Notes on the Global OutlookPresented at the Institute of International Finance
Jeffrey A. Frankel, Member, Council of Economic Advisers
Nov. 17, 1997
I am happy to be here today, to talk about the global macroeconomic outlook. Toward the end of this talk I am going to discuss some broad themes, evaluating a few capsule characterizations of the current outlook that one often hears, and adding one of my own: overheating, deflation, market clearing, New Economy, and new anti-internationalism. But I will begin by reviewing recent developments in the global macroeconomy.
During much of the last six years, the United States has been growing faster than its trading partners. At the start of 1997, we expected this pattern to reverse. On the one hand, it seemed unlikely that the rapid U.S. growth rate of 1996 would continue [3.3 on a Q4/Q4 basis]. On the other hand, it seemed likely that growth in Japan and Europe would pick up. And it appeared certain that developing Asia, the new "fourth growth pole" of the world economy, would continue to far exceed our own growth rate.
For example in the IMF WEO forecast of one year ago the U.S. was expected to slow to 2.4%, while Japan was expected to grow at about 2.7% and the developing countries of Asia were expect to continue chugging along at 7.6%. The PECC Economic Outlook said 8% [May]. As recently as last month's October WEO, when the outlines of the ASEAN problems were known, 1998 growth among Asian developing countries was still forecast at 7.4 %.
What happened this year was something quite different than forecasted.
The North Atlantic vs. the RoW
- Contrary to the slowing that most [incl. us] expected in 1997, the growth rate in the first three quarters averaged 3.9 %. Employment continues to rise, with over 13 millions jobs created since January 1993.
- The President's plan to cut (by 2/3>1/2 during the first term) and then eliminate (by 2002) the budget deficit has proceeded well ahead of schedule, in part due to rapid growth.
- With growth in excess of potential, and unemployment below 5% since April [for the first time since before the 1973 oil shock], and below traditional estimates of the NAIRU as well, one would have expected inflationary pressures to emerge by now. They have not. Inflation remains low. While the most recent statistics suggest higher compensation growth in the 3rd quarter, they also suggest more rapid productivity growth. The implication is that workers are earning their raises, and unit labor costs are still not putting upward pressure on inflation.
- Growth has also been strong in Canada, the British Isles, and the Nordic countries.
- (In many of these countries, recent fiscal consolidation has helped keep interest rates down.)
- In the rest of the world, however, 1997 was a disappointingly weak year.
- Odds look good for EMU taking place as currently scheduled (participants to be chosen in Spring of 1998, and the euro in place by January 1999). In the early 1990s, as German spending in the re-acquired eastern lander pushed up real interest rates, differences in countries' needs regarding monetary policy led to the 1992-93 ERM crises. Currently, differences in monetary policy needs are not as sharp, as reflected in the convergence of interest rates.
- EMU will be the most important change in the world monetary system since 1973, and an inspiring enterprise -- economically, politically, and historically.
- US has far less stake in EMU than Europe does. But nevertheless, we are following its progress with interest. To the extent that we do have a stake in it, it is congruent with the interests of Europeans. That is, a healthy and growing European economy is in the economic and political interest of the United States
- Growth has been unspectacular on the European continent, particularly among the major countries, and unemployment remains very high (an undiminished 11% in the EU overall). Monetary and fiscal policy are largely constrained by the needs of Maastricht (though of course price stability and budgetary discipline are good for long-term growth, regardless of plans for EMU). Monetary and fiscal policy will probably be equally constrained, after Jan. 1999 as before, by a new credibility-seeking European Central Bank and the Stability and Growth path, respectively.
- Policymakers cannot afford to let EMU distract them from fundamental reforms to reduce rigidities in labor and product markets. National economies need to be able to adjust flexibly to future shocks. Otherwise the loss of countries' monetary independence entailed in EMU will cause problems in the future. Procrustean attempts to address unemployment by reducing the supply of labor rather than letting demand increase (through flexibly-adjusting markets) are not promising [e.g., French ideas on mandating a shorter workweek at unchanged pay].
- Bursting of 1980s bubble (1990-95).
- Faltering of recovery in 1997. The US Administration was concerned that Japan's April 97 consumption tax increase (in an understandable desire to move toward long-term fiscal consolidation) might be too much too soon, and would choke off the nascent 1996 recovery. The Japanese government was confident that it would achieve 1.8% growth in 1997. In the event, U.S. concerns turn out to have been justified.
