Peterson Institute publications
The Peterson Institute for International Economics is a private, nonprofit, nonpartisan
research institution devoted to the study of international economic policy. More › ›
RSS News Feed Search

News Release

Global Growth Strong But Faces Risks From High Oil Prices, Budget Deficits, And Payments Imbalances

April 1, 2004

Contact:    Michael Mussa    (202) 328-9000
    Martin Neil Baily    (202) 328-9000
    Nicholas R. Lardy    (202) 328-9000

Washington, DC— Led by strong performances of the United States and emerging Asia, especially China, world economic growth will reach its highest rate in a generation in 2004 before moderating somewhat in 2005. High world oil prices and the threat of a further price spike pose some near-term risk to this happy scenario. Other important policy challenges cloud prospects for the longer term. In particular, the United States needs to get employment growth up and its budget and current account deficits down, while China needs to tame the excesses of an overheating economy and correct its undervalued exchange rate.

This is the diagnosis from the semiannual global forecast of the Institute for International Economics presented today. The panel, under the chairmanship of the Institute’s director, C. Fred Bergsten, consists of Senior Fellows Martin Baily (chairman of the US Council of Economic Advisers under President Clinton), Nicholas Lardy (renowned expert on the Chinese economy), and Michael Mussa (former chief economist of the International Monetary Fund and member of the US Council of Economic Advisers under President Reagan).

Mussa’s global growth forecast envisions a 4¾ percent rise in world real GDP for 2004, followed by a 4 percent rise for 2005. This will be the strongest two-year rise in world output since the recovery from the worldwide recession of the early 1980s. All regions are expected to participate in the global rebound. In particular, over the two years 2004 and 2005, real GDP is projected to rise 8 percent in the United States, 6½ percent in Japan, 14 percent in emerging Asia, and in the range of 8 to 9 percent in Africa, Central and Eastern Europe, the Middle East, and Latin America. Only for Western Europe is projected two-year growth somewhat disappointing, at barely 5 percent.

These projections assume that the surge in world commodity prices, including oil prices, will abate somewhat over the next two years, in line with the backwardation now observed in commodity futures markets. They also assume that industrial-country monetary policies will remain quite accommodative, with the US Federal Reserve raising the federal funds rate (in line with market expectations) to 2½ percent by late 2005, with the European Central Bank forgoing further easing (unless the euro appreciates above $1.35) but also not tightening ahead of the path followed by the Federal Reserve, and with the Bank of Japan keeping short-term rates very low even after it moves above its zero interest rate policy, probably by late this year.

Mussa also warned of key challenges to sustaining rapid growth over the medium term arising from three important global imbalances: (1) the imbalance associated with the very low level of world interest rates and its potential to generate asset price anomalies; (2) the dire state of the public finances in most industrial countries, especially in view of the rising burdens of providing for rapidly aging populations; and (3) the massive US current account deficit, whose correction requires adjustments in key macroeconomic policies as well as in exchange rates—including the exchange rates of key emerging-market countries.

US current account deficits of 5 percent of GDP are not sustainable. Hence the US dollar needs to depreciate from its recent peak by roughly 30 percent, of which less than half has already occurred. To accommodate the required improvement of $250 billion to $300 billion in its external position without overheating, the United States must depress growth of its domestic demand (relative to its output)—preferably by reversing much of the fiscal expansion of 2001–04. The rest of the world must correspondingly boost growth of its domestic demand, although to do so will be challenging because monetary policies are already quite easy and most budget deficits are quite high.

Baily shared Mussa’s optimistic view of near-term prospects for US growth but emphasized the worst performance on job growth of any postwar recovery. Contrary to popular and media fears, the increase in the US trade deficit accounts for, at most, 14 percent of the 2.6 million decline in payroll jobs since 2000.

Instead, rapid productivity growth (and a modest recovery in real GDP since the recession of 2001) mainly “explain” the weakness in job growth. Over a longer time horizon, rapid productivity growth will raise real wages and employment. However, the US economic expansion may prove difficult to sustain, and its benefits will surely not spread as broadly as they should unless job growth soon accelerates.

