, growing at an annual rate of 3%, compared with 0.8% in Germany and 1.3% in Japan. Europe is on the brink of recession. The Economist's poll of forecasters has reduced its GDP growth prediction for the euro area in 2003 to 0.8%, from 2.8% a year ago.
Germany is already back in recession. Its growth over the past three years has been even slower than Japan's, and it is tipped to see virtually no growth this year, compared with 0.9% in Japan. A research paper by the IMF recently warned of a high risk that deflation could soon emerge in Germany. Preliminary figures suggest that Germany's inflation rate rose to 1.0% in June, but its core rate is still falling.
The problem for Germany is that interest rates are set by the European Central Bank (ECB). Because Germany has lower inflation than the rest of the euro area, real interest rates are higher in Germany, even though it has by far the weakest economy. Indeed, growth in the euro area excluding Germany has been virtually the same as in the United States over the past three years (see chart 3). Critics of the euro area who focus only on Germany therefore tend to have an overly pessimistic view.
Throughout the euro area, exports are being squeezed by the rise in the euro, which has risen by about 15% in trade-weighted terms since the start of 2002. The euro is now above most estimates of fair value against the dollar, but it could well climb further. To correct America's massive current-account deficit, the dollar needs to become cheaper still; because many of its biggest trading partners, such as Japan and China, are resisting a rise in their currencies, this means it will have to fall further against the euro. Several forecasters now suggest that the euro could hit $1.40 by the end of next year.
A falling dollar need not export deflation to Europe, so long as the ECB offsets the impact of currency appreciation with lower interest rates. Later this year, Jean-Claude Trichet is to take over as the ECB's new president. The Frenchman is a better communicator than the Dutch incumbent, Wim Duisenburg, but it is not obvious that he will push for any broad softening of policy. The ECB likes to argue that nobody worries about deflation in a single state of the United States, so why should deflation matter in Germany? The answer is that Germany accounts for 30% of the euro-area economy, so there is a bigger risk that it could drag the rest down. The other big difference is that there is more labour mobility between states in America, and also larger fiscal transfers from central to state governments, which makes it easier for depressed states to recover.
Most economists reckon that inflation in the euro area will fall faster than the ECB expects. Dresdner Kleinwort Wasserstein forecasts that inflation could be below 0.5% in the second half of 2004 (down from 1.9% now). It concludes that interest rates will be cut to 1% (from today's 2%) by early next year.
Germany is certain again this year to breach the ceiling set by Europe's stability pact for its budget deficit of 3% of GDP. But that is only because the weak economy has depressed tax revenues; German fiscal policy will be acting as a brake on the economy. France and Italy also look likely to overshoot the 3% limit, but not by enough to allow a fiscal easing. Under pressure from weak growth, some governments are leaning to more fiscal loosening in 2004. There is growing political support in Germany for income-tax cuts to be brought forward a year to January 2004. But Hans Eichel, the finance minister, insists that this must be paid for by cuts in spending or tax breaks, which would offset any economic stimulus.
While Germany stands out, the rest of the euro area is hardly a picture of economic health. New figures this week showed that consumer confidence fell in June in Italy and Belgium to nine- and ten-year lows respectively. In the Netherlands business confidence fell to its lowest level since 1985. This poses a puzzle. Why does the euro area seem weaker than the United States, when its financial imbalances are supposedly more modest? Europeans who had suspected that America's new economy was largely a bubble had longed for the day when they could gloat over America's misfortunes. Instead, they are hurting even more.
One reason is that Europe, too, suffered its excesses, with massive overinvestment in telecoms. In addition, European investors financed much of America's boom and have since suffered big losses. As the dollar falls, those losses will swell. Europe's failure to push faster with its structural reforms has also meant that a drop in demand causes bigger losses in output and jobs than in America. The ECB and the fiscal stability pact have also prevented the euro area benefiting from anything like the sort of stimulus enjoyed in America.
Not only has Japan's economy actually outperformed Germany's in recent years, but in the year to the first quarter official figures suggest that it was the fastest-growing of the G7 economies, with GDP up by 2.6%. The snag is that prices, as measured by the GDP deflator, fell by 3.3%. In other words, Japan's economy continues to shrink in nominal terms, making it harder for firms to work off their excessive debts. The rise in the yen over the past year, though a lot smaller than the rise in the euro, may also damage Japan's recovery.
Since Toshihiko Fukui took over as its new governor in March, the Bank of Japan has shown a bit more flexibility in its policy to try to halt deflation. The central bank has further increased the monetary base and, in an unprecedented move for a central bank, has announced that it will buy corporate debt with the aim of helping smaller firms to obtain loans. However, the bank continues to reject more radical measures to defeat deflation. Worse, the Koizumi government remains set on reducing the budget deficit, which risks snuffing out the recovery and worsening deflation. The best way to restore fiscal health is to end deflation. Faster growth in nominal GDP would help to boost tax revenues and reduce the deficit.
What lessons does Japan hold for America and Europe? The most important was spelled out in a research paper last year by a team of Fed economists. They concluded that Japan's monetary policy in the early 1990s looked appropriate, given forecasts at the time for growth and inflation. In other words, it is wrong to blame the central bank's incompetence for all of Japan's woes; nobody inside or outside the bank had forecast deflation. By the time it arrived it was too late. The lesson is that, when inflation is low and there is the slightest risk of deflation, policymakers should take out insurance by cutting interest rates more than they otherwise would.
