The cycle won't stop without a wobble

The UK economic cycle is clearly far from dead, so is it credible to claim that the world cycle no longer exists? And if not, will the present cycle end with a whimper or a bang?

These are perhaps the most important questions facing the world economy at the moment. For a start, soaring Wall Street relies heavily on the conviction that America's long boom can continue almost indefinitely, and were Wall Street to be given any reason to change its mind, the ripples would spread throughout the world.

But if there were a bump in the American economy, the scale of that bump would matter enormously for the rest of us. Remember, the global recession of the early 1990s was led by America. Remember, too, that hardly anyone predicted it.

When trying to look forward it is often helpful to start off by looking back. I suppose the best starting point is the early 1980s, because the 1970s were distorted by the oil shock and the 1950s and 1960s were anchored by the Bretton Woods fixed exchange-rate system. Seen from a 16-year perspective, there does seem to be some evident damping down of the economic cycle. The International Bank Credit Analyst team have calculated a proxy for world industrial production (the G7 plus the most important emerging economies) and, as you can see from the graph on the left, the early 1990s recession was somewhat less serious than the one in the early 1980s. Equally important, the peak growth in the first full year of the recovery was lower in the early 1990s than it had been in the early 1980s.

You can see this point even more clearly in the middle graph, which shows the deviation from trend; the amplitude of this deviation is significantly lower through the most recent cycle than it had been through the previous one. Looked at globally, the world economy is not particularly stretched at the moment - it is growing close to trend. It is just that some parts of it, in particular the US, are now moving above theoretical full capacity, while other parts - including most of continental Europe and Japan - remain substantially below capacity.

Sitting here in Britain, we are very conscious of the economic cycle because we can remember the peak of the late 1980s and the slump of the early 1990s, and we can sense now the elements of boom. But if you look at the whole world, rather than at one country with a relatively poor record of macroeconomic stability, there is a fair degree of support for the idea that the cycle seem less marked now that it did a decade or so ago.

Nevertheless a less marked cycle is still a cycle. If the amplitude of future cycles continues to decline, you can perhaps justify the present American euphoria, for the growth phase would indeed end gently. The dip, when it came, would presumably simply push US growth below trend. There would be a couple of years of slow growth - say between 1 per cent and 2 per cent - during which time any inflationary pressures would ease and unemployment would creep up a little, before a new bout of faster growth would begin.

That sounds both plausible and encouraging - a benign cycle at last. There are, however, three problems with this sort of scenario. One is that even that sort of benign cycle may not be priced into the markets. The second is that while the world economy as a whole might experience smaller swings, there are considerable tensions between different regions, and these may become destabilising. The third is that while US growth might well ease in a benign way, the rest of the world's growth might not. The world economy is no longer dominated by the US, or indeed the G7, to the extent that it was even a decade ago. Within about five or six years the total output of what we still think of as the developing countries will exceed that of the developed ones.

Whether Wall Street could take a knock to the American growth rate is anyone's guess. It is easy to show that, by historical standards, US equities are seriously over-valued. World stocks, on the other hand, may not be. And the swings in world share prices do seem to have become more stable through the past 15 years (see graph on the right). The principal explanation for this solid performance - that conditions for sustained, low-inflation growth are more favourable than they have been for a generation - may well justify some re-rating of shares, but no one knows ex ante how big a re-rating that should be. Look at the present re-rating of sterling. Everyone now is saying that this was obviously going to happen, and that the pound may go to DM3.10. Well, it wasn't obvious, and they were not saying that six months ago.

Even if the markets have got the direction right, they may have the scale wrong. Markets generally overshoot. At some stage there will be a reassessment of the extent to which equities should be re-rated, and the longer that this reassessment is postponed, the more brutal it is likely to be.

The obvious danger, then, is that a sharp shock on Wall Street would feed back, though its impact on confidence, into the real economy and thereby undermine the latter still further.

The second set of concerns - the tensions between the regions - may not matter while they are relatively modest, for they can be defused by differences in exchange rates and interest rates. For example, the enormous current account imbalance between the US and Japan has now continued for a couple of decades, but the tension that this has created has been reduced by the chronic under-valuation of the dollar against the yen and by the willingness of Japanese investors to recycle the surpluses in the form of foreign investment in the US.

Similarly, the tensions between a fast-growing UK economy and the slower- growing ones of continental Europe have been accommodated by the rise in sterling and in UK interest rates. That is a good example of the way in which differential growth rates are balanced by differential interest rates.

But while markets can cope with imbalances, they can only do so for a while, and at some stage the fundamentals have to adjust. The US current account deficit is one soft point in the country's economic performance, for accumulated deficits have now transformed the States, not just from being the world's largest creditor to its largest debtor, but also from running a surplus on invisibles to a deficit. At some stage, however far forward, the US will have to bring its current account back towards a balance.

Finally, even if the countries at the head of the cycle, like the US, manage a soft landing, that does not guarantee a soft landing for the entire world economy. This is a new problem. For the whole of the post- war period the world economy has been dominated by the mature developed countries. They remain, even now, enormously important. But gradually, inexorably, the balance of world output is shifting.

Soon - maybe not during this cycle, but perhaps the one after - it will be excessive economic growth in China (or a deep recession there) which will exacerbate the swings in the world cycle.

None of this should be seen as grounds for an early panic. But it really is worth remembering that some sort of economic cycle surely still exists. While the present upswing in the world economy may end in a benign way, it will certainly end. Are we prepared for the downturn?

It is also worth remembering that the world economy remains inevitably subject to unexpected shocks. Are we prepared for these? Probably not.