Cuaderno De Documentacion

SECRETARIA DE ESTADO DE ECONOMÍA,

MINISTERIO DIRECCIÓN GENERAL DE POLÍTICA ECONÓMICA DE ECONOMÍA Y SUBDIRECCIÓN GENERAL HACIENDA DE ECONOMÍA INTERNACIONAL

CUADERNO DE DOCUMENTACION

Número 69

Alvaro Espina Vocal Asesor 16 de febrero 2004

CUADERNO DE DOCUMENTACIÓN 16022004 Nº69 DEFLATION & LIQUIDITY TRAPS (XII) 1. PRESENTACIÓN: ¿Existe una amenaza real de trampa de liquidez en el G3? Conclusión (II), por Álvaro Espina...... 3

2. “La curva de Laffer ataca de nuevo, por Luis de Sebastián...... 8 3. Japón comienza a recuperarse del estallido de la burbuja inmobiliaria, por Georgina Higueras...... 9 4. The latest views of Morgan Stanley Economists…………….……. 11 5. [email protected] El pulso económico en el 2004...... 38 6. The Economist.com Global economic outlook………………………………… 61 7. FT.com.- The world in 2004………………………………………………………… 117 8. Deutsche Welle.- Volatilidad de cancilleres y mercados...... 129 9. BusinessWeekonline.- 2004 INVESTMENT OUTLOOK ..…….. 136 10. La globalización y sus quejas en 2004, by Joseph Stiglitz...... 164 11. Le nouvel ordre Internet, by Ignacio Ramonet...... 166 12. El escándalo de la pobreza mundial, by Paul Kennedy...... 168 13. 'IT'S THE SYSTEM, STUPID!', by John Elkington………………. . 170 14. From the magic mountain: the World Economic Forum by Simon Zadek…………………………………………………………………………..173 15. Comisión 'versus' Ecofin: consecuencias jurídicas y políticas por Antonio Estella...... 181 16. Financial integration: Where do we stand?, by Jean-Claude Trichet …………………………………………………………………………………………….. 183 17. Bank of England: News Release and Inflation Report (11-II-04)………… 189 18. Rubin Gets Shrill, by Paul Krugman (New York Times Op-ed)…………. 192 19. Sustained Budget Deficits: Longer-Run U.S. Economic Performance and the Risk of Financial and Fiscal Disarray by Peter R. Orszag, Robert E. Rubin, Allen Sinai……………………………………. 194 20. U.S. Fiscal Policies and Priorities for Long-Run Sustainability.- I. Overview: Returning Deficits and the Need for Fiscal Reform, M. Mühleisen and Ch. Towe, Editors (IMF)………………………………………….. 197

1 21. Testimony & Remarks by the Chairman and Governors of the FRB Alan Greenspan, February 11, 2004…………………………………..213 Susan Schmidt Bies, February 4, 2004….…………………………….220 Alan Greenspan, January 26, 2004……………………………………227 Alan Greenspan, January 13, 2004……………………………………233 Donald L. Kohn, January 7, 2004……………………………………..242 Ben S. Bernanke and Vincent R. Reinhart, January 3, 2004………….272 Nobuyuki Nakahara, former board member of the Bank of Japan (BOJ) (NBER 2002)……………………………………………………..……...279 Ben S. Bernanke January 3, 2004…………………………………….281 Alan Greenspan January 3, 2004……………………………………...292 Ben S. Bernanke, January 4, 2004…………………………………….303 Alan Greenspan, November 20, 2003………………………………...311 22. Brad Delong: Starve the Beast?……………………………………..320

BACKGROUND PAPERS…………………………….……..323 23. What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules, Lars E. O. Svensson (52 pp.) 24. OCDE press conference in Davos, by Jean Phillipe Cotis (8 pp.) 25. Sustained Budget Deficits: Longer-Run U.S. Economic Performance and the Risk of Financial and Fiscal Disarray Robert E. Rubin, Peter R. Orszag, and Allen Sinai (20 pp.) 26. ¿Firmaría Laffer la próxima rebaja del IRPF?, por Carlos Cuesta, Expansión, 10-II-2004 (2 pp.) 27. Understanding the Effects of Government Spending on Consumption”, by Jordi Galí, J.David López-Salido & Javier Vallés (39 pp.) 28. Economic reform in Europe, by J.C. Trichet, (5 pp.) 29. When Leaner Isn’t Meaner: Measuring Benefits and Spillovers of Greater Competition in Europe, by Tamim Bayoumi, Douglas Laxton &Paolo Pesenti , (56 pp.) 30. Hard and soft economic policy coordination under EMU: problems, paradoxes and prospects, by Iain Begg, (13 pp.) 31. The Stability and Growth Pact in need of reform, by Paul De Grauwe, (9 pp.) 32. ¿Cómo reconstituir el Pacto de estabilidad?, por Carlos Mulas- Granados (1 p).

2 ¿EXISTE UNA AMENAZA REAL DE TRAMPA DE LIQUIDEZ EN EL G3? Conclusión (II) Álvaro Espina Conclusión El G3 se encuentra amenazado o inmerso en una situación de deflación con trampa de liquidez, lo que supondría caer por un precipicio económico. Aunque las etiologías de los males de cada área son por completo diferentes –así como las oportunidades e indicios de una recuperación duradera- en caso de recaída siempre aparece el mismo diagnóstico: las causas que condujeron a la situación crítica impiden también la utilización de los instrumentos de política económica disponibles para impulsar una recuperación sostenible a medio y largo plazo. Existe también el riesgo de contagio y mutuo reforzamiento. Además, en la medida en que más de una de estas áreas –o todas ellas- caigan o persistan en la situación de estancamiento y grave desequilibrio, la corrección del problema será todavía más difícil, porque las medidas beneficiosas para una zona dañarán la recuperación de las otras. En síntesis, puede decirse que la intensidad de la amenaza actual –y la imposibilidad de corregirla con simples medidas de política monetaria y fiscal convencionales- proviene de la incapacidad o la lentitud de cada una de estas zonas para adaptarse a los shocks producidos por la globalización, la demografía y la nueva revolución tecnológica, que abre paso a la sociedad de la información y el conocimiento globales, cambiando la economía y la forma de interpretarla y gobernarla1. Esta incapacidad es idiosincrásica de cada área, de modo que puede hablarse de tres males: el Japonés (J), el Americano (A) y el Europeo (E). El mal J ha sido calificado con un nuevo término, la “disflación”, 2 que consiste en la combinación de deflación con el mayor cúmulo concebible de actuaciones equivocadas (disfuncionales) llevadas a cabo por el gobierno japonés y los reguladores autónomos de los mercados monetario y financiero durante el último decenio. El primero se ha mostrado incapaz de acometer la liberalización y/o la re-regulación de los mercados –interior y exterior; de factores y productos-, la transparencia contable de las empresas de los keiretsus y el saneamiento de la banca y del sistema de pensiones, fiándolo todo a paquetes estimuladores que encubren el déficit corriente y distribuyen los bienes públicos en razón de intereses clientelares. Para obligarle a cumplir sus tareas y a pasar de un sistema de financiación dirigido por la banca a otro centrado en el mercado de capitales,3 las otras autoridades se han resistido a colaborar, acumulando ineficiencia institucional, de modo que “unos por otros, la casa por barrer”, proporcionando con su actuación un verdadero campo de experimentación para el análisis de los errores en política macroeconómica4. Todo ello con un trasfondo de trampa de liquidez y de deuda, reflejada mejor

1 Véase Joseph E. Stiglitz , “Information and the Change in the Paradigm in Economics” Prize Nobel Lecture, December 8, 2001, en: http://www-1.gsb.columbia.edu/faculty/jstiglitz/download/NobelLecture.pdf [CD 68]. 2 Véase “Fixing Japan. Kill or Cure?”, The Economist, 25-Sep-2003, [CD 61] en: http://economist.com/displaystory.cfm?story_id=S%27%298%2C%24QQ%5B%2A%21%20%21%3C%0A 3 Véase Takeo Hoshi & Anil Kashyap (2001), Corporate Financing and Governance in Japan: The Road to the Future, MIT Press. [La recensión de JEL se incluyó en CD 68]. 4 La mejor síntesis puede verse en los abstracts de los últimos números de Financial Review, del Ministerio de Hacienda japonés, disponibles en: http://www.mof.go.jp/english/f_review.htm [CD 68].

3 que otra cosa por la burbuja inmobiliaria que estalló a finales de 1991 y sólo parece haber tocado suelo en 2003.5 El mal A es el de la confianza absoluta en el mercado y el de un activismo monetario, que, cuando actúa discrecionalmente, eleva igualmente la volatilidad económica, reduciendo el crecimiento, y, cuando lo hace orientado por la regla de Taylor, reproduce la política de los años setenta y tiende a sobreestimar la tasa natural de crecimiento, lo que podría conducir a los pésimos resultados de entonces,6 por mucho que la FED haya aprendido mucho desde entonces y se muestre ahora dispuesta a invertir su actual política tan pronto repunten las expectativas de inflación observadas “a través de las encuestas y en los mercados financieros”, reafirmándose, además, en la regla de Taylor, que implica una respuesta asimétrica.7 Por el contrario, la evidencia indica que -en lugar de obcecarse en el empleo de reglas- es preferible la fijación de objetivos de inflación.8 Todo ello combinado con la acumulación exponencial de déficit de acción colectiva, de regulación –tanto a nivel doméstico como global-, y de dotación de bienes y servicios públicos, que vienen a añadirse al déficit público y al exterior.9 Este último sobrepasa ya el 5% del PIB, que es la mediana del punto en que los mercados se resisten a continuar financiándolo, por mucho que la deuda bruta norteamericana con el exterior suponga todavía un modesto 25% del PIB.10 Según el FMI, la proyección del déficit público para el próximo decenio implica una grave amenaza para la estabilidad monetaria y supondrá una elevación de hasta un punto en los tipos de interés de los países industrializados, con el consiguiente impacto negativo sobre su crecimiento.11 Para la OCDE esa es la amenaza principal que se cierne sobre la reactivación actual.12 Además, las insuficiencias del Estado de bienestar13 hacen gravitar la cobertura de riesgos sobre los planes médicos y de pensiones de las empresas, insuficientemente dotados y

5 Véase en este CD: G. Figueras, “Japón comienza a recuperarse del estallido de la burbuja inmobiliaria”, El País, 29-XII-2003, en este CD. 6 Véanse A. Orphanides, “Activist Stabilization Policy and Inflation: The Taylor Rule in the 1970s”, Center for Financial Studies, Working Paper No. 2002/15, November 2002, http://www.ifk-cfs.de/papers/02_15.pdf; Athanasios Orphanides & John C. Williams, “ The Decline of Activist Stabilization Policy: Natural Rate Misperceptions, Learning, and Expectations”, en Second Conference: International Research Forum on Monetary Policy, Federal Reserve Board of Governors, Washington D.C., 14-15 Noviembre 2003, y Robert G. King & Alexander L. Wolman, “Monetary Discretion, Pricing Complementarity and Dynamic Multiple Equilibria, NBERWorking Paper 9929, disponibles en: http://www.ecb.int/events/conf/intforum/intforum2.htm [CD 68]. 7 Véanse los discursos de Alan Greenspan y Ben S. Bernanke ante la Asamblea de la AEA en San Diego, California, el 3 y cuatro de enero de 2004, en: http://www.federalreserve.gov/boarddocs/speeches/2004/ y en este CD, junto a todos los discursos de los gobernadores de la FED entre el 4de enero y el 11 de febrero de 2004. 8Véase Lars E. O. Svensson (2003), “What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules”, Journal of Economic Literature Vol. 41 Nº 2, Junio, pp. 426-477, en este CD. 9Véase J. Stiglitz, “La globalización y sus quejas en 2004”, El País, 6-I-2004, y A. Greenspan, Current Account , 20- XI-2003, http://www.federalreserve.gov/boarddocs/speeches/2003/, ambos en este CD. 10 Véase: Alan Greeenspan, “Globalization”, Bundesbank Lecture 2004, Berlin, 13-I-2004, disponible en: http://www.federalreserve.gov/whatsnew.htm, en este CD. 11 Véase M. Mühleisen and Ch. Towe, Editors “U.S. Fiscal Policies and Priorities for Long-Run Sustainability”, IMF Occasional Paper 227, 7 January 2004. La síntesis (I. Overview: Returning Deficits and the Need for Fiscal Reform) se encuentra disponible en: http://www.imf.org/external/pubs/nft/op/227/index.htm, en este CD. 12 Véase el comunicado de J-P Cotis en Davos, disponible en: http://www.oecd.org/dataoecd/8/48/25125880.pdf, en este CD. 13 Véase John F. Cogan and Olivia S. Mitchell, “The Role of Economic Policy in Social Security Reform: Perspectives from the President’s Commission”, http://www.nber.org/papers/w9166, NBER Working Paper 9166 [CD 38].

4 amenazados de insolvencia, 14 a lo que se añade el saqueo de los fondos de inversión por sus gestores,15 con la consiguiente amenaza de trampa de liquidez a medio plazo. Finalmente, el nivel actual de protección no será sostenible cuando empiece a jubilarse la generación del baby- boom a partir de 2008, momento en el que la política fiscal “a la argentina”,16 practicada actualmente por el Partido Republicano,17 ya habrá “matado de hambre al animal”, si los electores no lo impiden, ahora que todavía queda tiempo para corregirlo.18 Pero la corrección implica ahorrar más, reducir la demanda interior y reestructurar amplias zonas de la producción, tanto dentro como fuera de Norteamérica, lo que plantea nuevas incertidumbres.19 Además, la necesaria combinación de reducciones de gasto y vuelta atrás en las pasadas reducciones de impuestos no resulta electoralmente rentable para ningún partido, de modo que sólo son practicables a través del consenso, pero cuando éste se alcance puede ser ya demasiado tarde.20 En suma, aparentemente entre los años ochenta y noventa Norteamérica pasó de estar en la parte superior de la curva de Laffer –en donde una reducción de la provisión de bienes públicos eleva el potencial de crecimiento- a situarse en la parte inferior, en donde sin una elevación de tal dotación el crecimiento se desacelera,21 porque de poco vale la I+D en microelectrónica si falta electricidad y si Silicon Valley se quema por falta de planificación ecológica a largo plazo. El problema es que nadie ha podido definir todavía los parámetros de la curva de Laffer. Como afirma Juan Corona, “sólo se sabe si funciona una vez que se ha efectuado la rebaja fiscal”, así que es fácil manipular la idea a efectos meramente electorales, para justificar bajadas de impuestos.22 Y en esta situación, la elevación desproporcionada de los gastos del gobierno sólo tiene efectos expansivos sobre la demanda si la mayoría de los hogares se comporta inconscientemente, apurando hasta el borde su capacidad de endeudamiento, inflada artificialmente por las burbujas durante el ultimo decenio -con la consiguiente elevación del riesgo sistémico (gráfico 13)-, y haciendo caso omiso del “efecto ricardiano”.23 Porque aquellos

14 “A ‘Perfect Storm’ of Circumstances Batters Corporate Pension Plans”, Knowledge@Wharton February 12, 2003. en: http://knowledge.wharton.upenn.edu/index.cfm?fa=viewArticle&id=712 [CD 38]. 15 Véase Martin Howell, Predators and Profits: 100+ Ways for investors to Protect Their Nest Eggs, Prentice Hall, 2003, y la serie de Business Week: http://www.businessweek.com/investor/list/mfcrisis_toc01.htm [CD 65]. 16 Véase Paul Krugman, “Rubin Gets Shrill”, New York Times, January 6, 2004, en este CD. 17 Véase Christopher Farrell, “How Bush Is Mortgaging the Future”, BusinessWeekonline, 5, Diciembre, 2003. 18 Véase M. Mühleisen and Ch. Towe, “US Fiscal Policis…”, Occasional Paper 227 del IMF, ya citado, y "Starve the Beast"?, en: http://www.j-bradford-delong.net/movable_type/2003_archives/002821.html y en este CD. 19 Véase el discurso del Gobernador de la FED Donald L. Kohn “The United States in the World Economy”, Atlanta, Georgia, January 7, 2004, en: http://www.federalreserve.gov/boarddocs/speeches/2004/ , en este CD. 20 Véase Robert E. Rubin, Peter R. Orszag, and Allen Sinai, “Sustained Budget Deficits: Longer-Run U.S. Economic Performance and the Risk of Financial and Fiscal Disarray ”, Paper presented at the AEA-NAEFA Joint Session, Allied Social Science Associations Annual Meetings, The Andrew Brimmer Policy Forum, “National Economic and Financial Policies for Growth and Stability,” January 4, 2004, San Diego, CA, disponible en: http://www.brook.edu/dybdocroot/views/papers/orszag/20040105.pdf , en este CD.

21 Véase Joseph E. Stiglitz, Los felices noventa. La semilla de la destrucción, Taurus, Madrid, 2003. 22 Véase Carlos Cuesta, “¿Firmaría Laffer la próxima rebaja del IRPF?”, Expansión, 10-II-2004. Una comparación de la utilización de la curva de Laffer en la Norteamérica de Reagan y en la Alemania de Schroeder puede verse en: Luis de Sebastián, “La curva de Laffer ataca de nuevo, El País, 29-XII-2003. Ambos en este CD. 23 Jordi Galí, J.David López-Salido & Javier Vallés; “Understanding the Effects of Government Spending on Consumption”, en Second Conference: International Research Forum on Monetary Policy, Federal Reserve Board of Governors, Washington D.C., 14-15 Noviembre 2003, disponible en este CD y en: http://www.ecb.int/events/conf/intforum/material/Galietal.pdf

5 gastos, junto a los estímulos fiscales para reactivar la economía a corto plazo, son sencillamente “pan para hoy y hambre para mañana”. El mal E esta sobrediagnosticado y la agenda de reformas claramente identificada24: consiste en la proverbial falta de flexibilidad de los mercados de productos y de factores – particularmente los de trabajo-, o euroesclerosis, y en la excesiva proclividad hacia la dotación de bienes y servicios públicos, incluso en áreas en que la acción colectiva resulta ineficiente y estimula el abuso, el derroche y el afán por viajar sin billete. Una estimación reciente indica que los límites y barreras a la competencia son responsables aproximadamente de la mitad del output gap en la Eurozona.25 Al mismo tiempo, este exceso de bienes públicos, regulación y sistemas de protección en el ámbito nacional, contrasta con un enorme déficit de regulación homogénea, bienes públicos, infraestructuras y mecanismos de transferencia coyuntural de recursos a escala europea. Existe todavía una fuerte inconsistencia entre el nuevo interés público europeo y los intereses públicos nacionales. La escrupulosa atención hacia estos últimos forma un velo que impide ver que un crecimiento más equilibrado en lo temporal y en lo territorial –impulsando el crecimiento de forma asimétrica: con carácter estructural y territorial, para fomentar la convergencia, y con carácter coyuntural, para suavizar el ciclo- no es un juego de suma cero en el que lo que unos ganan otros lo pierden, sino que resulta beneficiosa, no sólo para los países directamente favorecidos durante cada fase cíclica o por cada política estructural, sino para todos. Pero el proceso de aprendizaje (learning by doing) de la UE no ha hecho más que empezar.26 Después de que el ECOFIN dejara en suspenso el Pacto de Estabilidad, decidiendo no sancionar a Francia y Alemania el 25 de noviembre pasado, parece claro que esa regla ha quedado inutilizada, por mucho que la Comisión prosiga ejerciendo su función de vigilancia y coordinación de las Políticas económicas, mientras el Tribunal resuelve su litigio contra el Consejo27. Se trata en cualquier caso de una pérdida irreparable, ya que quiebra el sistema normativo fundacional de la Eurozona, pero probablemente resultaba inevitable porque el Pacto es antinatural, por procíclico –como lo evidencia el caso de Portugal, incapacitado para combatir la recesión por la imposición de cumplirlo a rajatabla-, al exigir el bloqueo de los estabilizadores automáticos precisamente en el momento en que son más necesarios, al igual que lo sería la pretensión alemana de tomar represalias contra España por su elevada inflación, cuando ésta se deriva del efecto Balassa-Samuelson, inherente al proceso de convergencia real –o la escasa prioridad concedida por Francia, pese al Informe Van Miert, a las inversiones para facilitar las conexiones de transportes e infraestructuras con España.28 Hoy resulta evidente la necesidad de

24 Para una síntesis breve véase J.C. Trichet, “Economic reform in Europe”, Enterprise Conference London, (26-I- 2004) en este CD, disponible: (http://www.hm-treasury.gov.uk/media//78FFD/Advancing_Enterprise_Trichet.pdf.) 25 Véase Tamim Bayoumi, Douglas Laxton &Paolo Pesenti , “When Leaner Isn’t Meaner: Measuring Benefits and Spillovers of Greater Competition in Europe”, en Second Conference: International Research Forum on Monetary Policy, Federal Reserve Board of Governors, Washington D.C., 14-15 Noviembre 2003, disponible en: http://www.ecb.int/events/conf/intforum/material/Bayoumietal.pdf, en este CD. 26 Véase Iain Begg, “Running Economic and Monetary Union: the challenges of policy co-ordination”, en Europe: Government and Money, Kogan Page, 2002, y , “Hard and soft economic policy coordination under EMU: problems, paradoxes and prospects” Center for European Studies Working Paper Series nº 103 disponible en: http://www.ces.fas.harvard.edu/working_papers/BeggHardEMU.pdf , en este CD. 27 Veáse en http://europa.eu.int/rapid/start/cgi/guesten.ksh?p_action.gettxt=gt&doc=IP/04/35|0|RAPID&lg=ES la estrategia adoptada el 13-I-2004, de acuerdo con el Tratado y el Pacto de Estabilidad. También: Antonio Estella , “Comisión 'versus' Ecofin: consecuencias jurídicas y políticas”, El País, 3 de febrero de 2004, en este CD. 28 Véase “Los camiones se atascan en los Pirineos”, “Francia margina a España en sus 50 proyectos de grandes infraestructuras”, El País, 12-I-2004 y 19-XII-2003, y Gregorio Martín, “El cuello de botella francés”, El País 19- XII-2003“ y “¿Francia nos estrangula?”, El País, Comunidad Valenciana, 15-I-2004. La cartografía de los proyectos de red viaria (y ferroviaria) en el horizonte 2006-2007 se encuentra disponible en http://www.midi-

6 disponer de una verdadera política anticíclica a nivel europeo –combinada con la de equilibrio territorial- para compensar el impacto asimétrico de la política monetaria única y de los shocks externos, sin que ello signifique pretexto alguno para dejar de acometer las reformas estructurales, cuyos principales efectos sólo resultan observables a largo plazo.29 Lo que sucede es que la presión debería aplicarse y las penalizaciones habría que imponerlas a los países que no equilibren sus presupuestos u obtengan superávit en la fase de auge, cuando el saneamiento de las cuentas depende de su propia política estructural, y no cuando se ven arrastradas por los estabilizadores automáticos, que ayudan a la recuperación de todo el área. De este modo el Pacto tendría efectos contracíclicos, acumulando los recursos depositados por sanción –o penalizando la recepción de los fondos PEC, PC y PAC30- cuando los países que crecen por encima de sus posibilidades no hacen sus deberes estructurales –lo que drenaría liquidez y les ayudaría a moderar el auge, previniendo la formación de burbujas-, e inyectando recursos durante las fases recesivas. Esa debería ser la clave de la inevitable reforma del Pacto, cuyo lema podría ser: “Mano dura y reformas en tiempos de vacas gordas, por flexibilidad y financiación en tiempos de vacas flacas”.

pyrenees.equipement.gouv.fr/atlas/html/espagnol/fichescartographiques/fiche375.htm (/fiche380.htm). Las zonas de sombra y saturación viaria en 2002 en: /fiche340.htm, /fiche315.htm; la red ferroviaria 2002 en: /fiche30.htm. Los flujos de mercancías en 2000, en /fiche60.htm. y los de intercambios en /fiche345.htm y /fiche335.htm. 29 Véanse las propuestas de reforma de Iain Begg, Dermot Hodson & Imelda Maher, “Economic Policy Coordination in the European Union”, National Institute of Economic and Social Research , Quarterly Economic Review, January 2003, y de Paul De Grauwe, “The Stability and Growth Pact in need of reform”, CEPS 2003, disponible esta última en este CD y en: http://www.econ.kuleuven.ac.be/ew/academic/intecon/Degrauwe/PDG- papers/2003%2001%20Stability%20and%20Growth%20Pact%20CEPS%202003.pdf 30 Véase la propuesta de Carlos Mulas-Granados sobre “¿Cómo reconstituir el Pacto de estabilidad?” en Expansión, 10-II-2004 en este CD.

Economía - 29-12-2003

La curva de Laffer ataca de nuevo Tribuna: Luis de Sebastián* Esta vez en Alemania. La curva de Laffer representa gráficamente la teoría de que, en ciertos supuestos, si se rebajan los impuestos, la Hacienda pública recauda más. Algo de eso debe estar pensando el Gobierno alemán, cuando anuncia una rebaja de impuestos al mismo tiempo que promete reducir su déficit fiscal, que es piedra de escándalo en la Unión Monetaria. El sentido común nos dice que, al reducir los impuestos, se recauda menos, y, si no se reducen los gastos en la misma medida, el déficit aumenta. La única manera de reconciliar una reducción de impuestos con una reducción del déficit, sin reducir el gasto, es que se dé la siguiente secuencia: menores impuestos-más inversión privada-mayor crecimiento económico-mayor recaudación fiscal. Eso es lo que promete la curva del profesor Arthur Laffer, con la que convenció al candidato Reagan en 1980 de que la reducción de impuestos no iba a perjudicar al déficit, sino que, por el contrario, iba a eliminarlo. Es crucial, sin embargo, para el funcionamiento de la curva, y del mecanismo que implica, el hecho, repito, el hecho de que los impuestos sean tan altos que estén frenando la inversión privada en sectores productivos. Sólo en este caso la reducción de impuestos afectará al crecimiento, vía una mayor inversión en sectores productivos. Insisto también en lo de sectores productivos, porque, si el aumento de ingreso disponible que generaría la reducción de impuestos se destinara a inversión financiera, especulativa o no, o a inversión en el extranjero, el mecanismo de la curva de Laffer fallaría por la base. También es crucial la cuestión de los plazos. Porque puede que el mecanismo funcione, dados los dos supuestos mencionados, pero que no funcione a corto plazo, es decir, al año siguiente o a los dos años de la reducción de impuestos. En ese caso se podría obtener el efecto Laffer, pero después de pasar un periodo de mayor déficit fiscal y los problemas que eso significaría para Alemania y para la Unión Monetaria. Como es sabido, la lógica de la curva de Laffer no funcionó en el caso de la economía norteamericana en los años ochenta. El presidente Reagan heredó en 1981 un déficit del 2% del PIB y en 1986 lo había multiplicado por tres (a 6% del PIB). Eventualmente se recuperó la inversión y el crecimiento, pero después de haber elevado los tipos de interés, haber revaluado el dólar, y hacer estragos en el comercio internacional y en la deuda externa de los países emergentes. Ni tampoco está funcionando en los años 2000. A pesar de las enormes reducciones de impuestos llevados a cabo por el presidente Bush júnior, y de una política de dinero barato a ultranza, la recuperación de la economía norteamericana en términos de empleo y de ingresos deja mucho que desear, a pesar del resultado espectacular del crecimiento en el tercer trimestre de 2003. Además resulta difícil determinar cuánto de este crecimiento se debe a las reducciones de impuestos y cuánto se debe a tener el tipo de interés más bajo de su historia. Es decir, si debe a la lógica de la curva de Laffer o a una lógica keynesiana tradicional. Y en todo caso el déficit fiscal norteamericano es enorme, sigue creciendo y amenaza con una subida de tipos de interés que podría dar al traste con todo lo logrado. Sólo nos queda desear suerte a Alemania en su aventura fiscal; que el Gobierno acierte en su apuesta por que el ingreso disponible adicional después de la rebaja de impuestos se invierta en sectores productivos y tenga efectos sobre el crecimiento rápidamente. De otra manera aumentará el déficit, con el peligro que eso supondría para el euro, o tendrá que reducir los gastos sociales provocando descontento entre la población. *Luis de Sebastián es catedrático de Economía de la ESADE.

