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A joint initiative of Ludwig-Maximilians-Universität and the Ifo Institute for Economic Research Forum SPRING 2001 Focus WORLD AND EUROPEAN ECONOMIES Ignazio Visco Barry Bosworth Willi Leibfritz Pro and Contra THE U.S. ECONOMY: RECESSION AHEAD? William C. Dudley Gail D. Fosler Special ECONOMICS IN EUROPE Assar Lindbeck Spotlights EAST GERMAN ECONOMY MEASURING INFLATION DICE Reports TAXING CO2 IN EUROPE Trends ECONOMIC SURVEY INTERNATIONAL STATISTICS UPDATE CESifo Forum ISSN 1615-245X A quarterly journal on European issues Publisher and distributor: Ifo Institute for Economic Research Poschingerstr. 5, D-81679 Munich, Germany Telephone ++49 89 9224-0, Telefax ++49 89 9224-1461, e-mail [email protected] Annual subscription rate: Euro 50.00 Editor: Heidemarie C. Sherman, Ph.D., e-mail [email protected] Reproduction permitted only if source is stated and copy is sent to the Ifo Institute CESifo Forum Volume 2, Number 1 Spring 2001 _____________________________________________________________________________________ Focus OUTLOOK ON THE WORLD ECONOMY AND THE EUROPEAN ECONOMY Challenges and Risks for the World Economy Ignazio Visco The Outlook for the U.S. Economy: Soft or Hard Landing? Barry Bosworth Forecast for the European Economy Willi Leibfritz 3 14 21 Pro and Contra THE U.S., ECONOMY: RECESSION AHEAD? Pro: Weakness Will Persist William C. Dudley Contra: Economy Rebounding Gail D. Fosler 28 29 Special Economics in Europe 31 Spotlights The East German Economy Stopped Catching Up How Inflation is Measured 33 34 DICE Reports Taxing CO2 in Europe 35 Trends Economic Survey International Statistical Update 37 39 Focus OUTLOOK WORLD ECONOMY AND THE EUROPEAN ECONOMY ON THE On 1–2 March 2001, the ifo Institute conducted an international conference in Munich at which macroeconomic forecasts and policies were discussed during the first day and the outlook and driving forces for individual industries in various European countries were the topics of the second day. Three papers presented on the first day on the world economy, the U.S. economy, and the European economy are reproduced here. ment of developments based on the information currently at hand. CHALLENGES AND RISKS FOR THE WORLD ECONOMY Recent developments IGNAZIO VISCO* The outlook for US growth has changed rapidly since the end of last year, as the actual slowdown occurred substantially faster than the large majority of forecasters had considered as the most likely outcome (Figure 1). Some slowing of growth had been expected, driven by the tightening of US monetary policy since June 1999, the actual and projected weakening of equity prices, and the impact of rising energy prices on real incomes. In addition, a sharper slowdown had been considered (in particular in the most recent OECD Economic Outlook), although mainly as a risk that might result if financial market conditions (especially equity prices and risk premia) were to deteriorate Introduction D evelopments since the previous OECD Economic Outlook was finalised in autumn 2000 have brought substantial changes to the short-term outlook for the world economy. Even if a U.S. slowdown – after some 6 percent output growth in the first half of 2000 – was anticipated, such an abrupt correction as appears to have taken place was only indicated as a risk. In addition, the economic situation in Japan, while difficult to interpret, appears poised for further deflation and disappointing growth. Finally, some financial instability has resurfaced in emerging markets, hitting the Turkish economy. The Figure 1 OECD is currently in the process of producing its new Outlook, and we are, of course, taking these developments into account in our projections. While it is too early to discuss a consistent set of short to medium-term projections, I shall, at this point, highlight what I see as the key issues affecting the outlook and provide an assess- Slowdown in the U.S. * OECD, Chief Economist and Head of the Economics Department. The views expressed in this paper are my own and do not necessarily represent those of the OECD or of its Member countries. 3 CESifo Forum Focus Figure 2: Financial Indicators in the United States No rebound in Japan CESifo Forum sector and widely looked at measures of consumer sentiment/confidence dropped sharply in the final months of the year and continued to fall in January and February. In Japan, economic activity has seemed unable to pick up in a self-sustaining fashion, and deflation has continued. While recovery in Japan may still be underway, the pace appears to be slower than had been thought. Corporate sector profits and a weaker yen have helped, despite higher real interest rates, to underpin business investment, but while, as expected, public investment has slowed, real net exports have started to decline with weaker growth in the United States and the economies of East Asia. Moreover, the weak income growth, due in part to restructuring, has evidently restrained private consumption. Even more importantly, perhaps, there are renewed concerns about the financial sector in Japan, amid indications of the need for further significant balance sheet adjustments by banks and some major adjustments as well by life insurance companies. Finally, wholesale and consumer Source: Bloomberg; Board of Governors of the Federal Reserve System. prices are continuing to decline despite higher energy prices, in further and spill over into business and consumer part due to deregulation in a number of key sectors, confidence. but probably also in response to sustained weakness in aggregate demand. US financial market conditions did in fact deteriorate further in the fourth quarter. Equity prices fell Economic activity in Europe also appears to be slowsharply and risk spreads on corporate bonds ing a bit, but its performance still looks relatively picked up (Figure 2). Real economy indicators also good and is not much different from what was expectsoftened, driven by exceptionally weak capital ed a few months ago. Export growth has slowed in goods spending, a drop in real exports and a part as the boost from the earlier depreciation of the marked slowing in consumption (Figure 3). At the euro ended and foreign demand dropped. The growth same time, real inventories increased while final of investment spending has softened as business consales of goods declined. Initial claims for unemfidence indicators have slipped slightly. Consumption ployment compensation continued to rise throughspending has remained strong, however, with conout the quarter, and both the purchasing managers’ sumer confidence near record levels and employment index of business conditions in the manufacturing continuing to grow rapidly. 4 Focus Figure 3: Recent Economic Indicators in the United States Relatively good performance in Europe a) Excluding aircraft. – b) Three-month moving average, percentage change from three months earlier at annual rate. – c) Level of shipments in December relative to fourth quarter at an annual rate. – d) The average balance of opinions on production expectations, order-books and stocks. Source: Bloomberg, Bureau of the Census, Bureau of Economic Analysis, Datastream, Employment and Training Administration. For most of the rest of the OECD area, develop- price of oil does not drop sharply the economic out- ments seem to be broadly in line with what was look for these countries is generally favourable. expected some months ago. Korea, however, may be affected more than others by the U.S. slowdown and the fall in demand of ICT products, given its The U.S. correction export specialisation in the ICT component producing sector. In Turkey, the situation is serious in Against this background, much of our revised view that it marks a significant setback in the attempt to of the global outlook will depend on how we see achieve stabilisation objectives. economic activity in the United States evolving. In this regard, the key issue is to form an assessment The situation in the non-OECD area softened in the on whether the slowdown since late 2000 is transi- second half of last year, as the U.S. slowdown and the tory and mostly due to temporary factors or fall in demand for semiconductors and other electri- whether it presages a protracted period of adjust- cal goods is likely to have significantly reduced ment. It is important, therefore, to try to under- export growth also in dynamic Asia. South American stand the nature of the factors behind the recent countries, which have weaker trading ties with the developments that have been taking place in the United States, have been less affected than Asia by United States. Significant pieces of data are, how- the slowing of economic activity in the United ever, still missing and, as a consequence, any analy- States. Output growth in the oil-exporting countries sis at this point can only be preliminary. is rising in line with expectations and provided the Nonetheless, one can tentatively identify a few key 5 CESifo Forum Focus deepening and in the rapid rise in the equity price of ICT producing firms. ICT expenditures were by far the fastest growing component of investment spending over the past two to three years and accounted for more than a third of all business investment in 1999 and 2000. Recently, adverse profit movements have helped to reduce what have appeared for some time to be clearly overvalued stock prices of several ICT firms. forces that likely contributed to the slowdown in the United States and speculate about others. Transitory factors One element that seems to have been important has been the exceptionally cold weather in the United States in November and December, which likely suppressed retail sales during that period and also construction activity. The impact, however, on the economy is transitory and may, to the extent that some purchases are only delayed, spur output in coming months. High oil prices There also seems to have been a significant stock adjustment taking place in the demand for durable consumer goods in the last months of 2000, particularly in the motor vehicles sector, which had enjoyed several years of strong growth before the second half of the year. This downward adjustment in the demand for automobiles as consumers work off existing stocks was possibly influenced also by high gasoline prices. In addition, investment demand for trucks appears to have dropped off significantly at the end of last year, probably for similar reasons. A related factor has been the high price of energy (both oil and natural gas), which together with apparently limited stocks of refined products, such as home heating oil and gasoline, led to increased final product prices and must have absorbed a larger-than-normal share of discretionary income. Since December of last year, crude oil prices have eased back a bit from recent peaks, as additional crude oil production entered the market, heating oil stocks began to recover and energy demand softened. These developments were expected six months ago when the OECD was finalising its current published set of projections, but the changes have come earlier than anticipated. Moreover, while oil and commodity markets are inherently volatile, it is reasonable to believe that the risk of a substantial additional hike in oil prices has abated. The fourth quarter also saw a fall of U.S. exports in nearly all categories of goods. A significant portion of the drop was in aircraft, which are typically volatile, and in semiconductors and ICT equipment. It is not clear, however, what factors were behind the generalised drop-off in exports. Even if the slowdown in investment, given signs of over-capacity in some sectors, was to an extent anticipated, it appears to have exceeded expectations. Rather than occurring smoothly over time, a sharp correction has taken place. The interaction between profit movements, stock price developments, consumer and business confidence (the “animal spirits”) is obviously very complex. Especially labour market consequences have to be watched with care, as they will be crucial in determining the path of consumer expenditures. Finally, as a result of the sharp correction in final demand, an inventory adjustment is also to be expected, which adds some uncertainty to the timing of the recovery in activity growth. Other elements, advanced by some commentators, have been the protracted periods for settling the outcome of the US presidential election and the electricity utility crisis in California (one of the world’s largest economies). These may have served to puncture confidence. The somewhat nebulous nature of confidence, however, makes it difficult to assess these influences. But to the extent that these forces did play a role, their impact is also likely to be transitory. Areas of greater uncertainty Stock adjustment in ICT equipment and autos CESifo Forum An assessment Stock adjustment effects appear to have been present in the demand for computing and telecommunications equipment, whose growth declined sharply at year-end. The slowdown followed a period of exceptional demand growth, which was reflected both in the process of strong capital Positive developments In many respects, recent developments have been accompanied by adjustments that appear to be 6 Focus would have been considered reasonable