How to Sustain the Global Rebound

Op-ed in the Financial Times, London edition

January 2, 2004

The world economy is rebounding strongly, generating optimism that real economic growth for 2004 is likely to reach the 4.5 per cent rate of the boom of 1999/2000. Beyond the near term, however, five crucial policy challenges cloud prospects for sustained expansion.

The US and emerging Asia are leading the global recovery and aiding a respectable performance in Japan. Growth is accelerating to a moderate pace in Europe, and Latin America is poised for a decisive upturn.

This global recovery comes at a welcome time. President George W. Bush seeks re-election later this year. European countries, especially France and Germany, are struggling with budget deficits widened by persistent economic sluggishness. Japan, despite its recent economic upturn, needs continued growth to tackle problems in its financial sector and the challenges of its large public debt and rapidly ageing population.

High world oil prices, the potential return of the severe acute respiratory syndrome epidemic and the threat of another massive terrorist attack pose near-term economic risks. But these downside risks are counterbalanced by the tendency for global economic recoveries (and slowdowns) to be mutually reinforcing to a degree that is under-appreciated in most economic forecasts. Of greater concern, however, are the following five critical issues:

First, policy interest rates are very low in the leading industrial countries and likely to remain relatively low for a considerable period. These countries need to develop and communicate policies concerning gradual increases in official interest rates in order to achieve longer-term objectives of reasonable price stability and to continue providing appropriate support for economic activity.

This challenge is complicated by the fact that when inflation is very low, policymakers cannot rely on the prices of goods and services to provide timely indicators of the need for monetary tightening. Instead (as in Japan in the late 1980s), anomalous behaviour of real estate, equity and other asset prices may initially signal the need to tighten monetary policy. The reluctance of some central banks, especially the Federal Reserve, to acknowledge this problem is not reassuring.

A second and related challenge concerns capital flows to emerging markets. After collapsing during the Asian crisis and falling further after Argentina's default, private capital flows to emerging market countries have begun to revive.

The nascent boom has not yet reached the frenzied pace seen in 1997 but the warnings are there. Economic recovery in most emerging economies, continued low interest rates in the industrial countries and rising optimism in global financial markets all suggest the frenzy may soon return.

Meanwhile, the world's vulnerability to emerging market financial crises has been lessened by the shift of some countries to genuinely floating exchange rates and by the accumulation of large foreign exchange reserves by several Asian economies.

At the same time, risks have increased because of the general rise in the debt levels of emerging market countries (as detailed in the International Monetary Fund's September 2003 World Economic Outlook). And, as demonstrated by Argentina's recent crisis and the continuing saga of its sovereign debt default, mechanisms for crisis avoidance and crisis management by the IMF and the international community leave much room for improvement.

Third, for almost all industrial countries, substantial fiscal consolidation is necessary over the medium term-both to reduce present deficits and to deal with the fiscal implications of ageing populations. This means that re-invigorated private demand, supported by suitably accommodative monetary policies, will need to offset fiscal drag so that aggregate demand growth can keep output close to potential gross domestic product.

Fourth, the enormous US current account deficit must be reduced to levels consistent with the sustainable appetite for foreign net investment into the US. This requires significant dollar depreciation from its exceptionally strong levels of 2000/2001. Substantial correction has already occurred against the euro, the Canadian and Australian dollars and, to a lesser extent, the Japanese yen. But too little adjustment has so far occurred against the currencies of emerging Asia, including the Chinese yuan; and many Latin American currencies have depreciated against the dollar since 2001.

Reduction of the US current account deficit also requires two concurrent developments: a slowdown in demand growth below output growth in the US and, in the rest of the world, an acceleration of demand growth above output growth. For US policymakers, the challenge is to implement a timely reversal of recent fiscal stimulus. This should coincide with the positive effects of dollar depreciation in improving net exports to become a positive influence on US output growth.

For the rest of the world, the challenge is to stimulate domestic demand to offset drags from both fiscal consolidation and modest worsening of current account positions. The fiscal proclivities of the Bush administration and US Congress raise serious doubts about America's contribution to this process. The zero interest bound for Japanese monetary policy and the reluctance of the European Central Bank to acknowledge much responsibility for output growth raise symmetric doubts on the other side.

Finally, America's huge current account deficit and recent large losses of manufacturing jobs combine with widespread anti-globalisation sentiment to heighten concerns about protectionism well beyond the usually limited effects of individual protectionist actions. This adds to the urgency of getting global trade liberalisation efforts back into forward gear before too much momentum develops in the opposite direction.