Baily also stressed the grim prospects for the US budget deficit. Even under very optimistic economic and policy assumptions (without major tax increases or politically infeasible spending cuts), federal deficits on the order of $300 billion will persist for a decade. Under more realistic assumptions, it is easy to see deficits rising persistently, especially as the fiscal burdens of population aging take hold after 2010. Continued rapid productivity growth—above present expectations—would make the deficit problem somewhat easier to handle but still fall far short of a complete solution.

The Chinese economy, as emphasized by Lardy, grew spectacularly during 2003, with real GDP rising by an officially reported (but probably underestimated) 9 percent. Chinese international trade boomed, with imports and exports rising, respectively, by 40 and 35 percent. This made China the world’s third largest importer (behind the United States and Germany) and the world’s fourth largest trading economy (behind the United States and Germany and just behind Japan) in total trade.

An upsurge of domestic investment, to 47 percent of GDP, was the main driver of the Chinese economic expansion. Massive expansion of money and domestic credit (rather than foreign capital inflows) fueled this investment surge and threaten to overheat the Chinese economy. Official efforts to contain domestic credit expansion, however, have so far had only limited success.

The policy of massive foreign exchange market intervention to resist appreciation of the Chinese yuan against the US dollar has seriously complicated China’s efforts to control risks of overheating. Both for its own sake and to contribute appropriately to necessary global economic adjustments, China needs to appreciate the value of its currency (by 15 to 25 percent) and then allow greater exchange rate flexibility around a parity defined in terms of a basket of currencies.

About the Authors

Michael Mussa, senior fellow since 2002, served as the chief economist at the International Monetary Fund from 1991 to 2001, where he was responsible for advising the Fund's Executive Board and the management on broad issues of economic policy and for providing analysis of ongoing developments in the world economy. Dr. Mussa served as a member of the US Council of Economic Advisers from August 1986 to September 1988. He was a member of the faculty of the Graduate School of Business at the University of Chicago (1976–91) and was on the faculty of the Department of Economics at the University of Rochester (1971–76). During this period he also served as a visiting faculty member at the Graduate Center of the City University of New York, the London School of Economics, and the Graduate Institute of International Studies in Geneva, Switzerland. He has published widely on macroeconomics, monetary economics, international economics, and municipal finance in professional journals and research volumes.

Martin N. Baily, senior fellow since 2001, was the chairman of the Council of Economic Advisers and a member of the Cabinet from August 1999 until January 2001, after having been a member of the Council of Economic Advisers during 1994–96. He was a principal at McKinsey and Company during 1996–99, where he co-led its Global Institute's projects on services and manufacturing productivity in a number of major countries (including Brazil, France, Germany, Korea, Russia, and the United Kingdom). Dr. Baily has taught at MIT, Yale, and the University of Maryland and was a senior fellow at the Brookings Institution through most of the 1980s, where he cofounded the microeconomics issue of the Brookings Papers on Economic Activity. He was also an academic adviser to the Congressional Budget Office and the Federal Reserve Board. His research at the Institute focuses on the international competitive position of the United States and possible strategies to increase productivity and growth in Europe.

Nicholas R. Lardy, senior fellow since 2003, was a senior fellow in the Foreign Policy Studies Program at the Brookings Institution from 1995 to 2003 and also served as interim director of Foreign Policy Studies in 2001. He was director of the Henry M. Jackson School of International Studies at the University of Washington from 1991 to 1995. From 1997 through the spring of 2000, he was the Frederick Frank Adjunct Professor of International Trade and Finance at the Yale University School of Management. While at the University of Washington, Dr. Lardy was a professor of international studies since 1985 and an associate professor from 1983 to 1985. He was also the chair of the China Program there from 1984 to 1989. He was an assistant and associate professor of economics at Yale University from 1975 to 1983.

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. The Institute's staff of about 50 focuses on macroeconomic topics, international money and finance, trade and related social issues, and international investment, and covers all key regions—especially 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.