8 Economía - 29-12-2003 Japón comienza a recuperarse del estallido de la burbuja inmobiliaria

Después de 12 años de descenso de los precios, la tendencia se invierte GEORGINA HIGUERAS - Madrid Los inversores internacionales vuelven lentamente a interesarse por el mercado inmobiliario japonés, especialmente en la ciudad de Tokio, tras el estallido de la burbuja que dejó en la ruina a numerosas familias y empresas y en una situación extremadamente delicada a la banca, buena parte de cuyos créditos impagados están avalados por propiedades que en muchos casos han perdido más del 50% de su valor. Después de 12 años de caída ininterumpida en picado del precio de los edificios, sobre todo de oficinas, en los últimos meses se observa un mayor movimiento del mercado inmobiliario, que parece querer salir de una larga hibernación. En la década de los año ochenta, el suelo de Tokio se convirtió en el más caro del mundo, pero en el mes de enero de 1996 el metro cuadrado en un distrito comercial de la capital costaba 10,1 millones de yenes, lo que suponía una bajada del 44,8% con respecto al mismo mes de dos años antes, aunque aún fuese muy alto para la media española. Este dramático descenso tiene todavía restringido el movimiento de propiedades que están ligadas a créditos impagados y cuyo valor asciende a unos 160.000 millones de euros. La crisis económica que vive Japón desde el año 1991 desató el estallido de la burbuja inmobiliaria, lo que, a su vez, ha retroalimentado la crisis hasta encerrar a la segunda economía del mundo en un callejón del que apenas ahora comienza a ver la luz al final del túnel. El índice de suicidios se disparó en una sociedad sometida a fuertes presiones y con muchos de sus 127 millones de habitantes encerrados en viviendas minúsculas por las que habían pagado precios astronómicos que descendían irremisiblemente. El archipiélago japonés tiene una extensión de 377.880 kilómetros cuadrados, pero su superficie es montañosa y boscosa en más de un 65%, por lo que la cantidad de suelo disponible es mínima. Confianza para el sector Sólo la megalomanía del principal constructor japonés, Minoru Mori, que ha levantado en el corazón de Tokio el complejo de Roppongi Hills, una ciudad dentro de otra ciudad, que ha costado más de 3.500 millones de euros y que alberga el Museo de Arte Mori, además de dos torres de apartamentos de 43 pisos de altura y una de oficinas de 54, un hotel y 200 tiendas, el Museo de Arte Mori, construido en el corazón de Tokio, ha devuelto una cierta confianza al sector inmobiliario tokiota. La enorme mole de acero y cristal, inaugurada en abril pasado, está plenamente ocupada. Según el Ministerio de Tierra, Infraestructura y Transporte, en septiembre el precio medio del suelo en Japón había descendido un 5,6% con respecto al mismo periodo de 2002 y a nivel nacional la bajada de los precios sigue sin frenarse. Tokio es supuestamente una excepción motivada, en parte, porque juegan a su favor algunos de los factores causantes de la deflación, como el envejecimiento de la población. Sólo en 2002 más de 120.000 personas, en su mayoría jubilados que vivían en los alrededores de la capital, optaron por trasladarse al centro.

9 De ahí la cierta alegría que se respira en el mercado inmobiliario del corazón capitalino. Muchos ancianos consideran que el centro cuenta con mejores y más modernos servicios y, cansados de años de largos desplazamientos, deciden mudarse a una vivienda más céntrica. También influye en la recuperación de Tokio la opinión cada día más generalizada entre los inversionistas de que el estallido de la burbuja ha tocado fondo. En noviembre, el precio del suelo en el céntrico distrito de Shiodome repuntaba en los siete millones de yenes por metro cuadrado. "Estamos viendo un creciente número de casos de inversores individuales que compran edificios pequeños y medianos en Ginza y Aoyama", dos de los barrios de moda de Tokio, dice el director de una agencia inmobiliaria. Las subastas van cobrando también nueva vida. Sin embargo, existe el temor a que, como sucedió en 1997, la recuperación de la economía sea coyuntural. En aquel año, la crisis asiática provocó un nuevo desplome del suelo japonés, si cabe más brusco que el experimentado al estallar la burbuja inmobiliaria seis años antes. El fenómeno del aumento de los precios inmobiliarios en Japón y sus posterior desinfle de la burbuja es un fenómeno por el que se han interesado expertos y analistas inmobiliarios de otros paises occidentales por si se repite en esta zona. En varios países europeos y, sobre todo, en España existe el temor de que un brusco cambio en la tendencia de los tipos de interés provoque un estallido de la burbuja inmobiliaria que, a juicio de muchos expertos, se está produciendo.

The latest views of Morgan Stanley Economists http://www.morganstanley.com/GEFdata/digests/latest-digest.html Feb 09, 2004

Contents

Global: Coping with the Global Labor Arbitrage United States: Crosscurrents for the Fed United States: Review and Preview Europe - All: Schizo-GDP Preview Europe - All: Cut, Hike, on Hold Italy: Not According to Script Russia: A Further Boost to Fiscal Performance Israel: Geopolitical Shifts and Changing Fiscal Priorities

Global: Coping with the Global Labor Arbitrage

Stephen Roach (New York)

Month in and month out, the basic story really hasn’t changed. The United States remains in the midst of the most jobless recovery in modern-day, post-World War II history. It’s not the lags — especially after a 6% annualized growth spurt in the second half of 2003 and indications of more vigor to come in early 2004. Nor is it a measurement problem — with a small sample of households conveying a truth that a much larger sample of businesses is missing. Let’s face it: The Great American Job Machine has finally met its match. To be sure, jobs are finally increasing. But the current hiring upturn pales in comparison with historical norms. Gains in private nonfarm payrolls have averaged only 84,000 over the past five months (September 2003 to January 2004) — less than half the 183,000 norm that was recorded, on average, over the comparable five-month interval of the previous six recoveries. Scaled for the expanded size of the US economy, this shortfall is even more serious. When compared with the 6.5% increase in private sector hiring that has occurred, on average, in the first 26 months of the past six cyclical upturns, the current decline of a little less than 1% translates into a shortfall of 8 million Americans who would have been at work had the US economy been on the hiring trajectory of the typical recovery. The income implications of this hiring shortfall are equally profound. Private sector wage and salary disbursements — by far the largest component of personal income — are still down about 1% in real terms relative to levels prevailing at the trough of the last recession in November 2001; that compares with gains that averaged about 9% over the 25 months of the previous six upturns. That’s the functional equivalent of a $400 billion shortfall in real consumer purchasing power. Lacking in the fundamentals of income support, the current rebound is being fueled by more “toxic” sources of growth — budget deficits, reduced private saving, debt, and the extraction of purchasing power from over-valued assets such as property. Until that changes, the sustainability of this recovery remains an open question, in my view. Nor do I buy the commonly expressed view that the data are simply wrong — that the payrolls-based survey of business establishments simply misses miss the inherent dynamism of risk-taking entrepreneurs

11 whose enthusiasm for hiring can only be captured in the so-called household survey. Yes, the household- based job count is up 1.4 million workers in the 12 months ending January 2004 — well in excess of the paltry gain of 6,000 as measured by the establishment survey. According to the US Bureau of Labor Statistics, a little more than 25% of that discrepancy can be traced to definitional differences between the two surveys — namely a household survey that includes the self-employed, unpaid family workers, and private household staff. But the remainder of the difference could well be a perceptual one — disaffected workers sampled in the household survey who have downgraded their aspirations and simply won’t admit to the tougher reality depicted by businesses in the establishment survey. Yet there is really no comparison in the sampling accuracy of these two surveys. According to the US Bureau of Labor Statistics, the “active sample” of some 400,000 establishments in the payroll data covers about one-third of the total universe of such workers; by contrast, the monthly sample of only 60,000 households covers only 0.0006% of the universe of over 106 million households in the United States. There is no doubt in my mind as to which of these two surveys should be trusted. In these days of froth, the broad consensus of investors has continually ignored the hiring shortfall — choosing instead to draw comfort from the spin that vigorous job creation is just around the proverbial corner. I have stressed the “global labor arbitrage” as an alternative explanation as to why those hopes may not be realized in any short order (see my October 6, 2003 essay in Investment Perspectives, “The Global Labor Arbitrage”). In coming up with this hypothesis, I made an effort to step back and identify new characteristics of the macro environment that are coming into play, which might alter the traditional relationship between employment and aggregate demand. Three such forces quickly went to the top of my list — the maturation of offshore outsourcing platforms in places such as China and India, the Internet, and the cost-cutting imperatives of a no-pricing-leverage world. It is the confluence of these forces that strikes me as so unique in the current climate — an unprecedented interplay that has the potential to have a lasting impact on the hiring dynamic in high-wage economies such as the United States. I have been criticized for exaggerating the potential impact of this cross-border arbitrage on current US hiring trends. Right now, the metrics are fuzzy, at best. The benchmark estimate of white collar offshoring comes from the IT research firm, Forrester, who calculates that “only” 3.3 million US business processing jobs will shift offshore by 2015. Like all estimates of IT-enabled transformations in the real economy, this one could also be well short of the mark. The details of the just-released January payroll employment survey hint at just such a possibility: Job losses were evident in a host of service sector categories that are prime candidates for offshoring — namely, accounting and bookkeeping (-18,000), business support services (-8,000), architects and engineers (-2,500), legal services (-800), and computer systems design (- 600). For these areas, combined, US headcount is essentially unchanged over the past 12 months. At the same time, our calculations suggest that payrolls in America’s IT and information services segment are currently running about 350,000 below the profile of the recovery of the early 1990s — not exactly what would normally be expected of an increasingly IT-intensive US economy. Halfway around the world, anecdotal reports abound of surging employment in India’s IT-enabled export sector. In my view, these two seemingly disparate trends in America and India are not a coincidence — they are part and parcel of the same global labor arbitrage. Painfully for disenfranchised workers, this is the way globalization is supposed to work. The theory, of course, is that surging incomes in the developing-world that arise from such offshoring spawn new markets and a new class of consumers. As supply begets these new sources of global demand, goes the argument, displaced workers in the developed world are presumed to be well positioned to uncover new sources of job creation. It’s a great theory, and, over the long run, inarguable, in my view. But the long run may be a good deal further in the future than most are willing to admit. First of all, consumers in low- wage developing nations such as China and India do not have job security or the benefit of institutionalized safety nets. China, for example, continues to eliminate 7–9 million positions a year under the guise of state-owned enterprise reforms and is lacking a national social security and pension system; little wonder its consumers remain predisposed toward saving. That underscores one of the inherent asymmetries of globalization: The shifting mix of global job growth may initially be driven more by the supply side of the equation in the low-wage developing world; conversely, demand-side impacts, which might spur hiring in the high-wage developed world, could lag for a considerable period.

12 But there’s another serious problem as well — a narrowing of the educational attainment gap between the developed and developing worlds. That could well inhibit the knowledge-based job creation that high- wage western economies are counting on to fill the void of the cross-border labor arbitrage. That possibility should not be taken lightly. US National Science Foundation data show that the United States is currently awarding only about 200,000 bachelor’s degrees in engineering and science, little changed from trends in the mid-1980s. By contrast, Asia’s annual graduates of science and engineering students (for China, India, Japan, South Korea, and Taiwan, combined) has now hit approximately 650,000 per year; that’s up over 50% from the graduation rate in the mid-1980s and fully three times the comparable degree production rate in the US. The US has long drawn comfort from the quality differential of its educational system; however, in the Internet Age with its ubiquitous diffusion of knowledge, innovation, and technological change, that may turn out to be an increasingly false sense of security. Needless to say, convergence on the human capital front raises serious questions about America’s future competitive prowess, as well as its ability to uncover new sources of job creation. In the end, the global labor arbitrage may well meet its biggest challenge in the political arena. A record hiring shortfall in an election year certainly raises this issue to the top of America’s political agenda; that’s especially the case if job-related angst continues to move up the white-collar occupational hierarchy to segments of the US workforce that have never before felt the pain of economic hardship and distress. But harsh verdicts are also likely to be rendered by other politicians and policy makers around the world. The G-7’s Boca Raton communiqué is but the latest example. In my view, Europe and Japan are now united in pointing the finger at China as the scapegoat of global rebalancing; consequently, they seem to believe that China must now bear a greater share of the impacts of a weaker dollar — a point of view that doesn’t exactly sit well in Beijing these days. The IT-enabled global labor arbitrage is emblematic of the inherent contradictions of globalization: It is the means by which jobs are created in poor countries while it is also the breeding ground of a political backlash in rich countries. Ultimately, these tensions will have to be vented — either through economics, or politics, or both. The steady drumbeat of America’s jobless recovery tips the scales more toward the political resolution. So does the recent verdict of the G-7. For that reason alone, I continue to fear a backlash against globalization that that takes the form of heightened trade frictions and mounting protectionist risks.

United States: Crosscurrents for the Fed

Richard Berner and David Greenlaw (New York)

Forecast at a Glance

2003A 2004E 2005E

Real GDP 3.1 4.8 3.8

Inflation (CPI) 2.3 1.5 2.2

Unit Labor Costs -1.2 -0.3 1.8

After-Tax "Economic" Profits 18.5 17.2 3.2

After-Tax "Book" Profits 13.1 19.1 36.8

Source: Morgan Stanley Research

13 When Fed Chairman Alan Greenspan testifies before Congress this week, he will appraise the outlook for inflation and growth and probably clarify the Fed’s future policy options. In all likelihood, Mr. Greenspan will affirm the message he and other Fed officials have clearly spelled out in recent speeches: With inflation low, ample slack in the economy, productivity growth high, and job growth still tepid, the Fed “can be patient in removing its policy accommodation.” Indeed, we now think the Fed will raise its target for the Federal funds rate to 1½% by yearend; previously we forecast a rise to 1¾%. But the Fed’s new language, used following the January FOMC meeting, marked the second change in tone in the past two meetings — from a Fed worried about further unwelcome declines in inflation and committed to an accommodative stance for a considerable period to one that sees the risks as more nearly balanced. Do those nuanced changes suggest that the Fed might be in motion sooner than market participants now expect? Although monetary policy is extremely accommodative, two factors do suggest that any Fed tightening still looks far off. First, reaching “price stability” rules out the need for the preemptive tightening the Fed has employed to bring inflation down through much of the past two decades. Second, with “core” inflation that is too low for comfort, “risk management” in the conduct of monetary policy dictates an asymmetric policy response to make sure that inflation doesn’t fall further. Put differently, the risk of tightening prematurely when legitimate questions about the direction of inflation and the sustainability of the recovery still abound currently seems higher than the risk of being “behind the curve” if inflation rises faster and growth proves more vigorous than policy makers expect. But because the consensus view seems to be pushing any Fed action further into the future, we think it’s helpful to look at the factors that could promote action sooner rather than later. Inflation is what matters most to the Fed, especially in light of concerns that, as Fed Governor Bernanke noted last week, too-low inflation could begin to have harmful effects on the economy’s performance. With core inflation below the Fed’s presumed 1% to 2% comfort zone and apparently trending lower, a reversal even to the midpoint of that range may seem unlikely soon. Core inflation measured by the change in the personal consumption price index (PCEPI) over the past year stands at just 0.7%, a 44-year low. But in our view, the ingredients for a faster pace are in the mix. Specifically, our call for a rebirth of pricing power in 2004 has long hinged on three factors: “Capital exit” (Corporate America’s efforts to reduce excess capacity or slack), a Fed committed to fighting a decline in inflation and inflation expectations, and stronger growth would combine to reverse the loss of pricing power companies have experienced over the past several years. We think that there has been progress on all fronts, suggesting that inflation is headed gradually higher, and, while it is a close call, that the Fed will have reason to begin moving in the third quarter. The Fed’s December shift to an “almost balanced” inflation risk assessment, seemingly at odds with recent inflation data, may reflect changes in one of those factors, namely consumer inflation expectations: In the past three months, median one-year-ahead inflation expectations in the University of Michigan canvass have risen to 2.7% from 1.9% at mid-2003. The recent increase in energy quotes may have contributed to the rise, but the dollar’s decline, sharp increases in a variety of commodity prices, and reduced discounting may also have played roles in the expectations rebound. And these surveys often anticipate changes in inflation and consumer behaviour. Moreover, it wouldn’t take much to get back to the midpoint of the 1% to 2% core inflation range fairly soon. Arithmetic helps, because core inflation as measured by the PCEPI was flat in the first three months of 2003. So if upcoming core inflation readings average 0.1% monthly, year over-year core inflation will be back to 1.1% by March. The trend in unit labor costs — a second key ingredient in the Fed’s and our analysis of inflation — is still quite benign, but now appears to be bottoming. Over the past four quarters, such costs shrank by 1.9%, for the second consecutive annual decline. However, with labor hours now on a rising trend (1.5% annualized over the past four months), productivity therefore slowing to a still-strong 2½ to 3% trend, and compensation gains as measured by the employment cost index stabilizing at 3¾% rate over the past three quarters, the disinflationary impact of those unit cost declines is likely to fade significantly in coming quarters. In the Fed’s and our view, slack in the economy is a third key ingredient affecting inflation. There’s still ample slack by any measure in labor markets, manufacturing, and the overall economy, but uncertainty

14 clouds measurement. The unemployment rate stands at 5.6%, well above its level in the late 1990s and certainly not signaling that labor markets are tight. Indeed, the rate would be significantly higher had not discouraged workers dropped out of the labor force. In manufacturing, capacity utilization stands at 74.5%, nearly 6 percentage points below its long-term average. And the output gap — the difference in percentage points between actual and potential GDP — currently stands at about 1½%, as reckoned by the Congressional Budget Office. But that presumes potential growth to be “only” 3½%; if potential growth has really been 4% since 2001, the gap would now be 3%. For the Fed, such uncertainty over how much slack there is in the US economy — not to mention the slack that exists globally —may require more attention to inflation itself. And the inertia in inflation would add to the Fed’s policy patience. However, it’s not just the level of these gaps that determines inflation, the Fed and we agree that how fast they close also matters. On that score, the unemployment rate has declined by 0.7 percentage point from its peak in mid 2003, though a jump in labor force participation could arrest the slide. The factory operating rate has risen 2 percentage points in the past eight months, and given the ongoing declines in capacity apart from IT and motor vehicles, seems likely to rise significantly even with moderate production gains. And the output gap is narrowing as a brisk, above-trend recovery takes hold. Even if growth slows to 4½% in the first half of this year, as we expect, and potential growth has been 4%, the gap will have narrowed by 100 basis points by mid year. Clearly, however, the future pace of recovery will determine whether and how fast the gaps narrow further. We believe that the fourth quarter halving in growth represented a more abrupt deceleration than was warranted by fundamentals, and that the economy is poised to reaccelerate (see “The Next Growth Surprise,” Global Economic Forum, February 2, 2004). But that prognosis is still a forecast. While nonfarm payrolls rose in January by 112,000, the strongest gain in three years, the employment shortfall still could threaten the sustainability of recovery (see “Debating the Jobless Recovery,” Global Economic Forum, January 30, 2004). And the debate over which measure of employment may be telling the right story — the payroll survey or the household survey — further clouds understanding. In our view, the payroll survey is far more reliable, but neither employment canvass represents ultimate truth (see “Review and Preview,” Global Economic Forum, February 6, 2004 for details). Other incoming data depict that production is catching up to demand growth — notably in manufacturing surveys — but improvement in factory orders and non-auto retail results suggest that the it would be a mistake to underestimate the vigor of demand. With inflation so low, the Fed will want to be sure that deflation risks have truly faded, and at the very least, has the luxury to be patient. Yet, how far monetary policy is from “neutrality” may also determine how soon and how fast the Fed will tighten. A “neutral” monetary policy may ultimately be consistent with a 4% to 5% Federal funds rate (see “Output Gaps, Productivity, and the Fed,” Global Economic Forum, November 21, 2003). If that is the case, would it be best for the Fed to tighten relatively soon and gradually over two years or more, as we expect? Or, should policy makers buy disinflation insurance by keeping policy on hold until inflation really begins to rise, and then to be more aggressive in returning to neutrality? Which strategy the Fed adopts matters critically for financial markets: The former could backfire, if, despite the Fed’s best intentions and careful communication, market participants extrapolated from a first cautious move the whole series of tightening moves much more quickly than the Fed intends. The latter would encourage greater use of leverage and easier financial conditions for now, but when policy inevitably turned toward restraint, financial markets might undergo a more abrupt and wrenching adjustment to the new policy reality. Balancing those considerations will require the utmost skill even from a Fed chairman who is at ease in navigating between the Scylla of Congress and Main Street and the Charybdis of Wall Street. There’s no doubt in our minds that the Fed’s change in language last month was designed to pave the way for the chairman’s testimony in two related respects: It realized the Fed’s desire to reconnect any change in monetary policy to circumstances rather than the calendar now that financial conditions seem to be supportive of sustainable recovery. And it reflected the fact that officials likely also wanted to remove the one-way bet that their earlier language gave to market participants. In that sense, asset prices and

15 incipient bubbles have become important for the Fed. Despite officials’ protests that acting to prevent bubbles is beyond their ken, we suspect that they are becoming wary of creating another one.

United States: Review and Preview

Ted Wieseman/David Greenlaw (New York)

In what's becoming a regular monthly event, Treasury prices posted solid front-end led gains the past week as nonfarm payrolls again showed disappointingly low growth in January. Although the January results weren't as bad as December, establishment employment continued to run surprisingly soft relative not only to the general pace of economic activity the past few quarters but also just about all other labor market indicators — claims, ISM employment measures, consumer confidence, hiring surveys, et al. Most notable, of course, has been the ever-widening chasm between establishment payrolls and a comparable household measure. We're loath to rely on the volatile household survey over the much more comprehensive establishment count, but the former's behavior over the past year and in the most recent few months in particular certainly seems a lot more reasonable compared to the rest of the available information. Along with Fed Governor Bernanke, we still expect we could see some "big numbers" to redeem the establishment survey in coming months, but in the meantime the conflicting recent signals should certainly buttress the Fed's "patient" stance on monetary policy. The key event in the coming week will be Fed Chairman Greenspan's monetary policy testimony, where we should get a much clearer sense of whether the FOMC's recent language shift was merely rhetorical or instead signaled a fundamental adjustment in policy makers’ thinking. Benchmark Treasury yields fell 4 to 8 bp the past week, with all of the gains coming in a solid 5-year-led rally after the weaker-than-expected employment report. Prior to Friday's surprise, the market had been trading a bit softer on the week in fear of a much stronger jobs report and ahead of significant supply at the upcoming refunding auctions. Our CIF model ended the week close to flat, indicating that the Treasury curve is now priced for no change in Fed policy over the next 4 to 6 months. On the week, 2s- 30s steepened 4 bp as the 2-year yield fell 8 bp to 1.76% and the long bond yield fell 4 bp to 4.93%. The 3-year performed strongly, as its yield fell 8 bp to 2.17%, matching the 2-year on the week as 2005 eurodollar futures led the market up Friday. The belly of the curve reversed some prior relative underperformance in the post-employment report rally, with the 5-year yield down 6 bp on the week to 3.09% and the 10-year 4 bp to 4.09%. Although prices rallied strongly Friday, the week's closing levels indicate some significant doubts among investors about the reliability of the labor market numbers. Front-end yields remain meaningfully above pre-FOMC levels and the curve correspondingly flatter. Even after solid gains Friday, fed funds futures are still priced for an earlier start to Fed rate hikes than we think is likely. At 1.135%, the July fed funds contract continues to price in a better than even chance of a rate hike at the June FOMC meeting and the May contract at 1.05% reflects a not insignificant chance of an earlier move. Nonfarm payrolls rose a less-than-expected 112,000 in January. Most of the gain was accounted for by retail trade (+76,000), as lower than normal temporary Christmas hiring from October to December left fewer people to be fired in January. The main downside surprise was in business and professional services (-22,000) as temp workers (-21,000) declined for the first time in nine months. Other aspects of the report were more positive. The unemployment rate fell a tenth to 5.6%, as the household measure of employment (adjusted for a population break) jumped 496,000. The average workweek rose two tenths to 33.7 hours after having hit a record low in December, which, combined with the gain in payrolls, resulted in a 0.8% jump in aggregate hours worked. Since the turn in labor market conditions in September, nonfarm payroll growth has average a measly 73,000 a month, a significant disconnect from the much larger improvement seen in various other indicators of labor market activity — jobless claims, ISM employment gauges, consumer confidence related job market questions, business hiring surveys (e.g., the Manpower and NFIB surveys), etc. The recent behavior of the household survey has been much more consistent with the cyclical upswing seen in

16 these other employment indicators than the meager establishment payroll growth. This certainly should not be the case, as the coverage of the establishment survey — 400,000 worksites accounting for a third of all employment — dwarfs the household sample size and should make it the much-preferred measure of wage and salary employment. But the size and length of divergence between the two series is reaching ludicrous proportions, and the household results certainly make a lot more sense relative to the rest of the data. Since the recession trough in November 2001, adjusted household employment is up 1.7 million and establishment payrolls are down 716,000. The benchmark revisions indicate that at least in the first year or so, the establishment count was more accurate. But the more recent results — as the economy has posted several quarters of strong output growth with little payroll change and resulting hard to believe productivity numbers — look more questionable. In the year through January 2004, the establishment payroll count rose only 6,000. A comparable version of the household survey — stripping out self- employed workers, farmers, and household workers and adjusting for multiple job holders, unpaid leave, and breaks in the data caused by the January population control adjustments — was up over 1 million in this same period. Since August, nonagricultural wage and salary jobs in the household survey (adjusted for the January discontinuity) have risen about 275,000 a month, way above the 73,000 establishment average. Something strange is going on here. It is certainly possible that the establishment count will be vindicated again a year from now at the next benchmark revision, repudiating all of the other labor market data we watch. It seems more likely that something is causing an underestimation, at least to some degree. Clearly the prime suspect is the BLS' relatively new birth/death model that has been phased in over the past few years to replace the old bias adjustment in attempting to account for net jobs created by new firms (who are therefore not picked up by the usual sampling procedures). Once again the employment report was an outlier versus other data released the past week that showed considerable strength on the production side of the economy — notably ISM manufacturing and nonmanufacturing, construction spending, and factory orders. Consumer demand numbers were mixed — car sales pulled back more than expected in December, falling to an estimated 16.1 million unit annual rate from 17.7 million in December, but chain store sales were considerably stronger than expected across a wide range of stores, pointing to a solid gain in ex auto retail sales. The main focus in the upcoming week will be Fed Chairman Greenspan's semi-annual monetary policy testimony on Wednesday and Thursday. Remarks from Governor Bernanke the past week did not suggest that the shift in language at the last FOMC meeting was indicative of any fundamental change in Fed thinking about the likely timing of a move to higher rates, and clearly Greenspan's remarks will be closely watched for any indication to the contrary. We continue to look for the first rate hike in September after we see clear signs of a turn higher in underlying inflation. The Chairman's appearances come right in the middle of the quarterly refunding, with a $24 billion 3-year auction Tuesday, $16 billion 5-year Wednesday, and $16 billion 10-year Thursday. The $56 billion refunding package was again smaller than we expected as Treasury trimmed the 10-year size again. Our estimates show that at current coupons sizes, Treasury has about a $140 billion financing gap to fill in the rest of current fiscal year if the deficit is near $475 billion. The clear implication from the recent cuts in coupons is that the bulk of this is likely to come in the bill sector. This is clearly cheaper in the short-run, but it creates significant rollover risks heading into a Fed tightening cycle. There are a few key data releases later in the week, highlighted by retail sales and the Treasury budget Thursday and trade Friday: * We look for a 0.2% rise in January retail sales and a 0.6% gain ex autos. Unit sales of motor vehicles posted a somewhat larger-than-anticipated fall-off but the chain store results were quite impressive. Meanwhile, we expect some weather-related softness in the hardware and furniture sectors but this is likely to offset by price-related gain in the service station category. Overall, while we expect only a fractional rise in headline retail sales, the nonauto component is likely to register a solid advance. * We forecast a $5 billion federal government budget surplus in January, close to the $11 billion surplus recorded in the corresponding period a year ago. This is consistent with our expectation for a $475 billion deficit for the fiscal year as a whole. Estimated tax payments by individuals came in right on expectations in January, but the upcoming tax season continues to represent the main source of uncertainty in the FY 2004 budget outcome.

17 * We expect the December trade gap to rise to $40.6 billion, reversing most of sharp narrowing seen last month, with exports falling 1.5% and imports gaining 1.0%. The bulk of the anticipated decline in exports should be accounted for by a pullback in the aircraft category — which soared in November. Meanwhile, the recent slowing in manufacturing shipments points to some moderation in other capital goods exports on the heels of sharp gains in recent months. On the import side, most of the elevation should reflect a price-related surge in natural gas imports. Port data indicate that imports of other goods were little changed again this month.

Europe - All: Schizo-GDP Preview

Eric Chaney (Paris)

Europe is still largely “terra incognita” as far as business cycle analysis is concerned, for lack of comprehensive, timely and consistent statistics. Did you know that Germany has renounced undertaking censuses, that Italy has no quarterly income accounts and that France has more detailed data on agriculture (4% of GDP) than on services (60%)? Politicians should think about re-allocating funds currently wasted on agricultural subsidies and give the money to statisticians, provided that they become more accountable for the quality of their work and tell us what’s really going on. We are not there — actually, nobody seems to care about it — and I have to comment on the upcoming round of Q4 GDP releases in the euro area. This is why I am alluding to schizophrenia in the title of this piece. On the one hand, the most reliable business cycle indicators we have, i.e., business surveys, for once backed by industrial production data, are pointing to a strong Q4 GDP reading, between 0.7% (our long-held call) and 0.8% to 0.9% (as suggested by our survey-based models). Translated into quarterly annualized terms, as it is the tradition in the US, we are talking of GDP growth between 3% and 4%, not bad for old Europe. On the other hand, our country analysis is giving a much less upbeat view on recent trends. For instance, my colleague Vincenzo Guzzo writes in the current Weekly International Briefing that “the Italian economy appears to have lost momentum over the final three months of the year, and signs of inflection in the main confidence indicators suggest that conditions might not improve over the current quarter”. Not only Vincenzo is predicting that Italy’s GDP increased by no more than 0.3% at the end of last year, but he is so concerned about the underlying picture that he has cut his 2004 GDP forecast from 2.0% to 1.7%. Two idiosyncratic factors seem to be weakening the Italian economy. First, the Parmalat scandal is, other things being equal, much larger than similar scandals in the US (although, as one client observed during our MacroVision session last week, most European corporate scandals originated in their US subsidiaries). More concretely, Italian savers might have to foot a large part of the €16 billion bill. Second, Italian consumers are getting ever more angry about euro-denominated prices, which they feel are unfairly high. On Vincenzo’s reckoning, Italian consumers feel that inflation is running at double-digit rates, even though statisticians say it is only 2.3%. There is even a political row about the accuracy of inflation measurement, which gives me a feeling of deja vu. The truth is that, although perfectible — quality effects are probably underestimated — the Italian CPI is a world-class statistical tool and is the best measure of inflation in this country. However, frustrated by the stagnation of wages and the way many retailers and bar keepers took advantage of the conversion, Italian consumers feel otherwise. Then, what about the best performer in European equity markets in 2003 — the best beta play in Europe, as some investors named her — Germany? My colleague Elga Bartsch had long ago called for a significant acceleration of German GDP growth, to 0.5% in Q4, from 0.2% in Q3. So far, news from the supply side has confirmed her call, with IP up 2.6% on the quarter and business sentiment reaching levels not seen since 2001. With IP up more than 10% on an annualized basis, you would expect that the largest manufacturing platform in Europe would generate 3% to 4% GDP growth. However, German statisticians have undertaken a major review of industrial production data, which calls at least for some caution. Elsewhere, retail sales were disappointing, not a big deal, given their poor correlation with aggregate consumer spending, but nevertheless not a good signal. Last, the Bundesbank advanced

18 estimate for Q4 was rounded to 0.25%, which, as Elga wrote in her comment, is "a warning no to get carried away by IP data”. In the next two large economies of Europe, France and Spain, we are still confident that GDP growth accelerated to 0.7% and 0.8%, respectively, in the last quarter of last year. French IP was up more than 1% and retail sales (manufactured products) up 0.4%, suggesting some limited downside risk to our call. As far as Spain is concerned, a slight acceleration from Q2 and Q3 GDP readings (both reported at 0.7%), on the back of booming global trade and robust IP data and a still-roaring construction sector, does not look particularly over-stretched. In the end, I think that GDP growth in continental Europe was strong at the end of last year, as it was in the UK. Our forecast, 0.7% or 3% quarterly annualized, seems to me to be a lower bound for what really happened. In two or three years time, I would not be surprised if we read that growth reached 4% (annualized) in statistical books that nobody will consult. However, the risk is that, next Friday, Eurostat might announce only 0.5%, if not even less.

