This Morning, Out on the Trail...
Some Bursting Bubble References...

Michael Mussa's Take on Global Imbalances as of Early 2004

He wrote:

Paper: Global Economic Prospects: Bright for 2004 but with Questions Thereafter: More generally, while global economic prospects look quite bright through 2004, there are important imbalances in the global economy that raise concerns for the longer term. It is useful to reflect briefly on these concerns before turning to a region-by-region assessment of near-term prospects.

Policy interest rates are exceptionally low in most industrial countries: zero in Japan and Switzerland, 1 percent in the United States, 2 percent in the euro area, and at or near historic lows in the United Kingdom and Canada. Inflation rates also are generally very low in the industrial countries, but, even taking this into account, short-term real interest rates are very low. (Realized short-term real rates went negative during some periods of rapidly rising inflation in the 1970s, but this was an anomaly that is not comparable to the present situation of low anticipated real interest rates.)

The very low level of policy interest rates is an imbalance (relative to normal conditions) that reflects exceptionally easy monetary policies to combat economic weakness. This policy imbalance poses an important challenge for the future conduct of monetary policy. Situations of low policy interest rates and low inflation tend to be associated with unusual inertia in the processes of general price inflation, which makes traditional indicators of rising inflationary pressures less reliable as measures of the need to begin to tighten monetary conditions. Also, these situations tend to be associated with high valuations of equities, real estate, and long-term bonds, which can become fertile ground for large, unsustainable increases in asset prices. In this situation, if monetary policy is tightened too much too soon (perhaps because of worries about unsustainable increases in asset prices), the result can be an unnecessary asset market crunch and economic slowdown, and monetary policy may have relatively little room to ease in order to counteract this outcome.

On the other hand, if monetary policy remains too easy for too long (perhaps because subdued general price inflation gives no clear signal of the need for monetary tightening), then large asset price anomalies may develop before corrective action is taken. The monetary authority would then confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing.

A further concern related to the general monetary policy imbalance in the industrial countries is its effect on emerging market economies. Interest rate spreads for emerging market borrowers have contracted substantially and flows of new credit have increased. The boom in emerging market credit has not yet reached the frenzy of the first half of 1997, but it is headed in that direction. Another major series of emerging market financial crises (such as 1997-99) does not seem likely in the near term in view of the very low level of industrial country interest rates and the favorable global economic environment for emerging market countries. By 2005 or 2006, however, either upward movements in industrial country interest rates or deterioration of market perceptions of the economic and financial stability of some emerging market countries could trigger another round of crises.

Another important policy imbalance of global significance is the medium- and long-term fiscal imbalance of most industrial countries. Ratios of government debt to GDP are high in several countries, most notably Japan and Italy. Fiscal deficits are large in Japan and the United States and above the desired ceiling of 3 percent of GDP in Germany and France. Most important, industrial countries generally face enormous fiscal challenges from financing social benefits for aging populations that will materialize during the next two to three decades. These problems imply that, even in the near term, expansionary fiscal policy cannot prudently be used as a significant means for stimulating more rapid growth of aggregate demand in the industrial countries. To the extent that such stimulus may be needed, monetary policy is the prudent tool. But, as just noted, monetary policy does not at present have much remaining capacity to play this role and may not regain this capacity any time soon.

The other key global imbalance is the massive US current account (and net export) deficit and the corresponding surplus of the rest of the world. While it is plausible to suppose that the United States can continue to attract voluntary net capital inflows sufficient to finance a current account deficit of 2 to 2½ percent of its GDP, continuing deficits of 5 percent of US GDP are not plausible. The global adjustment necessary to reduce the US current account deficit by roughly half involves three essential elements.

First, in order to shift world demand toward US goods and services and away from those of the rest of the world by $250 billion to $300 billion, the real effective foreign exchange value of the US dollar needs to decline from its peak in 2000/01 by roughly 30 percent. Substantial downward corrections of the US dollar against the euro, sterling, and the Canadian and Australian dollars, and lesser correction against the Japanese yen, have now delivered somewhat less than half of the total required correction. Some further depreciation of the US dollar against these (aforementioned) currencies, particularly the Japanese yen, is needed over the next couple of years. However, the key remaining challenge for exchange rate adjustments is securing appreciations in the exchange rates of key emerging market currencies, especially in Asia. The exchange rate of the Chinese yuan has rightly received much recent attention in this regard (and Nicholas Lardy will comment further on this issue). But the issue is much broader. For most of emerging Asia, there has been little or no currency appreciation against the US dollar since 2000/01 (implying effective depreciation of the trade weighted exchange rate), and most of these countries have recently been intervening massively to resist market pressures for appreciation. These policies need to change to allow a broader downward correction of the value of the US dollar.

Second, for the US current account deficit to decline, domestic demand in the United States must grow more slowly, by a corresponding amount, than US output (real GDP). (This is the reverse of the pattern of recent years, when the excess of domestic demand growth over real GDP growth has accounted for the large deterioration in the US current account.) Getting this to happen in the United States, while also keeping US output close to potential, poses some difficulties. If domestic demand growth falls below potential output growth, the improvement in US net exports must step in to keep total demand for US output growing in line with potential. Otherwise, margins of slack will increase in the US economy. On the other hand, if output (and, hence, income) growth matches potential (with the level of output near potential), then there must be something to depress the growth of US domestic demand below the growth of US income. Otherwise, if US net exports are improving (due to the effects of a weaker US dollar and stronger demand growth abroad), then there would be undesirable overheating of the US economy. The necessary depressing force on US demand growth could come from a progressive tightening of US monetary policy. But this would depress domestic demand growth primarily by slowing private investment, thereby slowing the longer-term growth rate of the US economy. The preferable policy solution would be for the reversal of the fiscal expansion of 2001/04 to provide the desired negative impetus to domestic demand.

Third, for the rest of the world, the counterpart of US adjustment must be that domestic demand grows more rapidly than output. The amount of this difference corresponds to the deterioration of the current account in the rest of the world, which must match the improvement in the US current account. (Since the US economy accounts for about one-quarter of world output at market exchange rates, an improvement in US net exports equal to 3 percent of US GDP requires a worsening of net exports in the rest of the world of about 1 percent of GDP.) In recent years, however, the rest of the world has had difficulty generating sufficient demand growth to keep output growing at potential—and has relied on a net contribution of demand from the growing US net export deficit. Thus, securing a boost to demand growth in the rest of the world over the next couple of years poses a challenge, particularly so because, as previously noted, fiscal policy is generally not available to provide much demand stimulus, and monetary policies (at least in industrial countries) are already quite easy. At a minimum, it would appear desirable to keep monetary policies easy to support demand growth, but not so easy as to frustrate the exchange rate adjustments that are also a necessary factor in correcting global payments imbalances...