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CHAPTER 1 CHANGES:
FIGURES: Extended Data:
Figure 1.2: Sweden line (red on figure) climbs by 300 (on the left scale) between
2000 and 2001, and by another 300 between 2001 and 2002. Argentina line
(blue on figure) falls by 300 (on the left scale) between 2000 and 2001, and falls
by another 500 between 2001 and 2002.
Figure 1.3: American business cycle line (red on figure) falls from 104 to 101
between 2000 and 2001.
Table 1.2: The Flow of Economic Data, 2001-2002
Figure 1.5: Unemployment rate rises to .055 [5.5%] in 2001.
Figure 1.6: Inflation rate drops to .015 [1.5%] in 2001.
TEXT: New Text for Section 1.3: Previous version: 2122 words. Revised
version: 2122.
1.3 THE CURRENT MACROECONOMIC
SITUATION
The United States
As of the mid spring of 2002, the U.S. macroeconomy seemed poised to recover from
what had been a short and shallow recession in 2001. Although the National Bureau of
Economic Research announced that the business cycle peak—and the start of the
recession—occurred in March, 2001, it was not until the September 11 terrorist massacre
and destruction of New York’s World Trade Center that the decline in economic activity
became large enough to be called a “recession.” The terror attack inflicted a large
negative shock to consumer confidence. The terror attack led businesses to decide to
postpone implementing plans for investment spending. The Federal Reserve began to
worry that it would not be able to reduce interest rates low enough in order to generate
enough business investment to maintain full employment: after all, nominal interest rates
cannot fall below zero. Between the beginning of the recession and the end of 2001, the
U.S. economy lost 1.5 million jobs.
However, the fall of 2001 and the winter of 2002 saw other forces swinging into action to
boost production and employment in the American economy. First, the large sustained
reductions in interest rates that the Federal Reserve began early in 2001 had now had
enough to time to affect the economy and boost investment spending. The three month
money-market nominal interest rate that had been 6.74 percent per year in the summer of
2000 had been cut to 1.75 percent per year by the late fall of 2001. Second, the tax cut of
2002 happened—as rarely happens—to push disposable income up at exactly the right
time. Morgan Stanley estimates that it provided an extra $120 billion of stimulus to real
GDP in the first half of 2002. Third, additional defense and security spending provided a
further boost to demand in 2002. Fourth, everyone anticipated that the Federal Reserve’s
low interest rate policy would be durable and prolonged: as of early 2002, inflation
looked extremely low and unthreatening.
These factors combined to make observers raise their estimates of the speed of economic
recovery throughout the spring of 2002. Consumer confidence jumped sharply,
recovering from the impact of the terror-attack on the World Trade Center. And durablegoods orders rose as well, suggesting that business investment was also recovering from
the wait-and-see pause in spending that had followed the 911 terrorist atrocity. As of mid
spring, most observers expected unemployment to decline or at worst remain stable in the
remainder of 2002. And most observers expected stable or falling unemployment to be
accompanied by rapid productivity growth, as it became more and more clear that rapid
productivity growth in the late-1990s was much more “structural” than “cyclical” and
could be expected to continue.
The recession of 2001 had been preceded by a remarkable decade long economic boom.
Policy makers and economists advocating the Clinton administration’s economic
programs — deficit-reduction and the lowering of trade barriers — had done so in the
interest of accelerating long-run growth. Reduced trade barriers would allow for closer
international integration, a finer international division of labor, and increased
productivity. Deficit reduction would make possible a high-investment economic
expansion, which would then become a high productivity growth expansion.
Until 1996 there were few signs that high investment was leading to high productivity
growth, but then the pace of economic growth exploded. Perhaps the political claims in
the early 1990s that deficit reduction would ignite a high investment and highproductivity growth recovery were coming true. Perhaps the U.S. economy was simply
benefiting from the sudden wave of rapid productivity growth driven by the technological
revolutions in data processing and data communications. The most likely possibility was
and is that both were true, and that they reinforced each other — higher investment
allowed businesses to more rapidly take advantage of technological advances in data
processing and data communications. In the United States the strong growth in
production and sales in the second half of the 1990s had pushed the unemployment rate
down to a level, four percent, that had not been seen in a generation. A tight labor market
was good news for workers: Employers appeared eager to pour resources into training
them for their jobs. And rapid productivity growth meant that even low unemployment
did not lead to accelerating inflation. Inflation was less than two percent per year in the
early spring of 2002.
Thus the U.S. economy in the spring of 2002 appeared poised to pull out of its recession
and resume the rapid technology and investment-driven growth path of the 1990s. Either
the terror-attack on the World Trade Center would prove to be the only major atrocity, in
which case growth would resume as confidence was restored; or there would be
additional atrocities on a similar scale, in which case expanded defense and security
spending would produce a boom driven by a somewhat different kind of technology.
There were, however, three clouds on the horizon: three signs and policies indicating that
growth over the whole decade of the 2000s might turn out significantly slower than
growth over the 1990s. First, the Bush tax cut of 2001, in combination with the extra
defense spending called for after 911, eliminated the government budget surplus that had
been painfully created during the 1990s. Given the U.S.’s low private savings rate, the
elimination of public savings was likely in the medium run to reduce investment, and
thus to slow growth. And the tax cut was not designed in a way that would produce any
significant supply-side production benefits. The surprising decision by the Bush
administration in early 2002 to impose tariffs on imports of steel promised to slow or stop
the process of reducing trade barriers and expanding international economic integration
that had been so successful in the 1990s. Morgan Stanley’s chief economist, Stephen
Roach, spoke of a “serious setback for worldwide economic integration,” with slower
worldwide economic growth likely to be the result.