Europe - All: Cut, Hike, on Hold

Joachim Fels & Elga Bartsch (London)

Something strange is happening in Europe — this past week, three different central bank policy meetings in London, Frankfurt and Stockholm resulted in three different outcomes. The Bank of England opened the dance with its second 25 basis point (bp) rate hike since November. Then, the ECB issued its on-hold message without any discernible bias in either direction soon after. Last, but not least, the Swedish Riksbank stepped up to the plate and lowered the repo rate by 25 bp to an all-time low of 2.5%. While each of these moves was in line with our and market expectations, the diversity of outcomes remains puzzling. And a comparison of the outlook for growth and inflation as well as the relative monetary policy stance in these three regions does not help to clarify matters either. For starters, recall that business cycles in the euro area, the UK and Sweden have become increasingly synchronized over the past decade. True, the three areas have grown at different paces on trend, but the turning points of the three cycles are highly correlated. The latest twist in the cycle is no exception: the current economic recovery started around the middle of last year. Moreover, the three central banks all forecast a return to around their respective trend GDP growth rates this year, with the ECB defining the lower bound of the range (a 1.6% growth forecast that translates into 1.9% once the positive calendar effects this year are added to the picture), the Riksbank in the middle (2.4%) and the Bank of England at the upper end with its 2.7% GDP growth forecast. While the ECB is clearly more cautious than we are, there is no major difference between our projections and that of the Bank of England and the Riksbank. The puzzle deepens when looking at real short-term interest rates. Using current CPI inflation of 1.3%, real rates in the UK are now at 2.7%, the highest in the group and smack in line with the estimated GDP growth, and still the Bank aims at raising rates further, in our view. Meanwhile, real rates in Sweden are fully 200 basis points lower than in the UK and significantly below GDP growth in the largest Nordic economy. Nonetheless the Riksbank felt this week that a further easing was needed. Finally, Euroland has the lowest real rates (zero to be precise) and abundant liquidity, but the ECB currently sees no need to tighten the screws, as ECB President Trichet’s balanced statement at the press conference illustrated yet again. Inflation doesn’t really explain the diverging interest rate moves either. The UK has the lowest current inflation at 1.3%, the euro area the highest (2.0%), and Sweden somewhere in-between (1.7%). To make the confusion complete, the currency moves since the previous monetary policy meetings also don’t really gel with the rate decisions. The Sterling TWI rose by some 3% during January, while both the Swedish krona and the euro weakened around 2% on a trade-weighted basis last month. Where do these conflicting monetary policies leave the European bond markets? For starters, we expect bond yields to rise as the euro-area market starts to re-price the likely path of future ECB interest rates. We see ten-year Bund yields climbing to 5% by the summer. At the same time, the Bank of

19 England seems to be the most preemptive central bank and might even have to tighten less than what the markets are pricing in. Meanwhile the Riksbank is at risk of falling behind the curve and might be forced to reverse its past easing more abruptly than the market foresees at the moment. We’d therefore expect gilts to outperform Bunds and remain concerned that Swedish bonds might underperform Bunds. The short-rate puzzle though remains unresolved — at least for now. Italy: Not According to Script Vincenzo Guzzo (London) Let’s face it. Things are not playing out according to script everywhere in Europe. After a surprisingly strong third quarter, the Italian economy appear to have lost momentum over the final three months of the year and signs of inflection in the main confidence indicators suggest that conditions might not improve over the current quarter, as we originally expected. Numbers speak louder than words. While business sentiment has advanced steadily in Germany and France (up seven and ten points respectively from last August), in Italy it is two points lower than where it was six months ago. Households are certainly not in a better mood. The consumer confidence gauge is some six points off its August level and has pierced to the downside the 100 mark for the first time since the end of the 1993 recession. Italy seems to have missed the recovery train. Real data tell a similar story. After the most solid gain in ten quarters, industrial production will likely be flat in Q4 and we would not rule out a contraction for the manufacturing sector. As for GDP, in our current estimate, we foresee a deceleration to 0.3%Q in Q4 from the 0.5%Q recorded in Q3 and risks appear to be skewed to the downside now. That is clearly at odds with the 0.7%Q we expect for the euro area as a whole over the same quarter. The shock comes mainly from domestic demand. Against a staggering 4.3%Q rise in foreign industrial orders, domestic orders are virtually stagnating. Car sales in January were up 5.7%Y on an annual comparison, but this number is biased by the big drop recorded over the same month last year, following the end of a period of tax breaks. Our seasonal adjustment suggests that sales might have actually eased in Q4 as compared to the previous quarter and the decline likely extended into early 2004. Italians think inflation is 12%. Parmalat is the buzzword in these days. But, while corporate scandals might be blamed for the recent loss of confidence and might undermine the recovery path in the months to come, they cannot explain why the economy started losing momentum with the end of the summer. We think that inflation, or rather the perception of it, has played a role. It is just astonishing how far apart actual inflation and households’ perception of price increases are at the moment. Using a diffusion index of price perception as measured by the ISAE consumer survey, we see how negative sentiment took off well ahead of the changeover to the euro, eased towards the end of last year, and then unexpectedly rose again over the past year. Regressing this series against actual inflation, we observe a perceived inflation rate of roughly 12% (!), nearly ten percentage points higher than the actual one. It may sound like an old story, but pessimism is not fading. We have witnessed the same phenomenon elsewhere in the continent. The introduction of the euro notes and coins led to upward adjustments in prices. Retailers took advantage of households’ difficulties in reading the new currency units and pushed prices up. In our view, the impact was magnified by the fact that round-ups were more frequent for those goods and services which are purchased on a frequent basis, and hence more visible. But, while both anecdotal evidence and sentiment surveys suggest that the malcontent is fading elsewhere in Europe, it is proving extraordinarily resilient in Italy, where as we said pessimism seems to be picking up again. News of an unexpectedly soft inflation rate in January had the result of exacerbating rather than calming the angry consumer associations. Bad news for spending. We fear that the presence of such a large persistent gap between perception and reality could lead to two undesirable consequences: knocking down consumer spending and heightening labor disputes over contract renewals. As for consumption, the tax breaks on car registrations have been supporting spending through the spring of last year. A somewhat smaller payback than expected and a surge in energy consumption related to the summer heat wave prevented consumption from slowing down during the first three quarters of last year. We believe that entrenched negative sentiment could now lead to a temporary setback in spending, even in the presence of a favorable income dynamics, thus pushing the savings rate higher. Evidence of it might have already surfaced over the last three months of 2003.

20 There is no reason why eventually perception should not collapse back to reality, but the protracted complaints about the new price levels could lead to a correction in spending. Tougher wage negotiations. In an environment where employees perceive a loss of purchasing power, expectations of wage increases are higher and negotiations become tougher. The example of the contract renewals for the transport sector, where angry bus drivers in December brought several cities to a standstill after a national agreement had already been signed, is indicative of deterioration in relationships between employees and employers. Data on the number of working hours lost in labor disputes for the fourth quarter will only be available with a big delay and probably will not reflect entirely the size of the disruption. But, if on top of that, we add the strikes against the proposal of a pension reform, we may easily anticipate a dampening effect on demand. And note that this is not only a story for 2003. With the share of contracts awaiting renewal jumping from 28% to 64% in January these conflicts are not going to abate, in our view. If any, they might intensify. Retail investors bearing a big share of the Parmalat burden. All this tells us that the Parmalat crisis hit business and consumer confidence even more so at a difficult juncture. The collapse of the Italian dairy group has implications for both the corporate and the household sector. Latest statistics from the Bank of Italy show, ahead of the crisis, a share of gross non-performing loans over total customer loans holding steady at just below 5%. With a total domestic loans exposure to Parmalat that our banking analysts estimate at around €2-3.5 billion (see Davide Serra and Guglielmo Zadra, Parmalat: Wake Up Call for ‘Blue Sky’ Scenarios’, January 20, 2004), the potential impact is a rise in non-performing loans of some 7% that could push that share close to 5.5%. We think, however, that the impact on households might be larger. More than 100,000 lawsuits filed by retail investors with the Milan prosecutor suggest that consumers might have to bear a large burden of a bond exposure that could add up to some €6-7 billion. The lengthy Parliamentary path of a reform bill of the financial supervisory authority, already watered down relative to the initial proposal, might not do much to cheer them up. Bottom line. Even in the presence of a vigorous global upswing, the combination of stubbornly high inflation perception, heightened labor disputes, and financial distress might prevent Italians from fully enjoying the recovery party. Amid rising downside risks, we maintain our call of GDP growth slowing down to 0.3%Q in Q4 from 0.5%Q in Q3, but cut our estimate for Q1 to 0.4%Q from a previous 0.7%Q. This change takes our 2004 full-year forecast to 1.7% from 2.0%. Russia: A Further Boost to Fiscal Performance

Riccardo Barbieri - Alexei Khalioulline (London)

Economy Minister German Gref confirmed on February 4 that the Russian government intends to raise the taxation on the oil industry effective January 2005. He also stated that the proceeds from new taxes would not exceed US$2-3 billion. Other government sources mentioned a slightly higher figure of US$3.5 billion. An increase of around US$3 billion would be equivalent at most to 10% of projected revenues from oil taxes in 2004, though it would eat more heavily into oil companies' net income (approximately 25%, on our reckoning). The taxation of the oil industry has become a hot political issue following the Yukos affair last year and the campaign for the Duma elections in December. The government had already announced that on February 26 it would debate whether and how to increase the tax burden on petroleum-related activities. Particularly if oil prices remain elevated by historical standards, as we expect, the implementation of additional oil taxes could indeed bring into the state coffers additional revenues worth between 0.6% and 1.0% of GDP, depending on the exact formulation of the tax and on the level of oil prices. Given the Oil Stabilisation Fund (OSF) mechanism that has been put in place this year, most of the additional funds probably would not be immediately available for raising public expenditures. The stimulative effect on the economy would thus be delayed and mediated by political decisions in a context of continuing fiscal prudence. Moreover, the new law will not go into effect until 2005 at the earliest.

21 The specifics of the new or modified tax are not yet known. Given that the new levy is meant to tax the 'rent' enjoyed by Russian oil companies, as well as discouraging companies from taking a 'predatory' approach to the exploitation of oil fields, it should differentiate among different oil fields. In practice, this could be very complex to regulate and enforce. In our view, the most efficient way to achieve the stated goal would be to appoint highly regarded international consultants to assign a rating to oil fields depending on the cost of pumping oil based on state-of-the-art (homogeneous) technology. The tax paid by each company would then depend on the composition of its output among oil fields of different 'grade.' Companies operating relatively disadvantaged fields would pay a lower average production tax. The key reason for the high profit margins enjoyed by Russian oil companies is that they are integrated producers and are thus reaping all the benefit from currently high oil prices and from Russia's relatively low extraction costs. The low level of domestic energy prices reduces such profitability but creates an incentive to focus on exports of oil products. Given its progressive structure, the export duty allows the government to capture some of the benefit from high oil prices. A steeper tax curve could be considered for the export duty. We understand that, given the difficulty of structuring a differentiated tax on different oil fields, the bulk of the tax hike in 2005 could ultimately consist of making the export duty more progressive and from raising the oil production tax. With the OSF in place, the economy and the federal budget are more insulated from the fluctuations in oil prices. However, the new tax on the oil rent will further boost oil tax revenues and the OSF. We expect that already in 2005 the OSF will move above the R 500 billion threshold below which the funds are blocked unless the oil price declines below US$20 per barrel for the Urals quality. While we would not be surprised if the OSF were not tapped at all next year, we would expect some of the funds to be ultimately be spent on public investment, and we believe this could be a plus for economic growth in the medium term. Russia's overall fiscal approach, however, remains very prudent and decision-making is slow. The key conclusion is thus that, while the oil industry will have to contend with higher taxes, government savings will rise and sovereign creditworthiness will improve further. Meanwhile, according to preliminary figures from the Ministry of Finance, Russia's budget surplus in January was R 55.5 billion, against a target of R 25 billion. The budget surplus amounted to 5.3% of estimated monthly GDP, against 4.0% of GDP in January 2003. Revenues exceeded the budget plan by 6.4%, and expenditures were 9.4% short of the target. The surplus in January not only exceeds the target by more than 100%, but also covers two-thirds of the full-year target surplus of R 83.4 billion (0.5% of GDP). This suggests that the annual target will be probably far exceeded. The planned budget surplus of R 83.4 billion for this year is earmarked for the OSF. Any additional surplus over and above that level would not be automatically added to the OSF, and could be transferred to the budget for next year. However, we expect that at least some of the budget surplus overshoot will end up in the OSF. This implies that Russia continues to save a significant chunk of its oil dividend and that if oil prices fall later in this decade, it will have some ammunition to support the economy.

Israel: Geopolitical Shifts and Changing Fiscal Priorities

Serhan Cevik (London)

Economic recovery is already under way, but structural initiatives will remain key. Israel’s central government budget deficit widened from 3.9% of GDP in 2002 to an estimated 5.6% last year. Although this was a disappointing deviation from the original 3% target, fiscal deterioration did not come as a surprise given the country’s economic and political problems, which hurt tax collection. However, the light at the end of a depressingly long tunnel is becoming brighter, in our view. The Israeli economy has already shown signs of improvement, and the global recovery should provide a further boost. We expect real GDP growth to accelerate to 3.2% in 2004, from 1.8% last year, generating a real increase in tax receipts. We also believe that geopolitical shifts in the Middle East in the aftermath of the war in Iraq present a historical opportunity to rethink Israel’s national security strategy and fiscal priorities. Reducing government spending will boost economic activity and ensure fiscal sustainability. Unlike previous stabilisation attempts in the last three years, the economic programme that has been implemented

22 since July 2003 puts the onus on spending cuts and structural reforms. The authorities have reduced public-sector salaries and social transfers, increased the national insurance ceiling, tightened requirements for unemployment benefits, eliminated regional tax incentives, and initiated an ambitious income tax reform. We are particularly encouraged by the government’s resolve to tackle politically sensitive issues such as social transfers, which increased by 60% against a 15% rise in the country’s population in the last seven years, and the pension deficit, which amounts to 23% of GDP. Along with steps to rationalise social payments, increasing the retirement age and ‘commercialising’ pension funds will improve the actuarial state of the country’s pension system. Even with conservative assumptions, the budget deficit would narrow to 4.2% of GDP this year. Total budget revenues declined 2.5% in real terms last year, while non-interest spending kept rising. However, contrary to market expectations, we have long argued that the budgetary impact of these fiscal measures would be realised in 2004 and beyond. Indeed, the latest data support our view. For example, budget revenues increased by 16.3% year on year in real terms last month thanks to higher import duties and VAT revenues. Public spending declined by 10.3% in the first month of this year, after increasing at an accelerated pace in the last two years due largely to social transfers and defence expenditures. As a result, the central government budget balance moved to a surplus of 615 million shekels from a deficit of 2,084 million shekels last year. Though there have been one-off factors contributing to higher tax receipts in January, we believe that the 2004 budget assumptions (such as a growth projection of 2.5% and tax revenues that are only 2 billion shekels higher than last year’s outcome) are reasonably conservative and should lower the budget to, at worst, 4.2% this year. The major risk to public finances is on the spending front, in our opinion. Even though the authorities have taken encouraging steps to limit non-interest spending, political pressures for increasing social transfers and military expenditures and bailing out deficit-ridden municipalities remain the crucial burden on the central government budget. Because of chronic budget deficits, the accumulated debt of local governments rose 15 billion shekels last year. More importantly, the breakdown of the peace talks and the subsequent wave of violence and regional tensions have reversed the downward trend in military spending. The Oslo Agreement with the Palestinians had produced a substantial ‘peace dividend’ by allowing Israel to reduce its defence spending to an average of 8.5% of GDP in the second half of the 1990s, from 22% in the two previous decades. Regrettably, military expenditures increased from a low of 8.2% of GDP in 2000 to an average of 11.8% in the last three years. Geopolitical changes in the Middle East allow rethinking of Israel’s fiscal priorities. Defence spending excluding loan repayments accounts for about 20% of the government budget. We believe that recent geopolitical changes in the Middle East (specifically, the removal of the so-called eastern threat) present an opportunity to re-evaluate Israel’s national security strategy without reducing its deterrence capability. In fact, Israel’s immediate security problem stems from conflicts within its own territories. Unfortunately, its deterrence capability against a conventional war has little relevance to internal conflicts, which leads us to conclude that a peace agreement with the Palestinians is a necessary condition for Israel’s economic welfare and credit fundamentals in the long run. For the time being, economic recovery and spending cuts should stabilise the public finances and support the central bank’s monetary policy framework. http://www.morganstanley.com/GEFdata/digests/20040209-mon.html

The latest views of Morgan Stanley Economists

Feb 06, 2004

Contents Global: Time to Reload United States: Watershed for Credit Demand Currencies: USD -- 'Q' and My 'A' on Global Imbalances and the Dollar Germany: The Last Metal Battle? Japan: Monetary Growth Myths Thailand: A Sick Birds' Eye View of a Healthy Thai Economy Currencies: G-10 -- Freedom from the USD Trade? Asia Pacific: Tighten Capital Controls, Please

Global: Time to Reload Stephen Roach (New York)

Economic policy-making requires a touch of art as well as science. But it also needs a good deal of common sense. Like war, one of the basic principles of stabilization policy is never to run out of ammunition. Policy stimulus is to be used in bad times, but when circumstances improve, it is critical to “reload the cannon.” Otherwise, there will be no ammo for the inevitable next battle. As simple as this basic rule is, it has all but been forgotten in the current climate. The Bank of Japan’s zero interest rate policy is the most obvious case in point — a central bank that has completely run out of basis points. But it’s not as if the monetary authorities in America and Europe have vast stockpiles of arms either; their policy rates are only 1% and 2%, respectively. The same rule, of course, applies to fiscal policy — deficit spending in bad times should be followed by fiscal restraint in good times. The recent globalization of fiscal profligacy is not exactly comforting in that regard either. The basic principle of the “policy reload” is particularly relevant to the dilemma now faced by America’s Federal Reserve. Alan Greenspan’s recent “victory lap” in celebration of the Fed’s so-called successes of the past few years makes me especially worried that the US central bank is ignoring this principle at great peril. In a now infamous speech given about a month ago, the chairman argued that the Fed should be vindicated for its controversial approach in dealing with the great stock market bubble of the late 1990s (see “Risk and Uncertainty in Monetary Policy,” remarks presented at the meetings of the American Economic Association, San Diego, California, January 3, 2004). Notwithstanding the usual caveats of Fedspeak, one phrase from that speech says it all: “Our strategy of addressing the bubble's consequences rather than the bubble itself has been successful.” Think about the implications of this strategy. Chastened by the criticism he faced after declaring the stock market “irrationally exuberant” in December 1996, Greenspan now argues that central banks should remain agnostic on the existence of a bubble. Their job, instead, should be to contain the post-bubble damage — if and when it occurs. Fortunately for the Fed, it had some 600 basis points of ammunition in the federal funds rate at the time the equity bubble popped. But now 500 of those basis points have been used up.

24 That underscores the critical issue: With only 100 bp left on the federal funds rate, what can the Fed do for an encore? Last spring, in the midst of the great deflation scare, Fed officials argued that they had plenty of options left — namely, the “unconventional” weapons that could be deployed in the event the central bank ran out of basis points. But, in my view, there was more bluster than substance to those long- discredited monetarist claims. Japan’s post-bubble pitfalls seem to add considerable credence to this critique. But that’s really not my point. The real problem with using monetary policy only to contain post- bubble damage is that the central bank unwittingly locks itself into an asymmetrical policy tilt — ending up with an economy that becomes addicted to rock-bottom nominal interest rates. That makes it all but impossible to reload the policy cannon. That is precisely the Fed’s dilemma today. Sure, the US economy came through the bursting of the equity bubble in considerably better shape than most feared. But the real question is, at what cost? Ironically, post-bubble America finds itself even more dependent on asset markets than was the case during the pre- bubble build-up. In part, that’s because a new and unexpected development has also come into play — a jobless recovery that has put an unprecedented crimp in the economy’s personal income generating capacity. In retrospect, that was the critical complication that called the Fed’s bluff at precisely the point when it had all but run of ammo. Lacking in the traditional fuel of income support, consumers have had little choice but to extract purchasing power from yet another asset — this time, property. But such asset-driven growth spawns the lethal combination of debt and reduced saving. And America has willingly complied. Household debt outstanding has soared to a record 82% of GDP, while the net national saving rate plunged to a record low of less than 1% in 2003. Unfortunately, the shortfall of domestic saving has given rise to America’s massive current-account deficit — leaving the US economy with the worst confluence of macro imbalances in its modern history. All this and more is an outgrowth of the Fed’s asymmetrical strategy of coping with asset bubbles — holding its fire on the upside but then deploying maximum defenses on the downside. Meanwhile, this approach has another worrisome by-product: It has become a breeding ground for a string of additional asset bubbles that have come on the scene in the aftermath of the burst equity bubble. That’s not just true of property but also of bonds, credit instruments, emerging market debt, and tech stocks (again). This multiple-bubble syndrome is strikingly reminiscent of the moral hazard play that became central to the Great Bubble of the late 1990s — the recognition on the part of investors and speculators that Fed accommodation was here to stay. As long as the Fed takes interest-rate risk out of the equation, one bubble begets another. And so today’s Fed finds itself very much at odds with the time-honored principle of the policy reload. And yet the imperatives of replenishing the ammunition have never seemed greater. What would the Fed do if the US economy unexpectedly stumbled, another asset bubble popped, or an exogenous shock occurred? What worries me the most is that the Fed’s new strategy as articulated in San Diego by Alan Greenspan could boil down to a one-bubble fix. Unless the Fed can replenish its policy arsenal, it may well be helpless to deal with the inevitable next problem. Far from congratulating itself on the brilliance of its post-bubble-containment tactics, America’s central bank should be doing everything in its power to replenish its arsenal and get its policy rate back up to a more normal level. This is a delicate balancing act, to say the least. Deflation still lurks on the downside, but there is also a need to take advantage of swings to the upside. The risk-reward calculus is daunting, but the Fed has no choice, in my view. It needs to exploit any chance it can to normalize its policy rate. It’s the analog of what became known as “opportunistic disinflation” in the early 1990s — allowing periods of economic slack to reinforce the Fed’s battle for price stability. That war is now over. Now it’s time for “opportunistic reflation” — a Fed that uses every instance of strength as an occasion to reload the policy cannon. There is always the risk of overkill — an increase in short-term interest rates that takes a toll on the real economy. But the far bigger risk, in my view, is a central bank that is not only fostering a series of asset bubbles but is also lacking in ammunition for future problems. Nearly two years ago, the Fed’s research staff published a now seminal paper that tipped us off on how the US central bank would cope with America’s asset bubble. Billed as an assessment of the lessons of Japan, the Fed’s economists argued that the Bank of Japan should have eased quickly and aggressively in

25 the immediate aftermath of the bursting of the bubble in the Nikkei (see Alan Ahearne et al., Preventing Deflation: Lessons from Japan's Experience in the 1990s, Federal Reserve International Financial Discussion Paper No. 729, June 2002). The Fed obviously took those lessons to heart in implementing its own post-bubble strategy of aggressive monetary accommodation. Unfortunately, the Fed’s research staff never took their analysis to the next level — how a central bank executes the policy reload by extricating itself from the exceedingly low nominal interest rates of a post-bubble period. Let’s hope someone at the Fed is hard at work on writing that paper. United States: Watershed for Credit Demand

Richard Berner and Betsy Graseck (New York) At long last, one of the remaining missing pieces in the economic recovery puzzle is falling into place: Both the demand and supply for commercial funds improved significantly over the past three months. That’s the message in the just-released quarterly Federal Reserve Senior Loan Officer Survey, covering the three months ended in January. While these improved trends haven’t yet shown up in commercial and industrial (C&I) loans outstanding, this canvass has never failed to anticipate a lending upswing. As a result, we think the stage is now set for stronger growth in C&I outstandings later in the year. In turn, we think that increased business credit demand will usher in a period of rising real interest rates, reversing the three-year downtrend in those yields.

What’s going on? First, easier money. Banks recently eased commercial lending standards for the first time in six years. This represents a sea change in lender attitudes: While most banks stopped tightening lending standards in the previous three months, virtually none reported easing them. Now, fully 18% of respondents report that they have eased lending standards to large and medium-sized commercial borrowers over the past quarter. The only time a larger percentage of respondents to this survey reported easing C&I lending standards was 10 years ago in 3Q93, when just over 19% of respondents reported they were making business credit more available.

It’s worth noting that the 1993 easing in standards followed a period of severe stress among commercial banks. Credit quality had deteriorated sharply, especially in real estate. Total charge-offs reached 1.75% of all loans in 1991 and 2% of C&I loans outstanding. Bank capital ratios were sorely depleted. Aggressive monetary easing successfully countered the headwinds of bank credit restraint.

That was then. Today, the US banking system is in much better shape, with stronger balance sheets, more capital and better risk management. But there are some similarities to the earlier period that made bankers cautious over the past six years, and that more recently have made them eager to lend. The LTCM crisis and Russian debt default in 1998 unleashed a volatility storm that made bankers rethink the cheap credit lines they sold to Corporate America. Again, credit quality deteriorated: While real estate loan portfolios remained pristine, C&I charge-offs jumped from a low of just 0.25% in 1996 to 2.12% in 3Q02 for C&I loans. Again, it took an ultra-accommodative monetary policy to counter the financial headwinds that peaked following the corporate governance crisis of 2002, but charge-offs have since plunged (to 1.25% in 3Q03).

Against that backdrop, the Senior Loan Officer Survey indicates that companies are also finding it cheaper to borrow from banks. In the recent survey period, more banks trimmed lending spreads than at any time since 1998. A large 27% of respondents reported that they lowered their loan spreads from the prior quarter, an increase from 4Q03’s 14%.

Two factors have compressed lending spreads: First, still flush with deposit growth, banks are eager to substitute higher-yielding loans for the securities they acquired when credit demand contracted. Second, competition from the capital markets is forcing bankers to tighten spreads. Indeed, the spread narrowing since October 2002 in investment-grade and junk credit is virtually unprecedented. For example, the spread on the Morgan Stanley Tracers™ basket of 100 corporate bonds has narrowed from 260 bp then to a tiny 40 bp today. We expect that C&I lending margins will shrink over the next two years and that upcoming Fed Senior Loan Officer Surveys will show more banks tightening loan spreads. The early 1994 experience, when 60% of banks narrowed spreads, may be instructive in that regard.

26 Easier and cheaper access to business funding is a key factor behind our call for sustainable economic growth. Both increased access to credit and lower costs of borrowing increase the likelihood of stronger investment activity and inventory accumulation. In response, credit demand has turned the corner: The Fed survey shows that business confidence is rising as more banks are reporting stronger demand for credit. The swing was dramatic, from 12% of banks reporting weaker demand for C&I loans in 4Q03 to 11% reporting stronger demand. This is the first time in four years that banks are reporting more demand for credit than shrinkage.

With so many positive signs, why are C&I loans outstanding still shrinking? First, companies thus far have continued to reduce inventories in relation to sales; in December, the manufacturing I-S ratio plunged to a record low of 1.26. Work by Betsy Graseck last year showed that the single biggest predictor of C&I loan growth is a change in inventories (C&I Loans: Not Your Father’s Earnings Leverage, July 10, 2003). However, we believe that continued strength in the economy, higher levels of business confidence, and lower relative funding costs should support a powerful inventory snapback in coming quarters.

A second reason for the continued shrinkage in C&I outstandings is that amid the lowest corporate yields in 40 years, incremental borrowers with access to the capital markets have funded out debt rather than borrow short-term funds from their banks. To minimize interest expense, they have swapped some of those fixed-rate cash flows back into floating payments. As the yield curve flattens out at somewhat higher interest rates, and with long-term corporate debt in relation to the total at a 45-year high of 70.5%, we expect borrowers to be more indifferent to where they fund themselves along the curve. Consequently, shorter-term C&I loans should regain some ground over longer-term market borrowings. Finally, not all loan activity shows up on bank balance sheets. To conserve capital, many larger banks have preferred to securitize loans and collect origination fees rather than keep loans on their books.