macroeconomic performance. appropriate and reasonable, even if their timing was not well predicted. In addition, the favourable background against which these adjustments have occurred might ease concerns about the likely severity of the slowdown overall. Low inflation and stable inflation expectations The rise in oil prices since early 1999 has had little effect so far on underlying inflation trends. Excluding food and energy, the four-quarter changes in US consumer prices have increased only slightly (Figure 4). Consumer prices in the euro area have also remained low. In addition, there are no signs of higher long-term inflation expectations in the United States and a number of other economies, based on measures of inflation expectations derived from consumer and producer surveys, as well as from regular and index-linked government bonds. Market long-term inflation forecasts also continue to be low and stable relative to current inflation in the United States and Europe (Figure 5). These developments are all the more remarkable given that many economies have been either above estimated measures of potential output (e.g. the United States, the United Kingdom and Canada) or approaching it, in some cases rapidly (e.g. the euro area). The exception is Japan, where deflation is continuing. An orderly decline in US equity prices Equity prices, especially in the high-technology sectors, were by most estimates too high in recent years. It seemed almost inevitable that an adjustment would eventually occur, and the risk was that such an adjustment, when it did occur, might overshoot its true equilibrium and destabilise economic activity. However, what we saw in the past year was a large but reasonably orderly decline of equity prices, most notably in the high-technology sector, where it was believed that such an adjustment was most needed. Current prices clearly reflect more reasonable prospects for earnings growth than those of a year ago, although valuations may still be a bit high relative to historical norms. Continuing productivity growth in the United States US labour productivity continued to grow in the fourth quarter, at a rate similar to those of previous quarters. This is encouraging in part because the end of a cycle is typically accompanied by a sharp slowdown in labour productivity growth, as firms are less able to adjust employment when demand for output falls. Productivity growth and low inflation It is noteworthy that the general pattern of modest inflation outcomes has been occurring for a while and has not been well anticipated by forecasters. For example, while OECD projection errors for GDP have been somewhat evenly distributed around zero over the period from 1993 to 1999, projection errors for inflation over the past decade have generally been negative, indicating that actual inflation outcomes have generally been below the projections (Figure 6). This may highlight the occurrence of an important regime change in the state of inflation expectations, possibly linked to the success in the setting and conduct of monetary policy. The productivity figures serve to reinforce the view that there has been a structural shift in the U.S. economy. Sustained strong increases in productivity compared with the performance of recent decades support the conclusion that the trend rate of growth of potential output in the United States has improved. Indeed, OECD estimates of U.S. potential growth have been revised up on several occasions over the past few years. The most recent upward revision was late last year, when potential growth was increased to around 4 per cent. This compares with an estimate of 23/4 per cent in 1998. An implication of the improvement in potential, which is consistent with temporarily subdued inflationary pressure, is a reassessment of the extent to which cyclical imbalances need to unwind and to which policies need to react. Furthermore, these imbalances can now unwind while maintaining a pace of economic growth that until quite recently Improved employment conditions in the euro area Labour market trends in the euro area have been favourable in recent years. More or less comprehensive reforms have been undertaken in many countries, with all of them adopting measures that lower labour costs and/or raise real wage flexibility. Also, reflecting policy measures to make European labour markets more flexible, part-time and temporary employment has contributed very significantly to overall employment growth. This 7 CESifo Forum Focus Figure 4: Actual and core inflation in major OECD areas and world oil prices ployment rate has declined from a peak of 11.5 per cent of the labour force to around 9 per cent, even as the participation rate improved. High consumer confidence in Europe Consumer confidence, according to the European Commission Survey, remains near record levels in Europe, even if some signs of softening are beginning to appear (Figure 7). Provided that labour market trends continue to be favourable and that equity prices remain around their current levels, consumption should remain healthy. It is notable that consumer confidence measures in Europe have remained relatively strong overall, despite the sharp downturn in the United States. Job growth and high consumer confidence in Europe Modest adjustment of the euro The recent period has also witnessed a reversal in the foreign exchange value of the euro, which until October-November of last year had been on a declining trend since its inception. This sustained decline prompted renewed questions by some commentators about the relationship between foreign exchange market developments and economic fundamentals. The slide of the euro elicited both verbal and, ultimately, market intervention on the part of monetary authorities in Europe and elsewhere. The recent turnaround of the euro against the dollar and the yen constitutes, at this point, only a small reversal of its earlier slide. However, this reversal is consistent with a shift in views about the relative strength of economic activity in the euro area in the past few Source: OECD Main Economic Indicators. has occurred while demand conditions have been gradually improving, and it has been reflected in employment growth exceeding, over the past three years, that in the United States. The area unem- CESifo Forum 8 Focus By most accounts, US banks are well-capitalised. Therefore, banks should not be reluctant to lend on the grounds that they need to work down bad debts or build up capital, as they were at the beginning of the 1990s. Nonfinancial corporations also appear to have reasonably comfortable balance sheet positions. While the debt levels of these firms have moved above previous highs, debt positions are quite low relative to the market value of enterprises (Figure 8). Furthermore, with interest rates low, net interest payments relative to cash flow are at easily sustainable levels. The household sector, however, is perhaps one area where some concern over balance sheets may arise. Debt loads are high and, because of the high levels of debt, debt-servicing costs have grown to be close to the peak levels of ten to fifteen years ago (Figure 9). Offsetting these concerns, to some extent, are the relatively large holdings of liquid assets, which appear to offer a substantial cushion to households, although mutual fund holdings comprise a significant portion of this buffer, and their values may fall with equity prices. Figure 5: Long-term Inflation Forecasts According to Consensus Forecasts Source: Consensus Forecasts (October 2000). months and may mark the beginning of a period in which exchange rate movements contribute to the overall adjustment towards longer-run equilibrium. More troubling developments U.S. household debt in high Figure 6 There is more uncertainty about certain other aspects of recent developments, which may serve to prolong or complicate the adjustment period. Balance sheets in the United States Balance sheet positions in the United States, which were important in prolonging the US recession of the early 1990s, do not appear to be restraining activity to the same extent now. a) Unweighted average of projection errors for inflation and real GDP growth (actual minus projected) from 1993 to 1999. Projections are from the December Economic Outlook for the next year. Changing the starting date of the sample does not materially change the results. 9 CESifo Forum Focus United States, and, combined with an economy that seemed already to be running beyond the limits of its capacity, it appeared that a period of downward adjustment would be inevitable. The decisions by the Federal Reserve to cumulatively raise short-term interest rates by 175 basis points between June 1999 and May 2000 were designed to help unwind this imbalance. Tighter monetary conditions may have started to bite in the second half of 2000, but that may have come too late to prevent a significant amount of over-investment in capital goods and consumer durables. How long it will take to complete this adjustment is not obvious, although continuing price declines for ICT equipment and software and its rapid depreciation should work to shorten the process to some extent. Figure 7: Confidence Indicators U.S. investment in downward adjustment Japan Balance sheet problems in Japan CESifo Forum The chances that growth in Japan might deteriorate again look to have increased. If a downturn occurred, the situation would be made all the a) Consumer sentiment is measured as 100 plus the balance of positive minus negative opinmore difficult by the underlying ions. Purchasing managers’ deliveries (15%) and inventories (10%). – b) Consumer sentiment structural problems. Balance is calculated as an average of five indicators concerning household standard of living, income growth, commodity price increases, employment environment and optimal time for durable sheet problems, which reflect goods purchases. The business situation prospects is the balance of positive over negative poor future prospects for the replies expressed as a percentage of total replied to questions concerning the business situation, stocks of finished goods and capacity utilisation. – c) Consumer sentiment refers to the heavily indebted parts of the average balance of positive and negative opinions on the expected financial situation, expectcorporate sector, are continuing ed general economic situation and advantage to make major purchases at present. The purchasing managers’ index refers to the average balance of opinions on production expectato act as perhaps the major tions, order-books and stocks. restraining force on growth. Source: OECD Main Economic Indicators. While dealing with them will create “head winds”, delaying U.S. over-investment appropriate responses will only exacerbate the problem. In addition, despite the measures taken Fuelling the exceptional growth performance of the in March 1999 to address pressing problems with United States, particularly in the period from midfinancial institutions, many underlying problems 1999 through to the first half of 2000, were rapid remain with the banking sector (particularly the increases in investment spending. Growth during major banks). Furthermore, as bankruptcy procethis period was well above even the upwardly dures continue to gather pace, the recognition is revised estimates of potential output growth for the growing that banks will have to increase their pro- 10 Focus banks, has also been established. Nevertheless, the industry is likely to come under further stress in the period ahead. Figure 8 Turkey An important concern is the risk of contagion to other emerging market economies from the crisis in Turkey. One cannot predict with certainty what kinds of spillovers might result from the crisis in Turkey. Certainly those with exposure to Turkey will be affected. It is clear, however, that the Turkish crisis is very much linked to specific conditions in that country; and also that widespread international exposure to Turkish risk is not very high. These considerations suggest that spillovers, if any, should be modest and short-lived. Outlook: positive growth in the U.S. Tentative outlook and risks Our preliminary analysis leads us to think that the US economy is currently going through a period of needed adjustment. To be sure, it started earlier and more abruptly than all analysts and commentators had anticipated. But going forward, it appears that two different scenarios are likely. The more pessimistic scenario calls for a recession in the United States, which in the worst case could be protracted and have significant spillover effects on the rest of the world. The more optimistic scenario, which appears to be held by most analysts and towards which I personally lean at this point in time, is for significantly lower but still positive growth in 2001. This means that GDP growth might end up being, overall, around 2 per cent in the current year, and higher for 2002. This central scenario acknowledges that a sharp slowdown has occurred, but expects also the speed of correction to be relatively rapid, as temporary conditions pass, fuel prices stabilise or ease, potential output growth remains strong, and capital stock adjustment is concentrated in the rapidly evolving ICT sector. The sharp easing of US monetary policy in January