Nout Wellink: The business cycle in perspective
Address by Mr Nout Wellink, President of De Nederlandsche Bank and President of the Bank for
International Settlements, on the occasion of AkzoNobel's New Year's function for its management, 8
January 2003.
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You are of course familiar with the phenomenon of perspective distortion, which makes things close by
look bigger. Interestingly, the effect becomes less strong as the distance from onlooker to object
increases. Similarly, a certain distance in time is often required in order to put things in their right
perspective. This is why historians so seldom discuss events of less than several decades ago.
Economists and policy makers, however, cannot afford to keep that much distance. And by
consequence, much of what they write and say shows the effects of perspective distortion: the current
recession invariably looks greater than the previous one. Architects in 15th century Florence
discovered how to draw a correct perspective. Much later, the architects designing the building of the
Nederlandsche Bank used this knowledge: By making the tiles that line the outside of the building
larger for higher stories, they cancelled out the distortion in the eye of the observer below. Today, I
have set myself the ambitious goal of putting the business cycle in perspective. I intend to regard
recent cyclical developments in the light of preceding business cycles. This gathering presents an
eminent opportunity to discuss the international and Dutch business cycles, for AkzoNobel is an
international concern - active in 80 countries. But you are also a Dutch company, with its head office
established here and almost 20 per cent of production concentrated in this country. At the same time, I
suspect that AkzoNobel has a greater than average interest in the analysis of cyclical developments:
An important part of the firm's activities - basic chemicals - may be characterised as early cyclical. For
us, incidentally, this makes companies in this sector interesting, because they provide a leading
indicator for the business cycle.
The economic slowdown since the year 2000 has so far been roughly simultaneous in Europe and
North America. It has often been claimed that this is the result of the increasing economic
intertwinement of both large blocks. That increase can, of course, hardly be denied. World trade today
represents 17% of global production, against only 8% in 1914. And this excludes the increased
internationalisation of businesses, through the establishment of branches and plants abroad and
through cross-border mergers. Also highly visible is the fact that the connection between financial
markets has become stronger over time. The terrorist attacks in the United States and the dubious
accounting practices revealed in the aftermath of the Enron collapse have hurt stock market
sentiments world-wide. Recent research conducted at the Bank confirms this image: the correlation of
German, British and US share prices has more than doubled over the past twenty years, from around
0.30 to 0.65.
The simultaneous cyclical movements of the large economies are not determined primarily by
increased intertwinement but through the occurrence of global shocks. Cyclical coherence between
Germany and the US was especially strong in the aftermath of the oil crises of the 1970s. The current
cyclical harmony is explained by two recent global shocks: the oil price rises and the bursting of the
ICT bubble. Almost continuously for the ten years up to 1998, oil prices moved within a bandwidth of
10-20 euro per barrel. In the course of 1999 and 2000, however, the oil price rose by almost 300%
from the lower limit of this bandwidth to over 37 euros. Since late 2000, oil prices have come down
under the impact of global economic slowdown. But a possible war against Iraq might push them up
again. The second shock was caused by the bursting of the ICT stock market bubble. Share prices of
ICT companies took a plunge from the peak reached in March 2000, losing two-thirds of their value.
ICT investments - which in the US had risen by 10% to 20% every year since the early 1990s - have
been falling since mid-2000. The present synchronicity of international cyclical movements has largely
been caused by these two shocks. There is a good possibility, however, that the international
convergence will dissolve again when the effects of both shocks have ebbed away. When the tide
turns, the speed of recovery may be different on both sides of the Atlantic.
Another, related phenomenon is the decline in amplitude which cyclical waves have shown in recent
years. In most industrialised countries, cyclical movements have been strongly damped since the first
half of the 1980s. Several explanations have been offered, one of which is the gradual shift in the
economy from industry to services. This may cause damping because fluctuations in industrial
production tend to be relatively large. The share of services in overall employment has increased from
47% in 1960 to 70% today. However, research based on US figures shows that this shift has played
only a minor part: it appears that the industrial and the services sectors both follow more stable
patterns than they did a few decades ago. A second explanation offered for cyclical damping is that
ICT developments have led to improved inventory management efficiency. ICT applications have
enabled businesses to organise their inventory management in more efficient ways. But ICT
applications have not helped predict the future development of consumers' inclination to spend. If
consumers spend 100 million euro less than expected on their Christmas shopping, stocks increase by
100 million euro's worth. In other words: greater or smaller-than-expected sales affect inventories just
as much as they did ten years ago. Therefore, the observed damping of the business cycle must be
attributable to other causes.
A third explanation given for the flattening of cyclical patterns is that monetary and budgetary policies
nowadays tend to be aimed more towards the medium term. Over the past two decades, monetary
policy has succeeded reasonably well in curbing inflation, thereby enhancing the predictability of the
macroeconomic environment. The risk that a cyclical boom will trigger a wage-price spiral has also
diminished. As for budgetary policy, the 1960s and '70s were characterised by activism, which served
to magnify rather than damp cyclical movements. The 1980s were the years of austerity measures,
taking away the potential stabilising effects of public finance. Since then, the budgetary position of the
Netherlands - and of some other countries - has greatly improved, allowing a trend-based budgetary
policy to be pursued. Such a policy implies that in principle, public finance has a damping effect on the
business cycle. In the meantime, however, developments in the US show that active budgetary policy
is not yet entirely a thing of the past. The US budgetary position (as a percentage of gross domestic
product) has deteriorated by 41⁄2 percentage points in just two years' time. A fourth factor connected
with cyclical damping is the fact that fewer global shocks have occurred during the last twenty years.