Third, the values of foreign currency and goods in terms of the dollar and of U.S. goods
are low. Should foreign exchange speculators lose confidence in the dollar, the value of
foreign currency could rise far and fast, possibly causing macroeconomic problems.
Economists are very good at pointing out economic situations that are inconsistent
with fundamental values — policies, imbalances or balance sheet problems such
that they cannot possibly last, and are bound to end, perhaps in a crisis. The value
of the stock market and the value of the exchange rate as of the late spring of 2001
appear at odds with fundamentals, and possible sources of financial crises in the future.
But, as economist Rudiger Dornbusch has written, “to get to the crisis takes
longer than you think, and then it happens faster than you would have thought.”
Third, and most important, job growth is rebounding. Job and thus real
wage and salary income gains are the single most important factor affecting
consumer spending, and their decline played a key role in the spending
slowdown of 2001
At the beginning of the year, I speculated that the IT Bust might be coming to an end (see
"Is the IT Bust Ending," Global Economic Forum, January 11, 2002). Now the time has
come to speculate on an IT revival. Technology capital spending, following a record bust
over the past 18 months, is in my view poised to improve on a sustainable basis. That
optimism doubtless seems like whistling past the graveyard to technology bears. After
all, the sharpest decline in corporate profits in 50 years promoted the bust — a decline
that accounted for more than half of the deceleration in the economy over the past year.
So the bears warn that the legacy of that profit squeeze coupled with a massive
"overhang" of IT capital will extend the tech recession for at least several more months, if
not quarters.
I disagree. In my view, much of the capital spending overhang is gone and the
fundamentals for tech spending are turning up. A spate of US and global economic
indicators suggests a tech turning point. The question now is how strong and sustainable
will be the rebound. On that score, our analysts and I agree that the next few months may
be rough and spotty. And Corporate America's appropriate focus on capital spending
discipline may restrain a tech recovery for now. But a healthy economic acceleration and
a recovery in profitability suggest that a strong tech rebound is likely in 2003.
Capital spending analytics are critical to that judgment. It has become fashionable to
note that the mild recession of 2001 was a "capital-spending-led" downturn, and that thus
no strong or sustainable economic recovery is likely without an upturn in capital
spending in general, or in IT spending in particular. But it is crucial to separate the
impact of poor economic fundamentals on capital spending from the effect on the
economy of the capital-spending recession. In that regard, we believe four factors
affecting tech spending all are beginning to turn positive along with economic revival.
First, contrary to popular fears, except in telecommunications equipment, the tech
overhang is largely gone. There's no mistaking the excess in telecom: Despite the 32.6%
plunge in real outlays for communication equipment over the past year — triple the rate
of any previous decline — the stock of telecommunications capital in relation to output is
still well above what appears to be a desirable level. And, as in January, I agree with
Morgan Stanley communications analyst Simon Flannery that a 20% decline in such
spending this year is both likely and needed to bolster returns.
But in computers and software, our metrics suggest that last year's bust wiped out the
excess, and actual tech spending is now running below what fundamentals would
indicate. We measure those gaps by examining statistical relationships designed to
predict investment outlays. Even allowing for falling IT prices and a lush financing
climate, such relationships consistently underpredicted IT spending over the past five
years, hinting at excess. Cumulating the errors from such relationships suggests that the
overhang for computers and software at its peak amounted to about $30 billion in real
terms, or about 3% of the outstanding stock. This crude metric suggests that the excess is
now gone. That could still be too optimistic, but I believe that this calculation gets the
direction right.
So does the lack of excess simply argue for a bottoming, or is recovery likely? Three
other factors are turning strongly positive. The "reverse accelerator" mechanism, which
helped to crush business investment over the past year, has already begun to wane, and
will likely turn positive by the summer. That mechanism works to depress capital
spending growth when overall growth slows or when the economy contracts by
undercutting output in relation to capital on hand, making some of that capital redundant.
The dramatic 5-percentage-point deceleration in nonfarm business output through mid2001 was thus a surefire recipe for a capital-spending bust. Already, the deceleration is
slowing to an estimated 1.7 percentage points in the current quarter, and by the end of
this year, we estimate that output will reaccelerate by more than 4 percentage points. As
evidenced by earnings revisions, profits and margins are bottoming. And the cost of
capital, which skyrocketed last year for many firms with declining stock prices and wider
debt spreads, is beginning to fall again as markets rally and spreads tighten. Those
developments have increased the incentive to substitute cheap capital for expensive labor.
The macro evidence for an improvement in technology demand grows more impressive
daily. New IT orders have begun to rise again for the first time in a year, up at a 5.5%
annual rate in the three months ended in January. Growth in domestic demand —
measured by IT shipments less net exports — accelerated to a 20.8% annual rate in
January compared with three months ago; as recently as October that aggregate was
contracting at a 22.2% annual rate. As companies have trimmed inventories to
acceptable levels in relation to sales, production is rebounding. Industrial production in
computers, semiconductors, and equipment accelerated to a 13.6% annual rate in the
three months ended in February. Moreover, global data, especially from the Asian tech
powerhouses, also point to an upturn. For example, Morgan Stanley semiconductor
capital equipment analyst Steven Pelayo suggests that semiconductor capital spending in
Taiwan will likely end up flat, instead of at the declines suggested by his bottoms-up
survey. And DRAM prices, which have nearly doubled to $4, suggest a strong demand
pickup.
Europe
As of the spring of 2002, economic growth in the 11 countries belonging to the
European Monetary Union, and having the newly formed euro for their principal
currency, was slowing but not slowing as fast as people had feared. Rising oil prices
and rising interest rates (in large part a result of the fear on the part of the newly
formed European Central Bank that its currency, the euro, had depreciated too far)
had reduced growth in late 2000 below what had been forecast, and real GDP growth
for 2001 was forecast at between 2.0 and 2.5 percent.