and possible further cuts in interest rates will also serve to speed the adjustment. visions for bad loans (and disposing of bad loans is made more difficult by the small size of the market for asset-backed securities as well as the lengthy and inefficient bankruptcy procedures, which have nonetheless improved recently). This effect could be compounded as the true extent of losses in the non-financial sector are recognised (following the introduction of tighter accounting standards) and by any additional weakness in real estate prices that might emerge, as banks typically value collateral at historical value and only provision against the difference. Finally, bank loans have fallen, as major sound clients restructure their own balance sheets, and loan margins remain low. There are also severe problems in the life insurance industry, where firms have extensive cross holdings with the banking sector. These problems stem from high promised returns, which in a number of cases now cannot be met and which can only be altered during bankruptcy proceedings. A restructuring system is in place, and a safety net, smaller than that for the 11 CESifo Forum Focus Figure 9: Debt and Debt-Servicing Measures of U.S. Households and Non-Profit Organisations Relative to Disposable Personal Income Solid prospects for Europe Few policy options for Japan CESifo Forum Nonetheless, the short-term outlook for Europe appears to remain solid. The high level of business and consumer confidence, the employment gains, and the tax cuts implemented in some countries should underpin growth in domestic demand and without stoking inflationary pressures. Recent falls in equity prices may detract from private demand, but the magnitudes should be buffered by the small proportion of European net worth held in the form of listed company stocks. A modest slowdown in activity with respect to 2000 is nonetheless the most likely outcome. As core inflation is predicted to remain low, there would probably be little risk to implementing some modest monetary easing relatively soon. In the event the size of the external shock is larger than anticipated, or if the domestic conjuncture substantially deteriorates, there would remain considerable scope to counter such weakness with further monetary policy easing. In Japan, however, the monetary authorities may not see themselves as having the same degree of freedom. With policy targeting an interest rate that is already a) Home mortgage and consumer credit. – b) Deposits, credit market instruments and mutual close to zero, further substantial funds. easing to counter the decline in Source; Federal Reserve Board, Flow of Funds. external demand might require alternative, quantitative meaSlower growth in the United States will obviously sures for the injection of liquidity, such as through bear on the economic outlook in the other major outright purchases of government bonds or foreign economic areas. But the impact on the rest of the exchange. Absent such easing, Japan might suffer an world appears at this point to be manageable in even larger decline in aggregate demand if the yen most countries. Simulation results from the were to rise in reaction to the relative easing of monOECD’s Interlink model show that, considering etary policies elsewhere. Likewise, the scope to stimthe direct trade linkages, a decline of US GDP ulate demand through expansionary fiscal policy is 1 growth of 1 to 1 /2 percentage points – about the severely constrained by the already large budget magnitude of the recent adjustment to expectadeficit and rapidly growing size of outstanding govtions for US growth in 2001 – would ceteris ernment debt. paribus lead to declines of roughly 1/2 of a percentage point for growth rates in both Europe and Outside the OECD area, the reduction of global Japan. interest rates should help in many cases to reduce 12 Focus ments exerting a stronger influence on consumption behaviour through fluctuations in wealth and through confidence. As a consequence, U.S. consumption spending may be becoming more volatile and difficult to forecast than it had been in the past. financing costs in emerging markets. Most of these countries are also in a position to counter the effects of a slowdown in external demand by easing monetary policy. The impact, however, of the ICT stock adjustment in the United States may hit some countries in dynamic Asia hard, since a sizeable share of their output and exports comprise ICT components and equipment. In addition, as mentioned earlier, the relationships among inflation, inflation expectations, labour market pressures and fuel prices may have changed. Perhaps because of increased flexibility of labour and product markets and/or increased confidence in monetary policy making, inflation and inflation expectations seem to be responding less, in the current environment, to wage and commodity price pressures. Risks One risk to the outlook, however, is a more generalised cutback in investment and consumption outlays in the United States, which would detract from growth in domestic demand and, in time, impinge negatively on the US economy’s growth potential. So far disappointing returns and revised profit expectations have been concentrated among high technology investments. And the slide in equity prices, which persisted through to the end of the year, has been largely in these sectors. There is a risk, however, that equity markets continue to fall, triggering even steeper declines in consumer and business confidence. Such declines in confidence might in turn affect consumption and investment spending for a more protracted period, generating a more negative impact on domestic demand and larger spillover effects to the rest of the world. However, there is still scope for further monetary policy easing, which would tend to offset some of these negative effects on growth in the United States and elsewhere. The increased rate of potential output growth in the United States, which has altered the speed limit for the economy, and the greater share of capital stock devoted to information and computing equipment, which depreciates more rapidly and would lead to faster unwinding of stock adjustment imbalances, also change key economic relationships. As a result, policy makers will need to be prepared to come to grips with new developments, to look for changes in relationships and indicators, and to adapt their policies as needed to the evolving character of economic activity. The success policy makers have in understanding and adapting to the new environment will have an important influence on the way in which the world economy evolves. Changed economic relationships pose new challenges for policy makers This is a very general prescription and implementing it in specific situations will, of course, be difficult. At the moment, one of the key challenges facing the United States is to avoid over-reacting to the slowing of economic growth, which might foster more volatility in activity and risk dissipating hard-won gains against inflation. This task is complicated by the difficulty of measuring potential with a high degree of precision, making policy setting uncertain. For Japan, the main challenge continues to be to devise the right policy configuration to avoid deflation and spark self-sustaining economic activity. This will likely require the rigorous implementation of financial system reforms, vigorous structural changes and the perhaps creative use of existing macro policy tools. For Europe, the challenge is to continue with smooth, non-inflationary growth while at the same time to boost the growth rate of potential, which may come with the further diffusion of information and communication technology and a higher degree of exposure to competition in product markets. Another, perhaps less likely, risk to the outlook arises if the impacts of higher energy prices are still to be fully felt. If the increases we have seen ultimately do pass through to core inflation and inflation expectations, especially at a time when output growth is slowing, they could complicate the policy response to the slowdown in activity throughout the OECD area. Challenges for policy makers The current economic environment, which in many respects is quite favourable, presents at the same time some difficult challenges for policy makers. In part this stems from recent changes in the nature of economic activity and the patterns of economic behaviour. For example, equities have in recent years become an important component of U.S. household wealth, with equity market develop- 13 CESifo Forum Focus become the source of the instability that it seeks to combat. THE OUTLOOK FOR THE U.S. ECONOMY: SOFT OR HARD LANDING? However, the most striking feature of the economy in recent years is the extent to which its performance was dominated by developments in the high-technology sector, both during the boom and now during the slowdown. Thus, the overall economy is being driven by cyclical developments in the high-technology sector. During the boom period, the growth of aggregate demand was spurred by a surge in domestic investment, which we can attribute to purchases of high technology products, and a binge of consumer spending which I will argue can be largely attributed to the wealth effects of the boom in high-technology equity prices. High-technology products also had a large impact on the supply side of the economy, providing for a surge in productivity growth that allowed the U.S. to accommodate the demand side boom without inflation (see Table 1). BARRY BOSWORTH* T U.S. performance is dominated by hightech sector he U.S. economy performed extremely well over the period of 1995-2000; but it appears to have hit a wall at the end of 2000 and its poor performance in the first few months of this year has elicited talk of recession. The slowdown also seems to have caught policymakers unprepared: as recently as mid-December, the Federal Reserve professed to be leaning toward further interest rate increases. Yet in early January the Open Market Committee convened by telephone and decided to cut interest rates by 50 basis points, and followed that with another 50 basis point cut in less than a month. The prior restrictive policy has now been fully reversed; and when combined with a similar set of dramatic policy changes in 1998, there should be some concern about whether policy itself has With the bursting of the high-technology bubble in equity markets and the consequent loss of wealth, consumer spending has slowed; but the most substantial change has been a sharp drop in demand * The Brookings Institution. Table 1 Annual Rates of Change in Prices, Wages and Productivity December to December percent changes 1993 1994 1995 1996 1997 1998 1999 2000 Consumer Price Index ex. Food and fuels 2.8 3.1 2.6 2.7 2.6 3.0 3.3 2.6 1.7 2.2 1.6 2.5 2.7 1.9 3.4 2.6 Producer prices Crude Finished ex. Food and fuel 0.4 0.2 0.4 – 0.6 1.7 1.6 5.6 2.2 2.6 14.7 2.9 0.6 – 11.7 – 1.2 0.1 – 7.4 – 0.2 0.3 15.7 3.0 0.9 31.4 3.6 1.2 Employment cost – Private Sector Total compensation Wages and salaries ex. Sales occupations 3.6 3.1 3.0 3.1 2.8 2.9 2.7 2.9 2.8 2.9 3.3 3.3 3.3 3.8 3.7 3.4 3.7 3.1 3.4 3.5 3.6 4.4 3.9 3.9 Hourly earnings 2.6 2.7 2.9 3.9 3.7 4.0 3.5 4.3 Productivity growth Nonfarm Manufacturing 0.1 2.2 1.3 3.1 1.0 3.9 2.7 4.1 2.0 5.0 2.8 4.8 2.9 6.4 3.4 6.5 Unemployment rate (annual average) 6.9 6.1 5.6 5.4 4.9 4.5 4.2 4.0 Source: Bureau of Labor Statistics, U.S. Department of Labor. CESifo Forum 14 Focus for high-technology capital. The implosion of internet startup firms has left the industry with excess capacity, there has been a slowing of the pace on new product innovations, and financial strains have led other firms to slow the pace of their purchases of high-technology capital. The result is likely to be a transitory slowing of GDP growth to an annual rate of about one percent in the first half of 2001, and a return to growth at 3 percent or above in the last half of the year. However, the effect on government policy may be more longlasting, as the Chairman of the Federal Reserve has used the slowdown as an occasion to actively support a previously unpopular proposal for a large multi-year tax reduction. Thus, it will likely mark the end of a policy mix of fiscal restraint and monetary ease that was in effect for most of the 1990s. Figure 1 Adjustment in hightech sector leads to growth slowdown in the first half of 2001 In what follows, I would like to discuss the underlying cause of the boom in somewhat more detail before turning to the current economic outlook. In addition, the economic boom has Saving (NIPA) is from the national accounts; Saving (FoF) includes the net accumulation of had a profound affect on the consumer durables. U.S. fiscal situation and transSource: Federal Reserve System, Flow of Funds (FoF) Statistics. formed the debate in ways we never would have anticipated ket for home mortgages and the rise in the wealthan few years ago. Finally, the combination of a boom in investment and a sharp drop in saving has income ratio. Most Americans finance their homes generated a very large current account deficit. The with 30-year mortgages. Prior to the 1970s, these deficit in turn has stimulated concerns, more outwere truly long-term contracts that were binding side than inside