JAPANESE LESSONS ON ILL-TIMED FISCAL TIGHTENING / THE FINANCIAL TIMES MARKETS INSIGHT ( VERY HIGHLY RECOMMENDED READING )

Japanese lessons on ill-timed fiscal tightening

By Sushil Wadhwani

Published: September 8 2010 17:10

Financial market participants are increasingly preoccupied by the possibility of a double-dip recession. I am frequently asked what another recession would imply for equity prices and whether I believe that another bout of quantitative easing (QE2) might be desirable.

Although double dips are rare – only three out of thirty-two US recoveries since 1854 peaked within a year of the trough of the previous recession – markets usually fear another recession at this stage of the business cycle.

The ending of US recessions in the period after the second world war has been followed by rises in indices of manufacturing activity for about a year as inventories are rebuilt.

Typically, as the inventory contribution comes to an end, we see manufacturing indices weaken for some months before a recovery in consumption takes activity higher again.

This early cycle weakness is often associated with fears of another recession. During my own professional career, I can recall the US “growth scares” of 2002, 1992 and 1984.

Is the “growth scare” of 2010 different?

Assuming that the last recession ended during 2009, we have not, as yet, materially deviated from the historical script. However, at least three factors might lead to a different outcome.

First, the European sovereign crisis. The impact on global equity markets and confidence came at a unhelpful time, as it made the handing over of the baton from inventories to consumption and investment more difficult.

It is worrying that European policymakers have not created a mechanism for dealing with an insolvent state in the European Monetary Union. This makes us vulnerable to events in Europe.

A variety of possibilities exist, including political difficulties associated with sustaining austerity packages in some countries or a growing perception that Germany might be unwilling to renew the Stabilisation Fund.

Without fire-breaks in place in Europe, one of these known unknowns could, at some point, put us back into recession.

It would be no exaggeration to say that European policymakers could determine whether we have a global recession in the next two years.

Second, there are indications that the fiscal tightening being planned by many developed countries could prove ill-timed.

It was always rather risky to be announcing this change in policy just as the inventory contribution to growth was coming to an end.

Much better to have dealt with fiscal credibility concerns through longer-term measures – for example pre-announcing a steady increase in the retirement age – than hurting demand in the near term.

It is even more worrying that many of these governments do not appear to have a Plan B with respect to providing fiscal stimulus if growth is weaker than expected.

Third, even if we do avoid full recession, slow growth in the developed world is quite likely because of the effects of financial deleveraging and the fiscal tightening. This would plausibly push up the unemployment rate.

With core inflation low in several countries, this increases the probability of outright deflation, which as Japan attests, could turn into a self-reinforcing downward spiral with lower demand, further falls in equity markets and even greater demand falls.

It should, though, be acknowledged that equity market valuations have moved some way towards incorporating the possibility of weaker long-term growth and/or requiring a higher risk premium because of elevated uncertainty.

For example, dividend yields are quite high relative to bond yields. Our in-house dividend discount model points in the same direction.

Therefore, if we contrive to escape any nasty events in Europe, and if the US were to reduce the projected degree of fiscal contraction next year – say by preserving the tax cuts that are scheduled to expire – one can envisage a scenario where we see an uplift in equity prices.

However, monetary policymakers should not be relying on such a benign outcome. The time has come to act pre-emptively and decisively.

Waiting now for the economic data to weaken further could be costly.

By then the financial markets could have weakened further, which might make it even more difficult to stimulate demand.

Delay proved costly in Japan. Far better to reverse QE2 later on if, as one hopes, it proves unnecessary.

Sushil Wadhwani is chief executive of Wadhwani Asset Management and a former member of the UK Monetary Policy Committee

Copyright The Financial Times Limited 2010.