Current C&I loan shrinkage does not suggest to us that the markets have permanently disintermediated banks. Shared National Credit data from the Fed and the OCC show we’ve been here before. In the most recent economic recovery, it wasn’t until the second year after the recession that commitments from the largest borrowers started to grow, and not until the fourth year that outstandings grew. Utilization rates among shared national credits didn’t start to climb until the seventh year after the recession. We aren’t surprised to see a slightly longer lag this time around, given that low long-term rates are tempting large corporate borrowers into the capital markets.

However, middle-market and small companies still depend on bank loans. They are the ones that will most need the banks when inventories start to build, followed by the larger corporates as the yield curve flattens at higher rates. Indeed, credit demands by small companies and middle-market borrowers already appear to be growing briskly. Finance company loans to business, a typical habitat for the smaller borrower, rose by 2.6% in the year ended in November (the latest data available), and accelerated to a 7.1% annual clip in the latest three months. And according to the Fed’s H.8 data, small bank C&I loans outstanding accelerated to an 8.4% rate in the year ended January 21 from 6.7% in the year ended September 25.

These trends have important implications for real interest rates. Real rates are unsustainably low, in our view. For example, 10-year Treasury Inflation-Protected Securities yields stand at just 1.8%, and the five-year US Treasury yield less surveyed inflation expectations is only 45 basis points. We believe that the dearth of corporate credit demand has been the swing factor depressing real rates in the face of massive government calls on the capital markets. We expect real interest rates to rise as competition for capital builds. In our opinion, the Fed survey results mark a watershed reversal in the demand for corporate credit. As a result, we believe that real rates have nowhere to go but up (see “Competition for Capital Poised to Intensify,” Investment Perspectives, January 28, 2004).

27 Currencies: USD -- 'Q' and My 'A' on Global Imbalances and the Dollar

Stephen L Jen (London)

The outsized US current account (C/A) deficit has weighed on the USD and been blamed as one major impediment to sustainable global growth. Here, I offer my personal view on some often-asked questions. Question 1. What are the key global imbalances? The US external deficit is the first imbalance most investors think of. But global fiscal imbalances and the capital-labour imbalance are further problems. (1) The US C/A deficit reflects an underlying US savings-investment deficit. While the US already had a large and growing C/A deficit in the late ‘90s, it didn’t cause a problem for the USD, which rallied. The main reason is that the savings-investment deficit reflected strong investment rather than a lack of savings. In turn, such investment was ‘justified’ by a higher expected US return on investment. Now, however, the large C/A deficit reflects insufficient savings rather than too much investment. Investment has declined since the equity bubble burst in 2000; but savings declined even more. Hence, the US C/A deficit began to matter for the USD in 2001. Overall, this type of imbalance has the most intimate relationship with the dollar. (2) Fiscal imbalances are not solely a US problem: major European nations are also struggling with their fiscal affairs. The key difference between the US and Euroland is that counter-cyclical stimulus was the dominant factor behind the deterioration US fiscal balances, while Euroland’s fiscal difficulties reflect more the effect of automatic stabilisers. In any case, there is an imbalance between the public and private sector, and an inter-temporal one between current economic activity and future growth. (3) The imbalance between ‘capitalists’ and ‘labourers’, i.e., those who hold financial wealth versus those who don’t, is the least appreciated imbalance. One cyclical source of this imbalance has been rate cuts. Interest rates are the cost of capital: lower rates incentivise economic agents to engage in capital expenditures. However, wages are the cost of labour and these tend to be sticky. When interest rates collapsed, relative costs were heavily skewed in favour of capex rather than employment. This is one key reason why we are seeing a US jobless recovery: firms are not incentivised to hire workers when the cost of capital is so low. One structural source of this capital-labour imbalance is outsourcing. Outsourcing is also advantageous for US capitalists and is one of the key reasons why US productivity has been so high and the profitability of US firms should remain superior but, at least over the medium term, is negative for US labourers. Question 2. Do imbalances matter? Yes, of course. But while persistent imbalances will clearly be bad, US C/A and fiscal deficits, since 2000, have been good in my view. (1) The emergence of a large US C/A deficit as the US leads the rest of the world out of the recession reflects more the weak demand from the latter than excess US demand. From the US perspective, the C/A deficit is always meant to be compressed through relative income adjustments (preferably through the rest of the world raising their demand rather than the US trimming theirs) and not from a massive USD correction. Further, treating Asia as a part of an economic and monetary zone with the US is helpful in illustrating why the market’s fixation on the US C/A deficit is really not logical. (2) On fiscal deficits, it is important not to lump fiscal policy between 2001 and now with the fiscal stance going forward. I am of the view that the massive counter-cyclical fiscal stimulus was necessary to buy time for US corporations to restructure and to prevent a negative vicious circle from emerging. Fiscal prudence in the years ahead is a different issue. High public debt would push up interest rates, crowd out private borrowing, and impose a huge burden on future generations. It is clearly important that the US reestablishes fiscal prudence at the earliest opportunity. (3) The imbalance between capital and labour is the key propellant toward protectionism and an outright weak-dollar policy. This structural imbalance clearly matters for the USD.

28 Question 3. What is the endgame? The USD is a valuation, not a C/A deficit problem. I believe the most likely outcome is that the US C/A deficit stabilises first, as demand from the rest of the world recovers. The fiscal deficit may max out this year, followed by a steady improvement. The capital-labour imbalance, however, could take much longer to sort out, implying that the protectionism threat may linger. Bottom line. There are three key imbalances in the world: (1) the US C/A deficit; (2) the US fiscal deficit; and (3) the capital-labour imbalance. If these imbalances persist, the USD and bonds could be jeopardised, and the risk of protectionism could rise. However, these imbalances have actually helped the world avert a much more severe recession than the one we experienced in the last three years.

Germany: The Last Metal Battle?

Elga Bartsch (London)

The leaders of Germany’s second-largest trade union, the metal workers’ union IG Metall, are gearing up for what could turn out to be their last big battle. Unimpressed by the humiliating defeat they were dealt in Eastern Germany last summer and the internal power struggle that ensued, IG Metall leaders have threatened to resort to an all-out strike if no agreement on wages and working hours can be reached for the 3.4 million employees in the sector by the end of this month. In the meantime, while talks continue in the various regions, IG Metall is flexing its muscles by organizing short warning strikes. But a compromise doesn’t seem to be in sight yet. At face value, hammering out a wage agreement should not be too difficult. By historical standards, the gap between the IG Metall demand of a 4%-pay rise for a 12-month period and the employers’ offer of a 1.2% rise from January 2004 and another 1.2% from April 2005 are not very far apart. In addition, following a recent company-specific deal concluded in Lower- Saxony, which saw a pay rise of 3%, the union signaled its willingness to compromise. But pay is not really what this wage round is about. The issue at stake is a much bigger one: the whole wage-bargaining system could be turned upside down. The German wage-bargaining system is still dominated by the industry-wide, national wage contracts. True, over the last decade we have already observed a rapid erosion of the traditional system as many companies fled the umbrella of their respective employers’ federations and instead started to negotiate individual pay-deals with their workforce. But the sticking point in the present talks in the metal sector is exactly that of delegating some of the responsibility for negotiation on wages and working conditions from the national trade union board to worker representatives at the company level. In some sectors, such delegation has already been introduced by so-called opening clauses. These opening clauses allow companies to deviate from the industry-wide wage contract under certain, typically narrowly defined, conditions and pay lower wages, for instance. In its attempt to make the labour market more flexible the Schroeder government is actively encouraging such opening clauses and has threatened to make them compulsory through a change in the labour legislation if voluntary take-up remains insufficient. This places the IG Metall smack between a rock and hard place. This is because the metal industry employers’, which see their cost-competitiveness being squeezed by a sharply stronger euro and emerging low-cost rivals, have demanded more flexibility on working hours in exchange for the pay-rise they offer. Their proposal is to introduce a corridor for the average workweek ranging from the 35 hours, presently applying to Western German metal workers, to a maximum of 40 hours. The decision about the extent to which workers will get compensated for the extra hours — and this is bone of contention — would be taken at the company, not the sector level. So, all that would be needed to approve a deal on pay would be a majority of the employees at the company in question approving it. And it is this delegation of the decision-making on pay to the company level that is keeping trade union leaders awake at night. Their concern is that there could be cases in which workers would agree to not being fully compensated for the extra time. In the extreme case of no compensation at all for the extra time put in, this would effectively reduce pay by almost 15%. So, not surprisingly, the trade unionists would be willing to make concessions

29 on the share of the workforce that is allowed to a have regular work week above the sector norm, presently limited to 18%, if they can be assured that no pay-deals are struck at the company level. It’s precisely the marked reduction in labour costs that could potentially be achieved, together with the greater degree of flexibility on the part of the individual company, that makes the employers’ proposal so attractive for companies in the metal sector. This would be the first time that a wage contract would include such a general and unconditional opening clause allowing companies to deviate from the industry-wide agreement. Not surprisingly, trade unionists are up in arms. However, if they resist the opening clause altogether they risk a change in the government legislation tying their hands in the future. A compromise could include an industry wide agreement on compensation paid for the first, say, two extra hours, leaving the remainder to negotiate for the companies themselves. Personally I doubt that they can single-handedly stem the huge pressure from the stronger euro and EU enlargement by resorting to traditional trade union recipes. Even if trade unions were successful in resisting the demand coming from companies, a victory would likely only speed up the erosion of the sector-wide wage agreements and cause even more companies to leave the umbrella. In addition, outsourcing to both Central and Eastern Europe and to a lesser extent to South East Asia would likely accelerate too. There can be no mistaking the need to contain labour costs in Germany. Just take the last two years, for instance. They saw a negative wage drift — the difference between actual and negotiated wage growth — of around 1 percentage point per year as companies start to cut back on fringe benefits and other voluntary payments in order to offset the upward pressure coming from the negotiated pay increase. And there is ample scope for improving cost-competitiveness of German companies. Roughly half of the non- wage labour costs borne by German companies, which in the manufacturing industry amount to more than 80% of wages paid, are due to unilateral pledges or bilateral agreements with the trade unions, not statutory government provisions. Especially now that reform fatigue on the part of policy makers seem to be on the rise, company captains need to sit tight when taking their seats at the negotiating table. And if they do, the present wage round could turn out to be Germany’s last metal battle.

Japan: Monetary Growth Myths

Takehiro Sato (Tokyo)

Recently, I’ve gotten several similar queries on the current slowdown in the monetary base. Sequential monetary base growth is certainly slowing, having declined from more than +30% during the April-June quarter last year to +3.5% this January (change from six months ago, annualized base, seasonally adjusted). Some investors are concerned that it could spark further yen appreciation and/or a retracement by the Nikkei; they tend to criticize the BoJ as irresponsible in not pumping more liquidity into the system. This argument doesn’t make much sense to me, however. There seem to be a number of myths regarding the background of slowdown in monetary base growth and the functions of the central bank. Regarding the former, the monetary base is the total aggregate of the private commercial banks’ current-account deposits held at the BoJ and the banknotes in circulation (+coins). The policy target of the current-account deposit, which occupies roughly 30% of the monetary base, has been raised incrementally. The current target band is ¥30–35 trillion, while banknotes occupy more than 70% of the monetary base. Banknotes are slowing somewhat, despite aggressive action by the Bank. Thus, the key issues are how the Bank commits to the target, and the background of the slowdown of banknote issuance. Regarding the policy commitment, the Bank is not targeting a specific pace of growth, but rather commits to an absolute level. In this framework, the BoJ can certainly manipulate the level of the excess reserves, but cannot totally control the pace of growth. The reason is simple. It was easier to increase the target by 100% when the excess reserve target was ¥1 trillion; now that the target is more than ¥30 trillion yen, it would be hard to maintain the same pace. This has resulted in criticism. It has become increasingly tougher for the Bank as the policy target is nearing its saturation point, which is equivalent to the former outstanding balance of the call market. Liquidity is likely to

30 saturate if the BoJ tries to pump in more, since the reality is simply that the BoJ is replacing the function of the money market and is acting as if it is a money market broker. Second, regarding the function of the BoJ, it cannot, strictly speaking, manipulate the monetary base itself, although it can affect parts of it. This is because the Bank is just passively issuing the banknotes in response to demand from the banking system. At the same time, demand for banknotes is not merely a function of the level of general economic activity, but also sometimes decided by precautionary demand. This is accentuated in an economy like Japan’s where there is legitimate concern regarding the stability of the banking system. For example, we saw a significant rise in demand for cash during the financial turmoil in late 1990s, when people were stashing their savings under the mattress because they felt it was safer than depositing cash in bank accounts. The current slowdown in banknotes actually reflects a diminishment of this precautionary demand, which we find encouraging, although this is generally interpreted as negative. Thus, banknotes, or ultimately the monetary base, do not necessarily grow in proportion to general economic activity, and simply focusing on level or pace would be somewhat misleading. Finally, the impact of this slowdown on the market is questionable both in terms of causality and econometrics. For example, banknote growth is slowing but the yen is rising; however, it is apparent that the yen appreciation is not simply due to the monetary phenomenon, but to other factors such as the rising trade imbalances, FX policy and perception of the Japanese economy (where upside risk has been realized, particularly in the labor market and fixed capital expenditures). Likewise, the ratio of the US/Japan monetary bases seem to be fairly highly correlated during 1990–98. However, this is just limited to that period: the correlation is mostly unstable for all of the other periods, including now. Since the excess liquidity is only pooling in the money market and would not spill over into the real economy due to the lack of a transmission mechanism, we cannot say that such monetary variables have a real impact on exchange rates, equity prices or any other asset prices. So we should be looking for the real causes of these price shifts, but blaming the central bank is easier. As for the equity market, there seems to be a certain amount of risk now being priced in, such as the worsening of the terms of trade (profit margin) due to higher materials prices and subdued finished goods prices, that will have a lagging impact on the economy, like of the exchange rate. Thailand: A Sick Birds' Eye View of a Healthy Thai Economy

Daniel Lian (Singapore)

Blame It On The Bird By February 5, the countries with confirmed outbreaks of avian flu among their poultry population are Cambodia, China, Indonesia, Japan, Laos, Pakistan, South Korea, Taiwan, Thailand and Vietnam. Thailand and Vietnam are the only ones with confirmed human fatalities in the indigenous population resulting from the bird flu.

As the time of preparing this note, it remains unconfirmed whether the two German visitors who returned from Thailand are sick because of the bird flu, or if human-to-human transmission has happened in Vietnam. The World Health Organization (WHO) at this point does not advise travelers to avoid countries that have seen an outbreak of the bird flu, or to issue guidelines concerning quarantining those who visit affected countries.

Three Scenarios of Plausible Economic Damage to Thailand Among the affected countries, Thailand is deemed most vulnerable because of the extent of the viral infection that has hit its poultry industry, the large human infected numbers and death toll, as well as the sensitivity of its economy to such a shock – the poultry and livestock industry is relatively large and

31 tourism is a huge sector. I have constructed three scenarios to facilitate assessment of the possible economic damage (Exhibit 1):

(1) First Scenario – Economic damage is limited to the poultry and/or livestock industry. The viral infection does not mutate and spread amongst the human population. Human infection and death tolls are largely due to isolated incidents of close human contact with the poultry/livestock industry. Although the situation has deteriorated somewhat over the past week, this scenario thus far still approximates the real world situation; I assign a 50% probability to the real world situation staying this way.

In sub-scenario (a), economic damage is limited to the poultry industry for two quarters (until June 2004) and there is no material damage to other parts of the real economy.

Live poultry production is roughly Bt33.8 billion (US$860 million) for 2003, or 0.6% of GDP. Total destruction of the poultry industry for six months would slow our 8% GDP growth projection for 2004 to 7.7%.

Sub-scenario (b) is built on an assumption that the bird flu successfully mutates and affects the entire livestock industry. Under this hypothetical situation, the damage is still relatively small as the entire livestock industry is valued at approximately Bt62 billion (US$1.57 billion) in 2003, or some 1.1% of GDP. A six-month period of destruction until mid-year would slow our 8% GDP growth projection for 2004 to 7.45%.

Exhibit 1 Thailand Bird Flu Case Scenario 1 (50% possibility)

Impact on poultry production for 1H04 (a) Live poultry industry % of 2003 GDP 0.60 % contraction in 2003 GDP terms 0.30 Impact on entire livestock production for 1H04 (b) Livestock industry % of 2003 GDP 1.10 % contraction in 2003 GDP terms 0.55

2004 GDP growth 7.45% Scenario 2 (45% possibility)

Impact on tourism for 1H04, in addition to (b) above Tourism % of 2003 GDP 6.20 % contraction in 2003 GDP terms 0.62 % contraction when combined with scenario 1(b) 1.17

2004 GDP growth 6.83%

Scenario 3 (5% possibility)

More economic damage in 1H04 than scenario (b) above as limited human infection and fear of large scale human infection cause a more substantial reduction in tourist arrivals. Such fear also causes some damage to domestic confidence, resulting in more severe damage to service sectors such as retail and transportation. However, there is no material damage to manufacturing or soil-based agriculture. The economic damage is still on a scale smaller than the SARS outbreak. % contraction in 2003 GDP terms inclusive of Scenario 22.00 2004 GDP growth 6.00%

Source: CEIC, Morgan Stanley Research Estimates

(2) Second Scenario – This scenario combines the six-month destruction of the livestock industry with limited damage to the tourist industry. The virus remains animal-bound and does not mutate to spread amongst the human population. Also, the World Health Organization (WHO) does not issue a travel advisory against visiting Thailand. However, given the fact that some countries have either unilaterally issued travel advisories against visiting Thailand or are contemplating issuing such warnings, a reduction in tourist inflows causing limited damage to the tourism, transport and logistics, entertainment and retail sectors has become a probable outcome. As such, I assign a 45% probability to this scenario.

Our assumption for this scenario is that domestic confidence is not shaken but a reduction in tourist inflows amounts to 20% over the January-June period. Given that it is already February and Thailand has thus far not experienced much decline in tourist arrivals, things would have to deteriorate quite substantially from this point over the next four months. Given that tourism is roughly 6.2% of GDP, a ball park 20% decline in arrivals over a six-month period would cause a further 0.62% contraction in GDP. This combined with sub-scenario (b) of the first scenario – a six month destruction of the livestock industry – would slow our 8% GDP growth projection for 2004 to 6.83%.

(3) Third Scenario – Under this scenario, the bird virus successfully mutates and becomes capable of spreading amongst the human population. I assign a 5% probability to this scenario.

Due to the SARS experience, greater awareness and the higher standard of public health, I assume the outbreak amongst the human population is successfully contained. Fear of large scale human infection causes a more substantial reduction in tourist arrivals. It also causes some damage to domestic confidence, resulting in more damage to service sectors such as retail and transportation. However, there is no material damage to the manufacturing or soil-based agriculture sectors. Overall, the economic damage is still on a smaller scale than during the SARS outbreak. Under this scenario, my rough estimate is that GDP growth will slow from our 8% growth projection for 2004 to 6%.

The Proactive Thaksin Government and its Fiscal Latitude Should Cushion the Negative Economic Impact A mere three weeks ago, prior to the emergence of the bird flu, I revised up our 2004 GDP growth forecast for Thailand to 8% after an estimated 6.5% expansion in 2003. Two new macro drivers – fiscal expansion and an investment boom – are likely to supplement ongoing strength in private consumption and exports to further reinforce growth in the Thai economy in 2004.

The bird flu outbreak has clearly introduced downside risk to our 8% forecast as spelled out in our three scenarios above. However, these scenarios have not taken into account the proactive response of the Thaksin government. I see two ways in which the Thaksin government can limit the economic damage:

33 (1) Stay vigilant on public health – The extent of the spread of the virus within the poultry and/or livestock population and, in the unfortunate event of successful mutation, its spread amongst the human population, can be contained by a high state of alert on the part of public health and medical services. While there appears to have been some initial slippage in the public health response, the Thaksin government is now in full swing and taking aggressive steps to contain the problem. Thus, it is probable that the economic damaged envisioned in the above scenarios can be limited further.

(2) Fiscal expansion – The Thai government possesses a great deal of fiscal latitude that can be used to lessen the economic damage to the Thai economy. The government has achieved a 0.4% fiscal surplus ratio for F02/03 (October 02 to September 03) and is projecting a mere 0.9% fiscal deficit ratio for F03/04 (October 03 to September 04), after engineering a cyclical fiscal expansion of the magnitude of Bt179 billion (US$4.53 billion), or some 2.9% of GDP.

While Mr. Thaksin is embarking on fiscal expansion, the projected 0.9% fiscal deficit ratio in reality is the smallest government deficit ratio forecast for the entire Asia/Pacific region. In my view, the Thai government has considerable fiscal latitude to cushion the economic shock caused by the sick birds. Thus, it is entirely probable that additional fiscal expansion, capable of generating an additional 0.3% to 2% of growth, can be produced and keep the Thai economy close to its 8% growth trajectory, despite the materialization of scenario 1, 2 or 3.

Bottom Line: Proactive Government and Fiscal Latitude Should Limit Economic Damage I have constructed three scenarios of the varying degrees of economic damage that could be caused by the bird flu to the Thai economy. The assessed economic damage ranges from a 0.3-0.55% reduction in growth in the first scenario, where damage is limited to the poultry and livestock industry, to a 1.17% decline in growth in the second scenario, where the damage expands to include a 20% decline in tourist arrivals and receipts, or to a 2% reduction in projected growth when there is greater damage to tourism which spills over into other parts of the real economy.

However, I believe the Thai government is now vigilant on public health as well as fully capable of battling against the bird flu to contain the health and economic crisis that appears to be brewing. The considerable fiscal latitude the government possesses should also enable it to respond proactively to any economic deceleration caused by a deepening of the crisis, keeping the Thai economy not far off its 8% growth trajectory.

Currencies: G-10 -- Freedom from the USD Trade? Melanie Baker (London)

G-10 currencies could be freer to express domestic fundamentals, and yield differentials may play a key role, if the USD does start to consolidate against the majors. G-10 ‘bid for freedom’. While the USD correction likely has more to go, we look for a change in the ‘texture’ of this correction in 2004. We expect the correction to broaden out and think the USD may consolidate somewhat against the majors. This change could leave G-10 currencies freer to ‘express themselves’ in terms of domestic fundamentals. Tentative evidence from the past few months provides support for the view that 2004 may be a year to look for alternatives to the G-10 basket trade against the USD. January marked a departure. Post the September G-7 meeting, moves against the USD by G-10 currencies tended to follow EUR/USD’s lead. In September, November and December (month-end to month-end) GBP, CHF, CAD, AUD, NZD, SEK and NOK all moved in the same direction as the EUR against the USD (we except the JPY from this analysis). The difference in magnitude of these moves

34 (measured by the variance between them) was relatively small. However, in October and January the direction of the G-10 moves was less uniform and the variance in those moves higher. In both months the EUR/USD move was smaller, suggesting that consolidation in EUR/USD may have offered more of a chance for G-10 currencies to move according to diverse domestic fundamentals. I have several thoughts on this: USD consolidation gives G-10 currencies room to breathe. Given the 23% USD correction since January 2002 (on the Fed’s major currencies index), USD overvaluation has shrunk considerably, in our view. We believe the USD move this year will broaden out against emerging market currencies, rather than deepen against the majors. For the G-10 currencies, with the USD valuation case less dominant and given the potential for ‘broadening out’, factors other than a generalized USD down-move will be more influential than in 2003. Interest-rate differentials have mattered for G-10. One notable thing about the moves in October and January was that the G-10 currencies, bar CAD, moved in the same directions on both occasions — GBP, AUD and NZD strengthened against the USD. CHF, SEK and NOK weakened. Interest-rate differentials are likely one factor behind this: Over the period in question 3M interest rate differentials with the US have been increasing in Australia, New Zealand and the UK, but shrinking in Sweden and Norway. In Canada, in October the interest rate differential was increasing, but by January, this was narrowing. Switzerland doesn’t quite fit the story, but interest rate differentials were fairly steady. USD consolidation does not imply USD reversal. On our 12-model valuation framework, there is a case for USD strength against all of these G-10 currencies (although we do not have models for NOK and NZD) with the strongest case against GBP and the weakest case against CAD. However, the overshoot may ‘last for longer’ if the market transitions to selling the USD against the emerging market currencies, given that these currencies are ‘sticky’. Bottom line. An alternative to the G-10 ‘basket trade’ may be needed sometime this year. There should be more than just the USD to play for in 2004. As we saw in both October and January, cyclical and domestic factors may take more of a front seat, with yield differentials playing an important role.

Asia Pacific: Tighten Capital Controls, Please

Andy Xie (Hong Kong) Speculative capital flow into Asia reached a record high last year, surpassing the previous peak in 1996. The recipients of capital inflow were Hong Kong, Korea and Southeast Asia in 1996. China is the main recipient this time. Just as occurred for the recipients of capital inflow in the 1990s, China is experiencing an investment bubble. The Fed commitment to keeping interest rates low for ‘a considerable period of time’ fueled speculation in high-risk assets. The byproducts of this speculation are the wealth effect on consumption in the US and the cheap capital-fueled investment boom in China – the twin engines or bubbles, depending on your perspective, for the global economy today. The cycle will end with either the Fed reversing its policy – we saw a glimpse of this in its decision last week – or a financial accident from the high leverage that has been built up in high-risk assets everywhere in the world. History would not be kind to the Fed; its accommodation and even encouragement of speculative excesses would be viewed as the primary cause of the massive bubble in the global economy today, the consequences of which are yet to show. China must tighten capital controls to slow the inflow and achieve a soft landing. It is the only viable option, in my view. If China allows the inflow of speculative capital to remain at such a high level for another year, a painful hard landing would become quite difficult to avoid, in my view. The appreciation of China’s currency, which many advocate as the main means to cool the bubble, would only encourage more speculation, as we saw in Southeast Asia. The resulting bigger bubble would make a hard landing inevitable.

35 The Biggest Liquidity Bubble in History East Asia saw the highest level of capital inflow last year; the region’s foreign exchange reserves rose by US$279 billion more than its trade surplus compared with an average of US$26 billion in the 1990s and US$8.3 billion in the 1980s. China and Japan were the focal points for the inflow; China’s forex reserves rose by US$162 billion (including the US$45 billion used to recapitalize two state banks at year-end) versus its trade surplus of US$25.5 billion, and Japan’s by US$204 billion versus its trade surplus of US$89 billion. Contrary to popular perception, the rapid increase in East Asia’s foreign exchange reserves last year reflected capital inflow rather than trade surplus.

Exhibit ¡Error! Marcador no definido. Increase in Forex Exchange Reserves Minus Trade Balance (US$ Per Annum) East AsiaChinaHongTaiwanKoreaSoutheast Japan Ex-Japan Kong Asia

1980s 8.3 4.7 2.9 -2.1 0.6 4.4 -36.6 1990-96 62.8 8.0 14.5 -8.3 10.9 37.8 -73.5 1997-00-38.3 -19.1 22.9 -3.5 -0.8 -37.7 -63.4 2001 -14.6 23.5 15.0 -0.2 -2.7 -50.1 -13.7 2002 51.0 43.6 8.5 21.4 8.3 -30.6 -11.4 2003 118.8136.5* 15.0 28.0 18.4 -34.0 114.8

*Note: US$45 billion was taken out of China’s foreign reserves to recapitalize two state commercial banks at the end of 2003. This amount is included in the table to show the full extent of capital inflows. Source: CEIC, Morgan Stanley Research

The trend began in 2001 when the Fed cut interest rates aggressively; China’s forex reserves rose by more than its trade surplus for the first time since 1996. The inflow kept accelerating and reached an unprecedented scale last year. We can rule out foreign direct investment (FDI) as a cause of the inflow. China’s FDI last year was the same as the year before and Korea’s declined. Indeed, FDI has declined in China for the past five months, partly in response to the excesses created by the strong capital inflow, such as rising commodity prices due to the property boom. Equity portfolio flows appear to have played a major role. Korea, for example, experienced a new inflow of $17.4 billion in the first 11 months’ portfolio investment. Taiwan received $2.4 billion net inflow of equity portfolio investment compared to a $6.1 billion outflow in during the same period of the preceding year. Normal portfolio flows, however, do not explain what happened to China and Japan. China has a closed capital account. Its FDI did not increase. And its QFII for the inflow of foreign capital into its stock market is negligible. Speculative capital, mostly controlled by overseas Chinese and China’s nouveau riche, punting on China appreciating its currency is the dominant source of China’s capital inflow. Overseas Chinese control, by my estimate, $2 trillion of liquid assets that can be mobilized instantly to punt on anything from European football games to Shanghai property. This source of money is both the boon and bane of China’s economic development.

