Institute for International Economics

April 1, 2004

GLOBAL GROWTH STRONG BUT FACES RISKS FROM HIGH OIL PRICES, BUDGET DEFICITS, AND PAYMENTS IMBALANCES

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

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

Mussa's global growth forecast envisions a 4-3/4 percent rise in world real GDP for 2004, followed by a 4 percent rise for 2005. This will be the strongest two-year rise in world output since the recovery from the worldwide recession of the early 1980s. All regions are expected to participate in the global rebound. In particular, over the two years 2004 and 2005, real GDP is projected to rise 8 percent in the United States, 6-1/2 percent in Japan, 14 percent in emerging Asia, and in the range of 8 to 9 percent in Africa, Central and Eastern Europe, the Middle East, and Latin America. Only for Western Europe is projected two-year growth somewhat disappointing, at barely 5 percent.

These projections assume that the surge in world commodity prices, including oil prices, will abate somewhat over the next two years, in line with the backwardation now observed in commodity futures markets. They also assume that industrial-country monetary policies will remain quite accommodative, with the U.S. Federal Reserve raising the federal funds rate (in line with market expectations) to 2-1/2 percent by late 2005, with the European Central Bank forgoing further easing (unless the euro appreciates above $1.35) but also not tightening ahead of the path followed by the Federal Reserve, and with the Bank of Japan keeping short-term rates very low even after it moves above its zero interest rate policy, probably by late this year.

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

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

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

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

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

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

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

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