There was certainly room for economic expansion in Europe. The preceding year
had seen consumer prices throughout the euro zone rise by less than 2 percent. Economic
forecasters were projecting 3 percent real GDP growth for 2001. Unfortunately,
such a rate of growth would have little or no effect at reducing European unemployment,
which remained stuck near 10 percent. The challenge for European policy remained one
of avoiding rises in inflation while attempting to reduce western Europe’s distressingly
high and stubborn rate of unemployment.
For the first time in decades in Europe there was hope that the next decade will
bring a reduction, not an increase in unemployment. Changes in policy are making the
European labor market more flexible, and in the long run making it easier for firms to
change the number of workers they employ should make it easier for workers to find
jobs and lower unemployment. Western Europe is perhaps half a decade behind the
United States in its adoption of data processing and data communications technology,
and so the productivity growth acceleration experienced by the United States in the
late 1990s should be visible in western Europe in the decade of the 2000s.
With the formation of its new currency, the euro, monetary policy in Europe is
now being made by a new institution, the European Central Bank. It is being very
closely watched as it establishes its operating procedures and its fundamental rules
of thumb to guide policy.
Ifo index of western German business confidence showed signs of
economic recovery. It rose to 91.8 in March from 88.5 in
February. In a particularly optimistic sign, the futureexpectations component also rose in March after declines over
the past year. Consumer prices rose by 1.8% in the 12 months
to March.
The euro area's trade surplus rose to $46.6 billion in the 12
months to January, while the current-account deficit narrowed to
$6.5 billion in the same period. France's 12-month current-
account surplus rose slightly to $25.6 billion in January, while the
12-month trade surplus narrowed to $8.4 billion in Italy and
widened to $22.1 billion in the Netherlands. Spain's producer
prices rose by 0.2% in February. The volume of Italian retail
sales rose by 0.2% in the year to January.
March delivery of European business surveys amplified the surprise already
recorded in February. In a nutshell, European manufacturers scaled up their
short-term expectations, even more markedly than they did in February.
That was the loud and clear signal from the 20,000 or so manufacturing
companies surveyed every month in Britain, Germany, France, Italy, etc. In
the euro area alone, our index tracking output expectations jumped by 0.6
points of standard deviation (psd) in one month. It now stands 0.4 psd
above its long-term average, a level not seen since February 2001. Even
more impressively, our proprietary surprise gap index, which measures the
difference between business expectations and current conditions three
months later and which went though the roof in February, moved even
higher in this stratospheric region. It now stands 0.7 psd higher than it did
in January 1994, its previous all-time high. Is it already summertime in
Europe? And, if so, what is next? Given the scarcity of reliable hard
statistics, it is difficult to answer this question, but let us try, nevertheless.
1Q GDP Growth at 3.3%, Says Our Early GDP Indicator
We have recently extended our toolbox for business cycle analysis and now
have an early GDP indicator (see "An early GDP Indicator for Euroland" by
Eric Chaney and Anna Grimaldi, February 25, 2002) at our disposal. Not
surprisingly, this survey-based model reacted strongly to the burst of
optimism coming from corporate Europe. Interpreting the changes in
manufacturers' qualitative assessments together with some other variables of
lesser importance, the early euro-area GDP indicator now points to 0.8%
sequential growth in 1Q (3.3% annualised), and 0.5% in 2Q (2.1%
annualised). By European standards, this would be quite a strong rebound.
But can we fully trust interpretations of business surveys based on past
linkages between surveys and hard data? At this stage, our answer is that
we probably cannot blindly follow the model, because, with the benefit of
hindsight, companies expectations overreacted to the September 11 events
and, just as the scare was (ex-post) unjustified, the feeling of relief is
probably exaggerated. However, past experience told us repeatedly that
companies have a very good grasp of what is really going on in the economy
and that it would be foolish to ignore their messages. Indeed, the first tiny
evidence of a rebound in manufacturing activity came from the German
industrial production numbers. Stripping off construction output, highly
sensitive to weather conditions, manufacturing output increased by 1.5%M in
January and now stands 1.1% above its 4Q average. Our provisional
conclusion is that there is a significant upside risk to our 1Q GDP growth
estimate, currently 0.4%, but that we need to see more hard data before
transcribing it in our forecasts.
A Mega Global Inventory Cycle?
Another reason explains our cautiousness: So far, final demand did not give
clear signals of acceleration. Nowhere is this more visible than in Germany,
as our colleague Elga Bartsch pointed out in a recent forum on Germany
("Spring Feeling," 26 March). Browsing again through euro-area surveys,
manufacturers' assessment of orders (foreign and domestic), which had
improved over the turn of the year, remained unchanged in the last two
months. Some signs of demand's picking up came in February from Belgium,
but could be interpreted as a result of this country's specialisation on
intermediate goods, which are at the heart of the European inventory cycle.
The most likely explanation behind the powerful rebound of production
expectations is that inventories are leading the recovery. In every business
cycle upturn, in our view, the initial stage of the recovery has to come from
inventories. This time around, the main surprise comes from the magnitude
of the upgrade of business expectations. Our preferred interpretation is that
not only in Europe but in fact all around the globe, companies overreacted in
the aftermath of September 11 and took down inventories to levels
preventing them from meeting even normal demand trends. We are
probably witnessing the first perfectly synchronised global inventory cycle of
the globalisation age. Another possible explanation could be that companies
expect global final demand to accelerate sharply in the near term, but this
does not look consistent either with still cautious corporate communication or
with still weak consumer spending trends. If the global inventory cycle
explanation holds, then, be prepared for large upside surprises when 1Q GDP
numbers are released, but also for a significant payback in 2Q.