The Fed now seems to be following this advice, but it is running out of ammunition. There is little room to push short-term rates lower. Interest rates below 0.75%, say, could risk destabilising the short-term money market, because banks would have less incentive to hold idle cash in short-term deposits. However, the Fed insists that it still has the tools to fight deflation—even if, as officials insist, it is highly unlikely that they will be needed. These “unconventional measures” include large purchases of government bonds to reduce long-term interest rates, intervention to push down the dollar, or buying private securities to push up asset prices.
Nobody knows how effective such measures might be. But at least the Fed is trying to move inflationary expectations in the right direction, by saying that it stands ready to go down this road and publicly sounding confident that it can succeed. In contrast, by saying there is nothing it can do to end deflation, the Bank of Japan merely reinforces the expectation that deflation will persist. The Fed's most effective policy weapon so far has been to reduce bond yields, and thus borrowing costs, simply by airing the possibility of buying government bonds.
The Fed, it seems, will stop at nothing to keep the post-bubble economy afloat. Stephen Roach, chief economist at Morgan Stanley, worries that the Fed has become a “serial bubble blower”. After playing a key role in nurturing the equity bubble of the late 1990s by holding down interest rates, it has since propped up the economy by fuelling first a property bubble and now a bond bubble. Recessions are normally periods when the excesses of previous booms are purged. The late 1990s boom created some of the worst excesses ever, yet the recession in 2001 was the mildest in history, so many excesses remain. The Fed is wise to guard against the danger of deflation, but this still leaves big concerns about the unbalanced state of the American economy. Even Mr Greenspan's wizardry may not be enough to ensure a sustained healthy recovery.
Economic and Financial Indicators
America's consumer prices were unchanged in May, making a 12-month inflation rate of 2.1%. Prices had been expected to fall, so the news helped to calm fears about incipient deflation. The core consumer-price index (excluding food and energy) rose by 0.3%, its biggest gain in ten months, lifting the 12-month core inflation rate to 1.6%. The University of Michigan's index of consumer confidence dropped unexpectedly in June as fears about jobs outweighed the recent rise in share prices. Industrial production rose by 0.1% in May, after falling sharply in the two previous months. Output was 0.8% lower than a year earlier.
In contrast, euro-area industrial production increased by a larger-than-expected 0.4% in April, to give an annual rise of 0.8%. Output fell sharply in the month in Germany and France, but it rose in Italy and Spain. French inflation eased to 1.8% in May, down from 2.0% in April.
Britain's underlying rate of inflation (excluding mortgage-interest payments) fell to 2.9% in May, still above the Bank of England's target of 2.5%. But on the harmonised index of consumer prices, the measure used in the euro area, inflation fell to 1.2%.
Sweden's 12-month rate of consumer-price inflation fell to 1.9% in May, down from 2.3% in April. Over the same period, its unemployment rate fell from 4.6% to 4.2%. Those campaigning against Sweden's entry into Europe's single currency point out that this is less than half the average jobless rate in the euro zone.
The euro regained its lifetime high of $1.193 on June 16th. It slipped back after America's higher-than-expected inflation figures caused investors to bet on a smaller cut in interest rates by the Federal Reserve at its policy meeting on June 24th-25th.
THREE years after the bull market ended and the brutal cull of jobs on Wall Street and in the City of London began, there is suddenly a lighter mood among those who still have a job. A clutch of big investment banks have reported decent second-quarter results, and those yet to come are also likely to be good, considering the recent gloom.
Most of the banks' new profits have come from a roaring bond market, fuelled by falling interest rates. But now other businesses are stirring too. Stockmarkets are up around the world: this week America's S&P 500 index went above 1,000 for the first time in nearly a year. The mergers-and-acquisitions (M&A) market is showing signs of life. Companies are tip-toeing into the equity markets. “In the last month or so, there has been a different mood,” says one senior investment banker.
Morgan Stanley, America's second-biggest investment bank, and Bear Stearns, its sixth-largest, both reported second-quarter results on June 18th. Although Morgan Stanley's results were a touch disappointing (its profit was $599m, compared with $797m in the same quarter last year), Bear Stearns, a fixed-income specialist, made a record $280m. Lehman Brothers was due to report good results the following day.
In effect, the shares of investment banks and banks with big investment-banking businesses are geared bets on the stockmarket. Thus they hit bottom at virtually the same time as the market in early March, and have since risen even faster than the market as a whole.
Climbing markets are starting to benefit lots of the investment banks' businesses. Trading turnover is rising, which means higher commissions. The value of the funds in banks' asset-management arms is going up, which means more fees. In M&A, companies have found a bit more courage to buy and sell businesses, once again meaning more fees. In Europe, for instance, Telecom Italia is selling its directories business for some $3.5 billion. In America, one software company, Oracle, has made a hostile $6.3 billion bid for another, PeopleSoft.
Some new business in areas besides bonds will be welcome. For one thing, given how low government-bond yields and corporate credit spreads have fallen, the time of plenty in the bond market may have passed. For another, despite brisk activity in derivatives, foreign exchange and convertible bonds, banks' mainstay businesses have suffered badly. Initial public offerings have slowed to a trickle. According to Thomson Financial, there have been only three in America in the second quarter so far, compared with a peak of 127 in the third quarter of 2000. By both value and volume, worldwide M&A deals are at their lowest since 1995.