36 In Japan’s case, it was mostly its exporters that caused so much capital inflow. Because the US interest rate declined so much, Japanese exporters expected the yen to appreciate and rushed to lock in the current exchange rate. Throw Away the Textbooks Unlike other developing countries, China can tap into this vast pool of capital to develop its economy; all it needs to do is to create some sort of excitement and the money rolls in. But, the ensuing enthusiasm usually turns into a bubble that makes macro management difficult. How to manage the speculative drive of the overseas Chinese is the key to China’s successful development. It is highly dangerous to deal with China’s macro challenges by reading too much into the established macroeconomic models. Economic development is an irrational process full of boom-bust cycles with speculative drive at the center. Without speculative enthusiasm, who would pile up capital in a poor developing country? It is the allure of big bucks – the lottery psychology – that turns people into speculators or entrepreneurs and brings capital formation to a particular country. Successful economic development is a self-fulfilling process. China is now the focal point of capital formation in the world because overseas Chinese control so much capital and can operate in China with relative ease. Contrary to orthodox belief, a flexible exchange rate destroys economic development. No country has achieved successful development with a flexible exchange rate because speculative enthusiasm quickly turns into a strong currency, which kills capital formation. China should not and, in my view, will not fall for the so-called orthodox approach to embrace a flexible exchange rate that would make its economic development very difficult or even impossible. The most difficult part of a development process based on animal spirit is how to tackle too much enthusiasm. During a century of industrialization in the United States, business cycles have usually ended with a financial crisis, followed by excess capacity and deflation. China cannot afford that; the resulting instability would be too costly. Thus, China must take action before enthusiasm goes too far. Capital Controls Are the Only Way Out Most pundits would advocate currency appreciation to deal with the strong capital inflow. That would be a big mistake, in my view. Capital markets may be efficient relative to current market expectations, but these expectations are often irrational, like now. Perfect foresight, on which efficiency market theory is predicated, is a joke, in my opinion. The massive swings in capital flows into Asia could only be explained by the speculative drives that rise or ebb with some stimulus. The stimulus is usually Fed policy change. If Asian governments counter such speculative sentiment by moving their currencies, it would create so much volatility that capital formation would become difficult. This is why Japan, a mature economy, can allow its currency to fluctuate more than other Asian countries and why China, the poorest economy in the region, must fix its exchange rate, and other economies, such as Korea and Taiwan, adopt a policy between the two. Capital controls, in my view, are the most powerful tool to moderate business cycles. When China has too little money, arrest the people who take money out; when China has too much money, arrest the people who take money in illegally. This mechanism is the most effective tool to manage China’s macro economy.

http://www.morganstanley.com/GEFdata/digests/20040206-fri.html

11 Feb - 24 Feb

What's Hot Who Cares About the Deficit, and Why?

The numbers seem staggering: The U.S. federal budget deficit is projected to reach a record $521 billion this year, equaling about one-fourteenth of the federal debt accumulated over the nation's history. Democrats accuse Bush and the Republican Congress of squandering the surplus achieved in the Clinton years and forcing future generations to pay for today's spending excesses and tax cuts. But the White House and its supporters insist the deficit, while a record in dollar terms, is not so bad given the economy's size. Is the deficit a ticking time bomb or not? http://knowledge..wharton.upenn.edu/whatshot.cfm

Who Cares About the Deficit, and Why?

1990s, and the government enjoyed surpluses from 1998 through 2001. Ten- year Treasury yields fell to just over 4% in 1998.

Since 2001, spending increases, tax cuts and smaller tax revenues due to the weak economy and the bear market have caused deficits to mushroom. This year the deficit will likely match the early ‘90s level of 5% of GDP.

“No Single Trip Wire” Yet the 10-year Treasury has been relatively steady in the low- and mid-4% range since last summer. One reason for that, says Siegel, is the Federal Reserve, which has held short-term rates at 1% to stimulate the economy.

Also, China , Japan and some other countries have been buying enormous amounts of U.S. Treasuries. Their goal is to create greater demand for the dollar to prevent it from falling in value in relation to their own currencies, allowing Americans to continue buying products from those countries. The high demand for Treasuries helps keep yields low.

“Relative to past periods of high deficits, where the deficit was clearly having an impact on interest rates, I think no one could argue [with the statement that] the effects are much smaller,” says Wharton finance professor Joao Gomes. Because other factors influence rates, it’s impossible to say that a deficit of a given size will cause rates to go to a specific level, adds Nicholas Souleles, finance professor at Wharton. “There’s no single trip wire.” He says most economists agree that deficit spending is appropriate in times of emergency, such as war. During recessions, governments borrow so they can continue spending to stimulate the economy.

“I think the deficits are large, and they are worsening,” Souleles notes. “So you can ask yourself, are the reasons good enough to be borrowing at this large and growing rate? It can be perfectly reasonable to borrow … You just have to be aware of the cost.” While he declines to express a view on whether the current deficit is acceptable, he agrees with those who say deficits cannot

38 grow indefinitely without affecting the economy. “If fewer funds are available for the private sector, you will see some combination of less investment or higher interest rates.”

Gomez, however, calls the deficit “unsustainably large. It is not the highest it’s ever been, but it’s fairly big. It has to be reduced … We are adding at such a fast pace that it will get out of control.”

Tax Cuts in Time of War: Huh? Indeed, many argue that the problem is not so much the current deficit and debt level as it is the prospect for an enormous growth in both figures in the future. The president said his budget would cut the deficit in half in five years, but left a lot of costs, such as the Iraq war, out of the calculation. Also, he did not address the years after that. Most of his 2001 tax cuts expire after 2010, but he wants to make them permanent. There also is the looming problem of funding Social Security and Medicare when baby boomers start retiring in a few years.

While deficits have long been considered acceptable during times of war, the situation in Iraq is not analogous to World War II , Korea or Vietnam . Abel notes that if war is a compelling justification for increasing the deficit, isn’t it also a reason to raise taxes? In the midst of the Iraq war, Bush pushed through tax cuts in 2003, and he now proposes making the 2001 cuts permanent. “I think that’s probably unprecedented – to cut taxes in wartime,” Abel notes.

While deficit spending is also a commonly accepted way to stimulate the economy to recover from a recession, the economy is clearly recovering already, eliminating the need for enlarging the deficit, Abel adds. “You could argue about whether the [2001 tax cuts] were appropriate or not. There are different points of view on that. Maybe they made the recession less bad. But by the time you got to the 2003 tax cuts, that was really inappropriate.”

For the time being, the growing deficit does not appear to be a drag on the economy. But there’s no guarantee that foreign purchases of Treasuries will continue indefinitely, or that the Fed will continue to keep interest rates low. “The Fed has been working aggressively to try to keep rates down, but I don’t think the Fed can do that forever,” Abel says.

According to Siegel, bond traders have refrained from driving yields up because they expect the economy to grow faster than the deficit. “We could, in my opinion, grow out of this deficit,” he says, arguing that in the next 12 months or so, the economy may grow enough that the deficit will be only 3% of GDP, a level many countries have shown to be sustainable. “Anything up to 3% is not a long-run threat.”

Bond traders may also be looking at deficit history and finding that Washington tends to come to the rescue eventually, by cutting spending or raising taxes. So the sanguine mood in the bond markets isn’t because deficits are painless. It’s because traders know that sooner or later the public will be forced to suffer the consequences.

Web Links Kerry and Bush: Who’s the Liberal? Fortune.com

ELECTION 2004 Kerry and Bush: Who's the Liberal? The Democrat's 'tax and spend' label is being turned on the GOP in 2004: John Kerry is a deficit

39 hawk, while Bush has produced record deficits. By Jeremy Kahn

There was a time when the Republicans could effectively paint the Democrats as "tax and spend" liberals, while portraying themselves as the party of fiscal restraint. This election, however, that logic will be turned on its head, as President Bush is likely to face a Democrat whose credentials as a deficit hawk are surprisingly strong.

Meanwhile, President Bush has his own deficit deficit. Since he took office, the record budget surpluses built up during the Clinton administration have turned to record red ink, and government spending has expanded at its fastest clip in 40 years. As a result, the GOP has lost most of its edge over the Democrats on the issue of fiscal responsibility. In a recent NBC News/Wall Street Journal poll, 33% of respondents said the Republicans did a better job controlling government spending—just 2% more than said Democrats were better at cost control.

Massachusetts Senator John Kerry, the front-runner for the Democratic nomination, has a long history of fighting deficits. He co-sponsored the 1985 Gramm-Rudman-Hollings Balanced Budget and Emergency Control Act, which triggered automatic spending cuts if the President and Congress failed to reach predetermined targets (but which ultimately failed to balance the budget). He also backed the Deficit Reduction Act of 1993, which helped Clinton achieve those surpluses. Now Kerry says that if he's elected he'll halve the deficit during his first term in office.

Bush, meanwhile, has been scrambling to restore his credibility with fiscal conservatives. In his State of the Union address, he matched Kerry's pledge to halve the deficit, although Bush gets there through spending cuts rather than by repealing tax breaks for those making more than $200,000 a year, as Kerry would do.

As a first step, Bush has unveiled an austere 2005 budget proposal that seeks to hold the increase in domestic discretionary spending to a mere 0.5%. But there are reasons to doubt whether the Bush budget represents a realistic solution to the country's fiscal woes. For one thing, the 2005 budget doesn't include spending for Iraq and Afghanistan. Bush's own budget director says the cost for Iraq might top $50 billion. And, in order to achieve the goal of paring the deficit to $237 billion by 2009, Bush proposes keeping total discretionary spending virtually flat for the entire four-year period, a goal that budget experts say is politically unachievable. What's more, beyond 2009, the deficit is projected to explode when most of the $936 billion in tax cuts kicks in and the first baby-boomers become eligible for early-retirement Social Security payments.

Kerry, who several polls predict would beat Bush if the general election were held today, has already begun attacking Bush's budget. While it's unlikely that many fiscal conservatives would vote for a Democrat, if they remain disgusted they might stay away from the polls entirely. "The lack of spending discipline is starting to alienate a significant portion of the fiscal-conservative base," says Stephen Bainbridge, a UCLA law professor who runs a conservative website. And if one had any doubts that budget politics have gone through the looking glass, just guess which former GOP punching bag would get the largest funding increase in 20 years under the Bush budget: the National Endowment for the Arts.

From the Feb. 23, 2004 Issue

14-27 Enero-2004 http://wharton.universia.net/index.cfm?fa=SpecialSection&specialId=76

El pulso económico en el 2004

¿Qué espera a EEUU en 2004?

Tras una lenta y confusa recuperación económica, el 2004 será un año de sólida construcción positiva basada en las buenas noticias, incluyendo la captura de Saddam Hussein, que nos están llegando con el fin de 2003.

Las nuevas tecnologías y el cambio de las políticas públicas -ya que en Estados Unidos tendrán lugar elecciones presidenciales-, también afectarán a la estructura del mundo de los negocios durante el próximo año, predicen los profesores de Wharton que fueron entrevistados por Universia-Knowledge@Wharton en relación a cinco sectores considerados clave: la economía, el sector bancario, las compañías aéreas, las telecomunicaciones y los servicios sanitarios.

El profesor de finanzas de Wharton Jeremy Siegel sugiere que el PIB real crecerá un 3-4%, y el desempleo descenderá a medida que despegue la creación de nuevos empleos. “Soy optimista”, dice Siegel. “Creo que va a ser un buen año”. Las acciones seguirán disfrutando de una buena racha, en especial durante la primera mitad del año, antes de que la subida de los tipos de interés pueda deprimir las cotizaciones. Los tipos para los bonos a 10 años, en la actualidad un 4,25%, podrían alcanzar el 5% a finales de 2004, señala.

A lo largo del año el índice Dow Jones se situará entre 9.000 y 12.000 puntos, y es probable que a finales de año cierre entre 10.500 y 11.000 puntos, predice Siegel. El índice NASDAQ no crecerá tanto debido a que en 2003 ya se ha apreciado significativamente. “La captura de Saddam es una muy buena noticia para el mercado de valores. Pero la administración Bush debe capitalizar este acontecimiento intentando trazar un mapa mucho más ambicioso para el Oriente Medio, un mapa que implique más sacrificios tanto para israelíes como para palestinos. “A no ser que se llegue a un tipo de acuerdo, el terrorismo seguirá siendo una amenaza, aunque la captura de Saddam probablemente reduzca en cierto modo la amenaza en el corto plazo”.

Además de la amenaza del terrorismo, dice Siegel, otro posible shock al sistema podría originarse en caso de que tenga lugar un acentuado incremento de los tipos de interés como consecuencia de la rápida caída del dólar. El incremento de las importaciones o del precio del petróleo –que podría deberse a la inestabilidad en Oriente Medio-, también podrían causar un retroceso económico.

41 Siegel, que ha investigado la evolución de las acciones en el largo plazo, sugiere que el actual mercado es poco corriente, ya que parece no haber infravalorado extremadamente los sectores. Una excepción podría ser el sector farmacéutico, donde determinadas acciones podrían tener más potencial a largo plazo que lo que indican las cotizaciones actuales, dice Siegel.

Si echamos un vistazo a las tendencias históricas, Siegel señala que el tercer año de cualquier mandato presidencial es normalmente el mejor en términos económicos, y el cuarto año es habitualmente el segundo mejor. “Creo que de nuevo se ha probado ese mismo comportamiento durante este ciclo”.

Considerando la posibilidad de fusión

Richard Herring, co-director del Financial Institutions Center de Wharton, afirma que a pesar de que la Reserva Federal ha anunciado que el riesgo de que se produzca inflación o deflación es el mismo, en su opinión un escenario inflacionista es mucho más probable. La economía global puede estar a punto de iniciar un periodo de expansión, donde los precios de los bienes de consumo y otros productos podrían aumentar.

El mandato del presidente de la Reserva Federal de Estados Unidos Alan Greenspan, que durante años ha luchado con uñas y dientes contra la inflación, finalizará en junio cuando Greenspan cumpla 78 años. “Hemos tenido suerte; Alan Greenspan goza de muy buena salud y adora su trabajo. Pero ya no es un mozalbete”, dice Herring. “Hay un montón de gente con talento que podría desempeñar ese trabajo, pero debemos confiar en que el presidente elija a una persona a la que le preocupe la inflación. Ese no siempre ha sido el caso”.

En opinión de Herring, los tipos de interés estadounidenses pueden subir si los inversores empiezan a estar más preocupados por los enormes déficit gubernamentales, o si un dólar a la baja provoca una repatriación masiva de inversión extranjera. No obstante, dice Herring, ésta no parece ser una amenaza inmediata. “No es del todo inconcebible que esto ocurra en una época en la que los tipos de interés son increíblemente bajos”.

A nivel internacional Europa aún no ha completado totalmente la creación de un mercado único o de su moneda, el euro, dice Herring. “En Europa se han producido muy pocas fusiones interfronterizas y, en cierto sentido, aún queda mucho trabajo por delante”. Japón sigue siendo un tema preocupante, ya que el país ha tenido que solucionar sus problemas económicos de largo plazo fusionando bancos para transformarlos en instituciones de mucho mayor tamaño. Los japoneses –prosigue Herring-, no han tenido un gran éxito gestionando fusiones bancarias. “Se espera que los bancos sean mejores al aumentar su tamaño, pero es todo un reto”.

Mientras tanto –predice Herring-, es posible que el sector bancario y financiero estadounidense reanuden la consolidación que fue interrumpida por los mercados a la baja. Así, señala como ejemplos las propuestas de fusión de las empresas St. Paul y Travelers Property, o la de Bank of America y FleetBoston Financial. “Si efectivamente los mercados han vuelto a una fase más eufórica, entonces ésta es la vanguardia de una nueva oleada”.

Los bancos estarán buscando socios con los que fusionarse y expandir geográficamente sus negocios –añade-, pero también los buscará en el sector financiero con la esperanza de emular el exitoso modelo de Citigroup. “Lo malo cuando vuelves la vista atrás y miras esas fusiones, es que de hecho muy pocas han creado valor para los accionistas. Así, da la impresión de que el mercado va a ser bastante duro a la hora de evaluarlas”.

¿Pueden las líneas aéreas reinventarse a sí mismas? En opinión de W. Bruce Allen, profesor de empresa y políticas públicas en Wharton, una mejora económica disparará la fortuna del sector aéreo, el cual estaba pasando por un bache debido a la recesión económica y los ataques terroristas del 11 de septiembre.

Los consumidores que disponen de crecientes ingresos discrecionales normalmente eligen viajar más lejos y más rápido, y por tanto tienden a reservar billetes de avión en lugar de adquirir paquetes turísticos, señala Allen. “Creo que el mercado se recuperará en términos de tráfico. En ese sentido soy optimista. Nos hemos convertido en una economía en cierto modo más libre cuya base reside más en el ocio; una de las cosas que a los consumidores les gusta hacer en su tiempo de ocio es ir a Disney World y Nueva Orleáns”.

Aquellos que viajan por negocios también regresarán, predice Allen. “Puede que hayamos perdido a algunos debido al descubrimiento de las teleconferencias, pero sigo creyendo que la gente quiere mirar a los ojos de la persona con la que está negociando”.

“La pregunta clave a la que se enfrenta el sector es si las grandes compañías aéreas como United, Delta y American Airlines serán lo suficientemente hábiles para beneficiarse de la recuperación. Durante la reciente recesión las pequeñas compañías regionales -incluyendo Jet Blue, Southwest, Air Tran y Frontier-, lograron incrementar sus cuotas de mercado en las ciudades en las que operaban. “Ahora que la gente se siente a gusto con las nuevas compañías aéreas, ¿volverán con las viejas?” se pregunta Allen.

Al mismo tiempo, las grandes compañías aéreas están operando con estructuras de costes mucho mayores que las de sus competidores. Algunas han intentado reinventarse a sí mismas creando compañías aéreas de menor tamaño y bajos costes dentro de la propia empresa, como por ejemplo Ted, perteneciente a United, o Song perteneciente a Delta, la cual reemplazó a Delta Express. Allen afirma que ésta estrategia ha fallado en el pasado, señalando el caso de Metrojet, perteneciente a US Airways. “La verdadera cuestión es si puedes conseguir empleados que trabajen del mismo modo que en Southwest, no como en United o Delta”.

La preocupación de los pasajeros por los temas de seguridad disminuye a medida que transcurren los días sin que se produzca otro incidente como los ataques del 11 de septiembre de 2001, señala Allen; además, las compañías aéreas y el gobierno han mejorado los sistemas de seguridad que provocaban que los viajeros hiciesen cola durante horas fuera de los aeropuertos en las semanas posteriores a los ataques terroristas. Por su parte, a las compañías aéreas les preocupa que el gobierno exija controles adicionales del equipaje que viaja en la bodega de los aviones de pasajeros. El equipaje de los viajeros pasa a través de un escáner, pero no ocurre lo mismo con el correo u otros paquetes, los cuales representan lucrativos negocios para las compañías aéreas que tienen exceso de capacidad.

VoIP y VoWiFi

En telecomunicaciones, Gerald Faulhaber, profesor de empresa y políticas públicas de Wharton, predice que con la llegada del nuevo año crecerá la importancia del sistema Voice over Internet Protocol (VoIP), que permite a los consumidores hacer llamadas telefónicas a través de Internet.

La mayor empresa proveedora de llamadas a larga distancia del país, AT&T, anunciaba recientemente que empezará a vender servicios telefónicos empleando VoIP, y espera estar operando en 100 mercados a finales del primer trimestre de 2004. La empresa Time Warner Cable, la segunda mayor empresa por cable de Estados Unidos, ha estado probando la tecnología VoIP en Pórtland, Maine, desde el pasado mayo y ahora pretende ofrecer este servicio a sus clientes de todo el país. Las empresas Comcast, Cabletelevision Systems y Cox Communications también están ofreciendo servicios VoIP con carácter limitado.

El sector está pidiendo a gritos un debate sobre cómo se regulará dicha tecnología, dice Faulhaber. La Federal Communications Commission (FCC) ha creado un grupo de trabajo para el VoIP y ha mantenido reuniones para decidir si el VoIP debería estar sujeto al mismo tipo de regulaciones a las que hoy en día están sometidos los servicios telefónicos. “Va a ser una batalla muy interesante”, señala.

En octubre, el juzgado del distrito de Minnesota sentenciaba que la Comisión de bienes públicos de Minnesota no puede aplicar las regulaciones estatales en tema de telecomunicaciones a la empresa Vonage, que suministra VoIP. El juzgado declaraba: “La regulación estatal efectivamente diezmaría el mandato del Congreso referente a que Internet no debe estar sujeto a regulaciones”.

Faulhaber dice que a pesar de que la administración que ocupa la Casa Blanca es bastante pro- empresa, la FCC ha tenido dificultades para vender políticamente la desregulación. “Cualquier cosa que sea presentada como una desregulación provocará una batalla política. Ante los medios se presenta como algo indulgente con los intereses empresariales”.

Para finales de año, Faulhaber predice que el interés se centrará en Voice over Wifi (VoWiFi), una tecnología que permite comunicación telefónica a través de redes sin cable, principalmente a través de los ordenadores portátiles. Verizon está experimentando con el sistema y QUALCOMM en estos momentos lo está probando en Washington D.C. y San Diego, explica Faulhaber. La transmisión de datos a gran velocidad es competidora del DSL –añade-, y VoWiFi “podría ser el sistema que acabase con todo, el sistema definitivo”.

Wall Street sigue penalizando a las empresas de telecomunicaciones que están invirtiendo, opina Faulhaber, el cual afirma que los negocios no parecen estar dándose mucha prisa en comprar nuevos equipos de telecomunicaciones, aunque sí estén adquiriendo bienes esenciales. “Los negocios tendrán que gastar dinero en las telecomunicaciones. Es esencial. Pero aún no veo grandes ostentaciones”.

Los altos costes de los servicios sanitarios

Durante el pasado año hubo un debate predominante en el ámbito de los servicios sanitarios: si la legislación debería ampliarse para que los clientes de Medicare tuviesen cobertura en los medicamentos, algo de lo que disfrutarían por primera vez desde que este sistema sanitario para ancianos y enfermos fuese creado por el gobierno hace 40 años.

Después de tanto debate, en 2004 apenas habrá cambios en la legislación, sugiere Mark Pauly, profesor de sistemas sanitarios de Wharton. El único impacto en 2004 de la nueva ley puede que sean los mayores pagos a los suministradores que estén gestionados por Medicare, y una tarjeta de descuento con la que los clientes disfrutarán de menores precios en algunos medicamentos.

La cobertura de los medicamentos no se aplicará hasta 2006, y las provisiones diseñadas para que Medicare sea más competitiva no entrarán en vigor hasta 2010, señala Pauly. Esta nueva cobertura que proporcionará Medicare no tendrá un gran efecto sobre las ventas, beneficios o cotización de las compañías farmacéuticas, dice Pauly, y añade que las empresas farmacéuticas pueden perder negocio si los seguros médicos pagados por las empresas reducen o eliminan la cobertura de los medicamentos ahora que Medicare empieza a cubrirla. “No lo considero un regalo para las compañías farmacéuticas; si hay un número considerable de empresas que dejan de ofrecer esa cobertura, en realidad podría tratarse de un daño”.

En general el gasto en salud -que alcanzaba los 1,4 billones de dólares en 2001, el último año para el que se dispone de datos-, seguirá creciendo por encima de la inflación, a una tasa real del 5-7%, predice Pauly. El gasto en medicamentos, que ha sido el causante del incremento de los costes sanitarios durante los últimos años, podría caer en 2004 a medida que el sector pierde la protección proporcionada por las patentes en algunas terapias de gran éxito.

La tasa de crecimiento de las primas sanitarias también es probable que disminuya. “Me sorprenderían enormemente que en 2004 las primas sanitarias creciesen más rápidamente que en 2003”, dice Pauly. “Se han obtenido enorme beneficios y el mercado es competitivo. La tendencia fundamental del gasto parece ser a la baja más que al alza”. Es probable que la próxima campaña presidencial se centre en la cobertura de los 44 millones de personas que aún no están aseguradas pero, en opinión de Pauly, tras la legislación de Medicare el presupuesto federal únicamente dispone de fondos para hacer propuestas modestas. “Se producirán muchos debates, pero no estoy seguro de que se vaya a hacer algo. Los presupuestos federal y estatales serán una importante restricción, y la población que no tiene seguro no tiene tanta influencia política como el segmento de la tercera edad; y los ancianos estaban primero”.

45 La Unión Europea, cada vez más dividida, afronta su ampliación

La Unión Europea (UE) afronta 2004 con una agenda repleta de compromisos: por un lado debe culminar el proceso constituyente interrumpido en diciembre del año pasado y, además, debe enfrentarse al reto que supondrá su ampliación de 15 a 25 países el próximo 1 de mayo. Todo esto ocurrirá dentro de un ambiente de tensión creciente entre sus miembros debido a las diferencias sobre el reparto de poder contemplado en el actual texto constitucional, a la muerte del Pacto de Estabilidad y Crecimiento que rige el euro, y a la competencia en la distribución de los fondos estructurales -las ayudas regionales- en la futura Europa de los 25. Mientras tanto, la economía europea sale lentamente de su letargo.

¿Para cuándo la primera Constitución Europea? La primera Constitución Europea debía haberse aprobado en diciembre de 2003, durante la Cumbre de Bruselas. Sin embargo, los representantes de los 25 estados miembros de la Unión Europea (UE) -incluyendo los 10 países entrantes- no pudieron ponerse de acuerdo sobre el sistema de reparto de poder que ha de regir el futuro de Europa. Sin acuerdo, la aprobación de la carta magna quedo postergada sin un plazo fijo. “Hay dos visiones opuestas sobre como deben tomarse las decisiones en el seno de la UE”, explica Antonio Fatás, profesor de Economía de la escuela de negocios INSEAD. La primera de ellas es que a cada país le corresponde un voto (sistema tradicional) y la segunda es que los votos tienen que ser proporcionales al tamaño de la población (tradición democrática). “El debate es complejo y además hay que añadir los intereses particulares de cada país”, afirma Fatás. Los países más pequeños liderados por España y Polonia defienden el actual sistema de votación ponderado aprobado en el Tratado de Niza de 2000. Mientras que los países más grandes, encabezados por Alemania y Francia, propugnan el sistema de doble mayoría, según el cual las decisiones deben adoptarse por la mitad más uno de los estados que suman un 60% de la población. Este último sistema es el que recoge el proyecto constitucional. Según Fatás, “los países grandes ganan poder si los votos son proporcionales a la población, los pequeños lo pierden. El tratado de Niza fue un compromiso entre los dos sistemas, pero a medida que añadimos más países, el sistema de dar un peso significativo a cada país (sistema tradicional) es cada vez menos sostenible. El concepto de nación se diluye y los países grandes insisten en tener una unión de ciudadanos y no de países con lo que las decisiones deben de ser democráticas”. En opinión de Sara González, profesora de Economía Internacional de la Universidad Complutense de Madrid, la verdadera cuestión de fondo detrás del fracaso de la Cumbre “no está en el reparto de votos o en la reforma de Niza, se trata de una manifestación del liderazgo en Europa”. Hasta ahora, dice, “estaba muy claro que Alemania era la potencia económica y Francia la política. Sin embargo, en los últimos dos años se ha definido una nueva estrategia sobre política exterior en Europa: Francia y Alemania han mantenido una postura independiente, mientras que la de Gran Bretaña y España ha sido más atlantista, en la que Europa es un socio natural de USA”. En su opinión, la guerra de Irak ha puesto de manifiesto la existencia de estos dos bloques y cuestionar ese liderazgo es un reflejo del fracaso de la Constitución. Según González, para desbloquear la situación constitucional primero hay que resolver el

46 problema de liderazgo. “Hay que negociar una postura intermedia que no sea proamericana pero que tampoco sea antiamericana”. Y añade, “¿cómo puedes definir una Constitución europea si resulta que respecto a terceros no sabemos qué es lo queremos ser?”. Por lo tanto, ¿hasta cuándo tendrán que esperar los ciudadanos europeos para dotarse de su primera Constitución? “No creo que en 2004 se produzca un acuerdo”, dice González. En su opinión, es prácticamente descartable que éste llegue en el primer semestre del año, durante la presidencia de turno de Irlanda, debido a que este país no cuenta con el suficiente peso específico en Europa. Las elecciones generales de marzo en España y de otoño en Gran Bretaña hacen prever un alargamiento de las negociaciones hasta entrado el segundo semestre del año, durante la presidencia de turno holandesa. Aunque se aprobara un texto constitucional definitivo, habría que sortear otro obstáculo: la aprobación en referéndum del mismo por todos los países miembros. “Los ciudadanos de cada uno de estos países se sienten cada vez más alejados del concepto de UE que los políticos defienden, con tantas peleas internas la imagen es cada vez peor”, afirma Fatás. Eso significa, en su opinión, que aún en el caso de que los políticos lleguen a un acuerdo, “es posible que los ciudadanos lo rechacen (el texto) en un referéndum, como pasó con el tratado de Niza en Irlanda”. A pesar de todo, González hace una lectura positiva del proceso de construcción europea. “Así ha avanzado Europa, esto no es nuevo. En 60 años hemos pasado de una guerra mundial a discutir por una Constitución. Existe una negociación como en todo, pero las cosas necesitan el tiempo que necesitan”, dice sobre el plazo de aprobación de la Constitución.

La lucha por el reparto de los fondos estructurales Tras el fracaso de la Cumbre de Bruselas, el enfrentamiento político entre los países grandes y pequeños europeos se trasladó, casi inmediatamente, al terreno económico. A finales de 2003, los seis contribuyentes netos de la UE: Alemania, Francia, Reino Unido, Suecia, Austria y Holanda reclamaron, en una carta al presidente de la Comisión Europea, limitar al 1% del PIB comunitario las aportaciones nacionales al presupuesto de la UE, en lugar del techo del 1,24%. Las aportaciones han sido hasta el momento del 1%, pero a partir de la entrada en vigor del nuevo marco financiero en 2007, se esperaba que éstas se elevaran al máximo. Se calcula que limitar las aportaciones al 1%, supondrá unos 25.000 millones de euros menos de lo que la Comisión Europea considera necesaria para mantener, después de la ampliación, las ayudas regionales a los países con un nivel de desarrollo inferior a la media comunitaria. Hasta ahora los países mediterráneos como España, Grecia y Portugal han sido los más beneficiados por las ayudas estructurales, pero con la ampliación europea y la congelación de los fondos habrá una mayor competencia por la distribución de estos recursos. Pocos dudan del trasfondo económico que tienen los enfrentamientos políticos europeos. “Detrás de los debates están las luchas por los recursos limitados, ningún país quiere perder poder y no está claro qué tipo de solución puede ser satisfactoria para todos”, afirma Fatás. Es más, algunos medios españoles han interpretado la propuesta de los seis países europeos económicamente más poderosos como un acto de represalia a la posición de España y Polonia sobre el reparto de poder en la Constitución europea. “Se percibe un cierto castigo a la postura española dentro de lo que permiten las normas”, afirma González.