- When one looks around the world for possible threats to the global economy, there are perhaps more grounds for concern in Japan than anywhere else.
- Monetary policy can't push Japan's economy any further (liquidity trap), and the government seems determined not to cut taxes.
- Banking problems linger. Japan's slowness to acknowledge, deal with, and move beyond its bad loans problem has actually managed to make the U.S. record of the 1980s look good by comparison.
- Prime Minister Hashimoto's deregulation initiative is a hopeful sign (deregulation in construction, retail, telecommunications and transp., e.g., ports, and esp. Big Bang in financial markets). But deregulation is unlikely to provide a large boost to output in the short run.
- The weak Japanese economy, by comparison with the strong US economy, probably explains much of the depreciation of the yen against the dollar over the last two+ years. (Almost the same could be said of continental Europe.)
Origins of the crisis
We all believe that liberalized, open, and international integrated financial markets have many important advantages. Funds will be allocated more efficiently, developing countries can fund their investment at lower costs of capital than if they had to rely on domestic saving alone, investors in wealthy countries can earn higher returns on average than if they were limited to investments in their own countries, and everyone can benefit from diversifying risk and smoothing consumption across time.
It may be time, however, to reconsider the proposition that financial markets always get it right, that if an emerging market country adopts sound policies it can be secure in the knowledge that it is immune from speculative attack. What do we say to those countries who resist opening their financial markets by citing the danger of crisis brought on by successive and excessive waves of speculative inflow and speculative outflow?
- At one time, we said that the key was budget discipline. If the government is not running a deficit, then it is the private sector that is borrowing from abroad, and it can be relied on to use the funds for good purposes. This "Lawson fallacy" was discredited by Chile 1980, Britain 1992, and Mexico pre-1994.
- So we said that the problem in Mexico was other fundamentals, particularly a low private saving rate; consumption was too strong (in part a response to liberalization of consumer credit, retail and imports). Another fundamental was that a relatively high share of the capital inflow took the form of short-term liabilities denominated (in foreign currency), and not enough in the form of direct investment. When we looked around for other countries with high current account deficits, and saw that they were in SE Asia [Thailand and Malaysia], we were reassured that fundamentals such as the saving rate and the level of foreign exchange reserves looked much stronger. If the inflows were not going to finance government budget deficits or private consumption, then they must be going to finance investment. So everything must be alright.
Of course the crisis did not take everyone by surprise. Krugman's twin Foreign Affairs articles of three years ago, on the Myth of the East Asian Miracle, and Tulipmania, provided a good early warning. Many of us took note over the last few years of excesses in some Asian countries and flaws in their banking systems, and urged reforms. We also noticed in 1996 the sort of export slowdown (in the global electronics market) to which an overly indebted country is particularly vulnerable. The IMF duly warned the countries most at risk. But I think it fair to say that most of us were surprised at the depth and breadth of the crisis this Fall.
- What are we to conclude now? One answer is that much of the money went to finance -- not just investment in plant and equipment and infrastructure --but real estate and construction. The former generate the future earnings of foreign exchange from exports necessary to service the debt. Condo construction does not.
But this answer is a bit incomplete. For one thing, investment in plant and equipment was high in some of the countries most affected. For another, the crisis has of course spread widely, including to countries with stronger fundamentals. Contagion appears to be a genuine phenomenon. As in Latin America two years ago, the breadth and depth of the punishment visited by investors on the debtor countries seems to exceed the magnitude of the policy sins they have committed.
The conclusion I draw is certainly not that financial market liberalization is bad. Overall, the benefits outweigh the costs. But we must be prepared for occasional crises, not all of them fully understandable. If markets sometimes overreact, then countries need even sounder macroeconomic policies to compensate. As Robert Merton has said, modern financial markets are like superhighways: they get us where we want to go faster, but the accidents are bigger as well. Extra caution in driving, and airbags, are both appropriate. Public and private saving rates remain important. Strengthening of prudential regulation of banks and other financial institutions in these countries is key to reducing the risk of accidents. Increases in reserve requirements against banks' short-term foreign-currency liabilities may be in order in some cases.
