September 18, 2002
|Contact:||Michael Mussa||(202) 328-9000|
Washington, DCGrowth in the world economy, led by the United States, should hit 3 percent in 2002 and 4 percent in 2003 (both on a fourth-quarter-over-fourth-quarter basis). This will be about one-half percent slower than our forecasts earlier in the year, with significant uncertainty surrounding the outlook over the coming period.
The main policy changes that could improve the outlook center on Europe. The European Central Bank (ECB) should have cut interest rates by perhaps 75 basis points in 2001, and should still do so today. More expansionary fiscal policies are needed in several European countries (and the Growth and Stability Pact, which is blocking such actions, is seriously flawed and needs to be reformulated). Taken together, these steps could improve the prospects for European growth by half a percentage point in 2003 and provide a useful boost to the world economy.
This assessment of global economic prospects and policy possibilities was presented at a meeting on September 18, 2002, at the Institute for International Economics, by Senior Fellow Martin Baily, former Chairman of President Clinton's Council of Economic Advisers; Morris Goldstein, Dennis Weatherstone Senior Fellow at the Institute; and Michael Mussa, Senior Fellow at the Institute and former chief economist of the International Monetary Fund.
The slower central forecast and the level of uncertainty reflect several important factors: recent relatively weak performance in most industrial countries and the likely absence of significant policy actions to offset further sluggishness in Europe (despite our proposals) and Japan; the sell-off in global equity markets and the risk of further price declines; the economic side-effects of possible military action against Iraq; and potential financial turmoil in key emerging-market economies. The fundamentals for economic progress, notably continued strong productivity growth in the United States, nevertheless remain sound and the central forecast remains that the global economy will recover at a moderate pace, with little risk of inflation, at least through the end of next year.
Martin Baily notes a current consensus for US growth of 2 1/2 -3 percent for the second half of 2002 and about 3 1/2 percent for 2003. The acceleration of productivity growth remains intact, inflation is low, unemployment is modest by historical standards, and both monetary and fiscal policies remain expansionary. Autos and housing are strong, the stock market may be coming back, and business investment and industrial production are rising. The strength of the recovery is uncertain, in light of the recent softness in equity markets and some declines in consumer confidence, especially with the risks of a war with Iraq, but the risk of a "double dip recession" is no greater than 20 percent.
Looking to the world economy, Michael Mussa assessed that real GDP growth during 2002 (on a fourth-quarter-to-fourth-quarter basis) would reach 3 percent, up from about 1 percent during 2001. This outlook reflects importantly the solid performance of developing countries, where growth this year should reach 4 percent. Strong performance by Asian emerging-market countries, led by China, is sustaining reasonable progress for developing countries as a whole. In contrast, GDP in Latin America is now expected to contract by a full 2 percentage points.
For the industrial countries, our growth forecast for 2002 has been cut to 2 1/2 percenta pace that is somewhat below potential. This reflects growth of 3 percent for the United States, 2 1/4 percent for Western Europe, and 1 1/2 percent for Japan.
The new forecast for global economic growth during 2003 is 4 percent. This reflects half-percentage point reductions from the earlier forecasts for both industrial and developing countries.
These forecasts are about in line with the growth potential for sets of countries. Hence they are not particularly pessimistic. Moreover, there is clearly upside potential as well as downside risk. But with the world economy generally operating somewhat below potential and severe problems in some countries, there is greater reason to be concerned with the downside.
Negative economic side-effects from possible military action against Iraq (particularly through higher oil prices) are one reason to anticipate somewhat weaker growth. Even assuming that military action would be quickly successful, that other oil exporters would make up short-falls from Iraq, and that prudent use would be made of official oil reserves, an allowance for a short-term, one-quarter percent negative impact on global GDP is reasonable. Larger negative spillover effectscloser to what was experienced at the time of the Gulf Warare of course possible.
The probable impact of the decline in global equity prices since early April on industrial-country growth, and the spillover to growth in highly open emerging-market economies, is another reason for a more cautious global growth forecast. A further sell-off in global equity markets, to or below the levels reached this summer, would threaten to reduce global growth below potential.
Economic policy appears seriously constrained in trying to offset these weaker global growth prospects. The Federal Reserve would probably act to forestall a significant slowdown of US growth below potential and US fiscal policy will probably continue to be stimulative. However, macroeconomic policy has little room for maneuver in Japan and appears to be effectively paralyzed in much of Europe.
In particular, in the face of weaker than expected recovery in the euro area and the recent appreciation of the euro, the monetary policy of the ECB remains significantly less stimulative than that of the Federal Reserve. Unfortunately, the ECB shows little inclination to supply additional monetary stimulus even if growth in the euro area remains quite sluggish. The ECB should have cut its interest rates by perhaps 75 basis points last year, which could have boosted euro area GDP by about half a percentage point by the end of 2002. Similar steps could and should be taken now.
At the same time, European officials continue to pay homage (or at least lip service) to the Growth and Stability Pact, rather than recognizing and correcting its fundamental flaws. In fact, by focusing on actual fiscal deficits, the pact accommodates fiscal laxity during good times when deficits should be reduced and it adds to recessionary tendencies by pushing for fiscal contraction when economic conditions are weak. The time has come for European officials to stop worshipping the Growth and Stability Pact as a divine object and to focus on a reformulated mechanism that would make better economic sense.
Another key global economic concern, analyzed by Morris Goldstein, is the risk of financial crises in key emerging-market economies. A common feature of those emerging-market countries now in or near crisis (including Argentina, Brazil, Turkey, and Uruguay) is that they have too much public and/or external debt.
With Argentina already experiencing heavy costs from its recent crisis, concern has shifted to Latin America's largest economy, Brazil. Because of electoral uncertainties, the steady long-term climb of its ratio of net public debt to GDP to beyond 60 percent, its extremely high ratio of external (private and public) debt to export revenues, large external financing requirements, declining inflows of foreign direct investment, the slow pace of economic growth, and the sharp increase in interest rate spreads this year, Brazil's debt sustainability has come under intense scrutiny.
Some observers believe that Brazil's economic strengths (including its floating exchange rate, significant primary budget surplus, and successfully functioning inflation-targeting framework for monetary policy), together with the recently announced $30 billion IMF rescue package, will allow Brazil to avoid comprehensive debt restructuring. Dr. Goldstein, however, assesses the chances of sustaining such a favorable outcome through the end of next year as no better than about 30 percent.
In a similar vein, Turkey and Uruguay also face serious debt-sustainability challenges. These present challenges, together with the rash of recent emerging-market financial crises, argue strongly for a more conservative view of the requirements for debt sustainability and that debt sustainability needs, once again, to become a rigorous core condition for IMF financial assistance.
About the Institute
The Institute for International Economics, whose director is C. Fred Bergsten, is the only major research center in the United States that is devoted to global economic policy issues. Its staff of about 50 focus on macroeconomic topics, international money and finance, trade and related social issues, and international investment, and cover all key regionsespecially Europe, Asia, and Latin America. The Institute averages one or more publications per month; holds one or more meetings, seminars, or conferences almost every week; and is widely tapped over its popular Web site. In 2001, it celebrated its twentieth anniversary and moved into its new headquarters at 1750 Massachusetts Avenue, NW. The Institute recently helped create the Center for Global Development, an independent but closely affiliated institution that will address poverty issues in the developing countries and policies toward them in the United States and other industrial nations.