47 Tímido despertar de la economía europea El Banco Central Europeo (BCE) pronosticaba en su informe del pasado mes de noviembre sobre la economía de la eurozona un crecimiento de aproximadamente el 1,6% en 2004 frente al 1,5% anunciado en septiembre, y un repunte de la inflación de 1,8%, frente al 1,6% previsto anteriormente. Concretamente, el BCE esperaba un estirón del Producto Interior Bruto en la región de entre el 1,3 y el 2,3% en 2004 y de entre un 1 y un 2,2% en el ejercicio siguiente. Aunque estas cifras apuntan a una leve recuperación económica respecto al año 2003 (0,4%), están muy alejadas de las actuales expectativas de crecimiento en EEUU (3,9%). En opinión del profesor Rafael Pampillon, profesor de la escuela de negocios Instituto de Empresa, esta recuperación es “muy lenta y poco acorde con los tiempos”. Y añade, “la UE no tendrá un desempeño brillante mientras no controle el déficit público, continúe la apreciación del euro y no se produzcan reformas estructurales”. En opinión de los expertos, la economía europea se ha visto lastrada en los últimos tiempos por la crisis en Alemania. Este país no creció en 2003. Pero además, junto con Francia, sobrepasó el límite de déficit público del 3% establecido por el Pacto de Estabilidad y Crecimiento europeo por tercer año consecutivo. Sin embargo, ninguno de estos dos países fue sancionado económicamente por ello, tal y como se contempla en el Pacto. Sin duda, este hecho, que ha provocado un profundo malestar entre aquellos miembros de la Unión que se esfuerzan por mantener sus déficits bajo control, será uno de los temas que más dará que hablar en 2004. Con el Pacto de Estabilidad aplazado, “se van a volver a generar déficits públicos altos, lo cual conllevará un aumento de la deuda pública; el alza a medio plazo de los tipos de interés, que junto con un euro fuerte significará la perdida de competitividad y un descenso de los márgenes empresariales”, alerta Pampillon. En su opinión, una situación como la descrita se traduciría en un desempleo de grandes dimensiones. A pesar de todo, Alemania y Francia mejorarán levemente su situación económica. El primero de ellos crecerá, según el Economist Intelligence Unit, un 1,6% en 2004, mientras que el segundo experimentará un crecimiento de 2,1%, cayendo hasta el 1,8% en 2005. Además, Alemania llevará a cabo algunas reformas tímidas en su política Fiscal y Laboral, en Sanidad y Pensiones. En el caso de Francia, “los vicios adquiridos por parte de los sindicatos y los funcionarios hacen que sea muy complicado acometer reformas”, afirma Pampillon. Además del déficit público, la espectacular subida del euro es otra de las principales amenazas para la recuperación europea. La moneda ha repuntado un 17% desde septiembre y en los últimos días se ha llegado a cambiar a 1,2813 dólares. Aunque el BCE considera favorable tener un euro fuerte y estable, el alza de la divisa ha minado la confianza empresarial, cayendo ésta por primera vez en cinco meses. La recuperación europea se había sustentado hasta ahora en la reactivación de la economía norteamericana y en el mercado exterior. Sin embargo, “el tipo de cambio se está apreciando mucho más de lo que debería. Esto va a hacer perder la competitividad de las exportaciones europeas, en particular las alemanas. Lógicamente esto es un péndulo, el euro seguirá apreciándose pero en un momento determinado se volverá a estabilizar”, afirma Pampillon. A diferencia de otros países, España ha mantenido un fuerte rigor presupuestario y ha sido un firme defensor del Pacto de Estabilidad. Dentro del panorama europeo es una de las economías más sólidas y uno de los países con mejores perspectivas económicas en 2004. Tanto el ministerio de economía como el BCE auguran un crecimiento del PIB de aproximadamente el 3%. “España tiene sus limitaciones, por que su recuperación económica está basada en la construcción y el consumo interno”, dice Pampillon. Y añade, “puede que el modelo de crecimiento no sea el mejor, pero la economía española crece”.

48 Los principales motivos de preocupación sobre la marcha de la economía hispana son la solidez de la recuperación europea y, en mayor medida, una eventual corrección de los altísimos precios inmobiliarios. Respecto a esto último, Pampillon afirma que “una caída de los precios pondría en peligro la recuperación económica, pero no sólo en España, también en otros países. Frente al efecto riqueza -que estimula el consumo- podría producirse el efecto pobreza, colapsando la confianza de los consumidores”. En Gran Bretaña -el país europeo con mayor fortaleza económica- el PIB crecerá hasta el 2,4% en 2004 y 2% en 2005, según el Economist Intelligence Unit. Además, éste es año de elecciones en Reino Unido y el partido laborista del primer ministro Tony Blair podría encadenar su tercer mandato consecutivo. Pero, para conseguirlo, antes deberá recuperar la confianza del electorado tras las críticas por su postura en la guerra de Irak. Por eso, dos de sus prioridades son abordar las reformas de Sanidad y Educación Pública e, incluso, plantearse la celebración de un referéndum para su entrada en el euro. En medio de este puzzle de países, cada uno con su problemática particular, el principal reto económico al que se enfrenta la UE en 2004 es la ampliación a 25 miembros. Ésta beneficiará a los actuales miembros, porque podrán acceder a un gran mercado que ha adquirido una mayor estabilidad política. Para los países entrantes, “el crecimiento económico va a verse estimulado por el comercio y el acceso a formas de producción y organización más avanzadas”, afirma González. Aunque advierte que la modernización de las economías requiere un tiempo y todo dependerá de lo animada que esté la inversión europea. En un principio asistiremos a la deslocalización de empresas que van a establecer sus fábricas y plantas de producción en los países del Este.

49 Sólo Europa inquieta a las bolsas europeas

Los analistas de la mayoría de firmas de bolsa coinciden en pronosticar que las bolsas europeas tienen en 2004 las mejores perspectivas entre los mercados occidentales. Europa cumpliría así su tradicional papel de ir a remolque de Wall Street y recortaría la distancia abierta con los mercados americanos el año pasado. Pero la mayor amenaza para este escenario está en el propio continente. El riesgo de un crecimiento económico demasiado suave, una excesiva fortaleza del euro y las consecuencias de la ruptura del pacto de estabilidad incomodan el favorable horizonte bursátil.

El consenso de analistas de las firmas de bolsa es que en 2004 la economía europea crecerá entre un 1,5% y un 2%, menos de la mitad de las cifras que se estiman para la estadounidense. Pero si se le pregunta a los analistas y estrategas de estas mismas firmas, su elección preferida no es precisamente Wall Street.

Esta aparente paradoja responde al diferente comportamiento que han registrado en el recién finalizado ejercicio las acciones estadounidenses frente a las europeas. Mientras que los índices americanos de referencia Dow Jones y S&P 500 se dispararon más de un 25% y el Nasdaq Composite de las tecnológicas, un 50%, el paneuropeo DJ Euro Stoxx 50 apenas se revalorizó un 10,5%.

Estos avances han dejado una amplia distancia en las valoraciones, si se toma como referencia el ratio PER, una estadística que mide las veces que en los precios de las bolsas se están valorando los beneficios de las compañías. Los mercados estadounidenses tienen ahora un PER próximo a las 20 veces, tomando como base los beneficios esperados para 2004, mientras que el de los europeos está más cerca del 18%.

Para Joanna Luxton, directora de estrategia de inversión de la gestora de fondos de American Express, este contexto refleja que “la mejora de los beneficios empresariales ya se ha reflejado en el precio de muchas de las acciones en Estados Unidos”, por lo que “preferimos Europa como zona de inversión”.

Como Luxton opina Gary Dugan, director de estrategia de bolsas europeas de la gestora de fondos JP Morgan Fleming, quien considera que los mercados del continente “están infravalorados”. También mantienen opiniones similares numerosos estrategas e inversores tanto de firmas europeas como americanas, que ya ven poco recorrido en las acciones estadounidenses, a pesar de las favorables perspectivas para los beneficios de sus empresas.

De cumplirse los presagios más favorables, “Europa cumpliría su papel de ir a remolque de la recuperación de Estados Unidos”, según comentan en un informe reciente los analistas de Citigroup, el mayor grupo financiero del mundo.

En cifras macroeconómicas ya se está dando esta situación. Mientras en el tercer trimestre de 2003 Estados Unidos sorprendió a los mercados con un crecimiento de su economía del 8,2%, las principales economías de la zona euro, la francesa y la alemana, que suponen más de un 60% de la zona euro, apenas lograban salir de las arenas movedizas de la recesión en las que se habían visto atrapadas en los trimestres precedentes.

Los analistas partidarios de las acciones europeas esgrimen como uno de sus principales argumentos las perspectivas de beneficios por acción. El crecimiento esperado para Europa para 2004 será del 15% para las compañías del Euro Stoxx 600, mientras que en Estados Unidos estará en el 12%, según la consultora de datos financieros francesa JCF Quant. También las estimaciones de 2005 son de un mayor crecimiento, aunque más modesto, para Europa.

La amenaza a la reactivación está en casa

Sin embargo, las favorables perspectivas bursátiles para Europa se ven amenazadas por diferentes circunstancias, que en la mayoría de los casos tienen su origen en el propio continente. Federico Steinberg, profesor del Departamento de Análisis Económico de Universidad Autonoma de Madrid, se muestra positivo para las bolsas, pero subraya algunos riesgos: “Aunque las principales economías de la zona euro están saliendo de la recesión, se espera que la Unión Europea crezca sólo y en torno al 1,5% en 2004. La apreciación del euro con respecto al dólar, que supone ya cerca de un 50% desde que el euro tocara fondo hace casi dos años, encarece nuestras exportaciones, mientras que la inflación, que se resiste a bajar del 2%, no permite que el Banco Central Europeo reduzca aún más el precio del dinero. Asimismo, el colapso del Pacto de Estabilidad puede generar presiones inflacionistas que no favorezcan la mejora de las expectativas empresariales”.

De estos riesgos, el que más asusta a los analistas es el de una fortaleza excesiva de la moneda europea frente al dólar. La relación entre ambas divisas está en la actualidad cerca de los 1,28 dólares por euro, lo que supone marcar nuevos máximos históricos, algo que viene sucediendo desde noviembre, cuando la moneda superó el nivel de los 1,2 dólares.

Un euro demasiado fuerte resulta negativo para las empresas europeas. Por un lado, supone una merma para los resultados de las compañías exportadoras cuando trasladan a euros los ingresos obtenidos en la moneda de origen, y por otro lado, reduce su competitividad, ya que los productos que ofrece la competencia en otros países resultan más baratos. El banco de inversión estadounidense Goldman Sachs estima que cada subida del 10% del euro frente al dólar resta un 4% al crecimiento de los beneficios de las empresas europeas. El economista de la OCDE Patrick Lenain calcula que un fortalecimiento del diez por ciento del euro sobre el dólar en doce meses supone una reducción del crecimiento del PIB alemán del 1%. Las exportaciones del país germano se desplomaron en octubre, pero en noviembre han revivido con un incremento del 4,1%, según los últimos datos publicados.

El euro subió en 2003 más de un 20% frente al dólar y las previsiones para este nuevo ejercicio son de un debilitamiento progresivo de la moneda americana por lo menos hasta mitad de año. En la actualidad, el gigantesco déficit por cuenta corriente, partida de la balanza de pagos que mide el saldo entre importaciones y exportaciones de un país, de Estados Unidos raya los 600.000 millones de dólares, prácticamente el 5% del PIB. Este déficit seguirá aumentando mientras la economía estadounidense crezca a un ritmo superior al del resto de países occidentales, debido a que Estados Unidos seguirá necesitando ingresos del exterior para seguir financiando su déficit. Esto debería provocar más presiones a la baja sobre el dólar y hacer más baratos así los activos estadounidenses para atraer flujos hacia su economía.

El Banco Central Europeo (BCE) no ha mostrado excesiva preocupación por la fortaleza de la divisa y su presidente Jean-Jacques Trichet ha defendido un euro “fuerte y estable”. Lo que sí preocuparía sería que esa depreciación fuera brusca. Según explica Federico Steinberg, “Estados

51 Unidos necesita unas cuantiosas entradas diarias para financiar su déficit y para que lleguen es imprescindible que los inversores tengan fe en que los activos en dólares estadounidenses tengan más valor mañana que hoy. Si se pierde esa confianza y hay una salida precipitada de capitales, el sistema financiero de Estados Unidos se podría debilitar”, lo cual haría descarrilar la recuperación económica.

Sin embargo, aunque supone un riesgo, este escenario no es precisamente al que más posibilidades dan los analista y economistas. Los más optimistas incluso recuerdan que un euro fuerte también supone unas importaciones más baratas para las compañías europeas. E incluso hay quien, como Byron Wien, estratega de renta variable estadounidense del banco de inversión Morgan Stanley, maneja la teoría de que el dólar se apreciará frente al euro, debido a las incertidumbres sobre la política económica en Europa.

La cuestión está ahora en saber qué hara el BCE con esta situación ante la amenaza del frenazo a la reactivación. La autoridad monetaria dejó el jueves ocho los tipos de interés en el 2%, pero cada vez son más las voces críticas ante esta pasividad. Entre ellos el premio Nobel de Economía, Joseph Stiglitz, que en una entrevista con Financial Times Deutschland ha declarado la necesidad de recortar los tipos de interés de la zona euro al menos medio punto para evitar que un euro demasiado fuerte aborte la incipiente recuperación económica europea.

Curiosamente, también cabe la hipótesis de que, a medio plazo, puedan darse presiones para que la autoridad monetaria tome la decisión opuesta, es decir subir tipos, debido a las tensiones que puede generar la ruptura del Pacto de Estabilidad provocada por Francia y Alemania. Los pesos pesados de la zona del euro no están dispuestos a cumplir el requisito de colocar el déficit público por debajo del 3%. Según recuerda Federico Steinberg, “la ruptura del Pacto supondrá un mayor gasto público, lo que podría acelerar la inflación. Como consecuencia, el BCE podría ponerse nervioso y subir los tipos”, aunque el profesor de la Universidad Autónoma de Madrid, sin embargo, no cree que esto suceda. Joachim Fels, economista europeo de Morgan Stanley, considera en cambio que la ruptura del pacto pone en duda “la credibilidad de la Unión Europea” e incrementa sustancialmente los riesgos de una subida de tipos por parte del BCE. El banco de inversión espera que en los próximos meses empiece a programarse una segunda versión del Pacto de Estabilidad.

De momento, la inflación de la zona euro, cuyo control es el principal objetivo ahora mismo del BCE, parece estar controlada y los economistas esperan que en 2004 “se ubique en o por debajo del objetivo del 2% que maneja la autoridad monetaria”, según el servicio de análisis de Citigroup. José Luis Alzola, economista del mayor grupo financiero del mundo, cree que “los tipos de interés de la zona del euro se mantendrán más bajos de lo que los mercados descuentan, en medio de una débil economía y de la baja inflación”.

Según una consulta de la agencia de información Bloomberg entre 54 operadores, analistas y estrategas, las previsiones son que el euro marque un máximo anual de 1,35 dólares hacia verano, que luego podría corregirse hasta 1,25 dólares hacia final de año, si el BCE baja tipos y la Reserva Federal los sube.

Las recomendaciones de los expertos

Si Europa no sucumbe ante las diversas incertidumbres, las previsiones de los expertos sobre la revalorización de las acciones europeas en 2004 están siendo de un crecimiento que volverá a superar los dos dígitos. Según una encuesta de Standard & Poor´s entre grandes gestoras de

52 fondos, el rendimiento esperado por los gestores en renta variable europea es del 15,14%, frente a la subida media del 12,29% que se espera para Estados Unidos.

Por sectores, cada casa de bolsa tiene sus propias previsiones, aunque la mayoría optan por aquellos más relacionados con un relanzamiento de la actividad económica, así como aquellos que no tengan una elevada dependencia de las exportaciones, es decir, las más expuestas al consumo interno. Joanna Luxton, de American Express, ha orientado su cartera hacia los valores cíclicos, entre los que “priman las compañías más beneficiadas por la inversión empresarial y el sector de viajes, en detrimento de los fabricantes de productos de consumo discrecional”.

El banco de inversión Morgan Stanley recomienda a sus clientes poner especial atención en las industrias que pudiesen aprovecharse de un hipotético tirón de las operaciones de fusión y adquisición, entre los que señala también los de industrias cíclicas, los de telecomunicaciones y los de alimentación. “Todos estos grupos están generando importantes cantidades de caja –que coloca a las compañías en mejor posición para realizar adquisiciones- y están mucho más atomizadas que en Estados Unidos. Por ejemplo, en el sector de materiales y bienes de equipo, 27 compañías representan el 50% de las ventas, cuando en Estados Unidos este porcentaje se lo reparten entre sólo 16 empresas”. La firma subraya que el porcentaje de fusiones y adquisiciones de las compañías cíclicas en los últimos dos años ha sido el mayor desde la última recesión, lo que sugiere que esta actividad de concentración ya está en marcha.

Sobre el sector tecnológico, Morgan Stanley ve complicada la posibilidad de movimientos corporativos, debido a que estas compañías siguen centradas en programas de reestructuración. En el bancario, contempla dificultades “debido a la alta concentración del mercado”, pero sí ve opciones en Alemania, así como entre bancos especializados en el negocio minorista.

De momento, el año ha comenzado con una enorme pujanza del sector tecnológico, ante las mejores perspectivas sobre el crecimiento de la demanda de chips para determinados negocios, como el de la telefonía móvil. De hecho, el banco de inversión Goldman Sachs elevó recientemente hasta “atractiva” su opinión sobre las operadoras de telecomunicaciones, ante las perspectivas de que la llegada de la telefonía móvil de tercera generación seduzca a los consumidores europeos.

En 2004 también habrá dos acontecimientos políticos de enorme importancia para el continente: la ampliación de la Unión Europea a 25 países, que se hará efectiva a partir del 1 de mayo, y las elecciones al Parlamento Europeo, que se celebrarán el próximo 13 de junio, además de las elecciones legislativas en Francia y las generales en España. Sin embargo, los analistas no esperan que estos acontecimientos tengan demasiada influencia en la evolución de unos mercados para los que los presagios son optimistas.

How Parmalat Differs From U.S. Scandals

When the Parmalat scandal broke in mid-December it was quickly dubbed “Europe’s Enron,” suggesting that multi-billion dollar frauds are not, after all, a predominantly American phenomenon. But is the case of Parmalat, an Italian dairy company based in Parma that employs 36,000 people in 29 countries, really analogous to the American corporate scandals of the past three years?

Since the Parmalat case is still unfolding, it’s not clear to what extent it mimics the American cases, but there certainly are surface similarities, says Robert E. Mittelstaedt Jr., Wharton’s vice dean and director of executive education. “In some ways it’s no more than a symptom of the times; these are people who had great ambitions and when those ambitions weren’t being realized they wanted to create what wasn’t there. It’s no different than what went on with other companies like Enron.”

Parmalat, Enron, and other American firms such as Tyco and WorldCom all have number fudging at their core – efforts to make the companies look healthier than they were. They all raise questions about the behavior of accountants, auditors and underwriters who might have, should have, or did know that something was wrong.

These days “large companies seem prepared to engage in some appalling kinds of mischief in order to boost stock price or maintain market share,” says Thomas Donaldson, professor of legal studies at Wharton. That was not true 20 or 30 years ago, either in the U.S. or overseas, he adds. The Parmalat case demonstrates that it’s not just an American problem but the result of attitudes that are “baked into the contemporary mindset” of many corporate executives worldwide.

That said, Donaldson notes, Parmalat does have some unique features. Although the case is comparable in magnitude to Enron’s by some measures, “the way in which it was accomplished was very different … [Parmalat] is much more of a common, garden-variety fraud, but on an immense scale.” A key element of the Parmalat case, for example, was the outright forgery of a letter saying the dairy company had $4.9 billion on deposit at Bank of America.

Switchboard Operator as CEO Parmalat’s collapse began in November when its auditor raised questions about a $135 million derivatives profit. After additional evidence of accounting misstatements, the company’s chief executive and founder, Calisto Tanzi, resigned on Dec. 15. Four days later the company disclosed the fake Bank of America letter. On Dec. 23, Italian investigators said the company had used dozens of offshore companies to report non-existent assets to offset as much as $11 billion in liabilities, adding that Parmalat may have been falsifying its accounting for as long as 15 years.

Parmalat filed for bankruptcy the next day. On Dec. 27, Tanzi was detained by police. Seven other executives were detained several days later. Then on Dec. 29, the U.S. Securities and Exchange Commission filed suit against Parmalat, charging it had used phony financial statements to get U.S. investors to buy more than $1.5 billion in securities.

54 Investigators believe more than $10 billion may have been drained from the company. They are looking at what role, if any, might have been played by the company’s auditors, the Italian affiliates of Grant Thornton and Deloitte & Touche, and foreign banks, including Citibank and Deutsche Bank, which helped Parmalat do business. Among the more bizarre allegations: that a Parmalat switchboard operator was unwittingly listed as the chief executive of more than 25 affiliates used to disguise the company’s financial problems.

Initially, it appeared that the accounting maneuvers were designed to keep the company afloat after it lost fortunes in Latin America, rather than to directly enrich Tanzi and his family – though certainly they had a financial stake in seeing the company survive. In that respect, the case looked different from many of the American cases, such as Tyco and Enron, where the chief goal appeared to be enriching a handful of insiders. Most accounts say the Tanzi family lived a relatively modest lifestyle given their wealth. That can’t be said of the Americans accused of wrongdoing, such as the party-throwing, jet-setting chief executive of Tyco, L. Dennis Kozlowski.

By the second week in January, however, there were reports that the Tanzi family did directly benefit from some improper activities. Investigators said the company’s former chief financial officer reported that Parmalat’s Swedish packaging supplier, Tetra Pak, had paid the Tanzis millions in kickbacks. And prosecutors said Tanzi admitted shifting some $620 million from Parmalat to his family’s travel businesses.

Like the American cases, the Parmalat scandal has raised questions about how the company could fudge its numbers for so long without outside help. The auditors, says Mittelstaedt, should at the very least have spoken to Bank of America to verify it held the $4.9 billion Parmalat claimed.

Investigators are looking into whether Bank of America was in any way involved in the false claim, though the bank says it was not. The bank cannot reasonably be expected to search the world to see if someone is using its name improperly, Mittelstaedt notes, adding, however, that the companies that underwrote Parmalat’s bond and stock offerings should have investigated fully enough to learn the company could not back up its financial statements.

Business, Italian-style Although Parmalat shows that financial shenanigans can happen in Europe, Peter Cappelli, director of Wharton’s Center for Human Resources, thinks “it’s harder outside the U.S.” In the 1990s, federal legislation in the U.S. limited the corporate tax deduction to the first $1 million in executive salaries, spurring the turn to stock options as an alternative form of compensation. Because they typically expire in 10 years, options give executives an incentive to boost share prices in the short term, and some companies used accounting games to do so, Cappelli says.

As executive compensation packages got more complex, Cappelli adds, companies put more reliance on compensation consultants, who tend to feel they are working for the CEO and need to promote higher pay to keep the business. In the U.S. it’s acceptable for executives to reach for ever-greater compensation and perks. “It’s not very common in Europe,” he says. “I think that’s mainly what holds [things] in check, these social norms.”

In general, European companies have not followed the U.S. model. European executives are not paid as much and don’t have the same incentives to boost short-term performance at the expense of their companies’ long-term health.

Donaldson notes, however, that Italian business culture makes scandal somewhat more likely than it is in other European countries. “Parmalat would have been much more difficult to effect in Germany or Sweden or Great Britain. It’s no secret that the sometimes almost familial networks of friendship and business ‘clubbyness’ can go wrong as well as right.” Italy, Donaldson adds, “has many great strengths, but it also has many weaknesses, from the influence of the Mafia to the tendency of people in government and industry to engage in sweetheart relationships.”

In some respects, the Parmalat scandal reflects the effects of globalization and the increasing use worldwide of exotic derivatives to hedge risks such as currency fluctuations. Parmalat had some 200 affiliates, subsidiaries and other opaque relationships, just as Enron had a raft of “special purpose entities” used to hide debt.

In the wake of Parmalat, the European Union has announced plans to tighten accounting standards. One proposed change would require that a single auditor be designated to take overall responsibility for a company’s statements, which is the practice in the U.S. Investigators believe Parmalat’s use of two auditors left gaps that made the accounting maneuvers easier.

There also is a proposal to create auditing oversight agencies in each of the 15 member nations, similar to the oversight board established in the U.S. after Enron.

Donaldson suggests that while regulatory reform, oversight and enforcement are important, “smart people are always capable of finding clever ways to get around the rules. In the end, there’s no substitute for having people with consciences doing what they know is right … I have always believed being a manager is a professional activity. In order for it to be a true profession, it has to have an element that is not just centered on self-interest but is centered on the quality of the water in which we all swim.”

Knowledge@Wharton Newsletter January 14-27, 2004 http://knowledge.wharton.upenn.edu

56 América Latina en 2004: adiós a “media década perdida”

América Latina parece comenzar a despedirse definitivamente de la denominada media década perdida, seis años de turbulencias y crecimiento negativo que dejaron profundas huellas sociales en la región y que tardarán mucho tiempo en borrarse. Prueba de ellos son los 20 millones de habitantes latinoamericanos que se sumaron a los índices de pobreza a partir de 1997 y los 17,6 millones de desempleados urbanos al término de 2003.

De acuerdo con la Comisión Económica para América Latina y el Caribe (CEPAL), la región creció un 1,5% en 2003, superando la reducción de 0,4% del Producto Interno Bruto (PIB) durante el año 2002. A nivel de países, Argentina, después de una contracción de 10,8% en 2002, mostró una marcada reactivación (7,3%). Chile, Costa Rica, Colombia y Perú registraron tasas superiores al 3,0%, México se expandió 1,2%, aunque el crecimiento en Brasil fue apenas positivo (0,1%). En el extremo opuesto se encuentra Venezuela, que cayó un 9,5% sumida en una aguda crisis política y económica.

Según el CEPAL, el mejor desempeño en el conjunto de la región esta vinculado a la buena trayectoria de la economía internacional, donde destacan la recuperación de Estados Unidos y Japón, además del fuerte crecimiento de China. Para 2004, este organismo de Naciones Unidas con sede en Santiago de Chile prevé una expansión de la economía latinoamericana de 3,5%, pero el dato más optimista es que, por primera vez desde 1997, no se proyecta un crecimiento negativo en ninguno de los países de la zona.

Economistas y académicos consultados por Universia-Knowledge@Wharton coinciden con el escenario delineado por el CEPAL, donde es clave la continuación del dinamismo internacional, pero añaden que el cambio de tendencia se sustentará también en otra variable: la capacidad de las economías de mayor peso regional -Argentina, Brasil y México- para consolidar la estabilidad que han recuperado en el año 2003.

Expansión internacional: mayor demanda de productos básicos

Tomás Flores, director del programa económico del instituto Libertad y Desarrollo en Santiago de Chile destaca que el impulso regional vendrá de la mano de un mayor aumento de los términos de intercambio (en 2003 se incrementaron en 1,3% según CEPAL). “Nosotros vislumbramos un crecimiento de 3,5% para las economías del G-7 en 2004, evolución que se ha traducido y se traducirá en una mayor demanda y un alza de los precios de los principales productos básicos exportados por la región: cobre, café, oro, soja y, por supuesto, el petróleo”, estima el economista.

En cifras de CEPAL, los precios de los productos básicos latinoamericanos aumentaron un 15,9% en 2003. En Centroamérica, la Comunidad Andina y Chile, las ventas al exterior crecieron un 5% y en el caso del MERCOSUR se elevaron a tasas de 17,9%, escenario que debería continuar con mayor energía en 2004.

“Definitivamente, el mejorado panorama internacional es una de las noticias más importantes detrás de esta expansión”, coincide en afirmar Joseph Ramos, decano de la Facultad de Ciencias Económicas y Administrativas de la Universidad de Chile. Según Ramos, la economía

57 estadounidense consolidó su reactivación y cobró bastante fuerza durante el segundo semestre de 2003. Lo propio hizo Japón, “que sorprendió a todo el mundo y registró crecimiento después de un estancamiento de largos años, mientras que en Europa ya en el último trimestre se vieron signos de repunte, por lo que en el año 2004 (este continente) va a estar en una mejor posición. Además, China y el sudeste asiático siguen fuertes”.

El profesor Ramos añade que el entorno internacional favorable y la notable baja de los riesgos soberanos -el costo del financiamiento externo retornó a los niveles previos a la crisis asiática-, también debería potenciar el regreso de los flujos de capitales a la región. Sin embargo, advierte, “ojalá se trate de buenos proyectos y que no se produzca una especie de montaña rusa, que cuando vienen (los capitales) lo hacen en sobreabundancia y luego súbitamente se detienen, sin anestesia. Entonces, uno quisiera un ritmo más regular de entrada de capitales. Pero, sin duda, esta dimensión va por el lado de los riesgos positivos”.

Incertidumbre económica en EEUU

Y hablando de riesgos, los economistas están de acuerdo que hay algunos aspectos que podrían ensombrecer el dinamismo internacional y de paso frenar la recuperación de América Latina. Se advierte que los fuertes desequilibrios externos y fiscales de la economía estadounidense podrían conducir a nuevas depreciaciones del dólar, en cuyo caso las tasas de interés internacionales aumentarían. En CEPAL apuntan que estos ajustes son necesarios y deberían ocurrir a finales de 2004 o en 2005, “pero aún es prematuro delinear los escenarios en los que podría darse este proceso en la mayor economía del mundo”, señala el organismo en el Balance preliminar de las economías de América Latina y el Caribe.