Continue to Play the Recovery, but Watch Oil
So what comes next? Assuming that surprises are likely to be on the upside
in the first half of the year, could they be on the downside in the second
half? At this stage, we believe it is much too early to have strong convictions
about the exact unfolding of the recovery. Even if the inventory-led
acceleration proves temporary, we see no reasons to question our main case
scenario, based on a progressive recovery of capital expenditure, as capacity
utilisation rates start to creep up, and on stronger consumer spending, as
inflation comes down. A rise of inflation in the short term, caused by an oil
price spike, appears to be the main threat to the European consumer sector.
Despite all the noise made about wage negotiations in the engineering sector
in Germany, European unions seem to have lost their grip on wages. In
1998 and 1999, when unemployment was declining fast, creating large
pockets of labour shortages, and when inflation was rising even faster,
unions were not able to push nominal wage rates higher. It is hard to
conceive that they could somehow obtain concessions from employers when
unemployment is higher and inflation lower. Practically, a rise in import
prices would be bad news for the consumer sector and, if it became too big,
might deter companies from beefing up their capex plans. The lesson of the
Nineties is that trade shocks, such as higher oil prices, accelerate inflation in
a first stage, but then as real demand declines, end up as deflationary
shocks.
We are far from there. Given the magnitude of the upside risk that is
appearing on our radar screens now, it seems fair to say that Europe could
live with a barrel of crude oil at $25 without seeing the recovery peter out
prematurely. We would have to reconsider the macro analysis if crude oil
were to climb to $30.
Japan
Japan ended 2000 with an annual real GDP growth rate of 1.8 percent. This is an
astonishingly low growth rate given the large amount of unused capacity in the Japanese
economy and the extraordinarily low levels of nominal short-term interest rates
in Japan. One reason for the low growth rate is that people are unsure whether prices
have further to fall: Japan is actually undergoing deflation, with prices falling by 0.7
percent in 2000. Real GDP growth in Japan for 2001 is projected to be only 1.4 percent,
certainly less than the rate of growth of potential output.
The start of the 1990s saw the collapse of the Japanese stock and real estate markets,
the end of the so-called “bubble economy.” The 1990s as a whole saw the
breakdown of the Japanese model of economic growth, as the economy stagnated for
much of the decade. Now there is a general recognition that Japan faces a structural
economic crisis. But there is no political consensus on what is to be done, and the
major political steps that need to be taken to restore growth — restructuring the
Japanese financial system, and deregulating transportation and distribution — are
not being taken.
The Bank of Japan is now pursuing a policy of making short-term safe nominal
interest rates as close to zero as it can. But U.S. short-term safe nominal interest rates
were zero in the Great Depression, and that did not help the U.S. economy recover
and did not boost U.S. investment. What matters for investment spending is not a
low short-term safe nominal interest rate but a low long-term risky real interest rate,
and that remains high as long as bond traders fear that (i) the low interest rate policy
will not last very long, (ii) many companies may go bankrupt and never repay
the money they borrow, and (iii) prices may decline, turning low nominal interest
rates into high inflation-adjusted real interest rates.
Perhaps it is time for the Japanese government to pursue a policy of thoroughgoing
inflation to boost demand that has been extremely sluggish for nearly a
decade. But the conventional wisdom is that Japanese demand and production is unlikely
to pick up until ongoing “structural” problems — in particular the fear of
lenders that those who want to borrow from them are really bankrupt — are resolved.
Requiring businesses to declare the true value of their real estate holdings is
commonly pointed to as the key blockage to investment, higher demand, and economic
recovery.
Moreover, Japan’s public finances are becoming unstable. The budget deficit is
huge, officially-reported public debt is more than annual GDP and rising, and there
are many unfunded pension and other liabilities of the Japanese government that are
not on the official balance sheet. A government that has obligations that it cannot
meet from its normal tax revenue is a government that is likely to resort, at some
time in the future, to high inflation to balance its finances.
earlier pieces, I have emphasized the role of globalization in generating
deflationary pressures in Japan. Indeed, a breakdown of the contributions of
different components of consumer prices to the overall decline of the price
index demonstrates that globalization has been a key contributor. Food
prices (imports from China and the Asia-Pacific region), PC prices (ditto),
clothing (ditto), and household durables (ditto) have been the overwhelming
contributors. That said, other countries have also been subject to the same
globalization pressures, but have not fallen into generalized deflation (though
some might yet). What is the difference between Japan and these other
countries? I believe that the answer to this question lies in the transferability
of factors of production — i.e., labor and capital market flexibility. This point
is most easily seen by thinking of Japan over the last decade in terms of a
simple Heckscher-Ohlin trade model.
Harking back to the halcyon days of misspent youth will immediately conjure
up the simple but powerful trade models of textbooks. In diagrams of these
models, the horizontal and vertical axes represent two goods. The production
possibility frontier (PPF) is the technical ability of an economy to produce
different combinations of the two goods, as labor and capital are shifted
between the production of the two goods. This PPF is slightly bowed outward,
on the principle of diminishing returns. If an economy is operating on the
PPF, then all factors of production are in use. If it is operating inside the PPF,
then there is waste (unemployment of labor and capital). The consumption
side of the economy is determined by trade. With the world price structure
represented by a line showing the tradeoff of one good for the other, the
economy can trade from a point on the production frontier to a point outside
the production frontier. That is, through trade, the economy can consume a
combination of goods that it cannot produce. The optimal point to produce is
the point where the world price line is tangent to the PPF. Consumption is
then determined by the point along the price line where the highest possible
welfare is achieved, in terms of consumption of the two goods. This
consumption point occurs where the price line from the production point is
tangent to a locus of consumption combinations where welfare is identical.
(Call this the consumption indifference curve.)