Small wonder that investment banks have cut bonuses and jobs with equal savagery. Anybody other than the big money-spinners—and lately these have mainly been found at bond-trading desks—has been fretting about where the axe will fall next. Employment in the securities industry has fallen from a high of 200,000 in New York and 330,000 in the City, to 162,000 and perhaps 280,000 respectively (for London, there are no official figures yet). Prices of swankier properties in New York and London have suffered accordingly. Employment in America's securities industry has dropped from 786,000 to a smidgen over 700,000. In percentage terms, that is the largest fall since the early 1970s; in absolute terms, the largest ever.
Some banks have cut harder than others, either because their costs were too high, or because they thought the outlook was so bleak, or both. Credit Suisse First Boston, a big Swiss-owned investment bank, was particularly flabby, and John Mack (“Mack the Knife”), has been especially merciless in slashing away the fat. Merrill Lynch, Goldman Sachs, Morgan Stanley and J.P. Morgan Chase have also not flinched from shedding staff. J.P. Morgan Chase has got rid of two-thirds of its investment bankers in M&A and issuance because of overlaps from the merger that created the firm and the decline in business since. Others, such as Deutsche Bank and—until this week—UBS, have been more leisurely. However, on June 18th UBS made up for lost time and chopped another 500 investment bankers.
Now that business seems to have stabilised, banks must pull off a harder trick than the simple one of slashing jobs: how to position themselves to take advantage of an upturn, while keeping costs tight in case the market turns down again. Few seem ready to trust the recent upturn; most have enough staff to cope with a slight pick-up in business. So although general hiring freezes may be coming to an end, most banks will content themselves with filling gaps only as the need arises. Klaus Diederichs, J.P. Morgan Chase's European investment-banking boss, says that the bank does not want to dent profitability by hiring too early. With his current staff, he estimates, he could handle 15% more work.
There are, moreover, some big unanswered questions about the business model that investment banks should adopt. Regulatory ire and investor wrath from shady practices in the go-go years have drawn attention to the conflicts of interest that bedevil investment banks. The role of analysts, who advised investors but in essence acted as pimps for investment bankers, has been a particular problem. In the early 1990s analysts were two a penny, but by the start of this decade they were some of the banks' most expensive employees. But banks have now been told that they must not use them to tout for investment-banking business. Analysts' numbers and compensation have dropped sharply, but it is still unclear who will now pay for their research. Investors, themselves stretched by bear markets, seem unwilling to do so.
Overarching all this is the trillion-dollar question: is the bear market over? After all the job losses of the past couple of years, securities firms employ 170,000 more people in America than they did in the mid-1990s, when activity was last at today's levels. A lot of people must be hoping that the bear market has gone for good. Fingers crossed.
Confronting the enemies of
Mr Powell, in a joint news conference with Mr Abbas after their meeting, said that if the Palestinian Authority’s security forces were seen taking control of the situation in Gaza, the scene of most recent attacks, then Palestinians would have confidence that “Hamas and other terrorist organisations perhaps do not have the right answer.” Earlier, Mr Powell had criticised Syria for its “totally inadequate” efforts to restrain Palestinian militant groups which have bases there, such as Hamas. Aziz Rantisi, one of Hamas’s top political leaders, whom Israel had tried to blow up in his car on June 10th, retorted that: “Colin Powell proved that he is a real slave to the Zionists, a liar and a hypocrite.”
Mr Powell urged both sides to give priority to a proposal for Israeli forces to pull out of some especially sensitive spots in Gaza and the West Bank city of Bethlehem, handing control of these to the Palestinian security forces. In the past week, several parallel negotiations have been under way, none of which has made as much progress as had been hoped at the start of the week. Mr Abbas, and Egyptian mediators, have had separate talks with Palestinian militants, while Israeli and Palestinian security chiefs have also been in discussions. The main aims are to seek a ceasefire by the militants and a clampdown against them by the Palestinian security forces, in return for an Israeli pullback in the occupied territories, in particular the Gaza and Bethlehem hot-spots.
One of Mr Powell’s top diplomats, John Wolf, has been in region this week to mediate the talks between the Israeli and Palestinian officials, but so far a deal has proved elusive. The Palestinians have said a ceasefire is impossible while Israel continues to attack Palestinian militants, while Israel insists at the very least that it will continue to shoot “ticking bombs”—ie, Palestinian fighters it believes are actively preparing suicide bombs or other attacks.
Mr Sharon insisted that a ceasefire is not enough and that disarmament of the militant groups is needed. Mr Powell agreed and said he would press Mr Abbas to go beyond just negotiating a ceasefire with the militants and remove their capacity to strike at Israeli targets. He wants Mr Abbas to press ahead with reform of the Palestinian Authority’s security forces and produce detailed plans on how these would take over security in those parts of the occupied territories from which Israel is prepared to withdraw its troops. Mr Abbas, however, is reluctant to try to use force against the militants for fear of setting off a civil war among Palestinians. Hamas rejects the road map and accuses Mr Abbas of a sell-out, for failing to demand full Israeli withdrawal from the occupied territories and the right of return for Palestinian refugees who fled when Israel was created in 1948.
