Prof. Joseph E. StiglitzColumbia University

March 3, 2005

THE GLOBAL ECONOMY: THE PUZZLES OF 2004, THE

PROSPECTS OF 2005

Paris, France

The Two Puzzles

2004 was, on the face of it, one of the most best years for growth in the global economy; yet there was not a feeling of global prosperity (at least comparable to the 1990’s)

In spite of huge US borrowing, and prospects of even increased borrowing in future, long term interest rates remain very low

Why?

The Short Answer Strongest boom in Asia, not in Europe and the U.S.

America’s growth numbers good, but employment numbers disappointing- Huge levels of disguised unemployment and

underemployment- Growth not sustainable:

Some from temporary tax provisions, shifting investment from 2005 to 2004

Huge debt overhang in household sectorHuge fiscal deficit - Cutbacks in long term

investmentsHuge trade deficit

Europe continues to languish

Debates about the root causes– Lack of aggregate demand

Poor institutional framework— Stability Pact and independent central bank focusing only on inflation

– Labor market rigidities– Probably both are relevant, but Europe did not

suddenly become more rigid Without better macro-framework, there can be

little robust growth

The Short Answer

High Level of Global Uncertainty

Volatile Exchange rates:- Not a zero sum game- All lose with uncertainty

Volatile Oil prices:- Worst of possible worlds- High oil prices - but not sure that they will be sustained—so little

investment- U.S. foreign policy may be responsible for spreading instability

Global Growth Outlook for 2005OECD

Economic Outlook1

IMF World Economic Outlook

EIUCountry Reports3

2004 2005 2004 2005 2004 2005

U.S. 4.4 3.3 4.3 3.5 4.4 3.1

Euro Area 4 1.8 1.9 2.2 2.2 2.4 2.1

Japan 4.0 2.1 4.4 2.3 2.8 1.3

China 9.0 7.5 9.0 8.0

OECD 3.6 2.9 3.6 2.9 3.4 2.5

World - - 5.0 4.3 5.0 4.1

1. OECD Economic Outlook 76, http://www.oecd.org/dataoecd/21/13/33975094.pdf2. IMF World Economic Outlook http://www.imf.org/external/pubs/ft/weo/2004/02/pdf/chapter1.pdf3. EIU Country Report: USA http://db.eiu.com/report_dl.asp?mode=pdf&eiu_issue_id=15179517514. The EIU Forecast for Euro Area is actually for EU25

Growth prospects for 2005 is lower than it was in 2004, for all economic groups and regions, including China!

Whither the dollar?

Another Puzzle: Why was the huge U.S. fiscal and trade deficit of the early 80s

accompanied by a strong exchange rate, but today’s fiscal and trade deficit by a weak exchange rate?

- As a percentage of GDP, trade deficit is larger -- increased from -1.46% in 1983 to - 5.39% in 2004 (WDI and EIU)

- As a percentage of GDP, fiscal deficit is lower, from -5.47% in 1983 to -3.7% in 2003 (BEA)

Basic Economics: Trade deficit = capital inflows Capital inflows = domestic investment – domestic

savings

Effects of Fiscal Deficit

Large fiscal deficit contributes to low domestic savings:

Net National savings (as % of GNI) rate has fallen from 5.8% in 2000 to about 1% in 2004 (BEA)

National savings rate today is even lower than it was during the bad years of early 80s – it was 4.7% in 1983

Capital inflows (and therefore trade deficit) would be larger, except that domestic investment is weak– Gross domestic investment fell from 18.5 % of GNI

in 2000 to under 13% in 2004

PrognosisContinuing large fiscal deficits:

If the U.S. economy had a strong recovery, investment would increase and trade deficit would get worse

But prospects for investment in 2005 are weak – end of tax break for investment spending (due to end in 2005), and rising interest rates will reduce capital expenditure

Administration is asking to make tax cuts permanent And partial privatization of social security Both would add trillions to deficit - Making the 2001, 2002, and 2003 tax cuts permanent

will increase fiscal deficits by $2.0 trillion through 2014 ; Social security privatization may add another $1.5 trillion to the deficit in first 10 years, $5 trillion in the next 10 years

Key Question What exchange rate will accommodate these capital

flows/trade imbalances?

Real factors: U.S. imports are likely to remain robust

– Growth somewhat moderated– But little change in import share of GDP– Uncertainty about oil prices

U.S. exports will be limited by slow global economic growth– Growth to be lower in 2005 than in 2004

• European Stability Pact’s focus on inflation and other problems will limit European growth

Financial Factors:

Would revaluation of Yuan matter?