So damping is also a matter of chance. The 1990-91 recession in the US, for instance, was mitigated
somewhat by the boost which the European economy received from German reunification and which
kept up the level of US exports to Europe. A few years later, the reverse happened. Despite the
multitude of possible causes, only 40% to 60% of the damping effect can be explained. The latter two
factors - less activist budgetary policies and fewer global shocks - each account for 20% to 30% of
cyclical damping since the early 1980s.
Against this background of more moderate cyclical movements, I should like to "zoom in" on the
current cyclical downturn in the Netherlands. Contrary to some allegations, this downturn is not very
different from previous periods of cyclical decline - in fact, it is a textbook case. The depth of the
cyclical trough clearly varies across cycles, but its average level has been 11⁄2 to 2 per cent below the
trend. Thus over the past decades, cyclical lows in the Netherlands have tended not to bring an actual
shrinkage of the economy. The current five-quarter period of nearly zero growth also appears set to
steer just clear of recession. What was unusual about the last cycle was the length of its upturn. After
the economy had reached its potential production level, there followed three more years of relative
strong growth before the cycle turned down. The prolonged rise is attributable to consumer spending.
A strong autonomous increase of employment led to a favourable development of households'
incomes. This, combined with low real interest rates and a generous disposition by mortgage lenders,
led to a sharp rise in housing prices. The withdrawal of the resulting equity on the value of home
property gave a strong additional push to household expenditures.
The decline also shows a few distinct features, most prominently the development of foreign trade. In
the past, a decline in the Dutch business cycle usually began with a fall in exports - which should not
come as a surprise in such an open economy. This time, however, the downturn in exports was
somewhat delayed, indicating that the current cyclical movement has been driven to a much larger
extent than usual by domestic factors. The decline of investment demand set in relatively early on and
has been stronger than average. On the face of it, the situation here seems to parallel that in the
United States. There, the recent slowdown seems to have been initiated by the fall in ICT investments.
The development of other investments (i.e. excluding ICT) has been relatively stable. But things are
different in the Netherlands. It is true that the share of ICT in total investments increased strongly from
1995 to 2000, from 11% to over 16%. But the cyclical curve of non-ICT investments hardly deviates
from the overall pattern. The fall in investments in the Netherlands is mainly attributable to an erosion
of private sector profitability from 1998 onwards. The early slump in investment growth seems also to
have been caused by supply restrictions, for instance in the construction industry: during the second
half of 1999, almost 80% of vacancies in construction were difficult to fill. Reinforcing the downturn in
investment demand was the incipient deflation of the stock market bubble from the third quarter of
2000 onwards - a few quarters after the cyclical turning point. Added to this, the sharp increase in
housing prices levelled off in 2001, and with it the boost it had given to consumer spending. This has
had a negative impact on private consumption.
Another remarkable feature of the current downturn is the fact that Dutch inflation has risen relatively
strongly, not only compared to earlier business cycles, but also compared to other euro area countries.
In all EMU countries, inflation was pushed up by rising oil and food prices and the decline in the
exchange rate of the euro. In the Netherlands, however, this development was compounded by the
unusually low rate of unemployment reached well before the cyclical peak in output. Labour market
tightness resulted in strong wage increases, and hence in an acceleration of the Dutch inflation rate.
Dutch prices have risen more sharply than elsewhere in Europe, and I do not have to tell this audience
what that means for Dutch competitiveness. And although the difference in inflation between the
Netherlands and the euro area has declined from 2.2 percentage points in January to 1.2 percentage
point in November. This indicates that the rate of deterioration has come down. It does not mean that
any lost ground has been regained.
Analysing recent cyclical developments is not an art for art's sake. Understanding the nature of the
downturn may contribute to more accurate economic projections. The ongoing adjustments in the
Dutch business sector, like those elsewhere in the euro area, have not been completed. Thus far, the
US economy has appeared the more resilient. Recovery on both sides of the Atlantic is therefore
unlikely to be simultaneous. According to the latest figures, the US economy has already returned to
21⁄2 per cent growth over the past year, whereas the recovery in Europe which was expected for the
second half of 2002, failed to materialise. Current expectations are that the European economy will
only start to pick up in the course of 2003 - the latest economic projections by CPB, the Netherlands
Bureau for Economic Policy Analysis, predict 13⁄4 per cent growth for the euro area during 2003. The
inflation picture is rather flat, with a projected 2% on average for 2003. The projections are surrounded
by fairly large uncertainties. I want to mention the developments of the dollar exchange rate and the
price of oil in particular. Since 2000, the growth of the Dutch economy has lagged behind that of the
euro area, whereas our economy used to outgrow that of the euro area during nine out of ten years in
the 1990s. During the past year, the Dutch economy has hardly grown at all, for a number of reasons.
Declining stock market prices, rising unemployment and political tensions in the Middle East have
sharply depressed both consumer and business sentiments. Added to this, the wealth effect of rising
house prices on consumer spending has disappeared. The economy will recover only slowly in the
next few years. According to the CPB, economic growth will be only 3⁄4 per cent in 2003, which is well
below the projections for the euro area as a whole. Both business investment and employment are
expected to show negative growth in the year to come, while Dutch exports will fall behind the
expected growth of world trade. At the same time, the inflation rate for the Netherlands is estimated to
come out at 21⁄2 per cent. This means that the decline - from an excessively high level in 2001 -
continues.
I have reached my conclusions. Or rather, returning to the terminology of spatial perspective, I have
reached the point at the horizon where all lines merge: the central vanishing point. In this address, I
have been dicussing recent cyclical developments in the light of previous business cycles. Basing my
argument on a quantitative analysis, I have attempted to avoid being deluded by perspective
distortion. Regrettably, it will be some years before we may determine how successful my attempt has
been.