The longer term:
An end to the East Asian miracle, or just a temporary setback? Krugman claimed that there never was an East Asian miracle. (The appropriateness of the word "miracle" lies in the eyes of the beholder. If Krugman had chosen to phrase his conclusion differently: "The miracle of East Asian growth is due to miraculous rates of investment in physical and human capital," most readers would have been less surprised by the article than they were. Yet this is really what the article said.) Nevertheless, he forecasted a marked slowdown in East Asia. An article by Jeff Sachs in the current Foreign Affairs takes the contrary view: that East Asia's current financial troubles are purely transitory, and growth at miracle rates will before long resume. A natural guess is that the truth lies in between.
Japan's growth rate appears to have converged to that of the United States and other industrialized countries, not gradually, but in the course of two sharp kinks. The first occurred in 1973-74, with the world oil shock. The second followed the bursting of the 1987-89 bubble in Japanese financial markets. Japan's per capita growth rate averaged a remarkable 8 percent during the period 1962-1973, but slowed to 3 percent during 1974-1990. Over the last seven years, it averaged a mere 1 2 percent. Presumably Japanese growth will recover from its recent recession, but whether it will go back to the miracle rates of earlier decades seems dubious. The convergence is complete.
Are other East Asian economies now going through a growth-path kink analogous to Japan's 1973 slowdown? There is no necessary connection between transitory shocks such as a sharp increase in the price of oil or a financial crisis and the long-run rate of growth of potential output. With the exception of Japan, Singapore, and Hong Kong, East Asian economies still have a very long way to go before attaining the per capita incomes of the industrialized countries. But for those observers who thought that the miracle rates of growth attained by many East Asian economies over the past several decades were unsustainable, the 1997 episode of instability in financial markets may be interpreted as a signpost indicating that a more moderate and sustainable rate of growth lies ahead.
Other emerging markets
The most encouraging development in the world economy over the last decade was the choice by many countries to adopt the open market-economy model. Faced with the stark examples of the East Asia economic miracle on the one hand, and the economic fiasco of the communist countries on the other, countries in Latin America, the rest of Asia, Eastern Europe, and even Africa, opted for the capitalist model. Recent financial market developments have spread to Latin America, and may have a negative effect on 1998 growth rates. But assuming that this experience doesn't undermine the fundamental "Washington consensus," -- which favors stable monetary and fiscal policies, privatized enterprises and market-determined prices -- the long-term prospects for the emerging economies and transition economies remain excellent.
Possible short-term spillover from the crisis
Economists are busy updating 1998 projections for growth rates.
A common estimate that I have seen is that the loss in net exports due to the Southeast Asian crisis will amount to about 2 per cent of US GDP, based on the countries that have been hit as of mid November.
It is easy to see why there would be a range of numbers. Aside from the usual variation in models and assumptions, different forecasts refer to different dating, which makes all the difference. Forecasts from the early fall consider only the implications of retrenchment in the ASEAN countries, which are a relatively small part of US trade (4% of U.S. exports, though the import side is also relevant, more than some analysts appear to realize: price-taking economies react to devaluations by increases in production of traded goods, and decreases in consumption, which can show up as an increase in their exports as easily as a decline in their imports). Later numbers look at spillovers farther north in Asia [Korea alone is another 4% of US merchandise exports], and in Latin America and elsewhere. Also, evaluating a statement like "the impact may be a loss as large as 0.5 of GDP" depends on what baseline is being considered. Some of the Wall Street forecasters who are talking about the biggest negative effects had high estimates to begin with. They typically end up at about 2.5 per cent 1998 growth. That is also where Blue Chip Economic Indicators is (on a year-over-year basis; 2.3 on the basis of 4th quarter over 4th quarter).
Many of the estimates regarding the East Asian crisis are just the effect on US net exports. The ultimate effect on the U.S. economy could be larger than this, with multiplier effects, or smaller, if one takes into account that the likely effect would be interest rates lower than they otherwise would be, thereby replacing demand lost in the trade sector with output in producers' durable equipment, construction, and consumer durables.
The CEA makes official growth forecasts only twice a year, as part of the government's budget process. November is the time of year when we begin meeting with Treasury and OMB to prepare the forecast on which the February budget will be based. We have not completed this process. But I think it unlikely that the forecast will differ very greatly from what we called for last time: 2.0 percent in 1998 (4th quarter/4th quarter). This was a nice conservative forecast when we made it last January (and when we renewed it at mid-session review). No "rosy scenario" in this Administration's forecasts. But whatever the negative effects of the developments in emerging markets, we see little reason to believe that they will outweigh the unusual positive momentum that the US economy has shown in 1997.