When President George Bush got Mr Sharon and Mr Abbas to shake hands on the road map, on June 4th, there was a tacit understanding that Israel would hold back from retaliating against the militants’ attacks, to give Mr Abbas time to reorganise his security forces and negotiate a ceasefire. The Israeli people and media are also largely against Mr Sharon’s “assassination policy” against militant leaders. Mr Bush at first rebuked Israel for the attempt to kill Mr Rantisi but softened his criticism after Israel sent the White House an intelligence dossier which it said showed his involvement in various attacks, including a suicide bombing of a bus in Jerusalem on June 11th, which killed 17 people. During his visit, Mr Powell said it was “understandable” for Israel to target Palestinian fighters whom it had identified as preparing imminent attacks. But trying to assassinate their prominent political leaders was counterproductive, he said.
Israel seemed to be on its best behaviour in the run-up to Mr Powell’s visit. Despite several fatal attacks by Palestinian militants this week (including, just as Mr Powell was arriving on Friday, the shooting-up of a car on a road used by Israeli settlers) there were no further attempts by Israeli security forces to kill militant leaders. Furthermore, the day before Mr Powell’s arrival, Mr Sharon sent in the Israeli army and police to start dismantling the first inhabited Jewish settlement in the occupied territories, of those built since he came to power in March 2001—one of Israel’s main obligations under the road map. Some uninhabited outposts have already been torn down without much trouble, but around 30 people were hurt in scuffles when the Israeli forces began demolishing the inhabited outpost, Mitzpeh Yitzhar, in the West Bank. Settlers insist that the occupied territories are part of the promised land that God gave to the Jews, and are threatening to build several new outposts for every one taken down.
There have been calls, including from Kofi Annan, the United Nations’ secretary-general, for an international peacekeeping force to police the peace process in the occupied territories. France’s foreign minister, Dominique de Villepin, has suggested a European Union peacekeeping force. Richard Lugar, the chairman of the American Senate’s foreign-relations committee, has contradicted the White House's official pronouncements that American soldiers would not be sent to the region, and says that American involvement in any possible peacekeeping operations is indeed under consideration. No such peacekeeping force seems likely for the time being, though, and the main hopes for getting back on course with the road map rest on persuading the militants to call a ceasefire, even a partial and fragile one.
IS AMERICA'S economy finally set to shake off its funk? An increasing number of economists on Wall Street and politicians in Washington seem to think so. Many number-crunchers are forecasting a sharp acceleration of economic growth in the summer. John Snow, America's treasury secretary, suggested this week that the economy could be growing by around 4% by the end of 2003, more than double its current rate. After so many false dawns, is this optimism justified?
Financial markets certainly think so. All the big stockmarket indices have risen dramatically. The Dow Jones Industrial Average is now over 9,000, up more than 20% since mid-March; the technology-laden NASDAQ is up almost 30% from three months ago. Financial conditions have loosened across the board. Not only are government bond yields at historic lows, but spreads on corporate bonds have narrowed sharply, making access to capital cheaper and easier for firms of all kinds. A weaker dollar—the greenback has dropped by 8% against the currencies of America's trading partners this year—has also added to the loose financial conditions.
And there is more to come. Judging by recent comments from its top official, America's central bank is highly likely to cut interest rates when its policy-setting Federal Open Market Committee meets on June 24th-25th. Alan Greenspan and other central bankers have become increasingly concerned about the risk of deflation, and are determined to ward it off. With America's economy still swimming in spare capacity, the rate of inflation continues to decline. Core consumer prices—that is, excluding volatile categories such as food and fuel—were flat in both March and April, after several months of small increases. As economists at Goldman Sachs point out, that brings the annualised rate of core consumer-price inflation over the past six months to below 1%, the lowest rate in almost four decades.
Although Mr Greenspan reckons that the likelihood of “corrosive” deflation in America is low, he intends to “lean over backwards” to avoid it. That means cutting short-term rates, and keeping them low. Judging by the prices of futures contracts, investors now expect a quarter-point rate cut with certainty on June 24th, and see a 50% chance that short-term rates will be cut by half a percentage point.
Nor is looser monetary policy the only stimulus on the way. Mr Bush's latest tax package, signed into law on May 28th, will undoubtedly give the economy a short-term boost. The huge tax package—worth $350 billion over ten years if you believe Congress's gimmicks, and costing more than $800 billion over a decade if you take a more realistic view—may not be particularly efficient as a stimulus package. But it is big. Economists at Morgan Stanley reckon the tax cut will add about $160 billion, or 1.5% of GDP, in fiscal stimulus over the next four quarters, bigger than any tax change since the Reagan tax cut in 1981. Of that, around $64 billion will reach Americans quickly in the form of rebate cheques and less tax withheld from their pay. Even if a large chunk of this is negated by tax hikes and spending cuts at the state level, the net effect will still be a sizeable stimulus—and an increase in the budget deficit. The Congressional Budget Office this week raised its deficit forecast for fiscal 2003, which ends in September, to over $400 billion, or around 4% of GDP.
Add together loose financial conditions and a fiscal boost, and it is hard to imagine that the economy will not improve at all. Lower financing costs are continuing to prop up the housing market and maintain the surge in mortgage refinancings. The weekly tally of mortgage refinancing applications reached a new high of nearly 10,000 last week.