Applying this model to Japan gives some interesting insights. Let the two
goods be C-goods (what China produces) and J-goods (what Japan produces
but China does not). Japan produces both types of goods. As the starting
point (say in 1990), Japan was producing on its PPF. Japan exported J-goods,
and imported C-goods. Since Japan did not need at home all of the J-goods it
produced, the trade improved Japanese welfare. (Trade also improved
Chinese welfare — since China could obtain goods that it was not capable of
producing.)
Now cut to 2002. What has happened in the last 12 years is that China has
produced many more C-goods, and offered them to the world at lower prices.
Put another way, the terms of trade have shifted in favor of J-goods. This
sounds like a wonderful thing for Japan, and it is, with one problem: The Cgoods producers in Japan fall under extreme pressure. Indeed, many go out
of business. Even worse, the resources used for C-goods production in Japan
are not redeployed to J-goods, because of structural impediments (e.g.,
mismatch in the labor market, etc.). So, Japan ceases producing some Cgoods, but does not increase the production of J-goods. In short, the
Japanese production point moves inside the PPF. Japan still trades J-goods
for C-goods, and does so on much better terms. However, because the
production point in Japan is inside to PPF, there is unemployment, too.
Has Japanese welfare risen? The answer depends on whether the final
consumption point (achieved by trading from inside the PPF, but doing so on
better terms of trade) is on an indifference curve that is higher than the
original one. It is perfectly easy to draw the trade diagram such that Japan is
consuming more of both goods, despite production having moved inside the
PPF. In short, welfare has risen, even though unemployment has risen, too.
My sense is that this is precisely what has occurred in Japan over the last
decade. Improved terms of trade have raised welfare, even though
inflexibility in labor and capital markets have worsened the production point.
(Of course, technological change has altered the shape of the PPF as well —
but this is the subject for another essay.)
What does all of this have to do with deflation? The linkage is that the
deflation in Japan is directly proportional to the unemployment of resources
— i.e., the degree to which the economy is inside the PPF. This insight has
several implications. First, so long as China continues to increase penetration
of the Japanese market for C-goods, and so long as reallocation of resources
in Japan remains slow, deflation in Japan will continue. Second, ending
deflation in Japan would require that the resources no longer used in
production of C-goods be re-absorbed elsewhere. The mushroom farmers
would have to become precision instruments producers or auto producers.
Third, the role of the exchange rate in facilitating resource transfer (e.g., at
Y300/US$, there would be enough demand for Japanese autos that
mushroom farmers would become auto producers) must be considered in
light of the effect on the terms of trade. Initially, a weakening of the yen
would worsen Japanese terms of trade. Since the production point is fixed in
the short run, Japanese welfare would suffer immediately. In the longer run,
welfare will improve only if resource transfers return Japan to the PPF, and if
the worsening of the terms of trade is relatively mild (i.e., not sufficient to
offset the benefits from returning to the PPF).
The chief objection to this approach to deflation is that there is no price level
in the model — only relative prices. To put it another way, there is no money
in this model. Only with the introduction of money can a price level be
determined, and only then can deflation in the usual sense be discussed.
Hence, the contribution of Heckscher-Ohlin theory to the understanding of
deflation depends crucially on the relationship between unemployment and
price level changes. This relationship has been the source of much debate. It
is now generally accepted that unemployment has no necessary relationship
with the rate of inflation. However, it is also generally accepted that the gap
between actual unemployment and a certain level of the unemployment rate
(including frictional and some other types) is associated with changes in the
rate of inflation. Thus, while Japan would in the long run return to zero price
change even at current levels of unemployment, it would return to zero price
change faster if unemployment were reduced. To the extent that shifting
resources into J-goods production would reduce unemployment, deflation
would end faster.
In short, ending deflation in Japan is in part (in my view, in large part) a
microeconomic phenomenon. Therefore, I believe that structural reform
policies — ones that reallocate resources from ex-C-good producers to Jgood producers — are the key to ending deflation.
The Nikkei Financial of March 15 pointed out that one part of the
government’s end-February anti-deflationary package resembles the capital
and trading controls implemented in Malaysia in 1998. To be sure, once the
Malaysian currency crisis erupted in mid-1997, capital began to hemorrhage
and the stock market dropped sharply. In September 1998, Prime Minister
Mahathir was forced to impose restrictions on capital outflow. When the
current controls are examined closely, we believe the tighter Japanese
restrictions on short-selling are entirely different from the prescriptions of the
good doctor in Malaysia. However, both amount to a partial rejection of
laissez-faire and both in some way restrict the functioning of the market
mechanism. In this sense, in ratifying the new restrictions, Prime Minister
Koizumi arguably looks more like Dr. Mahathir than like Mr. Gorbachev, to
say nothing of former PM Thatcher, in terms of the CRIC cycle.
This might have been heretical, but orthodoxy does not always prevail.
The capital controls imposed in Malaysia on September 1, 1998, were aimed
mainly at stabilizing the stock market and the currency. The Malaysia
restrictions were initially seen by many as likely to reflect arbitrary
judgments of Prime Minister Mahathir, and because they were imposed so
suddenly, the market consensus was that sooner or later they would have to
be withdrawn due to market pressure. In addition, there was real concern
that because the currency controls aimed to isolate the country financially,
that even if they stabilized the equity and current market for the near term,
over the longer term they would erode the confidence of both domestic and
overseas investors, crimping the upside potential of the stock market. To the
consensus was that the current controls would also go eventually.
But the consensus was confounded when the stock market turned upward in
September, the same month the controls were implemented, eventually
climbing more than 290% from trough to peak, against the background of a
bottoming out of the world economy around year-end 1998, followed by a
global boom in IT demand. In addition, Malaysia has been able to maintain
its initial fixed rate for the currency notwithstanding the selling pressure that
came with the collapse of the IT bubble. Presumably, just what the doctor
ordered.