the United States, about the suson both the borrower and the lender. But under tainability of the expansion in future years. political pressure from homeowners, the government eliminated prepayment penalties for borrowers who wanted to repay the loan at an earlier peri- The Role of the New Economy od. Thus, borrowers have both the flexibility of short-term borrowing and the security of long-term As shown in Fig. 1, there has been a remarkable collapse of household saving in the United States over the past 15 years. I believe that decline can be traced to two phenomena: innovations in the mar- credit. In addition, the costs of refinancing a mortgage have been dramatically reduced by other regulatory changes, innovations in the mortgage mar- 15 CESifo Forum Focus ket, and expanded competition among mortgage lenders. Consumer spending boosted by mortgage borrowing and rising wealthincome ratio Investment in information processing dominated investment growth Figure 2 As a result of these innovations, periods of decline in mortgage rates now trigger episodes of mass refinancing of mortgages. If it were simply a roll over of debt at a lower interest rate, it would be of little economic consequence. But most homeowners cannot avoid the temptation to increase the mortgage amount, converting gains in their home equity to cash, and repaying their consumer credit. Mortgage interest is tax-deductible and the rates are much lower than for consumer credit. Note in the charts that consumer credit is an unchanging ratio to disposable income, whereas mortgage debt continues to rise. This is a relatively new mechanism for translating real estate gains into immediate gains to consumer spending; but it is also very sensitive to variations in interest rates, because it is only attractive when interest rates are declining. index in 1991, they rose 10-fold over the following eight years to the point where they represented a third of the overall index in early 2000. Nontechnology stock rose by 150 percent over the same period. The second factor behind the growth of consumer spending is the rise in the wealth-income ratio; and as can be seen in the figures, the wealth gains can be traced to increases in equity prices. Much of this wealth is held in retirement accounts, but with the conversion to defined-contribution accounts whose value goes up and down with the market, more Americans are aware of the short-term changes in their retirement situation, and a large proportion borrow against those retirement accounts to finance more immediate expenditures. In addition, the proportion of American households with equity market investments had increased to about 50 percent by the end of the 1990s. Business investment has had a long and remarkable expansion during the 1990s, admittedly from very depressed levels at the beginning of the decade. Again, as shown in Fig. 2, investments in information processing capital completely dominated that growth. High-technology capital is conventionally defined to include computers, computer software, and communications capital. While these components are an increasing share of nominal investments, their spectacular growth is the result of large reductions in quality-adjusted prices. It is important to note that part of the differences in the reported rates of growth and investment between the United States and Europe can be traced to differences in how we measure the real value of such investments; but in any case the production of high-technology capital is a more important part of the U.S. economy. Over the past decade, the net wealth of the household sector has increased from 5 times disposable income to 6.5 in mid-2000. The increased value of equity holdings, both direct and indirect through pension funds, represented 85 percent of that increase. The increase in equity values, in turn, was dominated by the performance of the technology sector. Even though technology stocks accounted for only 10 percent of the S&P CESifo Forum 16 Focus nated NASDAQ. Much of the rise of the NASDAQ in late 1999 was clearly unsustainable, as price-earnings ratios reached absurd levels; and the U.S. experience with internet startups seems to have been built largely on exaggerated hype. In any case, the resulting wealth losses have had an impact on consumer spending. Figure 3 The abrupt turnaround in capital spending was more surprising. Real expenditures on information capital fell at a 5 percent annual rate in the 4th quarter, in dramatic contrast to the double-digit rates of growth in prior years. More generally, capital good orders also plunged in the final few months. To some extent the NASDAQ collapse may have been an occasion that led firms to reevaluate their budgets for high-technology products. In addition, the lack of new developments in computer hardware and software made it unnecessary to replace computers at the pace of past years. This is reflected in a much slower rate of quality improvement in the government price indexes for computers during 2000. Also, a decade of rapid growth in investment outlays has pushed up corporate indebtedness, and financing restrictions are becoming of increasing importance. On the supply side, the rate of productivity growth has accelerated over the last five years by about 11/2 percentage points, from 1.3 percent in the 1973-95 period (see Fig. 3). We can also factor that improvement among three components. About one-third of the gain can be traced to productivity gains in the production of high-technology products; another one-third is the result of the large rise in the capital-labor ratio (as previously mentioned, largely the result of high-technology investments.); and one-third reflects gains in multifactor productivity outside of the high-technology sector. The source of the last one-third of the gains remains controversial. Some analysts want to attribute it to supra-normal returns to information technology (network and similar effects), while others maintain that much of this improvement will prove to be cyclical or transitory in its effect. Interestingly, the current slowdown will provide a partial test of the importance of the cyclical factor. In either case, high-technology would appear to be the dominant source of the improvement in productivity growth, Just as it was the primary story behind the boom on the demand side of the economy. The Federal Reserve has responded to these developments in a very confusing fashion that may reflect a lack of consensus on future policy. Rates were cut very quickly and by large amounts, and some of Greenspan’s remarks seemed designed to promote recession fears. For a while, it looked like the new Administration and the Fed were trying to generate a recession to strengthen the case for tax reductions. But more recently Greenspan has backed off and argues that there is no immediate need for further actions. Burst of equity price bubble depresses capital spending Monetary policy was eased sharply The Slowdown Outside the government, there are expectations of further interest rate cuts. Primarily, this reflects a view that the economy is fundamentally in very good condition, that there is no economic reason for a recession, and therefore the Fed should do everything it can to be sure that a recession does not occur. Certainly, the Fed has the power to prevent a recession should it desire to do so. Thus, nearly all of So what happened at the end of 2000? First, a restrictive monetary policy cut the growth of residential spending and a reduction in the refinancing of mortgages was a factor behind the growth of consumer demand. But the rise in interest rates also played a role in pricking the bubble of equity prices, particularly in the high-technology domi- 17 CESifo Forum Focus est forecasts of the CBO, the fiscal surplus would reach 5 percent of GDP by 2010 and the government would retire all of the publicly-held debt. Most surprising, this changed budget situation is the product of little or no legislative action. Figure 4 Instead the fiscal turnaround is the result of a higher rate of projected growth, based on a continuation of the pickup in productivity growth, and a sharp rise in the effective rate of personal income taxation. The increase in the effective tax rate, in turn, largely caught the budget forecasters by surprise, with large unanticipated revenue inflows beginning in 1997. It reflects an unusual concentration of the income gains of recent years among the highest income groups who pay the highest marginal rates and very large revenue windfalls from the taxation of capital gains realizations. The income gains of the lowest income groups have been surprisingly modest throughout the expansion. In the short run, the realization of capital gains will continue, even in a declining market, but the sustainability of the high revenue yield rate is a critical area of conflict in the argument over the long-term fiscal outlook. Furthermore, the projections assume continued strong restrictions on spending that reduce the ratio of federal government expenditures to GDP to levels not seen for the past half century. Large and growing budget surpluses to be scaled boule by tax cuts the forecasts show a V-shaped slowdown in which growth is not negative for more than one quarter, and it recovers to a trend growth rate of 3–31/2 percent. This outlook is based on a continuation of modest inflation pressures, and as shown in the attached table, there are still few indications of a significant rise in the inflation indicators. The Changing Fiscal Situation The current argument over fiscal policy is primarily a political dispute with little role for economic factors. Conservatives have learned over the past quarter century that deficits can serve as the most effective restraint on new expenditure proposals, and advocacy of tax reductions is far more popular than opposing new programs as being too costly. Thus, they will seek to eliminate the surpluses as a means of maintaining pressures for scaling back expenditure programs in future years. Similarly, liberals would like to use the funds to finance new programs, particularly expanded health care for the elderly. Advocates of saving the surplus as a means of offsetting a portion of the decline in private sav- Among the most dramatic developments of recent years has been the disappearance of the budget deficit as the dominante issue of political conflict in Washington (see Fig. 4). In just three years, the fiscal outlook went from large and growing deficits as far as the eye could see to large and growing surpluses equally far out into the future. In just the two years from March of 1997 to January of 1999, the projected fiscal balance for the year 2005 shifted from a deficit of $200 billion to a surplus of $300 billion; and this year the projected surplus was increased to over $400 billion. According to the lat- CESifo Forum 18 Focus Much of the external discussion has centered around the sustainability of the foreign capital inflows; but the issue generates surprisingly little concern within the United States. Because of the improvement in public sector saving, most of the growth of the current account deficit has been a reflection of very positive investment opportunities in the United States, and the fact that a booming U.S. economy has been the engine of growth in an otherwise weak and fragmented world economy. While Europe has been doing fairly well with a focus on its own internal economic concerns, the countries of Asia and Latin America have become increasingly dependent on exports to the United States to sustain their economies. That situation is unlikely to change in the near future, given the continued deterioration of the Japanese economy, financial sector weaknesses in the rest of Asia, and a decidedly mixed situation in Latin America. ing or to improve the financing of the old-age retirement programs are in a distinct minority. The most reasonable projection is that President Bush will achieve most of his tax reduction program, and that his own proposals for defense expenditures and a compromise with the Democrats on nondefense spending will eliminate the projected surpluses on the budget exclusive of the public Social Security programs. I would expect projections for the non-Social Security budget to return to rough balance within the next two budget cycles. The Current Account The economic concern with these budgetary outcomes lies with their implications for rates of national saving in future years and the pressures that will be placed on the current account. Over the past decade, improvements in public sector saving have fully offset the decline in private saving. Thus, the rise in the current account deficit to near five percent of GDP can be traced to increases in domestic investment (see Table 2 and Fig. 5). With the scaling back of public sector surpluses, there would seem to be a potential future problem of inadequate national saving. Barring a stock market collapse that would reverse the wealth gains of the past decade, there is little basis for projecting improvements in private saving rates. That implies, in turn, a continued large reliance on capital inflows from the rest of the world; or a substantial decline in the rate of domestic investment. In an increasingly global capital market, national balances seem less relevant as long as countries, like the United States, are unconcerned about foreign ownership of their production facilities. At present, we can see no evidence of a rising risk premium for investments in the United States, and U.S. governments and corporations still find it advantageous to borrow in their own currency. Inadequate national saving offset by foreign capital inflows Even if foreign investment capital should find alternative outlets, the implication for the United States would seem to be a declining real exchange rate and improved export opportunities. Only if the capital outflow should generate a Table 2 Net Saving and Investment by Sector, 1960–2000 Percent of net national product Sector 1970–79 1980–89 1998 1999 2000 Saving Private Household Government 1960–69 12.0 10.9 6.4 1.1 9.6 10.9 7.6 – 1.3 6.7 10.2 7.6 – 3.5 1990–95 4.7 8.6 6.1 – 3.9 1996 5.7 7.4 4.0 – 1.7 1997 6.7 7.0 3.5 – 0.3 7.5 6.3 3.4 1.2 6.9 4.7 1.8 2.1 6.7 3.2 0.1 3.5 Investment Private Government Net foreign 12.5 9.4 2.6 0.4 10.7 9.0 1.4 0.2 7.3 7.5 1.5 – 1.7 5.4 5.1 1.3 – 1.0 6.2 6.7 1.1 – 1.6 7.1 7.6 1.1 – 1.7 7.2 8.6 1.2 – 2.6 6.0 8.5 1.3 – 3.8 5.7 9.2 1.4 – 4.8 Statistical discrepancy 0.6 1.0 0.5 0.7 0.5 0.4 – 0.3 – 0.9 – 1.0 Capital consumption 10.9 12.3 14.2 14.1 13.9 13.9 14.0 14.3 14.4 2000 is average of three quarters. – Net saving excludes capital consumption allowances. Source: Bureau of Economic Analysis, Department of Commerce, National Income and Product Accounts. 