Flores, en todo caso, descarta devaluaciones de la moneda estadounidense durante 2004 y señala que el acento se debe poner en la manera en que una nueva administración de Washington (en 2005) enfrente los déficit fiscal y de cuenta corriente. Para Ramos, los cambios de gobierno en Estados Unidos tienen poca significancia económica. “(Si asumiera) un gobierno demócrata sería conservador desde el punto de vista fiscal y eso sería una señal tonificante para el resto del mundo. Sabemos que la duda a mediano plazo es cómo se resuelve el fuerte déficit fiscal y en cuenta corriente. Si esto se hace en forma gradual, entonces no va a pasar nada”, tranquiliza el profesor de la Universidad de Chile.

Tal y como apunta Susana Jiménez, investigadora de la Facultad de Ciencias Económicas y Administrativas de la Universidad Finis Terrae, la presencia de las elecciones estadounidenses en noviembre hace prever que la FED no subirá agresivamente las tasas de interés durante el 2004, “dejando gran parte del ajuste para el año 2005 hacia adelante, a pesar de que la economía pudiera estar acelerando demasiado su ritmo de expansión durante este año”.

El impacto de la estabilidad de los tres grandes

No obstante, el factor externo no es el único responsable del cambio de tendencia de la economía latinoamericana. Gran relevancia también adquiere el fortalecimiento interno alcanzado por los países que enfrentaron las crisis más profundas, como Argentina y Brasil, que recibirán el año 2004 con políticas fiscales y monetarias bajo control, así como con tipos de cambio más competitivos y mercados bursátiles que muestran una importante tendencia al alza.

58 Según estimaciones de CEPAL, Argentina crecerá un 4,5% en 2004, Brasil tendrá una mayor expansión (calculada en 3,3%) sustentada en la reactivación de la demanda interna, en tasas de interés en continuo descenso y en la recuperación de la actividad industrial, mientras México, más que nada por su fuerte ligazón comercial con Estados Unidos, como anota Ramos, crecerá un 2,8%. Estas tres economías suman alrededor del 75% del PIB de la región.

La solidez de los tres grandes ayudará también a la reactivación de sus vecinos más pequeños, afirma Jiménez. “En la medida que Argentina y Brasil consoliden su recuperación económica a lo largo de 2004 es posible esperar, además, que países más pequeños, como Uruguay y Paraguay, se vean beneficiados por el aumento del comercio que tendrán con estas economías, mejorando así sus perspectivas respecto de lo observado en los últimos dos a tres años”, dice la investigadora.

Flores y Jiménez coinciden con las estimaciones de CEPAL en cuanto a la Argentina. “La veo creciendo en torno a 4,5%, beneficiada por los positivos precios de los granos y la soja, y porque existe confianza en que volverá a lograr acuerdos con el Fondo Monetario Internacional (FMI)”, afirma el economista de Libertad y Desarrollo. “Durante el próximo año, el país continuará gozando de no pagar la deuda externa, por lo que los resultados económicos continuarán siendo favorables durante gran parte de 2004. Esto asegura que la economía podrá crecer a tasas superiores a 4%”, vaticina la investigadora de la Universidad Finis Terrae.

Brasil es otro de los países que acapara los mayores elogios. Flores proyecta un crecimiento de 3,5% y un claro avance en la reestructuración de la deuda con el FMI. “El gobierno (del Presidente Luiz Inácio da Silva, Lula) está siendo más estricto con los compromisos, las cuentas fiscales se están ordenando. Lula está comprometido con su programa de estabilización y las señales que ha dado han sido bien vistas por la comunidad internacional, que aprecia que este proceso no tiene vuelta atrás”, señala el economista. Igual perspectiva manifiesta el profesor Ramos: “Lula se ha mostrado como un presidente bastante responsable y lejos de la imagen populista que se temía”.

Junto con estimar una expansión del PIB brasileño superior a 3% para el próximo año, Jiménez sostiene que la ausencia de presiones inflacionarias y el aún aletargado comportamiento de la actividad económica “permitirán, además, que el Banco Central continúe reduciendo la tasa de interés”.

En cuanto al resto de los países, las proyecciones son en general positivas. Chile, por ejemplo, la economía más estable de la región, debería crecer un 4,5% de acuerdo a CEPAL, impulsada por un aumento de 6,4% en las exportaciones de bienes y servicios y una expansión de 5,6% en la demanda interna. En ese mayor intercambio tendrán un rol importante los tratados de libre comercio que este país ha suscrito con la Unión Europea, Estados Unidos y Corea del Sur.

Sin embargo, algunos nubarrones se ciernen sobre algunos países de la zona. Flores plantea que a raíz de la compleja situación política y económica, Venezuela seguirá con una economía frágil (CEPAL prevé un crecimiento de 7,0%, debido a la baja tasa de comparación), pero advierte que el comportamiento negativo durante 2004 será protagonizado por Bolivia, “considerando su alto endeudamiento y la crisis de balanza de pagos”.

59 ¿Es sustentable este nuevo ciclo de expansión?

José Luis Machinea, ex ministro de Economía de Argentina y actual secretario ejecutivo de CEPAL, se manifiesta “moderadamente optimista” respecto a la cuestión de si es sustentable este nuevo ciclo de expansión, pero advierte que la respuesta a esa interrogante dependerá de la capacidad de los países latinoamericanos para combinar tasas de crecimiento con un aumento en los niveles de ahorro e inversión.

En 2003, la inversión como porcentaje del PIB regional sólo alcanzó el 18%, aún lejos de los niveles sobre 22% que se registraban hasta 1997. “Se requiere atraer financiamiento, pero para ello necesitamos regularizar el sistema financiero y avanzar en la reestructuración de la deuda”, explica Machinea.

Flores recoge el punto y alerta de que las tasas de ahorro son todavía más bajas en las economías más grandes. “Brasil requiere emprender una reestructuración de su sistema tributario con el objetivo de impulsar la inversión. Sin embargo, ya es un avance lo obrado con la reciente reforma previsional”, argumenta. En el caso de Argentina, el economista señala que esta nación tampoco aprovechó el ciclo de ahorro, “y las AFJP (administradoras de fondos de pensiones) están en su mayoría quebradas”.

De ahí que Machinea plantee que la gran lección que deja la media década pérdida de América Latina es la necesidad, o más bien obligación, de anticipar las políticas contra-cíclicas. En otras palabras, dice el secretario ejecutivo de CEPAL, “se debe ahorrar en los años buenos. Sólo así la región podrá lograr tasas de crecimiento sobre el 4-5%”.

De igual modo, el economista sostiene que también es importante desarrollar políticas sociales para resolver un problema estructural en la región, como son las altas tasas de desempleo. "Crecer es el tema fundamental, pero también importan otras políticas en el terreno estrictamente económico, si usted apoya a las pequeñas y medianas empresas, ciertos procesos de agregar valor a las exportaciones y desarrollo regional, una misma tasa de crecimiento puede dar lugar a un mayor aumento de la ocupación. Eso no ocurrirá si existe excesiva concentración de capital”, concluye Machinea.

14-27 Enero-2004 http://wharton.universia.net/index.cfm?fa=SpecialSection&specialId=76

Global economic outlook Dec 30th 2003 From The Economist print edition

The economy is now rebounding strongly after its recent downturn, reckons the OECD. America is expected to have one of the fastest growth rates among rich countries this year. Its GDP is forecast to grow by just over 4% in 2004, more than twice that expected for the European Union and Japan. The risk of deflation seems to have receded in America and Europe, where the OECD now expects that consumer prices will rise by between 1-2% this year and next. Japan, however, will still have to struggle with falling prices in the absence of a stronger response by its central bank. By 2005, unemployment is expected to be just under 8% in Europe, compared with around 5% in both Japan and America. The OECD thinks that America's current-account deficit, now around 5% of GDP, will continue to grow and remain one of the biggest risks for global economic stability.

61 A $45 billion shot in the arm Jan 6th 2004 From The Economist Global Agenda

A massive cash infusion for two of China’s largest state-owned banks is just the beginning of a much-needed overhaul of the sickly financial sector

CHINA’S newish prime minister, Wen Jiabao, is a geologist by training. So far, the conversion of his country’s financial system from swadeshi communism to global capitalism has moved at the kind of glacial pace only a geologist could appreciate. But on Tuesday January 6th, the Xinhua news agency announced a great leap forward. At the end of December, it said, the Chinese state injected $45 billion—one tenth of its foreign-exchange reserves—into the country’s two largest banks, dividing the funds evenly between Bank of China (not to be confused with China’s central bank, the People’s Bank of China) and the China Construction Bank.

These lenders are two of China’s “big four” state-owned banks, the other two being Industrial & Commercial Bank and Agricultural Bank. With 116,000 branches across China, these four hold 67% of the country’s deposits and make 61% of its loans. But not all of those loans are likely to be repaid. The government estimates that 23% of the big four’s loans are “non-performing”. Most independent analysts think the true fraction is a third or more. Big as last month’s cash infusion is, it is just a drop in a bucket of bad loans totalling more than 3.5 trillion yuan ($422 billion).

What kind of bank makes loans of which a third will not be repaid? The communist kind. Some of the banks, such as Bank of China, founded by the legendary nationalist Sun Yat Sen in 1912, predate the Maoist takeover, but none of them escaped its wholesale distortion of capital allocation. For decades they made loans based on bureaucratic, not commercial, priorities. Some funds served to prop up bankrupt state enterprises and the legions of workers who depended upon them. Others served social policy of a different kind—keeping cronies happy and palms properly greased. Wang Xuebing, former head of two of the big four banks, lost his job for making dubious loans and lost his liberty for taking bribes.

In a sense, the capital infusion announced this week simply shifts money from one state tentacle to another: $45 billion of foreign exchange, once under the custody of the state’s monetary authorities, is now under the custody of two of the state’s banks. But the Chinese government is hoping gradually to withdraw its tentacles from the banking system, and this

62 latest injection of funds is a necessary part of that process. The state needs to clean its banks up in order to sell them off.

As a consequence, its funds have gone not to the banks in direst need, but to those most ready for the showroom. With a bit of tarting up, Bank of China and China Construction Bank will, it is hoped, make for an initial public offering (IPO) that investors (foreigners included) cannot refuse. Of the big four, China Construction Bank is in the best shape. A stockmarket flotation, perhaps as soon as this year, could raise between $5 billion and $6 billion, according to some investment bankers, who are already keenly offering their services as midwives to the deal. Bank of China, the country’s biggest foreign-exchange lender, which hopes to follow in 2005, could be even bigger. It already has some experience of going public, floating its Hong Kong operations on the territory’s stock exchange over a year ago.

The state will welcome these contributions to its coffers. However, its main purpose in selling the banks is not to raise money but to transform lending in China. The hope is that private banks run for the benefit of shareholders will lend more productively and more prudently than the big four have managed to date. They could hardly do worse. But although privatisation will undoubtedly help, privatisation without competition or regulation brings dangers of its own.

China’s people stash about 40% of their income in their nation’s banks. The big four do not have to chase deposits: deposits come to them. Privatising the banks will do little by itself to sharpen competition—a privately owned oligopoly is still an oligopoly. By the end of 2006, however, this cosy banking market will be shaken up by China’s commitments to the World Trade Organisation. Foreign banks will be allowed to do business in the Chinese currency with Chinese households. If the country’s banks, whoever owns them, do not learn how to compete for deposits, they may start losing customers to foreign entrants that do.

Complacent about the money coming in, China’s banks are also too free about the money going out. Lending by the big four grew by a fifth in the year to October, according to Goldman Sachs. Many economists fear that the Chinese economy is in serious danger of overheating. The central bank has raised reserve requirements in a bid to restrain lending, but to no great effect. Its job is greatly complicated by its desire to maintain a pegged currency: buying dollars at the fixed rate of 8.3 yuan creates a lot of extra liquidity that it then struggles to mop up.

Indeed, the Chinese authorities are caught in a bind. They cannot rein in their banks as long as they maintain their currency peg. But they cannot surrender their peg until the country’s banks are fit enough to live with a currency free to float and capital free to flee. It is a Gordian knot the Chinese state has only begun to unpick.

63 Back to basics Jan 5th 2004 From The Economist Global Agenda

Having concentrated on SUVs, pick-ups and minivans for the past decade, America’s big auto companies are rediscovering the passenger car

FORD

Is the new Mustang a must-have?

FOR much of the past decade, America’s Big Three carmakers—Ford, General Motors and Chrysler (now part of DaimlerChrysler)—have seen their share of the passenger-car market slip as they focused on the sport-utility vehicles (SUVs), pick-ups and minivans that make up the booming light-truck segment of the market. But enough is enough—or at least that is the message the Big Three are hoping to send at this year’s Detroit motor show. The product offensive at the show’s opening on Sunday January 4th showed that the Americans are determined to recapture lost ground in the not-very-lucrative but still huge market for saloons, hatchbacks and estates.

Between them, GM, Ford and Chrysler unveiled plans for 40 new or updated models. GM showed off the Pontiac Solstice, a small convertible that it plans to start selling next year, and a new generation of Corvette sports car, part of the Chevrolet stable that accounts for about half of GM’s vehicle sales in America. Ford displayed a new version of the iconic Mustang, its first for some years, and announced that it is reviving the Bronco marque. At Chrysler, it is much the same story. Among its new cars is the 300C, its first rear-wheel- drive saloon in more than 20 years, and the Magnum, its first estate car since 1984. These new products come with an array of marketing gimmicks. GM, for instance, has said it will give away 1,000 vehicles in a promotion lasting two months. And the carmakers will continue to offer hefty discounts and cheap or interest-free vehicle financing.

The American car giants are trying to reverse a trend that started in the 1980s. Since then, the market has split, with the Japanese coming to dominate cars with reliable, economical models, while the Big Three concentrated on light trucks and neglected traditional models. Foreign firms’ share of the overall American vehicle market has risen to 40%, from about half that 20 years ago.

Even so, the Big Three’s decision to place more emphasis on passenger cars may seem strange. The light-truck segment is still doing well: it accounts for over half the sales of the

64 Big Three (for Chrysler two-thirds). In recent years, this part of the market has provided all Detroit’s profits, while cars have lost money.

So why shift focus? Because American carmakers worry that light trucks will not be a cash cow for much longer. The Japanese have the segment in their sights, just as they did with cars two decades ago. Toyota offers more sport-utility models than Ford, while Nissan’s first big pick-up, the Titan, is expected to do well. Even Ford’s new version of its F-150 truck (America’s best-selling vehicle) is being sold at discounts of up to $1,000.

To survive, Detroit’s manufacturers have to retaliate on all fronts, which means tarting up dull, patchy car ranges so they can be sold profitably. GM, for instance, plans to replace almost 40% of its passenger-car offering this year (based on sales volumes in 2002). “I think we as an industry probably deserted the car for some time. It’s time to put the focus back on that,” Joe Eberhardt, Chrysler’s head of marketing, told the Reuters news agency.

This shift comes as the Big Three struggle to reorganise their operations and finances. Ford and Chrysler are both in the middle of multi-billion-dollar turnaround plans. Restrictive union deals have limited lay-offs but, with American car firms struggling, that is beginning to change. Following last summer's deal with the United Auto Workers Union (UAW), the Detroit carmakers will close at least six plants. However, the UAW refused to budge on health care, now one of the biggest single items in the cost of a Detroit car. On top of the health-care costs there are the carmakers’ huge unfunded pensions—the Big Three now have far more retirees than active employees. However, GM has almost closed its pension deficit (of $19.3 billion at the start of 2003) with help from a bond issue, rising stockmarkets and the pending sale of a large satellite-television business, DirecTV.

Ford, GM and Chrysler emerged from 2003 in slightly better shape than many sceptics expected, and Detroit’s car executives are more optimistic than they have been for some years. But now that Asian and European manufacturers have unleashed an assault on the light-truck market, Detroit is having to respond aggressively. The only way the Big Three can stay on the road is by making new cars that win customers—and do so profitably.

65 Ditching the peace Jan 1st 2004 From The Economist Global Agenda

Nine years ago, members of the World Trade Organisation agreed not to take each other to court over farm subsidies. But the “peace clause”, as this agreement is known, expired on December 31st. Will its end mean the beginning of a trade war? AP

IT IS one of the age-old functions of government: doling out taxpayers’ money to favoured national industries. It is, by contrast, one of the most laudable functions of the World Trade Organisation (WTO) to proscribe and police these subsidies. It gives members the right to retaliate against countries that stuff illegal feathers into the beds of their domestic firms. But not all subsidies are equal under the law. Hundreds of billions of dollars of largesse that governments bestow upon their farmers cannot be contested at the WTO. Until now. The so- called “peace clause”, agreed nine years ago, gave most agricultural subsidies immunity from the WTO’s punishments and procedures for settling disputes. But the clause expired on December 31st. The peace is over; is a trade war about to begin?

There are certainly a lot of subsidies to shoot at. The OECD, a club of rich nations, reckons that the agricultural subsidies of its members cost consumers and taxpayers about $230 billion in 2001 alone. The European Union, the United States and Japan were to blame for about 80% of those transfers. The typical milk producer in the OECD makes half its money from selling milk, and the other half from milking its government. Rice and sugar producers do the same.

So what? If profligate governments want to play sugar daddy with their taxpayers’ money, surely that is their sovereign right? What business is it of the WTO? The problem is that subsidies distort trade. Export subsidies do so by design, encouraging firms to increase their share of foreign markets. Other kinds of handout distort trade indirectly. By making production cheaper, they encourage more of it. This oversupply depresses world prices or accumulates unsold, in the wine lakes and butter mountains that used to characterise European agriculture. Slowly, the EU is moving away from paying farmers to overfarm. It wants to “decouple” subsidies from production.

66 Countries that import food (many of them poor) benefit from the largesse of rich-world subsidies, but agricultural exporters suffer. They are no longer willing to suffer in silence. The 17 countries of the Cairns Group, which includes Australia, Brazil and Argentina, have campaigned long and hard against export subsidies. But as long as the peace clause remained in place, they could not mount a legal challenge. The EU had hoped to wangle an extension of the peace clause earlier this year at the WTO’s ministerial meeting in Cancún, Mexico. But the Cancún talks fell apart when the G22, an ad hoc coalition of developing countries, proved to be feistier than anticipated. The G22 remains in contentious mood. Indeed, as one EU official told the Associated Press: “In this sort of atmosphere, everyone might start throwing things at each other.”

Brazil might cast the first stone. It is already challenging America’s cotton subsidies, arguing that they violate a term in the peace clause that caps subsidies at 1992 levels. Now the clause has expired, other targets will present themselves and other countries may join the fight. WTO members will be able to challenge any subsidy reserved for a specific industry (a sugar subsidy, for example) that can be shown to cause “serious prejudice” to their interests.

Such prejudice is easy enough to prove. Richard Steinberg of the University of California, Los Angeles, and Timothy Josling of Stanford University have read the statutes and crunched the numbers. They show that America’s extensive subsidies to its barley producers, for example, helped keep foreigners out of American markets. Its subsidies to corn producers helped to displace rival producers from third-country markets, such as Mexico, Canada and the Philippines. Meanwhile, by subsidising exports, the EU is depressing world butter prices by as much as a fifth, according to one economic model.

If a plaintiff wins his case, the offender would be forced to withdraw the subsidies and offset their damaging effects, or face the consequences. The penalties for non-compliance can be severe. The WTO sees export subsidies as a particularly egregious breach of free-trade principles. It came down hard on America’s tax breaks for exporters, giving the EU the right to impose more than $4 billion-worth of sanctions in retaliation. The Americans are now scrambling to comply with the WTO’s ruling before the tariffs kick in next March.

Some, especially in America, see the WTO as an infringement of With the expiry of their sovereignty. But the great trading powers tolerate the WTO’s the peace clause, rulings in the spirit of “you win some, you lose some”. America may have lost on export tax breaks and steel tariffs, but it won on the great trading bananas and beef hormones. powers—who are also the great With the expiry of the peace clause, however, the great trading subsidisers—may powers—who are also the great subsidisers—may lose rather more lose rather more than they win. Their enthusiasm for the WTO may wane. If so, they may choose to shrug off any retaliatory duties slapped on than they win their exports. It may be less painful to ignore the ruling, neglect their WTO obligations and face the sanctions, than to abide by the ruling and face their own irate farmers. A country such as Brazil, after all, can block only a tiny fraction of European or American exports. Angry farmers, on the other hand, can block their roads.

For the moment, however, America and the EU would much prefer to remain WTO members in good standing. This gives agricultural exporters a handy bargaining chip if and when global trade talks resume in the new year. As Messrs Steinberg and Josling put it, America and Europe will have to negotiate “in the shadow of this legal vulnerability”. They may be goaded into cutting subsidies more steeply than they would like.

67 Messrs Steinberg and Josling think the expiry of the peace clause will “light a fire” under farm-trade negotiations. For the past nine years, the WTO has given peace a chance. In the years ahead, its courts will be busier and the trade scene tetchier. But something is needed to push the big subsidisers into serious agricultural reform. Dispute is better than deadlock.

68 Buttonwood

Stock answers Jan 6th 2004 From The Economist Global Agenda

Dow 12,000? Hmmm

NEW year, familiar story: American shares are on the up. The venerable Dow again leapfrogged over 10,000 towards the end of last year (though in these less euphoric times traders did not sport “Dow 10,000” baseball caps) and is now closer to 11,000; and Nasdaq started this year by surging through 2,000, its highest level in almost two years. In the seemingly irresistible spirit that grips pundits at the start of every year, Buttonwood wonders whether the round numbers will continue to be breached—and in which direction. A self-confessed recovering bear, your columnist does not now treat every upward move with a snort of derision, and the market certainly seems to have the wind in its sails. But he can’t help feeling that headwinds aplenty loom on the horizon.

This is not a view held by most strategists at investment banks. Abby Joseph Cohen, Goldman Sachs’s stockmarket guru—dubbed “permabull” by those who treat her prognostications with a pinch of salt—thinks shares will rise again this year. Not, to be fair, as much as they did last year, when the S&P 500 rose by 26% and at the beginning of which Goldman Sachs thought the stockmarket a screaming buy. But given that (a) Ms Cohen thinks the market is still cheap and that fair value for the S&P at the end of this year will be 1,250, some 15% higher than now; (b) she describes her assumptions in calculating fair value as “conservative”; and (c) three-quarters of the ideal portfolio is devoted to shares, the permabull is snorting as loudly as ever.

It seems a stretch to describe America’s stockmarket as “cheap”. The S&P has a price-to- earnings (p/e) ratio of 29 or thereabouts, depending on how you calculate it. That is some way above its multi-year average of about 15. Ms Cohen and her like tend to decry high p/e ratios as misleading because the “e” is depressed, as it is in any recovery. In any case, she says, p/e ratios should be higher when inflation is low, as it is now, because profits are of better quality and the Federal Reserve is likely to be friendlier for longer. Which seems reasonable, except that such views are “rubbish”, says Andrew Smithers, a stockmarket consultant of independent mien. There is, he points out, no evidence that profits are of better quality now. Quite the opposite, indeed, thanks partly to the distortions produced by stock options. Mr Smithers thinks that the market is overvalued by at least 60%. Buttonwood tends to the Smithers view: shares are expensive.

For now, however, investors are flooding into the market for reasons other than valuations. A roaring economy is one of them. America’s GDP expanded by an annual 8.2% in the third quarter, and though economists expect that pace to slow, the forecasters polled by The Economist still expect the economy to grow by 4.2% this year. With a fast-expanding economy and some pretty savage cost-cutting have come bumper profits. Thomson Financial, a research firm, estimates that companies in the S&P 500 made some $474 billion in net profits last year—even more than the $445 billion they made in 2000, and almost

69 two-thirds more than they earned in 2002. In short, earnings are far from depressed. The quarterly reporting season kicks off on Thursday January 8th.

Although just about everyone is agreed that the growth in profits will slow (to about 15- 20% this year), they are divided as to what this means for the stockmarket. If you are a bull, the fact that profits are still growing is enough; if a bear, the best is already past. Moreover, analysts are quite probably still too optimistic about corporate profits, which are already above their long-term average as a percentage of GDP.

All of these arguments are rehearsed in a more heated way for a more heated market. Nasdaq, chock-a-block with technology companies, went up by 50% last year and is straining at the bit already this year. It is even more expensive than the S&P, with a p/e ratio of 36. Goldman Sachs has not provided fair-value estimates since 1998 because its models require positive earnings and cashflow, and too many of the companies had neither. Possibly, the profits of companies that do make money will rise fast enough to make buying them anything less than insanity. Certainly, technology companies as a group have slashed costs and would benefit hugely from any pick-up in tech spending.

On this, it is true, there are encouraging signs. For example, semiconductor sales rose for the fourth month in a row in November, and were a quarter higher than a year earlier. But most American companies seem to be doing very nicely with the technology they already have. Why would they want to buy a lot more of it? More fundamentally, the companies listed on Nasdaq are generally of a risky sort. Many will, quite probably, no longer exist in a few years. An old-fashioned view, perhaps, but shouldn't riskier assets be cheaper not more expensive?

Furthermore, there is a lot of risk about—quite apart from the geopolitical sort. Last year, America had strong growth, high profits, stable and low short-term interest rates, low long- term rates and a weak dollar (indeed, in euro terms the Dow rose by only 4%). This year, any number of things could upset that balance. Bond yields could rise sharply, especially if inflation started to climb, the dollar tanked or Asian central banks stopped buying American assets. Merrill Lynch, for one, thinks that ten-year Treasury yields will go up to 6%, from around 4.3% now. That wouldn’t be good for equities.

Equally, bond yields could fall. This is not as wild as it sounds. Disinflationary pressures are still strong, mostly due to excess capacity. A year ago, consumer-price inflation in America was 2.2%. In November, it was 1.8% and The Economist’s forecasters expect it to be only 1.5% this year. It might be lower still were American consumers finally to realise that they need to start saving for their retirement. Falling bond yields, falling consumption, strong disinflationary pressures. None of that would do much for equities either.

70 Here we go again

America's angry election Dec 30th 2003 From The Economist print edition

Prepare yourself for an unusually divisive year AND so the greatest show in modern politics rolls back into town. Four years ago, the American presidential election outdid itself in terms of spectacle. First, John McCain ran the front-runner, George Bush, surprisingly close in the race for the Republican nomination. Then, in the real election, the “50:50 nation” produced a dead heat. Finally came the drama of the Florida recount, twisting all the way up to the Supreme Court before Mr Bush was eventually declared the victor. Now 2004 promises to bring an even more combative show. A surprising number of people will dismiss the contest as mere hoopla. Even in the United States, only around half the electorate will bother to vote. Yet the contest is crucial—and not just because it will choose the most important man in the world. The election will be a verdict on the determined yet controversial way in which Mr Bush has steered his country. It also comes at a time when America is more bitterly divided than it has been for a generation. The stakes are high for both sides. For Mr Bush, success in November would dispel doubts over the “stolen” election of 2000 and counter the charge that he has exceeded his mandate in the war on terror. For the Democrats, the presidential campaign represents something of a last chance. They look unlikely to regain power in Congress. In the Senate, they are defending more vulnerable seats than the Republicans are, and in the House of Representatives another bout of redistricting to protect incumbents should reinforce the Republicans' position. Hence the Democrats' fear that a Bush victory would allow the Republicans to “conservatise” the country's institutions, particularly the judiciary, for years to come. If that seems paranoid, it reflects the atmosphere in which the contest will be fought. Much has been made in Europe of the way Mr Bush's policies have set America apart from the rest of the world; less noticed is the way that those policies have polarised his own country.The president's approval ratings show a huge gap between Republicans and Democrats. The divide is geographical, too, with the Bush-loathers clustered along the coasts, particularly in California and New York, and the Bush-lovers buried in the South and the west. How much is this Mr Bush's fault? American politics has been getting more ideological and partisan for the past quarter-century, as the conservative South has transferred its allegiance from the Democrats to the Republicans. Yet the current president, a conservative southerner himself, has tended to exaggerate the split. Right from the beginning, fume his foes, he ignored the narrowness of his mandate and set off in an unambiguously rightward direction, pushing through an even bigger tax cut than he had promised. The tragedy of September 11th produced a rally around the presidency, but many liberal Americans, like many Europeans, have since been taken aback by Mr Bush's hard-line approach to the war on terror.

71 The division between these two Americas will have an enormous impact on both phases of next year's spectacle. In the primaries, Mr Bush's popularity with the party faithful has already paid off: unlike his father in 1992, who was mauled by a conservative rebellion led by Pat Buchanan, this Bush faces no challenge for his party's nomination. So far, no sitting president who has avoided a primary challenge has lost. Meanwhile, the Democratic contest has been dominated by the rank-and-file's loathing for Mr Bush and its contempt for the way the Democratic leadership in Washington has kowtowed to the president. Senators John Kerry, Joe Lieberman and John Edwards and Congressman Dick Gephardt have all suffered for supporting the Iraq war; instead, activists have flocked to the standard of Howard Dean, a former governor of tiny Vermont, who opposed the war and promises to represent “the Democratic wing of the Democratic Party”. Mr Dean's partisanship has already forced all his rivals, except Mr Lieberman, to step up their own attacks on Mr Bush's foreign policy. Yet their change of tactics has not halted his advance. If the fiery Mr Dean can clobber Mr Gephardt in Iowa and Mr Kerry in New Hampshire, he may have the nomination in his grasp by early February. In that event, a polarised country would have to choose between a conservative Texan and a liberal north- easterner—on the face of it, the oddest couple since George McGovern took on Richard Nixon in 1972. The receding centre Like most caricatures, those of Mr Dean and Mr Bush are both a little unfair. The supposedly “conservative” president has expanded the federal government and its budget deficit at a speed few French socialists could match. As for the “liberal” Mr Dean, he was actually a rather conservative governor of Vermont, even supporting gun rights. He has tried to head off comparisons with the hapless Mr McGovern by stressing his willingness, normally, to send troops to fight overseas. As the focus turns from the primaries to the general election, both men will valiantly strive to prove they are really centrists. As they court the “soccer mom”, “Joe Sixpack” and all those other mythical floating voters who normally help decide American elections, Mr Bush will play down his views on abortion while Mr Dean will try to stay clear of gay marriage. Yet political caricatures have a habit of sticking—and there may be less to be gained by moving to the centre next year than in the past. With America's abysmally low turnouts, the focus in political campaigns is moving from the “air war” (all those ads aimed at floating voters) to the ground war (getting out your core supporters). And core supporters like red meat. Polarisation will, however, bring at least one benefit. It will force a brutal debate on how to make America (and the world) a safer place. In the last three presidential elections, foreign policy played second fiddle to the economy, health care and pensions. In this election, it should dominate. Mr Bush will come under fierce questioning about those missing weapons of mass destruction and the failure to plan Iraq's reconstruction. Any Democrat, but particularly Mr Dean, will have to explain what he would do differently. The campaign may well be nasty, brutal and long. But it will also drive to the heart of issues that matter for the whole world.