The Malaysia example teaches that government interventions can be ratified
by the market, even if they are inconsistent with the Anglo-American,
market-oriented approach, and even if they are initially judged misguided by
the consensus. To be sure, that the Malaysian market rebounded sharply
after controls were imposed does not mean that they caused the rebound —
we think the improving global fundamentals and the IT boom played the
larger role in that. But the rebound proceeded steadily even while the
controls remained in place. Something similar might be said of Japan’s case.
The short squeeze created by the new regulations is only one element in the
market rebound — for in the background there is the earlier-than-expected
global rebound of the economy, and we believe investors’ views have
changed strikingly, as they have come to believe Japan stands to benefit
from the upturn.
Calls for the Next Crises versus Cyclical Recovery
The February-March crisis has turned out to be only a virtual crisis; however,
there seem to be persistent expectations for the next crisis to come in May or
June, in line with the release of F2001 earning results. We believe the crisis
expectations are rooted in some ideas, including: (1) Despite the apparent
signs of recovery, the market continues to believe that as long as the
structural problems remain, any rebound is likely to be exceedingly weak;
(2) it is difficult for the market to discern fundamental valuations in this
rally, because it is driven by a short squeeze; and (3) in the past, the market
has sometimes shown an anomalous pattern of annual highs in the middle of
the year, particularly in June.
However, if the consensus remains pessimistic, the risks are likely to the
upside. Recovery momentum can — in the first place — become selfsustaining once the initial steps of the have been confirmed. This can have
an impact on stock prices as investors, fearful of missing the boat, jump on
the bandwagon, which can set share prices off on a wilder-than-unexpected
ride, and then the domestic demand is likely to be stimulated by the wealth
effect. Therefore, we think it seems safer to expect this kind of scenario
giving a short-term cyclical boost than to make a play on the calls for the
next crisis. And even if the original incentive for the controls was heterodox,
once successful they can be proclaimed correct.
What worries us about this rather optimistic scenario is the possible sideimpact on Japan of a premature tightening by the Federal Reserve, with a
negative impact on the US stock market and the economy. However, our US
economics team does not anticipate such a development at this moment.
Emerging Markets
As of the spring of 2001, the financial crisis in East Asia had been over for nearly two
years. The panic that started in 1997 on the part of investors in New York, Frankfurt,
London, and Tokyo, and the consequent withdrawal of their money from
emerging market economies imposed very high costs: Massive bankruptcies, high
interest rates, increases in unemployment, falls in production. However, foreign investors
appear to have regained confidence in East Asian economies. Recovery and
growth is rapid throughout the region, save in Indonesia.
Moreover, growth continues through the rest of the emerging markets of the
world, with growth continuing to be exceptionally fast in China and India. Together
those two countries make up 40 percent of the world’s population.
But the slowdown in growth in the world economy’s industrial core, especially in the
United States, is not good for emerging market economies. It is hard for their exports
to expand if incomes in the industrial core are not rising. In addition, as of the spring
of 2001 there were ongoing but localized financial crises in Argentina and Turkey, and
the fear of other crises elsewhere discouraged investment and slowed growth.
Nevertheless, consensus forecasts were for real GDP growth to average 4.0 percent
in 2001 and 5.0 percent in 2002 in emerging markets outside the world economy’s
industrial core. From one perspective, this glass is half full: The world’s poor
countries are growing faster than the rich, and closing the gap. From a second
perspective, this glass is nearly empty: The gap is being closed at a glacial pace, and not
being closed at all in large chunks of South America, in Africa, in much of the Middle
East, and in Indonesia.
Along with an improving US economy, 2002 should be a year of recovery for
Latin America’s two largest economies — Brazil and Mexico. However, given
the weakness seen in both the Brazilian and Mexican economies during the
first months of the year, yearly averages are likely to understate the force of
the recovery we expect to see later in the year. High interest rates in Brazil
and weak external demand in Mexico have kept the growth picture subdued,
or even negative, as the year begins. Improvements on both fronts should
allow for a resumption of growth, after the contraction in activity seen in the
latter part of 2001. Our greatest concern remains Argentina, where the
economic free-fall, brought on by the collapse of convertibility and the
ensuing rapid changes on the political front, has yet to show signs of
bottoming.
Brazil
We believe in a recovery in Brazil in 2002, but are concerned that many
Brazil watchers may be overstating the case of the economy’s improvement.
We remain cautious that the combination of external factors — including
continued turmoil in Argentina — as well as domestic political jitters may
produce bouts of currency weakness. We believe any negative shock on the
exchange rate could in turn pose a challenge to Brazil’s central bank, which
appears intent on cutting interest rates sooner than we had initially
anticipated. We expect interest rates to fall 250 bps in 2002, to reach 16.5%
by year-end, but expect the bulk of the interest-rate cuts to take place later
in the year.
Improvement on the interest rate front, along with an improvement in
consumer confidence, are two potential bright lights in an otherwise difficult
real economy. Industry still shows capacity-utilization levels that are among
the lowest in two years, suggesting that capital spending is unlikely to be an
important source of growth in 2002, even as interest rates fall. Meanwhile,
on the consumer front, of the four motors of consumer spending —
employment growth, real wage growth, consumer confidence, and access to
credit — only consumer confidence and, possibly, credit are likely to show
convincing signs of some improvement.
We continue to worry that currency weakness or greater-than-expected
inflationary inertia may pose difficulties for the central bank if it continues to
cut interest rates in the months to come, as we think it appears likely to do.
We understand the central bank’s argument that it cannot be bound to an
overly rigid set of inflation targets. The central bank rightfully, in our view,
argues that the 3.5% mid-point target in 2002 now appears too aggressive,
considering 2001’s actual inflation of 7.7%. Furthermore, the central bank
notes that inflation expectations in 2003 suggest that the target should be
beaten by next year.