19 CESifo Forum Focus Figure 5 The current economic expansion will contiune precipitous decline in the dollar, with resulting inflation pressures, would the implications be particularly negative for growth. While a current account adjustment may be an important issue in the long-term outlook for the U.S. economy, it does not seem to be determining the near-term outlook. I would conclude that the United States still has room to continue the current economic expansion; and, while there are some signs of increasing strains, they do not signal a recession in the near term. CESifo Forum 20 Focus is still an open economy, more open than the US or the Japanese economies. Last year the share of exports of goods and services of the Euro area (excluding intra-area trade) was around 19% of GDP compared to export shares of around 12% in the United States and in Japan. FORECAST FOR THE EUROPEAN ECONOMY WILLI LEIBFRITZ* Another important driving force of the cyclical development in Europe is the economic policy stance with respect to both, fiscal policy and monetary conditions. At an economic growth rate of around 31/2%, the Euro area and Western Europe as a whole achieved the best growth performance since 1990. But the year 2000 was exceptional. Most forecasters agree that growth will be lower this year, but views differ on how pronounced the slowdown will be and also on the medium-term growth path of Europe. With these three factors, i.e. world trade growth, fiscal policy and monetary conditions (the latter comprise interest rates and the exchange rate) one can fairly well explain the business cycle in the Euro area in past years, reflected in changes in the output gap, i.e. the difference between actual GDP and trend-GDP (Figure 3). Current situation The Euro area passed the cyclical peak at the middle of last year. Since then the business climate indicator collected by the ifo institute from experts in these countries (Economic Survey International) has declined (as has the Ifo business climate indicator for Germany) and economic growth in the Euro area decelerated (Figures 1 and 2). There is, first, the growth of the global economy. It is true that foreign trade is less important for the Euro area as a whole than it is for its individual member countries as a good part of their trade is intra-Euro area trade. Nevertheless, the Euro area • The boom in the early 1990s, which was greatly affected by German unification and expansionary fiscal policy, was followed by the recession of 1993 which was caused by a combination of slowing world trade growth and restrictive macro policies in Europe. Fiscal policy became restrictive when countries started to cut back their structural deficits which had gone out of control. Monetary policy was tight until the recession began because the inflation rate exceeded the inflation target.1 • In the period between 1994 and 1999 cyclical recoveries remained moderate and short-lived. During the entire period governments were cutting budget deficits to meet the Maastricht criteria and abide by the Stability and Growth Pact. Monetary conditions tightened in 1995 when the deutschmark (and the currencies which were linked to it) appreciated sharply against the dollar. World trade growth was also unstable during this period: strong growth in 1994/95 helped Europe to recover from the recession. The temporary slowdowns in the * Willi Leibfritz is Head of the Department of Economic Forecasting and Financial Markets at the Ifo Institute. 1 But during the recession in 1993 the Bundesbank reduced the discount rate in five steps from 8% in February to 53/4% in October. Main driving forces of the European business cycle There are many supply side and demand side factors which affect economic developments. In analysing the cyclical fluctuations of the European economy one can, however, identify a few factors which in the past played an important role and which will also be of key importance this year and next. 21 The Euro area business cycle is well explained by world trade growth, fiscal policy and monetary conditions CESifo Forum Focus the deficit (if tolerated by the policymakers) would then provide an automatic stabiliser effect. By contrast, during past slowdowns (like that of 1993) European fiscal policy often restrained aggregate demand. • With the increases in interest rates last year the European Central Bank tightened monetary conditions in the Euro area. The level of the monetary conditions index constructed by Ifo for the Euro area by weighting together the real shortterm interest rate and the real effective exchange rate of the euro is, however, still above its medium-term average. This implies that monetary conditions are currently not restraining aggregate demand. But a further appreciation of the euro would continue to depress the monetary conditions index unless the ECB cuts interest rates (Figure 7). The growth of the money stock M3 has decelerated from a high rate and is now close to the reference value (4 1/ 2%) which reflects a neutral policy stance. By contrast, the monetary policy stance (excluding the exchange rate) is found to be restrictive if instead it is assessed by the Taylor rate and assuming that the ECB is currently aiming to keep the core inflation rate below 2% rather than to push the actual inflation rate below 2% which is currently above this target because of the oil price effect (Figure 8). The yield gap, i.e. the difference between long and short-term interest rates, also indicates a tight monetary policy stance. In our forecast we have assumed that the ECB will cut interest rates by 50 basis points this year and that the euro will strengthen from currently 0.91 to around 0.97 dollars towards the end of the year. • The actual inflation rate is still above the ECB target but this is due to the oil price increase which we assume to have been temporary. Headline inflation has come down somewhat but core inflation has picked up. One reason is the effect of higher oil prices on the cost of domestic production. As we assume no further rise in oil prices, this second round effect should also be temporary. Most recently European food prices have increased in the wake of the spreading mad-cow disease, but this should also be temporary. The big question, however, is if and how wages in the Euro area will respond to higher headline inflation. So far wage increases have been moderate and in many cases they have a term of two years. Hence next year’s wage round will be of key importance for the sustainability of price stability. The greater (the smaller) the expansion of world trade in 1996 and in 1999 dampened growth in Europe. • In the year 2000 there was a combination of booming world trade and very favourable monetary conditions which were also a result of the weak euro. These two positive factors outweighed the higher oil prices so that economic growth could reach a new peak. Forecast for 2001 and 2002 The Ifo indicators (as well as other indicators) for the global economy show a significant slowdown in economic activity in all major regions of the world with the biggest decline in the United States (Figure 4). Obviously Europe cannot be insulated from the slowdown in the United States and in the world economy. Given the sharp decline of some of the indicators one cannot preclude a hard landing scenario for both the United States and Europe, although this is not our most likely forecast. A hard landing scenario for Europe would require: Hard landing of European economy unlikely • that the United States enter a recession and that this will be accompanied by • significant losses in confidence all over the world including Europe, and • a fall in the exchange rate of the dollar and a sharp appreciation of the euro. In such a pessimistic scenario, growth in Western Europe would decline from 3.4% last year to around 11/2% this year. In the United States, growth would decline from 5% last year to around 1% or lower this year. There are various reasons why this is not our most likely forecast. First, there are good chances that the slowdown of the US economy will remain moderate, in particular as monetary policy was eased quickly and may be eased further. In addition, in Europe macroeconomic policies are currently better suited to prevent a severe downturn than in past recessions. • Fiscal policy will stimulate demand in 2001 because of tax-cutting programmes in some countries like Germany, France, and the Netherlands (Figure 5). Furthermore, as the average budget deficit in the Euro area is now relatively small (Figure 6), there is room for an increase in the cyclical component of the deficit in case of a more severe downturn without violating the 3% deficit ceiling. Such an increase in CESifo Forum 22 Focus mainly driven by consumption. At average rates of around 21/2% this year and next, growth will be lower than last year and similar to that achieved in 1999 and also similar to the rate of potential (or trend) output. • As the slowdown will be more pronounced in the United States (13/4%), economic growth in the Euro area (and also in Western Europe as a whole) will be higher than in the U.S. The United States is, however, assumed to recover in 2002 when it may again achieve slightly higher growth than Europe. In the forecasting period there will be no growth differential in favour of the United States which is an important difference to the second half of the last decade (Figure 9). • Employment in the Euro area will continue to rise and unemployment will fall to under 8% next year. Compared to a peak unemployment rate of almost 12% this may be considered an achievement. However, while it takes only a short time in Europe to increase unemployment during a recession it takes a very long time to reduce it to its pre-recession level (Figure 10). This points to major structural rigidities in European labour markets which differ, however, among the various countries. Furthermore, some European countries have made more progress to reduce structural unemployment than others. Table 1 Euro Area Key Forecast Figures 1999 (*) 2000 (*) 2001 (s) 2002 (s) Percentage change over previous yeara) Private consumption Government consumption Gross fixed capital formation Domestic expenditure Exports Imports Gross domestic product (GDP) Employmentb) (% change over previous year) 2.8 1.6 5.3 3.1 4.7 6.7 2.5 2.6 1.6 4.6 2.8 11.7 10.4 3.4 21/4 11/2 31/2 21/4 71/2 7 21/2 21/4 11/4 4 21/2 71/2 71/2 21/2 1.8 2.0 11/4 11/4 10.0 9.1 81/2 73/4 Consumer pricesd) (% change over previous year) 1.1 2.3 31/4 13/4 Public sector financial deficite) – in % of GDP – 1.3 0.3 – 3/4 – 1/2 memo item: Real GDP in USA (% change over previous year) 4.2 5.0 13/4 23/4 Real GDP in Japan (% change over previous year) 0.8 1.7 1 11/2 Unemployment ratec) (in %) a) * Preliminary. – (s) Forecast by the Ifo Institute. – At 1995 prices. – b) Domestic employment. – c) Unemployment as a percentage of civilian labour force (employed and unemployed). – d) Harmonised index of consumer prices (HICP). – e) On national accounts definition (ESA 1995), in 2000 including revenue from the auction of UMTS licenses. Source: Bureau of Economic Analysis, Economic and Social Research Institute, European Central Bank, Eurostat, calculations by the Ifo Institute. risk of higher wages and increased inflation expectations perceived by the ECB, the more (the less) it will hesitate to cut interest rates. Based on these assumptions on the global economy and on macro policies we expect (see Table 1) that in the Euro area Growth of Euro area GDP projected to accelerate in the first half of 2001, but to be lower than in 2000 Medium-term outlook • exports will increase by 71/2% this year and next year (the major slowdown in export growth occurring in the first half of the year) (broadly in line with the growth of world trade), following a 