Not much for U.S. trade deficit (for arguments already made)

Trade deficit would appear somewhere else Europe might be helped Low price elasticity of demand for Chinese goods? Some of price adjustment would occur in China and

in margins So, even effect on other countries would be limited

Key Question

Key QuestionFinancial Factors:

Would revaluation of Yuan be in the best interest of China?

Large balance sheet effects– Just as a devaluation is bad for country with large dollar

denominated debts, appreciation is bad for country with large dollar denominated assets

– Magnitude of capital loss is huge Would dampen inflationary pressures

– But how serious a problem is inflation today? Might dampen global political pressures on China

– But if trade imbalance, loss of jobs in manufacturing remain large, only temporary palliative

If there is significant price elasticity, there may be better ways to do this

On the real side, prospect of a stronger dollar remains slim! Both real and financial considerations contribute to a cloudy outlook for the global economy and for dollar

The Basic Problems Deteriorating confidence in the U.S. economy and the U.S.

leadership, mainly due to worsening fiscal deficit- Short run problem is the tip of iceberg- U.S. uses ten year budget projections, but Changes in U.S. fiscal position as a result of Medicare bill alone in the next twenty years are in the range of $2.5-3.0 trillion - There simply isn’t room in discretionary budget to make the arithmetic work

And some of the cutbacks will be in areas which will harm U.S. long term economic growth– Investments in science and technology– Already suffering from war on terrorism, as supply of

foreign engineers/scientists/students drying up– And suffering from anti-science stance of administration,

or at least widespread perception of that within the scientific community

End of Dollar as the Reserve Currency Reserve currencies need to be good store of value Which is why inflation has always been viewed so

negatively by central bankers But the credibility of a currency as a reserve currency

depends also on exchange rates For foreign holders of dollars, weakening of the

exchange rate is as bad as an increase in inflation Even true for domestic wealth holders, because of

opportunity costs Negative dynamics—as confidence erodes, people

move out of currency, weakens currency Problem is partly inherent—reserve currency country

gets increasingly in debt as others hold its currency; ease of selling debt entices borrowing; but eventually, debt gets so large that credibility is questioned

Now there are alternatives to dollar And many in Asia are waking up to the new realities

– They are the world’s net savers– Why should they be lending money to the richest country of

the world at low interest rates?– Basic principles of portfolio diversification would call for

diversification of reserve assets– And increased perceived risk associated with U.S. dollar would

lead to further diversification out of the dollar– For small countries, this is easy– But for large countries, more difficult

Political ramifications Balance sheet effects as they move out Argues for a policy of gradualism And for the anticipation of further weakening of dollar

With so much of U.S. debt held as reserves, politics, not just economics, become important in determining exchange rates and even possibly long term Treasury interest rates

End of Dollar as the Reserve Currency?

Alternative Scenarios

Best case (for strong U.S. dollar): U.S. reins in its fiscal deficit Europe successfully pursues more expansionary policy Asian countries decide to continue to gamble on

holding dollar as reserve currency, no progress on Asian cooperative front

More pessimistic case: U.S. deficit not brought under control, and actually

increases with partial privatization of social security and permanent tax cut

Proposed budget gimmickry in social security unlikely to fool anyone

More Pessimistic Case: Financial markets wake up to long run prospects of U.S.

fiscal position and its long run real consequence– Political gridlock in the U.S.– Impossible to raise taxes, impossible to cut back

significantly on commitments– Especially problematic given huge gap between US’s

health technology and its health performance– Social tensions rise as even those in the middle see their

incomes erode (real median family income in U.S. down by $1,500)

Markets and governments wake up to changing global economic scene– Strength in science and engineering in China and India– Scientists are mobile; U.S.’s dominance partly due to

migration after World War II

Alternative Scenarios

More Pessimistic Case:

Political and economic pressures build up for movement out of dollar as reserve currency– Political accountability for foreseen loses in value of reserves– Popular sentiment about lending to U.S. at low interest rates,

demands for Asian cooperation, sensibilities about how to do it quietly

– WTO limits retaliation by U.S., though there will be plenty of talk

• Eventually U.S. and global real long term interests rise (matter of supply and demand), risk premiums rise, with adverse effects on weaker emerging economies, possibly new crises, and on U.S. economy, with heavy debt overhang

Alternative Scenarios

Concluding Remarks

Economics and politics are intimately intertwined

Economic forecasting is difficult Political forecasting is even more difficult The most sure bet is continued high levels

of uncertainty And even that is uncertain