Our concern is that, given the continued increase in trend measures of
inflation — from "non-tradable" to "core" — the central bank runs the risk
that by cutting interest rates in February and March, it may actually increase
inflation expectations, thus limiting its ability to cut as aggressively in the
future. While we continue to expect the Selic target rate to fall to 16.5% by
year-end, we fear that the central bank’s decision to cut rates early may limit
its ability to bring rates down to our forecast.
Mexico
For the first time in 30 years, Mexico is experiencing a cyclical contraction in
activity, accompanied by low inflation and a strong currency. The unusual
combination of a weak economy and strong peso in 2001 should set Mexico
up in 2002 for another "first" — namely, we expect to see a strong economy
with a weak peso.
This unusual turn of events is linked to the nature of the current slowdown —
it has been caused by a real economy slowdown in the US rather than
prompted by capital outflows. The result has been an unusual combination of
large dollar supply from FDI flows that are not business-cycle-dependent and
little dollar demand from a Mexican economy in a recession. However, once
the recovery begins, we expect the Mexican consumer to play a leading role.
After all, while job losses have mounted in 2001, we think the Mexican
consumer is in better shape going into the coming recovery — with his/her
purchasing power intact and a stronger currency — than at any time in past
three decades.
While we welcome the arrival of the business cycle to Mexico, we fear that
the atypical dynamics of the eventual recovery will create some cyclical
headwinds on the currency and inflation fronts. Consider the recoveries in
1984, 1989, or 1996 — each came after a period of pronounced currency
weakness and high inflation. This time, we expect the economic boom to
have a strong consumption component and to produce early pressure on the
external accounts, which, in turn, should feed through to currency weakness
and, with improving growth, to greater pass-through to inflation. Before the
currency’s weakening arrives, however, we would not be surprised to see
further peso strength as financial market flows arrive, signaling improving
sentiment.
In our judgement, the "structural" Mexican story of convergence with the US
remains compelling; however, we expect that in the latter part of 2002, the
balance will favor cyclical forces that are likely to produce some adjustment
to constructive inflation and currency trends. Over the long term, we remain
positive on the prospects for the Mexican economy, but argue that the
equilibrium reached in 2001 on the inflation and currency fronts may be
adjusted.
Argentina
Argentina’s economy continues to weaken, with little sign yet of where
activity might bottom. We expect a decline in GDP by at least 7.2% in 2002
and would warn that it could be even more severe. Despite the existence of
the floating exchange rate, the central bank is still trying to influence the
exchange rate through a combination of exchange controls and direct
intervention. In turn, the fiscal authorities are still tackling the need to
control spending given the absence of debt financing and the dangers of
relying on the central bank to finance (via inflation) the fiscal shortfall.
Whatever the outcome in Argentina, we expect to see a severe decline in
economic activity, and worry that the exchange rate will eventually weaken
from its current levels. We expect the peso to end 2002 at least at 2.8 per
US dollar and would not be surprised to see the peso trading above 3 during
the year. The risks in Argentina remain high, in our view, as the federal
government attempts to obtain concessions from powerful provincial
governments. While some progress has been made on eliminating the
guaranteed "floor" of transfers from the federal coffers to the provinces, we
sense that the authorities in Washington would like to see further progress
toward a legislative framework binding provincial spending and permitting a
large primary surplus.
Despite the dire state of affairs in Argentina, we believe that a solution is
possible and that aid from Washington will be forthcoming if the provincial
and federal policymakers tackle the larger fiscal issues raised by the IMF. The
right policy mix should allow for the disbursement of funds to help stop the
collapse in confidence and signal Washington’s conviction that the new policy
measures can produce a sustainable solution. While we remain extremely
cautious on the situation in Argentina, where the continued presence of
capital and exchange controls — originally implemented to stem capital flight
— have only exacerbated social tensions, we retain hope that there is a way
out that averts further institutional damage
Argentina: The Pressure Continues
Carlos A. Janada (New York)
Many investors are closely monitoring Argentina’s fiscal stance
and its foreign cash needs, but the key factor in the Argentine story
is growth. If the economy starts growing strongly this year, the
fiscal deficit will certainly decline (and consequently the country’s
spreads) and the government could come close to meeting the
fiscal convertibility law (that requires a fiscal deficit no higher than
$4.5 billion). At the same time, stronger growth would make
investors feel more confident about the country’s prospects, which
would facilitate the financing of the country’s foreign cash needs,
despite a moderate tightening of US interest rates.
We adopt a rather conservative stance with growth. We expect the
economy to only grow 2% in 2000. We analyze the fiscal situation
and the country’s cash flow, given this moderate recovery
expectation. We estimate that the fiscal deficit will be around $6
billion in 2000. If the economy grows 4% (as the government
assumes) instead of our 2% assumption, the deficit would probably
shrink to $5.2 billion instead. Bear in mind that the government
will not have to share additional revenues with its provinces this
year (the government reached an agreement with the provinces
whereby it fixed the amount of transfers this year in exchange for
other benefits).
Argentina is vulnerable to a hike of US rates. But since we’re
expecting only a moderate hike of 75 bp in 2000, the impact on
Argentina’s cash flow is likely to be moderate as well. This will
not be strong enough to hurt our 2% growth rate this year.
The major risk is growth. If for whatever reason the economy
remains flat (say, because we’re underestimating the impact of the
hike in US rates), then, needless to say, Argentina could face a
harder time. Lower growth would likely increase the deficit. A
higher deficit could make investors feel skittish and consequently
reduce foreign financing. Lower foreign financing, in turn, could
mean even lower growth. A vicious circle indeed.