11.7% expansion last year; • growth of fixed investment (equipment and construction) will decelerate from 43/4% last year to 33/4% this year and 4% next year; • private consumption will increase by around 21/2% this year and next. In view of the fact that taxes are being cut in major countries, this rather conservative outlook may be surprising. It follows from a low starting base due to the negative oil price effect and the assumption of a recovery of consumer spending during the course of this year. • GDP growth in the Euro area will – after a deceleration in the second half of last year – accelerate during the first half of this year, There is a good chance that the growth path in Europe will be higher than it has been in the past. Several reasons may be put forward: • Given fewer fiscal problems and lower inflation, both fiscal policy and monetary policy could be less restrictive than they have been in the second half of the 1990s. • Structural reforms in product and labour markets could make the European economy more dynamic. There are clear signs for such effects already. But structural reforms in labour markets are still lagging in particular in the large continental European countries. • The spread of new economy effects could also help Europe achieve a higher medium-term growth path. But some caution is in order here. First, measuring any new economy effects is not an easy task as it is difficult to separate the tem- 23 CESifo Forum Focus Table 2 Determinants of Growth 1990–1999 Comparison between the United States and Europea) Change in productivity caused by: GDP Labour Capital Labour Capital input stock productivity deepening TFP United States 1990–1995 1996–1999 1990–1999 2.4 4.4 3.4 1.4 2.1 1.8 1.9 3.7 2.8 1.0 2.3 1.7 0.2 0.5 0.4 0.9 1.8 1.4 Western Europeb) 1990–1995 1996–1999 1990–1999 1.4 2.2 1.8 – 0.4 0.9 0.3 2.3 2.2 2.3 1.9 1.3 1.6 1.0 0.5 0.8 0.9 0.8 0.9 Finland 1996–1999 5.5 2.3 0.9 3.1 – 0.5 3.7 Ireland 1996–1999 9.9 5.8 4.7 4.0 – 0.4 4.5 of which: high growth countries: a) b) Average annual percentage change, in constant prices. – Weighted average of following countries: Germany (1992–95, 1996–99), Finland, France, Ireland, Italy, Netherlands, Norway, Sweden, Spain, United Kingdom. Source: C. Gust and J. Marquez, Productivity Developments Abroad (http.//www.federalreserve.gov) and own calculations. Europe to achieve a higher medium-term growth path porary cyclical effects from overall productivity growth to find the rate of growth which is sustainable over the medium and longer term. So far no significant new economy effects can be detected in overall growth and in productivity growth in Western Europe (as officially measured). But in a few European countries like Finland and Ireland such effects are noticeable (Table 2). • Further integration of Europe could also provide positive effects on medium-term European growth. Here much will again depend on how structural policies in Europe will be adjusted to these new challenges. Figure 1 CESifo Forum 24 Focus Figure 2 Figure 3 Figure 4 25 CESifo Forum Focus Figure 5 Figure 6 Figure 7 CESifo Forum 26 Focus Figure 8 Figure 9 Figure 10 27 CESifo Forum Pro and Contra THE U.S. ECONOMY: RECESSION AHEAD? Moreover, this is all happening at a time that consumers are stretched. The household saving rate is currently in negative territory, the lowest rate since the Great Depression. In contrast, in 1987, the household saving rate was around 7% of disposable income. PRO: WEAKNESS WILL PERSIST WILLIAM C. DUDLEY* This suggests that the economy will remain weak for some time to come. As households try to save more, consumption will have to grow more slowly than income. This, in turn, will erode income gains, reinforcing the softness in consumer spending. It will take time for consumers to retrench, especially when there is no other global economic locomotive. I s this the beginning of the end or the end of the beginning of this bout of economic weakness in the United States? There are some signs that the worst of the slump is over. The factory sector appears to be contracting more slowly; factory inventories are being brought under control. Moreover, consumer confidence, after falling sharply, may be stabilizing. This has caused some observers to argue that we are at the beginning of the end. The economy will rebound sharply in the second half of the year. But what about monetary policy? Won't that turn the economy around? After all, the Fed has aggressively been cutting interest rates. I, however, am much more pessimistic. That is because, from my vantage point, all that we are close to is the end of the beginning, the first stage of what will be a continuing slump in U.S. economic performance. It is the end of the beginning because it is now widely recognized that an investment bust is fully underway. The factory sector is contracting sharply. But we are nowhere near the end because we have just begun to see the impact of the investment bust on the consumer sector. The answer is no. The problem is that the Fed has not accomplished much yet. Financial conditions have not eased. The decline in interest rates has been fully offset by a weaker stock market and a strengthening dollar. Our Goldman Sachs Financial Conditions index is tighter now than it was at the beginning of the year before the Fed starting cutting its federal funds rate target. This does not mean that monetary policy does not work, just that the easing lever will have to be pushed much more aggressively to have the desired effect. The Fed needs to get the dollar down and the stock market back up. To do this, they are going to have to ease monetary policy much more aggressively over the next six months. Put simply, the virtuous circle has turned vicious. It is going to take time and monetary and fiscal accommodation to engineer a reversal of the current trend. Although consumer spending has held up reasonably well to date, there is little reason to expect that this is sustainable. First, layoff announcements will soon translate into job losses that will push the unemployment rate higher and create more anxieties about job insecurity. Second, the wealth effect is now powerfully negative. More than $5 trillion of stock market wealth has been destroyed in about one year's time. This is far larger than at any other time in U.S. history. Scaled by the size of the economy, the wealth destruction is about 21/2 times as big as in the 1987 stock market crash. * Chief U.S. Economist, Goldman Sachs, New York. CESifo Forum 28 Pro and Contra that are, at best, rare. A cyclical recovery in 1996 was prolonged by the effects of the Asian crisis on U.S. inflation and interest rates, and strong productivity provided a degree of inflation control in near boom conditions. Now, and looking ahead, many of these forces are unwinding, placing stress on prices, profits, and U.S. financial markets not seen since the early 1990s. As was the case in 1987 – the last time the Fed moved from an inflation bias to an outright rate cut in an effort to restore confidence – the Fed will find itself again reversing course, as the dominant economic concern returns to inflation. CONTRA: ECONOMY REBOUNDING GAIL D. FOSLER* D espite the recent spate of negative economic reports, the bulk of the economic and financial data suggests that the U.S. economy is not in, nor is it about to enter, a recession. Rather, the U.S. economy is in the weak phase of a growth cycle marked by economic growth rates that are below recent rate trends. While the economy can exhibit recession-like characteristics during this phase – excess capacity, declining investment, layoffs, and weak profits, for example – the slowdown lacks the dynamics, severity, and duration of a recession, and is largely self-correcting. The U.S. economy continues to improve from month to month. Retail activity in January and February turned in good showings. Led by auto sales that rose from December lows in each successive month, this improvement in consumer spending is fed by the surge in mortgage refinancings that is adding significant liquidity to the consumer sector. Based on January and February performance, consumer spending could advance 4 to 5 percent this quarter. In terms of historical analogies, the industrial sector is immersed in a deep, though brief, adjustment process very much like 1998, while events in the financial sector this year will harken back to 1987. This adjustment process, which began in July 2000, is motivated by a desire to realign demand and supply to restore margins after a period of unsustainable growth. While the swiftness and intensity of the adjustment is instructive as to what might happen in a genuine recession, rising backlogs over the past six months suggest that production is being cut faster than orders, and will soon recover. The Conference Board’s Index of Leading Economic Indicators also rebounded in January – although in no way erasing all of the weakness of recent months. While a rebound of this magnitude is not likely to be repeated in February, the trend does suggest that December was the low point for industrial activity, and that a steady improvement can be expected as the spring unfolds. U.S. data for January and February appear consistent with The Conference Board’s forecast of about 3.4 percent growth for this year. However, the business cycle is well advanced, and the favorable inflationary conditions that have permitted the Fed to cut interest rates are not likely to prevail in the future. The U.S. economy strengthened on other fronts as well. Construction spending rose sharply in January, and, given housing and commercial activity, this strength should continue in February. The January durable orders numbers offered hints of a pickup in computer and electronics orders, and the February National Association of Purchasing Managers (NAPM) report posted small improvements across the full spectrum of activity measures. Indeed, vendor performance (the percentage of firms experiencing slower deliveries) and the price index (share of firms paying higher prices) contin- Until very recently, the United States has enjoyed a near perfect set of macroeconomic conditions * Vice President and Chief Economist, The Conference Board, New York. 29 CESifo Forum Pro and Contra ue the strong pattern of recent months and are very much at odds with the weakness in the rest of the NAPM survey. Overall, the current picture is one of relatively robust demand that is drawing down inventories at significant rates. Given the magnitude of the drop in orders and production in the auto sector alone (e.g. over 25 percent), total production – led by autos – should begin to pick up sharply in March and April. Thus the combination of both demand and production moving in the same direction in the second quarter will, in the second half of the year, add income stimulus to the Fed’s interest rate stimulus. CESifo Forum 30 Special ECONOMICS IN in many European university systems. Professors still favor their own students rather than allowing open competition among students regardless of country of origin and country of training. Newly graduated Ph.D.s from other countries, such as the United States, are often not welcome to take up academic positions, even in their country of origin. It is clear that academic training and research in Europe has much to gain from tearing down this archaic, hierarchical and protectionist organization. EUROPE ASSAR LINDBECK* As the result of evil political forces in the 1930s and 1940s, research and qualified academic education in economics nearly disappeared from the European continent. To a considerable extent, this loss of competence took the form of a brain drain to the United States. The damage to academic research and teaching was particularly pronounced in the field of “technical economics”, i.e., formalized economic theory and econometrics, since the role of teachers and course programs is particularly important in these fields. Nevertheless, considerable progress has been made in academic training and research in Europe during recent decades, as witnessed by the emergence of new generations of technically well-trained economists. But as often happens when one problem is solved, others rise to the surface. In particular, there is the delicate issue of balance between technical-analytical skills and basic (“intuitive”) understanding of economic problems. There are at least two serious enigmas in this context. First, the increased emphasis in graduate programs on mathematical methods and abstract theoretical analysis influences the recruitment of students to economics. It is valuable that a number of students from mathematics, natural sciences and technology enter Ph.D. programs in economics. But it is also important that less technically trained students with a genuine interest in social, economic and political issues join these programs and that they find the dicipline interesting enough to continue their studies. Second, many graduate students today have to devote so much effort to acquiring technical-analytical skills that they do not have time to develop a good and intuitive understanding of important economic, social and political problems. Many do not follow the general discussion about economic, social and political issues in the media. In some cases, they hardly know whether there is a boom or recession in their country of residence or for that matter in the world. I saw the mirror image of this development quite clearly while studying in the United States in the late 1950s. At Yale University I could not avoid noticing the unmistakably European accents in the lectures of Gerard Debreau, William Fellner, Tjalling Koopmans and Robert Triffin. I had a similar experience during a subsequent stay at University of Michigan, where I listened to and learned from George Katona, Richard Musgrave and Wolfgang Stolper. It took a long time for academic research and graduate training on the European continent to recover from the collapse. One reason, of course, is the roundaboutness of production in academia: while students need good teachers, the latter have to be recruited from well-trained students, as in a Leontieff input-output model – constructed by another escaped European economist. A further reason for the slowness of the recovery has been the archaic and hierarchical organization of universities in most continental European countries. Only a very few universities in Europe today have first-class graduate programs in economics. Moreover, intellectual protectionism still abounds One risk with this situation is that young economists learn their field rather mechanically. The responsibility for this, of course, lies with academic * Professor at Institute for International Economic Studies, Stockholm University. Improvised dinner speech in connection with the celebration of Richard Musgrave’s 90th birthday at Munich University. 