Even in the gloomy labour market, there are glimmers of hope. True, America's jobless rate hit a cyclical peak of 6.1% in May, and weekly unemployment claims are still extremely high. But the employment report released on June 6th was in many ways less bad than expected. Although the economy lost 17,000 jobs in May, the number of private-sector jobs was flat; the drop came in government posts. The number of temporary jobs rose by a healthy 58,000, and a rise in temporary workers is often a sign that firms are thinking of hiring permanent workers again. The latest monthly survey of purchasing managers also suggests that conditions in both the manufacturing and services sector are already improving, although they are far from booming.
A trickier question is whether any rebound will last. Can America's economy expect above-trend growth next year, for instance? There, it is much harder to be optimistic. America's economy still has huge fragilities. Although firms have undergone great adjustments since the excesses of the stockmarket bubble, there is still plenty of spare capacity around, making a sustained investment boom less likely.
More troubling is how long America's consumers can continue to fuel the economy. Levels of consumer debt are rising sharply, driven largely by the refinancing boom. According to Jan Hatzius, an economist at Goldman Sachs, household debt is growing at a 10.3% annual rate, more than twice the trend growth rate of disposable income. The ratio of household debt to disposable income is at an all-time high but, with interest rates falling, the ratio of consumers' debt-service bills to their income is below its historical peak.
Clearly, the rate of consumer debt accumulation cannot be sustained. At some point, it will have to slow, which means lower consumer spending. Falling interest rates and tax cuts will put off the day of reckoning, but not for ever. That, more than anything, is why the recovery may be less robust than the optimists expect.
Short memories, deep pockets
Suffice to say that upside now seems distinctly limited and downside rather less so. Spreads on Russian 30-year bonds are now about four percentage points less than before the country defaulted. Granted, the country has benefited from high oil prices; its central bank now has about $61 billion of reserves and a governor who is not Viktor Gerashchenko (once famously described as “the world’s worst central banker”); its rating has been upgraded a notch or two by the rating agencies; President Vladimir Putin’s stock is in the ascendant; and a few reforms have been pushed through. But have the risks really improved that much? Answer: almost certainly not. Russian yields, like those in just about every emerging-market and corporate-bond market in the world, have been pulled sharply lower over the past few months by a flood of money looking for yield wherever it can find it and whatever the risk.
Individual stories such as Russia’s would be more convincing were there not apparently so many of them and had everything not miraculously improved from the same date. That date was October 10th last year, when spreads of junk and investment-grade bonds in America, and emerging-market sovereigns elsewhere in the world, reached historic highs. Since then, the cost of borrowing for riskier bond issuers has been cut in half compared with what the American government pays.
Since that date, J.P. Morgan’s Emerging Markets Bond Index has tightened from 918 bps over Treasuries to 495bps on June 9th. Of all the countries included, only the Dominican Republic’s have widened. Bonds issued by Brazil, which has a less than unsullied record on default, will have allowed a few more happy people to retire: they have zoomed in from 2,326bps over Treasuries to 726bps.
In the American corporate-bond market, the spreads on outstanding investment-grade bonds have dropped from 280bps to 135bps, according to Bank of America. David Goldman, its fixed-income research boss, describes this as “the fastest period of tightening on record”. Bonds issued by a few telecoms firms, such as Sprint and Qwest, have apparently risen, Lazarus-like, from the dead. In the utilities sector as a whole, spreads have plunged from 330bps in early October to just 150bps now. The junk-bond market’s performance has been still more turbo-charged.
All this is splendid news for deflation-fighting central banks around the world, especially the Federal Reserve. By cheapening the price of credit, the bond markets are helping to keep companies on their feet, and giving them time to sort out their problems. Something of a virtuous circle has been created. And risks have fallen sharply for lenders, whose reward, remember, is fetching a high-enough price for selling an option to companies’ bosses to default (which is what a corporate-bond coupon is, in essence). The risks of terrorist attacks and a double-dip recession have receded. The economic outlook is less cloudy. The VIX, a volatility index widely used as a proxy for systemic risk, has fallen by about half. So, perhaps more importantly, has the volatility of individual issuers, which has dropped from 60% in October to about 30%.
After the scandals of the past few years—Enron, WorldCom, HealthSouth and the rest—companies appear to have got the message that, as well as other, less-savoury activities, buying back shares with borrowed money to boost profitability and other balance-sheet shenanigans will no longer be tolerated. Leverage had gone too far. The prospect of death seemed to concentrate minds most wonderfully. A few companies have shed assets, refinanced themselves, and reduced debts.
These individual stories, much like the improvement in Russia, have provided comfort to investors desperate for yield now that government-bond yields have fallen so low, and now that the equity market has proved that shares can indeed go down as well as up. What, after all, is a Japanese investor to do when his government will offer him only 1% to lend it money for 30 years?
Unfortunately, there is an element of circularity to all this. The equity market is rising because companies appear to be sorting themselves out, so shares go up and volatility falls. The corporate-bond market likes both of these, and gives another nod of approval to the equity market. And so the game goes on. The truth, however, is that little has been done to reduce debts around the world, not least in America. Defaults have dropped sharply, but that is largely because investors have been taking so much on trust. And without the pressure of punitive interest rates, corporate bosses' feet are no longer being held to the fire.