The East Asian crisis will have a substantially greater impact on Japan than on the United States. This is true both by virtue of geography (and corresponding patterns of trade and lending), and because Japan's banking sector and economy were already weak. There is an implication for the U.S.: just as Japan loses some of its net exports to East Asia, the U.S. will lose some of its net exports to Japan.
The US trade balance
Just as job-creation is less of a concern once we are close to the constraints of full employment, so the trade balance is less of a concern when we are up against the constraints of potential output. Nevertheless, I will talk a bit about recent external deficits.
The trade deficit on Goods & Services is still well below the 1987 peak of $153 billion, especially as a share of GDP. But it has been rising since its 1991 low-point [of $30 billion, and in 1996 reached $114 billion]. The current account deficit likewise remains slightly below the 1987 peak of $167 billion, especially as a share of GDP. But it too is well up from its 1991 low-point [of $10 billion, reaching $165 billion in 1996].
What have been the causes of these movements over the last ten years? The 1985-87 depreciation of the dollar was a major cause of the subsequent trade balance improvement. The 1990-91 recession was another clear source of "improvement," by depressing imports.
I think that the most important reason why the trade deficit and current account deficit have grown over the last year, or for that matter over the last six years, is that the US has grown more rapidly than our trading partners. Higher income brings higher imports. [See chart.] As I noted at the outset, our expectations that the relative growth rates would reverse have been contradicted by the developments of 1997. Thus the US trade deficit continues to increase.
As a share of GDP, the current account deficit is about the same as in 1989, the last time that unemployment was [almost] this low. It is well below its 1987 peak. As a matter of pure macroeconomics, I am not too worried about the "deterioration" of the last six years. That it represents rapid growth sucking in imports is a good thing. Better yet, both national saving and investment have increased steadily as shares of GDP. [See chart.] The explanation for the widening current account deficit evidently is that investment is increasing more rapidly than national saving. This too is a good thing. [National saving and investment rates generally rise during expansions, but in this case they have been increasing even on a cyclically adjusted basis.]
The recent situation is very different from the much larger current account deterioration that took place between the 1970s and 1980s. That was a fall in the national saving rate: the famous fiscal profligacy of the first Reagan Administration, and a continued fall in private saving in the 2nd Reagan and Bush Administrations. The declines in National Saving and Investment were grounds for concern.. Our low rates of National Saving and Investment are leading candidates to explain our low rate of productivity growth since 1973, and so the recent improvements are good news. So far in the 1990s we have made up a little of the earlier decline, but only a little. More needs to be done. [See table.]
Capsule diagnoses one hears
Overheating? No signs of it yet.
Deflation? Yes, in crisis countries, and the goods they sell: textiles, footwear, steel, chips, other electronics. But that's not worldwide or general deflation.
Market Clearing. A natural question: how can it be that half the talk is the danger of overheating (excess demand) and half deflation (excess supply). Surely one concern or the other (or both) must be nonsense? One possible answer is that we are indeed on a knife-edge between excess supply and excess demand, and that is what being in market equilibrium is all about. If it feels different today, perhaps it is because the economist's model -- whereby prices adjust to clear the market every time supply or demand shifts -- is closer to being an accurate description of the world economy than ever before. The volatility, and the risk of excess supply or excess demand if you are too slow to react, feel uncomfortable. But this is the system that gives us the most income growth for the most people.
New Economy. There have been important structural changes in the American economy, most of them good: deregulation, opening, flexible labor markets. But we haven't licked the business cycle.
A new anti-internationalism. The dangers of an upsurge in isolationism and protectionism are real. An increase in our trade deficit with Asia is worrisome in this political sense. In the U.S.: Congress has turned inward on fast-track, the New Arrangements to Borrow, and overdue UN dues. In the developing world: there could be an East Asian backlash against globalization, and Mercosur recently raised tariffs from 12 percent to 15 percent.
But I remain hopeful. When the international debt crisis of 1982 imposed huge income losses on Latin American debtor countries, they eventually responded by undertaking further liberalization, not by regressing. I hope the East Asian response to the latest crisis will be similarly constructive. It is an opportunity for the countries to correct some of their structural problems and remove additional trade barriers, rather than the reverse. It would help restore the confidence of global investors. The least the U.S. can do, with our economy in such good shape, is continue to provide internationalist leadership.