31 CESifo Forum Special technical economics has improved in recent decades. Perhaps the increased interest in empirical research in recent years, including experimental economics, will contribute to improve the situation in the future. Indeed, these new tendencies may be seen as a reaction to the problems that I have just described. teachers, many of whom squeeze innumerable formal models into their lectures and reading lists. They often do not have time (or the ability) to demonstrate the intuitive content and the relevance, or irrelevance, of the models they survey. One unfortunate side effect of all this is that we do not educate enough “two-legged economists”, who both master analytical techniques and have a feeling for real-world problems. This may be a reason for the receding role of academic economists in the general discussion of economic and social problems in several European countries. The role abandoned by economists tends instead to be taken up by others. For instance, other social scientists, including sociologists, political scientists and economic historians, increasingly take part in the general economic and economic policy discussion. It is fine, of course, that researchers with training in these fields participate in the public debate about important problems in society. But they can never replace competent broadly trained economists. The void created by “retreating” economists, in particular in the mass media, is also filled by spokespersons for various organizations – for instance, banks and interest groups. Again, they simply cannot fully fill the role of academic economists. What can be done about this? Basically, university teachers and researchers have to assume a greater responsibility for transmitting knowledge and understanding of real-world problems, including common sense, to their students. By this I mean a feeling for proportions and, and hence a realistic view of what is worth modeling. It is my experience that this is indeed possible – if we try hard enough. Do these views simply reflect an aging economist’s inability to catch up with contemporary research? I would, of course, resist this interpretation. I believe that there is a genuine risk that simple classroom exercises, with oversimplified and often unrealistic assumptions, become the end product rather than just an introductory step in the transmission of competence in economic analysis to new generations. This risk was pointed out a long time ago by the most influential economic theorist in the 20th century, Paul Samuelson, in his Foundations of Economic Analysis (1947, p. 4): Economists “are like highly trained athletes who never run a race”. There are many more such economists around today than in 1947 – both in Europe and in other parts of the world, where training in CESifo Forum 32 Spotlights THE EAST GERMAN ECONOMY STOPPED CATCHING UP The standard of living of east Germany is approaching that of the west. The average net income of an east German household already equals 80% of the west German level in nominal terms. This net income includes welfare payments, transfers to the unemployed and old age pensions. Because of lower goods prices and rents, in real terms this household has at least 90% of the west German net income at its disposal. The east German economy was modernised at a rapid pace; investment boomed during the 1990s. Whereas the share of investment in GDP amounted to 20% in west Germany, it was at least 40% in the east, peaking at 50% in 1994. This hides the fact, however, that the financial means available in east Germany by far exceed the output produced. Every third deutschmark which is spent in the east comes from the west. Public transfers amount to about 4.5% of west German GDP. And there is no end in sight. process. Economic growth depends on capital accumulation. Capital is not only a factor of production as such, it also embodies technical knowledge. That is why in east Germany investment per capita should be higher than in the west over a considerable period of time. Although this has been the case during most of the 1990s – albeit with a declining trend in recent years – net investment has primarily gone into construction and not into machinery and equipment. Thus building investment per employable person at times exceeded the west German level by up to 80%, while equipment investment (per employable person) was higher than in west Germany only in 1995 and 1996 and has declined since to 88% in 1999. No wonder then that convergence is not proceeding at the aggregate level. Since 1997 the economies of eastern and western Germany have drifted apart as east German growth has fallen below that of the west. A comparison of east and west German states (excluding city states) shows that even in the boom year 2000 the eastern states grew by a meagre 1.1% whereas the western states achieved growth of 3.2%. As a result, relative output per employable person in the former GDR which in 1996 – according to a recent revision of the national accounts data of the federal states – had amounted to 60.4% of the west German level, declined further, to 57.6% in 2000 (see Figure). The latest unemployment figures also confirm that east German states do much worse than those in the west. Whereas unemployment in west Germany declined to 7.7%, it remained at 18.6% in the east. To be sure, economic catching-up is occurring in individual sectors. Thus, real gross value added in the manufacturing industry has increased by an average 6.6% p.a. since 1996 – and thus faster than in western Germany (including Berlin; 2.4% p.a.). The construction industry, however, is mired in deep crisis; its output shrank by an average 7.1% p.a. during the past four years (west Germany: – 0.7% p.a.). Even the tertiary sector grew more slowly in east Germany: an average increase of 2.6% p.a. since 1996 compares to growth of 3% in the west. H.W.S. It is the output side of the east German economy with its poor supply conditions which remains the main problem. The level of investment spending points to a major reason for lower productivity growth and the stoppage of the convergence 33 CESifo Forum Spotlights HOW INFLATION IS MEASURED In the past year, German consumer prices increased noticeably, mainly due to the cumulative effects of a weak euro and the oil price explosion. Measured in terms of the price index for the cost of living of all private households, prices rose by 1.9% in 2000; in terms of the harmonised consumer price index (HCPI) by about 2%; but measured by the deflator for private consumer spending by only 1.4%. How do these three carefully watched indices differ? other private households (e.g. used cars) are not taken into account. To monitor price stability in the euro area, Eurostat, the EU statistical office, has published – since May 1998 – a harmonised consumer price index for members of the Monetary Union (HCPIEMU) based on individual country results. The Federal Statistical Office determines the German HCPI for Eurostat every month. Harmonised consumer price indices were developed in order to determine, on the basis of uniform standards, whether the price stability criteria were met for EMU membership. In the meantime, HCPI-EMU has become one of the most important economic indicators for the euro area. Differences in the national consumer price indices have historical reasons but they also reflect the differing social conditions in the member countries or different structures in the statistical systems. Because of the differences in the consumer price indices of the member states (as a result of diverging commodity baskets or weighting schemes), a complete harmonisation has not yet been achieved. W.N. Since June 1948 changes in the prices of goods and services at the consumer level have been measured by the price index for the cost of living of all private households. This index registers the monthly price changes of a representative sample of domestic consumer goods (commodity basket) on the basis of the average consumption behaviour of private households in 1995 (constant weighting scheme). Currently, the Länder statistical offices decentrally collect data in 118 west German and 72 east German municipalities on about 350,000 individual prices for ca. 750 goods. The overall results are calculated by the Federal Statistical Office. This Laspeyres type index leaves out interim changes in consumer behaviour as the result of changed prices or preferences as well as the money spent by German tourists outside the country. The money spent by foreign tourists in Germany, however, is taken into account (domestic concept). In the context of the national accounts, the Federal Statistical Office also calculates a quarterly price index for private consumer spending. This index differs from the price index for the cost of living in that it refers to total consumption of private households (i.e. including non-profit organisations) and in that current changes in the composition of consumption are taken into account (Paasche price index). In addition, the consumption deflator includes the tourist expenses abroad of domestic households (domestic citizen concept). However, domestic purchases by foreign tourists as well as domestic purchases by private households from CESifo Forum 34 DICE Reports DICE REPORTS1 sources of energy (Fig. 1). Demands for identical taxation of the pollutants from each energy source are based on the desire to have the substitution processes and savings efforts carried out in an economically and ecologically meaningful way. Even taxation of pollutants is of practical relevance only if energy savings and substitutions actually do or at least could occur. This is indeed the case within types of energy use (road traffic, heating, industry, electricity generation) but rarely between these sectors. This implies that demands for an even CO2 taxation is of practical economic and ecological relevance only within sectors of energy use but of less relevance between the sectors. Even great differences in taxation between the sectors would have few harmful effects as hardly any tax-induced substitution is possible. TAXING CO2 IN EUROPE The importance of greenhouse gases, especially carbon dioxide (CO2) for the world climate was again highlighted at last year’s World Climate Conference in the Hague. Whether nations will achieve the targeted reduction of the emission of theses gases depends on how these pollutants are taxed. Many countries in Europe tax the emission of CO2. All countries have a general consumption tax on energy. In addition, several countries have supplemental taxes explicitly labelled “environmental”, “energy” or “eco” taxes and in some cases a tax earmarked for financing reserves of certain energy sources. All of these taxes on the consumption of energy are also indirect taxes on the substances that burning releases, including CO2. A few European countries have, in addition, introduced specific taxes on certain pollutants. Thus Denmark, the Netherlands, Norway and Sweden place a direct tax on the CO2 content of energy sources. A comparison of the tax burden on CO2 discharge within each of the four sectors of energy use (Fig. 2) shows that especially in road traffic the unevenness of CO2 taxation is much less than in the other observed sectors. Thus, at 27%, Germany has the lowest coefficient of variation, whereas Norway has the highest, at 93%. In heating/households and industrial use, the size of the variation of CO2 taxation is very different. Some countries like Sweden, Denmark, Belgium and the Netherlands have relatively low figures, whereas in Germany From an economic and ecological perspective, the tax burden on pollutants should not only be noticeable but should also be even. In other words, the tax on a tonne of CO2 should be independent of the energy source that releases it. Only in this case do the substiFigure 1 tution effects and savings efforts go in the right economic and ecological direction. The reasoning is that a tax on pollutants is not primarily aimed at raising revenue, but is to force companies to include the social cost of a by-product in the production process in their cost accounting. CO2 emissions differ greatly between countries and between 1 DICE = Database of Institutional Comparison in Europe (www.cesifo.de). 