If the American economy falls back into recession, corporate spreads and defaults will obviously rise. The really troubling question for investors is whether they will do so if the economy picks up and interest rates rise to more normal levels. Either way, corporate bonds at current spreads look expensive. And so does Russia.
A tested theocracy
ONCE again, Iranians have been taking to the streets to criticise their clerical rulers. On Wednesday June 11th, thousands of people spent a second night demonstrating in Tehran, the capital, in the biggest anti-establishment protests for several months. The ostensible reason for the unrest is anger at plans to privatise Iran’s colleges, though many of the protesters are frustrated by the slow pace of political and social reform. Police and Islamic militia groups prevented the demonstrators from approaching Tehran’s university buildings—the scene of violent protests four years ago—and the government gave warning that “illegal activities” would not be tolerated.
Iran’s leaders are blaming America for their latest spot of bother. The Islamic nation’s supreme leader, Ayatollah Ali Khamenei, who supervises the country from a pedestal of unaccountability, said Washington had been stirring up trouble and encouraging people to take to the streets. “Now America itself is openly saying it wants to create disorder inside Iran,” he said in a speech broadcast on state television. “Their solution is creating disputes among the nation and separating the nation from the system.” America is certainly doing nothing to discourage the unrest. The administration of George Bush views both Mr Khamenei and Muhammad Khatami, the twice-elected and reform-minded president, as defenders of a detested theocracy.
Some evidence supports this view. In February’s local elections, once-enthusiastic voters stayed away; in Tehran, a miserable 12% of the electorate cast a ballot. The reformist parliament that was elected in 2000 has been a failure. Deputies recently ratified two presidential bills designed to hobble unelected conservative institutions, only for the bills to be rejected by the most egregious of those institutions, a de facto upper house called the Council of Guardians. Women’s rights, press freedom, trial by jury: in all these areas, Mr Khatami’s supporters have enacted enlightened legislation, only for it to be vetoed—in the case of trial by jury, more than a dozen times.
Last month, a majority of reformist deputies addressed a remarkable letter to the supreme leader. They accused institutions under his purview of creating the impression that Iran cannot change. Mostly because of the deputies’ elliptical call for Mr Khamenei to step aside, newspapers were forbidden to print the letter, and the signatories are under pressure to withdraw their names. Thugs disrupt their speeches. The office of one was bombed. The conciliatory Mr Khatami vows to renegotiate the passage of the two blocked bills, one of which would make it hard for conservatives to stop reformists standing in the next parliamentary elections, in 2004. Few expect him to succeed.
In spite of these setbacks for reform, the European Union wants to engage with Iran and is negotiating a trade and co-operation agreement. Unengaged Americans are less patient. Since he was elected, Mr Bush has resisted detente in favour of co-operation on specific issues. Iranian special forces helped the Northern Alliance during the war in Afghanistan and gave America useful intelligence. Iran’s role in Afghanistan’s political reconstitution was mostly constructive. Last year, Iran encouraged an Iraqi group it influences, the Supreme Council for Islamic Revolution in Iraq (SCIRI), to team up with other groups that were being organised by America into an opposition to Saddam Hussein. During the war, the Iranians turned a blind eye to American violations of their airspace and coastal waters.
But America identifies a deeper pattern of transgression. At the beginning of 2002, Iran was caught shipping arms to the Palestinians. Al-Qaeda agents in Iran may have had a hand in last month’s lethal bombings in Riyadh. In Iraq, the Americans have detained SCIRI operatives on suspicion of attacking American forces. Most damaging of all, on June 6th, Iran’s improbable claim that it does not seek nuclear weapons was further undermined by leaks from a UN report asserting that it had withheld sensitive information.
Few of these misdeeds had much to do with Mr Khatami; a few, in fact, may not be misdeeds at all. The president apparently knew nothing about the cache of arms before Israel intercepted it. (Hardliners, who control a panoply of military and intelligence organisations, were almost certainly responsible.) Even now, there is disagreement about what kind of support to give Islamic rejectionist groups. According to one well-travelled parliamentarian, the fall of Saddam Hussein has restricted Iran’s ability to ship arms, destined for rejectionists, across Iraq to Syria. According to a knowledgeable western official, there is no evidence of Iranian collusion with suspected al-Qaeda members.
When it comes to Iran’s nuclear programme, however, outside worries are more warranted. Nuclear development is one of the few issues on which Iranians on both sides of the political divide agree. They have come to regard their ambiguous nuclear status as a protective cloak, especially since Mr Bush included Iran in his axis of evil. Many Iranians are convinced that Mr Bush is determined to topple the Islamic Republic. But Iranian fatalism with regard to the president’s intentions may be premature. The Bush administration, for want of a consensus within it, gives every impression of having deferred a decision on what sort of policy to have towards Iran.
The administration clearly wants the Iranian regime to change. But for some in Washington’s right-wing think-tanks, and for elements in the Pentagon, this is not enough. They believe that the Iranian regime must be changed. Indeed, they say, evidence against Iran on the nuclear question and terrorism is stronger than the evidence that was used against Saddam.
If this argument is to be acted on, it makes sense to identify Iranian opposition figures capable of putting the case for regime change and willing to help achieve it. But the difficulty of this has been highlighted by suggestions that the Pentagon wants to use the People’s Mujahideen, an armed Iranian opposition group based in Iraq, as an Afghan-style Northern Alliance.