The Fiscal Story
Argentina’s fiscal deficit will probably be close to $7 billion in
1999, or 2.4% of GDP, which is nearly twice the 1998 level. The
rather strong increase of the deficit is mainly the result of two
elements: higher interest payments and the recession. Argentina’s
interest payments were 2.23% of GDP in 1998, and jumped to
2.85% in 1999E. The economy declined 3.5% last year. According
to our estimates, had the economy remained flat in 1999, the
government would have gotten 0.5% of GDP in additional
revenues.
We expect a $6 billion fiscal deficit in 2000. To simplify the
picture, we start with the estimated $7 billion deficit in 1999. We
add to this deficit (1) privatization resources of $1.5 billion that
will be hard to replicate in 2000, (2) additional interest payments
of nearly $1 billion, and (3) the impact of lower labor taxes, which
we estimate at $500 million (these taxes were reduced in February
and in August but a further reduction slated for December was
suspended). Therefore, the "opening" deficit in 2000 amounts to
$10 billion.
The new government has implemented two key measures to reduce
the deficit. First, it has substantially reduced public spending by
$1.4 billion (actually $1 billion was already included in the
original 2000 budget proposal submitted to Congress by the
previous administration, and $400 million was added in the course
of the negotiations with the new Congress). Close to $2 billion is
expected to come from tax reform (this measure is the core of the
fiscal program). Furthermore, roughly $2.1 billion should come
from the economy’s recovery and a reduction in government
transfers to the provinces (the government assumes that the
economy will grow 4% in real terms). All in all, if the
government’s forecasts are right, then the overall 2000 fiscal
deficit would be $4.5 billion, which is the amount required in the
fiscal convertibility law. So far so good.
We have a couple of concerns on the revenue side of the fiscal
program, however. The first concern is with the tax reform. This
reform relies on higher taxes for the self-employed (mainly
professionals). The problem is that the self-employed traditionally
underestimate their tax contributions, and it could be tough for the
Argentine IRS to make sure that they actually pay higher taxes.
Another part of the program relies on the expansion of internal
taxes. Domingo Cavallo tried this measure before and it didn’t
work.
The second concern is with the assumption that the economy will
grow 4% in 2000. True, the economy has most likely bottomed,
but the prospects for a relatively strong recovery are still uncertain.
We continue to believe that the economy will grow just 2% in
2000. Because of these two considerations, we estimate that the
2000 fiscal deficit will likely be $6 billion (2.1% of GDP). The
new government has done a fine job reducing the "opening"
deficit, but more needs to be done, if it wants to meet the fiscal
convertibility law.
The Cash Flow Story
Argentina’s currency board makes the country very sensitive to
international conditions. One of the key events that investors
anticipate in 2000 is a hike of US interest rates. Our US economist,
Dick Berner, expects a hike of 50 bp in the Fed funds rate in 1H00
and 25 bp in 2H00. The long rate should move to 6.70% at the end
of this year from 6.50% at the start of the year. As Chip Brown
pointed (see The Fed Threat Less Than in 1994, 1/6/00), we don’t
think that these increases will have a devastating impact on the
Latin region. Nonetheless, since Argentina is probably the country
that is the most exposed, we should pay attention to the country’s
financing needs and the impact that a potential US interest rate
hike could have.
Argentina’s gross financial needs in 2000 amount to roughly $54
billion. This comes from: (1) a current account deficit of $13
billion (slightly more than the $12.6 billion deficit last year), (2) an
increase of international reserves of $2 billion (since Argentina is
going to grow, the monetary base should expand), and (3) external
debt amortization payments of close to $39 billion (while the
public sector will likely amortize $7 billion, the private sector will
have to amortize $32 billion). From this side of the equation,
Argentina is more sensitive to changes in economic growth (which
could alter the size of the current account deficit) than a hike in US
rates. Amortization payments are already scheduled and we
assume that they can’t be changed.
We assume that Argentina will finance the $54 billion that it needs
through long-term capital and loans. Long term capital (including
privatization revenues) and other private capital altogether should
yield $1 billion. The public sector is scheduled to borrow $13
billion (a similar amount to what it got in 1999E). The core of the
financing will rely on the private sector; it should borrow $40
billion (up from $29 billion in 1999E). The financial and the nonfinancial sector should borrow in almost equal amounts.
This is the side of the equation where Argentina is the most
sensitive to a hike of US rates, particularly the public sector. In
1994, when the Fed tightened significantly, the Argentine public
sector foreign borrowing declined to $4 billion from more than $7
billion in the previous year. The private sector was also affected
but to a much lower extent than the public sector. However, bear in
mind that the hike of 1994 was much more substantial than what
we’re expecting for 2000 (the Fed doubled interest rates in 1994).
RECAP THE CURRENT MACROECONOMIC SITUATION
As of the late spring of 2001, economic forecasters expected U.S. growth
to resume. They expected Federal Reserve rate cuts to boost investment spending
and growth starting at the end of 2001. They expected European unemployment
to remain high, but European growth to continue.
Japan ended 2000 with an annual real GDP growth rate of 1.8 percent.
This is an astonishingly low growth rate given the large amount of unused capacity
in the Japanese economy, and the extraordinarily low levels of nominal
short-term interest rates in Japan. But what matters for investment spending is
not a low short-term safe nominal interest rate but a low long-term risky real interest
rate, and that requires confidence that policy will be continued, confidence
and companies will not go bankrupt, and confidence that prices will not decline.
Last, forecasts were for real GDP growth to average 4.0 percent in 2001
and 5.0 percent in 2002 in emerging markets outside the world economy’s industrial
core.
Box 9.4: Macroeconomic Effects of the Terror-Attack on the World Trade Center
Box 14.1: Bush tax cut box
15: Managing Crises
15.3 Argentina box addition…