35 CESifo Forum DICE Reports Figure 2 for industrial use and in the United Kingdom for heating the differences in CO2 taxation are large. In no European country and in no sector does an even taxation of CO2 emissions exist, although within end-use sectors even taxation would make sense because of the possible substitutability. A reasonable evenness of European CO2 taxation may be found in the road traffic sector, with Germany displaying the greatest evenness and Norway and Switzerland the greatest unevenness. Finally, taxation of a tonne of CO2 is higher in those countries which have a specific CO2 tax than in the others. Whereas the differences are small in road traffic and electricity generation, they are considerable in heating and industrial use. The variation in the taxation of the individual energy sources within sectors is lower in countries with specific CO2 taxes overall and in the individual sectors than in the other countries. In the long run, a rational and more effective economic/ecological policy will not get around a convergence of the marginal (not overall average) taxation of pollutants among the various sources of energy. Toward this end, taxes on specific pollutants are needed like those already applied by some European countries. The importance of such instruments which are able to achieve the targeted CO2 reduction at the lowest possible cost will increase all over Europe and especially in those countries which plan to get out of nuclear energy and increase the number of conventional CO2intensive power plants. Rigmar Osterkamp CESifo Forum 36 Trends ECONOMIC SURVEY INTERNATIONAL In its latest, the 71st Economic Survey International (ESI), the ifo Institute polled 717 economic experts in 78 countries in January 2001. income taxes. This may be offset, however, by weaker consumption growth in Portugal, Spain, Switzerland and Sweden. In Asia, assessments of the current situation slipped further below the “satisfactory” level. This negative trend is expected to continue during the coming six months. The economic climate was relatively positive in Singapore, Hong Kong and China and most negative in the Philippines. In Latin America the current economic situation was assessed as slightly better than in the previous survey when this indicator hit the “satisfactory” level for the first time in more than two years. Expectations for the next half year, though lower, are still slightly positive. The world economic climate continued to cool off (from 107.4 in October 2000 to 94.0 in January 2001. It had peaked in April 2000, at 117.2 (1995=100). The fact that assessments of the current situation were more pessimistic than the business outlook for the next six months indicates that the slowdown of the world economy may be rather temporary. The steepest drop in the current assessment was displayed by North America, where expectations have already been rather poor for some time. In Western Europe the upswing is losing momentum. Both the assessments of the current situation and the business outlook have deteriorated. This despite the fact that in Germany and France, in particular, private consumption is expected to be boosted by cuts in There is a growing belief that short-term interest rates and long-term bond yields will decline during coming months. This trend is most pronounced in the United States where despite several cuts in key Present and Expected Economic Situation Source: ESI 71, 1/2001. 37 CESifo Forum Trends interest rates, the level of rates remains relatively high. A steep downward trend in interest rate expectations is also visible in the United Kingdom. Expectations of rate cuts in the euro area have been disappointed so far. In most of Latin America and in Eastern Europe, short-term interest rates seem to have peaked and are expected to decline in the next six months. Inflation is expected to decline world-wide from the 3.6% average rate in 2000 to 3.3% in 2001. In the euro area, the expected inflation rate is moderately lower than in 2000 (2.4% vs. 2.5%), whereas it is expected to stay at 2.7% in the United States. In Eastern Europe expected inflation is around 8% in 2001 compared with 12% in 2000. In Latin America consumer prices are expected to rise by 7% which compares to 9% in 2000. Despite some correction in foreign exchange markets, the euro is still seen to be undervalued against practically all currencies. Overvalued are the dollar, the pound sterling and the Japanese yen in the view of most experts. A downward correction of the dollar exchange rate is expected during the next six months, especially against the euro and the Canadian, Australian and New Zealand currencies. In Asia the dollar is likely to remain unchanged vis-à-vis most currencies. In Latin America, Eastern Europe and Africa the dollar is expected to appreciate in the course of the next six months. CESifo Forum 38 Trends MONETARY CONDITIONS IN THE EURO-R EGION In its recent meetings, the Governing Council of the ECB decided to leave the key interest rates unchanged, reflecting the Council’s assessment of the risks to price stability in the medium term based on the two pillars of monetary policy. The first pillar, growth of the money supply, showed a continued moderation in the annual growth of M3. Its three-month moving average declined to 5.0% in the period from November 2000 to January 2001, from 5.1% recorded in the period from October to December 2000. Overall, the risks to price stability from the monetary side are viewed to have become more balanced during recent months. As regards the second pillar, euro area real GDP growth appears to have slowed last year, but the ECB’s outlook for this year is positive, as conditions on the domestic side, like long-term financing costs have remained favourable. Nominal long-term government bond yields continued to decline in the first quarter of 2001. The decline has been more pronounced in real terms since the peak in early 2000. 39 CESifo Forum Trends EU SURVEY RESULTS According to the latest revised estimate, quarter-to quarter growth of EU gross domestic product amounted to 0.7% in the fourth quarter of 2000 compared to 0.6% in the third quarter. Year over year, growth in the fourth quarter was 2.9%, following 2.5% in the third quarter. During the full year 2000 EU GDP increased by 3.3%, after 2.5% in 1999. * The indicator of economic sentiment is a weighted average of the industrial confidence indicator, the construction confidence indicator, the consumer confidence indicator and the share-price index. 1995 = 100. The economic sentiment indicator declined by 0.5 points in March, reaching 102.2. The Netherlands with – 0.9, followed by Belgium, France and Finland, with – 0.8 points, displayed the largest decreases. Spain and Austria were the only countries not to show a decrease in March. * The industrial confidence indicator is an average of responses (balances) to the questions on production expectations, order-books and stocks (the latter with inverted sign). ** The consumer confidence indicator is an average of responses to the questions on the financial situation of households and their assessment of the general economic conditions, both in the past and future twelve months, and the question on big-ticket purchases. The industrial confidence indicator declined by 3 points as a consequence of a deterioration in production expectations, higher levels of stocks and a lower level of order books. Increases were displayed by Ireland and Denmark, whereas significant decreases were recorded by Finland, the UK and Italy. Consumer confidence, after decreasing slightly in February, remained steady in March at levels that can be considered historically quite high. Consumer confidence increased in Italy, the UK, Austria and Greece, less so in Germany, Spain and Portugal. CESifo Forum Capacity utilisation in the manufacturing industry of the 15 EU countries has remained stable in March, whereas the decline in order books accelerated from – 1 in January, – 2 in February to – 6 in March. The largest March decreases were recorded by the UK (– 21), Austria (– 12) and Germany (– 9). 40 Trends EURO AREA INDICATORS Estimates (OECD Outlook December 2000) for euro area fiscal balances show a surplus of 0.3% of GDP for the general government financial balance in 2000, but projected deficits of 0.5 and 0.3% in 2001 and 2002 respectively. The more important structural balances are estimated at – 0.6% in 2000 and projected to rise to – 0.8% in 2001 and decline again to – 0.6% in 2002. The seasonally adjusted unempoyment rate of the euro area was unchanged, at 8.7%, in February 2001. A year earlier it had amounted to 9.4%. The EU 15 countries also had an unchanged unemployment rate, at 8%, compared to 8.7% in February 2000. The lowest unemployment rates were registered by Luxembourg (2%), the Netherlands (2.6%), Austria (3.7%), and Ireland (3.8%). At 13.7%, Spain continued to have the highest unemployment rate in the EU. 41 a) BIS calculations; to December 1998, based on weighted averages of the euro area countries’ effective exchange rates; from January 1999, based on weighted averages of bilateral euro exchange rates. Weights are based on 1990 manufactured goods trade with the trading partners United States, Japan, Switzerland, United Kingdom, Sweden, Denmark, Greece, Norway, Canada, Australia, Hong Kong, South Korea and Singapore and capture third market effects. Real rates are calculated using national CPIs. Where CPI data are not yet available, estimates are used. The real effective exchange rate of the euro which, at 90.3, had been approaching its year earlier peak in January 2001, declined again in February to 89.4, a – 1.1 percentage change against the previous month. In February, the bilateral euro exchange rate declined by 6.3% year-on-year against the dollar and by 4.4% against the Swiss franc, but rose by 3.1% against sterling. The harmonised index of consumer prices (all items) rose from a low of 2.4% in January to 2.6% in February 2001. It remained above the EU-15 average of 2.3%. Euro area core inflation continued its rise to 1.6% in January and an estimated 1.7% in February. CESifo Forum 29–30 June 2001 Area Conference on Employment and Social Protection 15–22 July 2001 3. Industrial Organisation CESifo-Delphi Conferences – Managing EU Enlargement Labour Market Institutions and Public Regulation 13–14 December 2001 11–14 September 2002 26–27 October 2001 28–29 May 2002 25–28 Sept. 2001 15–22 July 2001 2. Environmental Economics and the Economics of Congestion Institutional Competition 15–22 July 2001 1. Financial Crises and Recovery CESifo Venice Summer Institute (3 workshops) 15–16 June 2001 Redistribution and Employment – New Social Policies for the New Millennium 19–20 May 2001 18–19 January 2002 11–12 May 2001 Area Conference on Macro, Money and International Finance CESifo Growth and Inequality Conferences 4–5 May 2001 Date Area Conference on Public Sectors Economies Conference Title See below for a list of forthcoming conferences and events. Forthcoming Conferences CESifo Conferences Munich Delphi Munich Caddenabia, Italy Mannheim Venice Venice Venice Munich Munich Munich Munich Munich Place 31/12/00 28/02/01 expired 01/03/01 (extended) 01/03/01 (extended) 01/03/01 (extended) 30/04/01 15/12/00 01/12/00 27/02/01 15/03/01 Submission Deadline Helge Berger (CESifo): [email protected] Thomas Moutos (AUEB): [email protected] Hans-Werner Sinn (CESifo): [email protected] Abstracts sent to CESifo, Poschingerstrasse 5, 81679 Munich, Germany Michael Keen, [email protected] Jonas Agell, [email protected] A. Weichenrieder, [email protected] Prof. Benny Moldovanu, University of Mannheim www.socialpolitik.org Ray Rees (Munich): [email protected] Marcel Thum (Munich): [email protected] David Bradford (Princeton): [email protected] Ronnie Schöb (Western Ontario): [email protected] CESifo, Poschingerstrasse 5, 81679 Munich, Germany Aaron Tornell (UCLA): [email protected] Helge Berger (Munich): [email protected] Jonas Agell Uppsala University, Department of Economics Box 513, 751 20 Uppsala, Sweden E-mail: [email protected] Theo Eicher, University of Washington, [email protected] Stephen Turnovsky, University of Washington, [email protected] Hans-Werner Sinn, CESifo, [email protected] Paul De Grauwe University of Leuven, Economics Department Naamsestraat 69, 3000 Leuven, Belgium E-mail: [email protected] Peter Birch Sørensen, Institute of Economics, University of Copenhagen Studiestraede 6, 1455 Copenhagen K, Denmark E-mail: [email protected] Programme Chairman ORDER FORM If you wish to subscribe to CESifo Forum, please fill in the order form below and mail or fax (xx49 89 985369) to the Press and Publications Department of the Ifo Institute. 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