A front for the Mujahideen, the National Council of Resistance of Iran, has been a useful conduit for embarrassingly accurate revelations, thought to have been collected by western intelligence agencies, about Iran’s nuclear programme. The Mujahideen’s military forces are trained and used to be well armed—their heavy weapons are now in the possession of American forces in Iraq. For the moment, however, they make unsuitable partners. The State Department considers them terrorists. Their leader, Massoud Rajavi, has strange ideas about the cult of personality (his own). In Iran, their association with Saddam, who provoked the terrible Iran-Iraq war of the 1980s, will not easily be forgiven.
Most Iranians have little time for a second candidate to lead the opposition, Reza Pahlavi. The son of the former shah is American in manners—he lives in Virginia—and a professed democrat. Back home, however, he has an image problem. His father ran a state that was decidedly less democratic than Mr Khamenei’s. The people who ousted Pahlavi père, even if they regret what arose in his place, are unlikely to welcome Pahlavi fils.
The main reason for the dearth of attractive leaders outside Iran is their abundance inside it. Many, even if they acknowledge the failure of Mr Khatami’s movement, describe themselves as reformists and lean towards a version of democracy that the Bush administration would endorse. To the frustration of expatriates living in America, few of them are inclined to use violent methods, or to lay down their lives, to end the stalemate. In this, they typify the vast majority of Iranians.
A bloodstained road map
The round of bloodshed was triggered on Sunday June 8th—four days after Mr Sharon and Mr Abbas shook hands—when gunmen from Hamas and two other Palestinian groups, Islamic Jihad and al-Aqsa, joined forces to demonstrate their opposition to the road map by attacking an Israeli army post in Gaza and killing four soldiers. On Tuesday, Israel responded by trying to blow up Aziz Rantisi, one of Hamas’s most senior leaders, in his car. Mr Rantisi survived but three Palestinians were killed. There then followed an exchange of missiles between the two sides in Gaza, killing three more Palestinians. Hamas responded on Wednesday by sending a suicide bomber, dressed as an Orthodox Jew, to blow up a bus in Jerusalem, killing 16 and injuring more than 100. Israel replied with a series of helicopter-gunship attacks on Palestinian targets over the following 24 hours, killing 16 people, including two other senior Hamas leaders.
At the summit with Mr Bush and Mr Sharon in Aqaba, Jordan, Mr Abbas (also known as Abu Mazen) committed himself to ending the armed Palestinian uprising, the intifada, and called on the militant groups to give up their arms. He had been trying to persuade Hamas and others to agree a ceasefire but they accused him of a sell-out, for failing to demand Israel’s full withdrawal from the territories it occupied in the 1967 war (including East Jerusalem) and for not insisting on the right of return for Palestinian refugees who fled in 1948 when Israel was created. Mr Sharon, in turn, has faced hostility from the Israeli settler movement and its political backers, for beginning the dismantling of some of the Jewish outposts erected in the West Bank and Gaza since he came to power in March 2001—as the road map requires Israel to do. The settlers are threatening to build several new outposts for every one dismantled.
Facing fierce criticism from America and from much of the Israeli press over the attempted assassination of Hamas’s Mr Rantisi, Mr Sharon has insisted that he remains “deeply committed to the peace process” and will continue to comply with Israel’s obligations under the road map. But he also said Israel would continue its attempts to wipe out the leadership of those Palestinian groups opposed to the peace agreement. In an attempt to assuage America’s anger, Israel is sending to Washington the evidence it claims to have gathered that Mr Rantisi had been personally involved in planning the ambush on the Israeli soldiers that sparked off the latest round of blood-letting. Mr Sharon’s deputy, Ehud Olmert, said Israel would prefer that Mr Abbas and the Palestinian Authority’s security forces reined in the militants but, for as long as they failed to do so, Israel must wage war on them.
The trouble is, the attack on Mr Rantisi has undermined Mr Abbas’s authority, by showing Palestinian hardliners how little influence he has, either in persuading the Israelis to moderate their tough military response to the intifada, or in getting America to press Israel to do so. A jittery Mr Abbas called a press conference on Monday to insist that he remained committed to the issues of East Jerusalem, the refugees and the release of Palestinian prisoners. But some Palestinian militants are calling on Mr Abbas and his new Palestinian government to resign. Even Fatah, Mr Abbas’s own movement, joined in a declaration that rejected the conclusions of the Aqaba summit in favour of “national unity, resistance and the intifada”. The Palestinian Authority’s chairman, Yasser Arafat, who has recently been shunted aside at America’s insistence, returned to the fray, condemning both the Palestinian suicide bombing, which he called a “terrorist attack”, and the Israeli attacks on Hamas leaders. Mr Arafat called for a ceasefire by all Palestinian militants, to avoid letting Israel “drag us into destroying the peace process”.
The understanding at the Aqaba summit had been that Mr Abbas and his team would need some time to organise the Palestinian security forces, and to try to reach a ceasefire agreement with Hamas and other groups, before gradually taking back responsibility for security in the Palestinian areas. Mr Abbas, and apparently Mr Bush, felt they had an implicit commitment that Israel would largely desist from offensive operations during this period of grace. However, even if Mr Sharon does remain committed to the peace process, as he insists, he is under enormous pressure to be seen to be tough on terrorism, especially at a time when he is arousing the fury of the settler movement by dismantling some of their outposts.
