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Thursday, September 18, 2003

The Big Wheel Keeps on Turning

The latest issue of the IMF's World Economic Outlook is now available . There is nothing really surprising - partly at least because the substance of the document was leaked last month. The difficulty is we are playing a waiting game. Bets have been placed but the wheel hasn't stopped turning yet. In general, simply because basic business cycle theory suggests we should be due for a recovery, expectations are that next year will see more growth than this one. You put the numbers in the models and they duly come out as expected. Certainly the US gives the impresssion of going up the ramp, but as I suggested yesterday, the doubts remain. Today, everyone utters a sigh of relief as new signings fall to 399,000. The US labour market cannot be read off the number changes from one week to another, in fact in general data cannot be interpreted and re-interpreted on a weekly basis, there is too much room for spike and random, or one-off items. We really can't take decisions on whether the labour market is improving based on the impact of things like the electricity blackout, or on retail sales based on a bout of hot - or cold - weather. If we are reduced to doing this, it is because we want to believe. I'm afraid there is no shortcut to the truth here, we simply have to be patient and wait as the weeks and months pass.

As stressed at the time of the last World Economic Outlook, the recent weakness of the world economy has not just been due to the war. The equity boom in the late 1990s was the largest in modern history: the unwinding of its effects is uncharted territory, and it is perhaps not surprising that most observers, including the World Economic Outlook, have found it difficult to gauge the aftermath. While the direct impact of equity market losses on household consumption growth should now have peaked, household balance sheets in some countries, notably the United States, remain stretched and housing markets—boosted in part by the aggressive easing of monetary policy in the last three years—are unlikely to provide the same support to the recovery going forward as they did in the past............

Given the very substantial macroeconomic and other stimuli now in train, a stronger economic upturn is clearly possible. That said, the pace and extent of the pickup in investment may be constrained by relatively high excess capacity along with continued corporate caution in the wake of recent accounting scandals; corporate and household balance sheets, while improving, remain stretched; and the substantial support to consumption provided by the housing sector is unlikely to be sustained, while labor market conditions remain relatively soft.

More broadly, the record current account deficit—now matched by an equally large general government deficit is still an important vulnerability. Despite its depreciation over the last year, the dollar still appears overvalued from a medium-term perspective, and the risk that its adjustment may become disorderly— or that it might overshoot—cannot be ruled out. Against this background, U.S. policymakers have faced a difficult task balancing the need to provide short-term support to the economy while minimizing the risk of exacerbating long-run problems, a task made no easier by the weakness of demand in the rest of the world. Monetary policy has been highly accommodative, and the Federal Reserve has appropriately indicated that this can be maintained for a considerable period; the adoption of a medium-term inflation target could help to anchor inflationary expectations and reduce the risk of an adverse shock leading to unwanted downward pressure on inflation. With low interest rates contributing to a continued boom in house prices, which—after adjustment for inflation—are about 30 percent above their previous peak, concerns have been raised that the current stimulus has been achieved at the risk of a future housing bust, which could have a serious impact on consumption and growth.

Such concerns need, however, to be balanced against the certainty of greater current economic weakness in the absence of monetary easing and the risks that it would pose for the United States—and the global economy—at the current conjuncture. And with policy interest rates not expected to be raised until the recovery is on a firm footing, the impact of eventual housing price adjustment would likely be offset by strength elsewhere in the economy. Even so, the elevated level of housing prices is a potential risk, particularly if long-term interest rates were to continue to rise strongly.

On the fiscal side, the general government deficit (covering both the federal government and the states) is projected at over 6 percent of GDP in 2003, compared with a surplus of over 1 percent in 2000—the largest swing in the fiscal position over three years in at least three decades. While this has provided short-term support to the recovery, it has come at the cost of a substantial deterioration in the medium term fiscal position—in practice, with the U.S. Administration’s expenditure and revenue projections appearing relatively optimistic and a further supplementary budget expected to cover expenditures related to Iraq, the outlook may well prove worse. If sustained, higher deficits would offset the longer-term benefits from tax cuts—already reduced by complex and untransparent phasing and sunset arrangements—and make an orderly adjustment of the current account deficit more difficult. In addition, with public debt no longer projected to decline in coming years, no fiscal cushion will be built up in advance of the coming pressures from the retirement of the baby boomers. This would be of less concern if early action to reduce future costs of aging populations were envisaged, but that does not presently appear to be the case (recent proposals in fact increase Medicare spending). Consequently, implementation of a credible medium-term framework to restore broad budgetary balance (excluding Social Security) over the cycle is now even more pressing, along with measures to put the Social Security and Medicare systems on a sound financial footing.

The continued robust growth of labor productivity remains a key strength of the outlook. While this partly reflects the effects of recent labor retrenchment, productivity growth should remain solid in coming years—although not as fast as in the late 1990s—buoyed by continued advances in information technology and the gradual spread of IT-related productivity gains to other sectors of the economy. This, in turn, has been underpinned by the flexibility and investment-friendliness of the U.S. economy, strengths that should continue to be built on in the future, including by continuing to strengthen corporate governance and accounting standards. That said, as noted above, a number of downside risks remain, and based on historical experience even an orderly current account adjustment would likely be accompanied by weaker growth of both GDP and—even more—domestic demand. While such risks are clearly reduced by strong productivity growth, looking forward it seems unlikely that the United States can or should provide the degree of support to the global economy over the medium term that it has in the past.

Just one detail. I shall miss Rogoff when he goes. I think the last few numbers of the WEO have been a distinct improvement. I say this even though my main thesis, that ageing populations across the OECD world form an important backdrop to the 'weak recovery', doesn't even get a look in. On the US economy he says everything that needs to be said - though I would have investigated the productivity/output gap factor a little more - without needing to raise his voice even once. I think if you have technical expertise this may be the best way to use it.

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