On Thursday, Hamas warned all foreigners to leave Israel, as it pledged a new round of revenge attacks “in which we will target every Zionist occupying our land”. Mr Sharon, meanwhile, has promised “to pursue terrorist organisations and their leaders until the fight is over”. Thus there would seem little prospect of the Palestinian militants agreeing to Mr Abbas’s and Mr Arafat’s pleas for a ceasefire, nor of the Israelis believing it if one was agreed. But, hopeless as it seems at the moment, the only way forward is for Mr Abbas to continue to seek some sort of agreement with Hamas and for Mr Sharon not to scorn it once it is achieved.
Mending fences, mending economies
Gradually, all those concerned have accepted that, one way or another, their differences over the war must be set to one side. The new UN resolution on Iraq, passed on May 22nd, signalled the start of the process of mending fences. The Evian meeting should help too. Relations between Mr Bush and Mr Chirac have been cordial, if formal. A bilateral meeting was also arranged between the two men: though Mr Bush has avoided a similar meeting with the German chancellor, Gerhard Schröder, who also opposed the war.
Everybody seems to accept that another row about Iraq would be both unseemly and pointless. It would also be a distraction from the many other problems which the summiteers need to address. When these summits were first established, in 1975, their purpose was to discuss economic issues. Over the years, they have become more wide-ranging, encompassing political and security issues as well. (They have also become more cumbersome, in spite of repeated attempts to restore the original aim of an informal fireside chat among world leaders.) Mr Bush is apparently not wholly committed to the summit process: he is leaving a day early to begin his round of peace talks in the Middle East.
Mr Chirac had promised that tackling world poverty would be one of the summit's main themes (see story) and on June 1st, the summit's opening day, the leaders met leaders representing the developing world. But it is inevitable that the rich countries' own economic worries will also be high on the Evian agenda. Growth remains disappointing in America, non-existent in Japan and feeble at best in Europe. The SARS epidemic has dampened growth prospects in Canada, which earlier this year had been the only major economy where overheating, rather than recession, was the worry. The currency markets are more volatile than they have been for some time. And for the first time since the 1930s, deflation has become a real risk in some economies outside Japan.
Economic co-ordination, the dream of some of the early summiteers in the late 1970s, has long gone out of fashion. That sort of fine-tuning burned too many fingers. But it is striking that at a time when the stated economic objectives of the Evian participants—sustained non-inflationary growth and a commitment to free trade—are so similar, their policy responses are currently so different. Mr Bush has just signed into law another large tax-cut package, worth $350 billion over the next few years, at a time when his government's budget deficit is soaring. The Federal Reserve—America’s central bank—has cut interest rates aggressively since January 2001. They are now at their lowest level for more than 40 years. British interest rates have also been cut several times in response to falling inflation and signs of weakening growth. British taxes have been raised, but in order to finance a large expansion in public spending.
Continental Europe, by contrast, is struggling to tighten fiscal policy, in order to meet rules on budget deficits brought in alongside the single currency: but Germany is now technically in recession and French growth prospects this year look dismal. The European Central Bank (ECB) has consistently ignored pressure from economists, international institutions and European business for further cuts in interest rates. And the recent sharp rise in the value of the euro against the dollar has largely offset those interest-rate cuts that have been made.
Economists have long given up on Japan. Three recessions in ten years, and deflation now in its fourth consecutive year have brought little in the way of tangible, effective reform, in spite of the hopes that Junichiro Koizumi, who became prime minister in 2001, would bring sweeping changes. But now deflation is threatening to spread. Alan Greenspan, chairman of the Federal Reserve, says it is a small risk in America; but he also says it is currently a higher risk than inflation. A recent study from the International Monetary Fund (IMF) appeared to endorse that assessment, placing America in the low-risk category.
But the IMF put Germany in the high-risk group of countries, along with Japan—where the study reckoned deflation might get worse—plus Hong Kong and Taiwan. The German government is in the middle of a tough political battle, largely with its own supporters, over structural economic reforms intended to address some of the country’s longstanding problems. Nobody outside Germany doubts that these changes—to the labour market and the welfare system—are needed. But they will not, by themselves, help German economic recovery in the short term.
Discussion at Evian of the economic hurdles facing the global economy will not by itself make much difference to what happens at the national level. Europe’s problems ultimately have to be dealt with in Europe. So far, European governments, along with the supranational ECB, have displayed the same sort of inability to tackle their economic problems that has plagued Japan for the past decade. But America, too, has been reluctant to acknowledge the problems posed by its soaring budget deficit and a current-account deficit of more than 5% of GDP. The recent sharp fall in the dollar is adding to the discomfort of Europe and Japan as their currencies rise as a consequence.
Summits are not, on the whole, about action, or even commitments to action. Rather they are an opportunity for leaders to exchange ideas, and to acquire a greater understanding of each others’ problems. An atmosphere of suspicion or distrust is hardly conducive to such understanding. Given the events of the past few months, relations at Evian are bound to seem strained. The challenge for the participants will be to recognise that world economic prosperity depends on greater co-operation, if not co-ordination.