72 The race for the White House

Let the games begin Dec 30th 2003 | WASHINGTON, DC From The Economist print edition

The next 60 days will decide the Democratic nomination—and the shape of the presidential contest

THE coming months will see a flurry of electoral activity that is even more concentrated than in recent American election years. The first votes to pick the Democrats' presidential candidate will be cast in Iowa on January 19th and New Hampshire on the 27th, both slightly earlier than usual.

Thereafter, the votes come thick and fast. Seven states hold ballots a week after New Hampshire, including South Carolina (see article). Four days later come Michigan and Washington. Nine more hold their votes in February, and the process culminates on March 2nd—Tidal Wave Tuesday—with contests in ten states accounting for one-third of all pledged Democratic delegates to the nominating convention. They include California, New York, Ohio and Georgia.

The frontloaded timetable was designed by Democratic bigwigs to benefit one of their own— a senator, say, like John Kerry, John Edwards or Joe Lieberman, or Congressman Dick Gephardt, the party's former leader in the House. The idea was to give the establishment's anointee more time to raise money and heal wounds from the nomination battle before taking on the 800-pound gorilla, George Bush.

The timetable may still have that effect. But it seems almost certain to benefit a rank outsider. Cast your mind back a year. In early 2003, Howard Dean was one of the also-rans, the governor of a boutique state with about as much chance of winning as Carol Moseley Braun.

Now, the former governor of Vermont has achieved an unprecedented political transformation. By appealing to the party faithful's anti-war sentiments and especially their fury at President Bush, Mr Dean has won the “invisible primary”, the contest for money, momentum and endorsements. He is far ahead of the field in New Hampshire, and neck and neck with Mr Gephardt in Iowa (a state the congressman, who is from neighbouring

73 Missouri, might have expected to win easily). Insurgent candidates have won the nomination before, of course—and Jimmy Carter went on to win the presidency. But no insurgent has become the prohibitive favourite before a vote has been cast.

There is many a slip twixt the cup and lip, of course: even successful presidential candidates tend to stumble at some point, and Mr Dean has already made a few slip-ups. Yet the plain fact at the moment is that the Democrats' cup is Mr Dean's to grasp. But how unified can the party be in 2004 if he is its candidate?

As his grip on the nomination has tightened, the Stop-Dean machine has gone into overdrive, with ever-fiercer attacks on his temperament, veracity and electability. Optimists (and Mr Dean's campaign staff) say that there is nothing unusual about these attacks: contested primaries are always bitter, and become even more so when an insurgent launches a hostile takeover bid against the establishment.

Besides, add the optimists, Mr Dean is not really out of the mainstream. Except over Iraq, his foreign policy would be squarely in the post-cold war tradition of tough-minded American multilateralism. He ran Vermont as a pragmatic centrist. Mr Dean, on this view, has plenty of ways to scramble back to the centre (by, for instance, picking a centrist running mate). And, because of the frontloaded schedule, the party will have plenty of time to rally round him before November.

Pessimists argue, however, that the divisions within the party, and unease about Mr Dean himself, are more profound than normal. Just before Christmas, Mr Dean said he was unwilling to pronounce Osama bin Laden guilty of the September 11th attacks before a trial—a curious restraint considering that al-Qaeda's leader has boasted about his role in them. Mr Dean has also said that Saddam Hussein's capture would not make America safer. Mr Bush's henchmen will use such pronouncements to paint Mr Dean as ambivalent about national security.

At the same time, Mr Dean has hammered a wedge into his party's long-standing ideological division by accusing Bill Clinton of not doing enough to stand up to Republicans, saying he had tried “simply to limit the damage they inflict on working families”. It was bad enough to be sceptical about the most successful Democrat in living memory. But Mr Dean also called the centrist Democratic Leadership Council (which Mr Clinton once led) “the Republican wing of the Democratic Party”.

Such criticism, argue the pessimists, goes beyond normal primary-season sniping to a structural problem facing the party itself. Mr Dean has so far been successful by mobilising party activists, but in doing so he has deepened the party's ideological rifts. Democratic moderates may not openly attack Mr Dean, assuming he wins the party nomination. But the risk is growing that they will sit this election out, waiting for more propitious times in 2008.

Over the next two months, then, most political activity will be on the Democratic side. Thereafter, attention will shift to the Republicans, because elections with a sitting president almost always turn into a referendum on the incumbent.

In the abstract, Mr Bush looks vulnerable. Asked “would you like to see Mr Bush re- elected?”, Americans are split down the middle: 46% say yes, 46% no. But beneath this apparent vulnerability, there is a hidden upturn in the president's fortunes.

Mr Bush's job approval rating stood at around 55% in December (one Gallup poll put it as high as 63%). That approval level is the highest for Mr Bush since June and, more significantly, higher than any of his four predecessors enjoyed at the same point in their campaigns.

74 That does not mean Mr Bush is coasting to victory. His father had a 52% approval rating in December 1991 and lost with 37% of the vote. Mr Carter had a 54% approval in December 1979 and lost with 41%. In both cases, the economy turned sour in re-election year. But in 1996, with the economy strong, Mr Clinton held on to almost all his December approval, while Ronald Reagan's vote in 1984 was higher than his rating of December 1983.

The notable feature of this historical pattern is that sitting presidents who fail on polling day do so after losing a big chunk of their December approval ratings (13 points for Mr Carter; 15 for George Bush senior). So one way of thinking about 2004 is to ask whether anything might happen to depress Mr Bush's approval rating substantially.

Clearly, it would have to be something big. A perception among voters that the drawbacks of the complicated new Medicare bill outweigh the benefits would not be enough. The obvious candidates are the economy and national security.

Democrats will attack Mr Bush as the first president since Herbert Hoover to preside over net job losses. They can also point out that he inherited a bouncing budget surplus and blew the whole thing. Yet this line of attack is likely to be blunted by the recovery in the second half of 2003: the economy has been roaring back, with 50,000 jobs being created each month and consumer confidence rising. A year before the re-elections of Presidents Clinton and Reagan, the University of Michigan index of consumer sentiment stood around 90. A year before the defeat of Presidents Bush and Carter, the index was below 70. In November 2003, it stood at 93.7.

So the economy could well push up Mr Bush's ratings. Even at its worst, the economy looks likely to be a wash in political terms. Criticism and praise will cancel each other out. That leaves national security as a point of vulnerability.

Obviously, a sharp deterioration in Iraq could damage the president. So, potentially, might a report, due in May, from a commission set up to investigate the attacks of September 11th. If that commission were to find, say, that low-level people in the administration had information that might conceivably have deflected that attack, it would hurt Mr Bush's claim that his administration has made America safer. To make matters worse, it is an open secret that the new Department of Homeland Security is barely getting to grips with improving domestic security.

On the other hand, all this is hypothetical. The Democrats would have to show not merely that the administration had failed (which they might be able to do) but that they themselves would do better (which they have not done thus far).

None of this means Mr Bush is a shoo-in. In a country as evenly divided and polarised as America, no one can be. But it must mean he starts as the favourite. And, on the eve of the first votes, the president's position is strengthening, while the Democrats are still fighting

75 Brazil's president

The year of changing unexpectedly Dec 30th 2003 | SÃO PAULO From The Economist p rint edition Reuters

Having secured financial stability, can Lula move on to economic growth and effective social reform?

“MUDANÇA” means change in Portuguese. It is what Luiz Inácio Lula da Silva promised a year ago when he became Brazil's first elected left-wing president. He would end the economy's habit of crashing like a virus-infested computer, lift millions of Brazilians out of squalor and give his country international heft to match its vast population and territory. A former trade-union leader born in poverty, Lula's arrival in the presidency itself embodied change.

Yet, a year on, both his successes and his failures have defied expectations. On the one hand, his government headed off yet another financial crisis by slashing public spending and raising interest rates, which smothered growth, squeezed wages and killed jobs. A law to trim public-sector pensions, approved last month, angered many traditional supporters of Lula's Workers' Party (PT), who had expected him to expand the state, not reform it.

On the other hand, the PT did not escape the pitfalls of a first experience of national power, albeit in a coalition with centrist parties. Some of its ministers have proved incompetent. Its social policy has been muddled. The party, which boasts of its virtue, has stooped to trading favours for congressional support just as its predecessors did. Its image may yet suffer further damage from a smouldering scandal surrounding party finance and the murder of a PT mayor before the election.

Yet the magic endures. After a year of recession, Lula is as popular as his predecessor was after his first year (of boom). Abroad, he is a spokesman for critics of the United States' way of doing things, from trade to the Middle East. “People have never been as supportive of a government as they are of this one,” says Raquel Teixeira, a congresswoman from the opposition Brazilian Social Democracy Party.

Opinion polls show that most Brazilians are prepared to give Lula time, but that their patience is not endless. Unless the economic pain proves temporary, disenchantment will

76 surely grow. So can Brazil's first government of the left now bring about the kind of sustained job-creating growth that has eluded its predecessors for the past two decades?

The omens from Lula's first year in office are encouraging. He gave stout backing to the finance minister, Antônio Palocci, who administered a “credibility shock” upon taking office by voluntarily raising the target for a primary fiscal surplus (ie, before interest payments) from 3¾% of GDP to 4¼%. This, plus the pension reform, convinced investors that Brazil was serious about containing its huge public debt. The central bank, meanwhile, raised interest rates. The austerity hurt, but inflation retreated (see chart). With interest rates now falling fast, the economy may grow by as much as 4% in 2004, having stalled in 2003.

Lula has also been a deft manager of Congress, pushing through contentious measures such as the pension reform by striking broad alliances and gaining support from the opposition when necessary. “We did not lose one important vote in 2003,” boasts Luiz Dulci, a senior aide to the president.

All this adds up to the equivalent of mastering level one of a video game. The familiar target of macroeconomic stability does not disappear from level two but new targets pop up. The most important aims are more long-term investment, without which the economic recovery will quickly peter out, and cutting poverty, through welfare programmes and better education and health services. Here, the line between effective government action and unproductive meddling can be a fine one. Mistakes are not immediately detected and punished by the financial markets, as they are in macroeconomic policy.

In both microeconomics and social policy, Lula has started unsteadily. He came to office criticising Brazil's regulatory agencies, which are supposed to shield contracts from political whim. His telecoms minister invited consumers to go to court to overturn a tariff increase blessed by the regulator. The government “didn't create conditions for a revival of infrastructure investment,” says Adriano Pires of the Brazilian Centre for Infrastructure, a consultancy in Rio de Janeiro. The government also stumbled on welfare, betting on a big programme called Zero Hunger, which was roundly mocked as old-fashioned and ineffective.

Lula's team has been supple enough to bend on both issues. The government is now promising a new investor-friendly regulatory policy, as well as rules to encourage partnerships between the cash-strapped public sector and private enterprise. The idea is to “favour productive investment, especially in infrastructure, so it can sustain a new cycle of growth,” says Mr Dulci. But tension will persist between Brazil's market economy and a party accustomed to seeing markets as the enemy of social equality. The evidence so far is that the outcome will sometimes be an awkward synthesis, arrived at after drawn-out debate.

A long-awaited “new energy model”, unveiled in December, may set the pattern. This is the government's scheme for avoiding a repetition of the 2001 blackout, which hobbled the economy. It grants the authority to award concessions for building power stations to the energy ministry. It leaves the ministry much room to rewrite the rules, and private investors

77 have damned the model as “statist”. Moreover, the government has no intention of privatising electricity generation, 80% of which is in the hands of state companies.

Yet if the government sets clear and stable rules, the model may achieve its goal: new investment in energy at prices that reflect its true economic cost. Long-term contracts, which will pay generators a fixed charge for building and maintaining plants, will shield them from the vagaries of Brazil's volatile market. The ministry has discarded a populist plan to hold down the price of electricity by buying it cheaply from old hydro generators whose investment has already been written off.

This pattern of edited improvisation applies to social policy, too. Zero Hunger continues, but its importance is likely to be eclipsed by the Family Fund, which unifies a clutch of income- transfer programmes for the poor that had been scattered among various ministries.

Education has been hurt by the PT's ideological instincts. The new minister, Cristovam Buarque, when governor of Brasília pioneered the bright idea of giving cash to poor families if they would send their children to school. But his ministry has disappointed enthusiasts for university reform. It created a commission which proposed scrapping the provão, an exam which evaluates universities. Though disliked by students' unions, this is one of the few tools with which to improve the (poor) quality of teaching. Mr Buarque seems to have recognised this: he now says he will modify, but not scrap, the provão.

He also unveiled a noble-sounding drive to make every Brazilian literate within three years. This might give many people, including the elderly, a smattering of literacy. But the same money could be used to teach Brazilians aged 15-30 how to read and write proficiently, a more important goal, says Ms Teixeira, a former state education secretary from Goiás. Like many other specialists, she pronounces the education policy “worrying”.

Some Brazilians are also concerned by Lula's foreign policy. This seems to give greater emphasis to standing up to the United States than to a clear-headed pursuit of Brazil's interests. The president's frequent foreign jaunts have featured places such as Cuba, Libya and Syria; in global and regional trade talks, Brazil has led a charge against rich-country trade barriers but has seemed equally reluctant to liberalise itself. This pugnacity abroad at least provides some political cover for macroeconomic moderation at home.

In sum, what drives the government is Lula's own fusion of fervour and pragmatism. Unlike many other members of his party, he cares more about the overall goal than the methods used to achieve it. He insists that he is a negotiator, not an ideologue. His personal history bestows legitimacy on that pragmatism, making it look less like compromise. When Lula says that it does not matter whether services for the poor come from the public companies or private ones, it is hard to argue.

The coming year may bring more realism and competence to his administration as a whole. It is likely to open with a shuffling of ministerial posts, intended partly to bring into government the centrist Democracy Movement Party, the second-largest in Congress, which helped Lula pass pension and tax reforms. This may also weed out the weakest ministers and perhaps reduce their number from an unwieldy 33.

Lula's bluff reassurances do not still all doubts. Despite Brazil's best efforts, its giant debt means it remains vulnerable to outside events. A rise in international interest rates, for example, could suck capital away, forcing up domestic rates and halting recovery. Lula might then be tempted to ditch austerity and dash for growth in time for the 2006 presidential election. Another worry is that the president may never tackle many of the big reforms that Brazil needs if it is to achieve faster growth, including the modernising of a state that consumes 40% of GDP, shackles business with hefty taxes and makes employment needlessly expensive. Even Lula's appetite for change has limits.

78 79 Charlemagne

Of wars and weighted votes Dec 30th 2003 From The Economist print edition

The history and future of the German-Polish relationship

THE European Union was founded in reaction to the second world war. In many ways, its greatest triumph is that European leaders now spend their time arguing about fish quotas, not disputed frontiers. Yet occasionally memories of war bubble back to the surface. The recent deadlocked European Union summit in Brussels was just such an occasion.

That the central confrontation came between Germany and Poland was bound to stir up memories. But despite the tension, the EU could still claim to be exercising its civilising influence. This was not, after all, an argument about national survival. Rather it was a dispute between two democratic governments over voting rights, one to be settled by multilateral negotiations, not force of arms. The Germans want EU votes to reflect population size, giving them twice as much weight as the Poles. The Poles are leading the defence of the current system, which gives them almost as much clout as the Germans.

Poles usually make a point of not mentioning the war explicitly in any dealings with Germany. But they barely need to. It is implicit in their insistence that they will not be intimidated by demands from their bigger and more powerful neighbour. Asked by the BBC whether he was worried that Germany might make his country suffer for its obduracy, President Alexander Kwasniewski of Poland exploded that his country was not afraid of suffering: Polish history was about suffering.

These days, the German approach to Poland seems slightly less weighed down by memories of the war. This is new. In the tortuous negotiations over the enlargement of the EU, which took up much of the 1990s, Germany championed the Polish cause, making much of its need for an historic reconciliation with its eastern neighbour. When other countries mused that Poland might not be ready to join the first wave of new entrants, the Germans were always the first to insist that any EU expansion without Poland was not worth having.

Now that Poland's entry is secure, though, the Germans seem to feel that past debts have been settled in full. Indeed the new German refrain is that the Poles are being unreasonable and arrogant in blocking the adoption of a new constitution, even before they are officially inside the Union's pearly gates. (Poland, along with nine other countries, mostly from central and eastern Europe, will formally join the EU only in May, but all have been included in the constitutional debate as they will be full members when any new constitution comes into force.) Günter Verheugen, a European commissioner from Germany who handled the enlargement negotiations, recently fumed to the European Parliament that he now almost regrets all the efforts that he made on Poland's behalf. In the corridors of the Brussels summit one German diplomat was even heard to say, without apparent irony: “How can the Poles behave like this, after everything we have done for them?”

It is not just the Poles who are acutely aware of the weight of history. There was a distinct whiff of 1939 and all that in the reaction of British Conservatives to the way the plucky Poles had scuppered the EU constitution and “stood up to the Germans”. Perhaps the most tasteless comment in the summit's corridors came from a Swedish diplomat, who remarked: “Maybe the Poles could claim equal voting weight with Germany, by counting all the Poles that the Germans killed in the war.”

Not terribly funny, perhaps—but not entirely frivolous, either. Consider the reconciliation between France and Germany on which the EU was founded. The principle of absolute

80 equality between aggressor and victim was clearly fundamental to the bargain. For over a decade after German reunification had boosted that country's population well beyond France's, the French continued to insist that the two should retain precisely equal voting weights. France formally abandoned this position only in 2002. “In the end you have to accommodate yourself to reality,” explains a French diplomat. “The Poles will have to do the same, eventually.”

Think national, speak Europe

The closeness of today's Franco-German relationship is often cited as a model for the future of German-Polish relations. But, whereas France and Germany have now had 50 years of working together in which to overcome old fears and hatreds, for most of that time Poland was locked away behind the Iron Curtain. The French and German leaderships like to argue that, partly as a result, Polish politicians are still fixated on old ideas of national sovereignty, while their two countries have moved on to a new sort of relationship, based on a fresh way of thinking that transcends such old categories as the “national interest” or “national security”.

To make the point that Germany is thinking of European rather than national interests in pressing for the new constitution, German diplomats are now recounting a key moment in the Brussels summit. Searching for a compromise, Silvio Berlusconi, the Italian prime minister who was chairing the talks, suggested to Gerhard Schröder, the German chancellor, that rather than moving to a voting system linked to population, Germany could simply have more votes within the current system: perhaps three more votes, giving Germany 32 votes, against 29 each for France, Britain and Italy, and 27 each for Poland and Spain. Mr Schröder dismissed this angrily: the point, he said, was not to increase German power, but to give the EU a more rational system of government.

Maybe so. But then a population-based voting system is even more advantageous to Germany. And, as one distinguished German chancellor, Bismarck, once put it: “I have always found the word Europe in the mouth of those politicians who were demanding from other powers something that they did not dare demand in their own name.”

81 Arab economies

Improving? Dec 30th 2003 | CAIRO From The Economist print edition

Despite the region's instability, some economies are doing better than usual

WHEN war in Iraq loomed, the country's Arab neighbours predicted dire economic consequences for themselves. Egypt's government said it expected the country to lose $2 billion-3 billion, with tourists flocking elsewhere and fat contracts with Iraq abandoned. Jordan and Syria dreaded a cut-off of cheap Iraqi oil. Bahrain and Dubai feared a flight of investors. Regional shippers bemoaned hefty increases in their insurance bills.

In fact, Arab countries have done quite nicely, thank you. Several of the biggest oil exporters saw their incomes surge by a good 30% this year, as prices stuck at the comfortable end of OPEC's $22-28 target range. Saudi Arabia earned a delicious $74 billion from oil, letting its government bank a budget surplus of $12 billion, marking only the second time in 20 years it has balanced its books. Throughout the Gulf, the windfall has encouraged governments to invest in infrastructure on a scale unseen since the 1970s' oil boom. The reckoning that economists have long predicted, with oil monarchs failing to pamper their growing number of subjects, has again been put off.

But it is not just governments and contractors cashing in. The All-Arab Index, which tracks 79 stocks in 12 Arab countries, posted a gain of 50% in dollar terms in 2003. Another index reckoned that Kuwait's shares, boosted by heady profits for local firms servicing the American army and by the surge of joy due to the end of an Iraqi invasion threat, have doubled in value. Saudi Arabia's soared by a more modest 74%. Even the dowdy Cairo exchange, stalled for years by local troubles including an inexorable slide in the value of Egypt's currency, advanced by 60% in dollar terms.

Awash with cash, banks in Saudi Arabia saw profits rise by 15% in the first nine months of 2003, and those in the United Arab Emirates by an average of 30%. Egypt's Suez Canal, whose revenues have stayed flat at $2 billion a year for a decade, this year earned 32% more. Arab firms are also starting to do well out of reconstruction in Iraq. Egyptian and Kuwaiti ones are building the country's mobile-phone networks, with contracts for restoring power generation, water supplies and other such huge projects likely to follow.

As for those fickle tourists, they seem to have more nerve than expected. Lebanon has enjoyed its best year since 1974, the last year before civil war wrecked its reputation as the Switzerland of the Middle East. And Egypt hosted a record 6m tourists this year, up 20% on 2002

82 GDP growth forecasts, 2004 Jan 3rd 2004 From The Economist print edition

Africa is likely to be the home of many of both the world's fastest-growing and slowest-growing economies in 2004, according to the Economist Intelligence Unit, a sister organisation of The Economist. Chad's economy is tipped to outpace all others, including last year's front-runner, Equatorial Guinea. The EIU expects Chad's economy to grow by an impressive 58% in 2004, compared with 23% for Equatorial Guinea. Both countries can thank rising oil output for their good fortune. Yet other petro-states are not as lucky. Saudi Arabia can expect growth of only 0.5%, and Kuwait of 1.1%, in 2004. Zimbabwe remains at the bottom; its economy is expected to shrink by nearly 9% this year.

Letters Jan 15th 2004 From The Economist print edition

The rating game

SIR – Your article about Parmalat suggests that the company “failed to disclose lots of information” to Standard & Poor's, yet we maintained its rating at investment grade (“Déjà vu all over again?”, December 20th). This is not the case. Parmalat and its advisers repeatedly provided us with detailed information about its liquidity position and its liabilities, in response to our inquiries throughout the year and as recently as December 5th. This essentially confirmed the audited accounts. That information was enough to warrant our lowest investment-grade rating (BBB-), but has now been shown—just like the audited accounts themselves—to have been utterly misleading.

Rating agencies are not auditors or investigators and are not empowered or able to unearth fraud. They depend on truthful audited public accounts and honest private information from the entities that they rate. It is easy to be wise after the event, but before Parmalat missed its bond repayment on December 8th—and was immediately downgraded by S&P—there was no indication that it faced an imminent liquidity crisis. On the basis of the public and private information available to us about Parmalat, we have acted in a responsible and timely manner.

François Veverka, Executive managing director Standard & Poor's, Paris

83 George Bush's big-government conservatism

Can't last Jan 8th 2004 | WASHINGTON, DC From The Economist print edition

Between 1998 and 2001, America's federal government ran a surplus on its accounts. The prospect now is of years, even decades, of deficits. Is that scary?

IN HIS first three years as president, George Bush has cut taxes three times and yet orchestrated a sharp rise in public spending—not just, or indeed mainly, on foreign wars and “homeland security”, but also on domestic matters. For instance, spending on education has jumped by three-fifths since 2000, and spending on transport has risen by nearly half. Lower taxes, higher spending: the outcome is that the federal government, despite a steep fall in the interest it pays on its debt, has swung sharply into deficit—$450 billion this fiscal year, by most accounts.

That is not, yet, as big a deficit as that presided over by Ronald Reagan in 1983 (6% of GDP then, compared with about 4% of GDP for this year). Yet the deterioration of the government's finances today—from a surplus of 2.4% of GDP in the 2000 fiscal year—is certainly steeper.

What is more, by 1983 Mr Reagan and Congress were together attempting to do something about the deficit. Nowadays, no one with political power is bothering to try. All the Democratic presidential hopefuls want, to a greater or lesser degree, to repeal Mr Bush's tax cuts. Yet they aim to use the money not to bring down the deficit, but to expand public programmes. Mr Bush's own new legislation to pay for prescription drugs under Medicare, the federal health programme for the elderly, will cost $400 billion over the next ten years. A bipartisan conspiracy exists, it seems, to ignore the risks of a widening deficit.

What risks? After all, a year or two of sharply higher government spending in the early part of Mr Bush's presidency—when economic growth slowed sharply, a stockmarket bubble burst, and America faced unprecedented and confidence-sapping security threats—may well have been for the good. Yet, even as evidence grows that there is a reasonable chance of economic recovery, the long-term prospects for the budget look as bleak as ever.

84 A new and frank report by the Congressional Budget Office (CBO) shows that rising healthcare costs and an ageing population mean that federal “entitlement” programmes—notably for Medicare, Medicaid and Social Security (pensions)—will claim a much higher share of the country's economic output over the coming decades. Currently, Social Security funds run a surplus that helps to finance other parts of government. But by 2015 surplus will swing to deficit, and by 2030, on current policy, the cost of Social Security will have risen from 4.2% of GDP to 5.9%.

Spending on pensions pales in comparison with health care. The range of estimates is necessarily vague, since they involve assumptions about the future rate at which healthcare costs will grow faster than per-head GDP each year: since 1970, the “excess-cost growth” for retired people on Medicare has been around 3%. The CBO calculates that, if future excess-cost growth of both Medicare and Medicaid was only 2.5%, then federal spending on these programmes would jump from 3.9% of GDP in 2003 to 21% in 2050.

It is clear that holding back the growth in non-entitlement (or “discretionary”) programmes, such as defence and transport, will not be enough to ensure a sustainable budget in the long run. Unless entitlement programmes are cut too, or taxes raised to unprecedented levels, or both, the country is on a financially unsustainable path over the next half-century. “An ever- growing burden of federal debt held by the public”, the CBO concludes, “would have a corrosive and potentially contractionary effect on the economy.”

Some observers go further. In a paper presented to the American Economic Association last Monday, Peter Orszag of the Brookings Institution, Allen Sinai of Decision Economics and Robert Rubin, one of Bill Clinton's treasury secretaries, say that “substantial deficits projected far into the future can cause a fundamental shift in market expectations and a related loss of confidence both at home and abroad”—in other words, a full-blown, third- world-style financial crisis. Impishly, they quote Greg Mankiw, now Mr Bush's chief economic adviser, in a paper he co-wrote in 1995: “We can only guess what level of debt will trigger a shift in investor confidence, and about the nature and severity of the effects. Despite the vagueness of fears about [these effects], these fears may be the most important reason for seeking to reduce the budget deficits.”

The White House claims that the budget it is preparing for the 2005 fiscal year will be “committed to fiscal restraint”. But this is an election year, after all. A report in the New York Times suggests that the administration will claim to be able to halve the deficit over five years by relying on future economic growth and on cruel cuts in such programmes as housing for the poor and job-training for the unemployed. Certainly, these vulnerable groups do not tend to vote Republican. Also certainly, such cuts will barely dent the budget deficit.

Fortunately, others are thinking more seriously about the choices that need to be made to secure long-term deficit reduction. In “Restoring Fiscal Sanity”, a report to be published on January 13th by the Brookings Institution, edited by Isabel Sawhill and Alice Rivlin, once Mr Clinton's budget director, three options are offered.

The “smaller government” path emphasises cuts in “corporate welfare” (subsidised insurance, loans, etc), the devolution of responsibilities to the states, savings from that old chestnut of “waste, fraud and abuse”, and deep cuts in entitlements. The “larger government” path emphasises tax increases as the main route to sustainability. The “better government” path argues, in Clintonian style, that the government can be more effective without absorbing a larger share of GDP. The problem with this path, as the authors admit, is the difficulty of measuring the effectiveness of various government programmes, and of dealing with resistance to cutting them.

Given such resistance, it is more likely that higher taxes will play the largest part in plugging the deficit. The question, then, is whether the process of plugging begins sooner or later. Either way, Americans will soon have to accept that federal spending is rising to a permanently higher level, one closer to European levels of government spending. Perhaps they can soften the shock by taking their holidays in Paris

America's budget deficit Jan 8th 2004 From Economist.com

In 1997 Democrats and Republicans struck a deal to balance the federal budget by 2002. Events, however, overtook them: one year later, surging tax revenues (fuelled largely by the internet bubble) gave America its first balanced budget since 1969. Politicians responded by paying down America’s debt, but then increased spending and delivered “targeted tax cuts” to favoured groups in the run-up to the 2000 presidential election (in which both candidates made the distribution of the budget surplus a central campaign issue).

George Bush's series of tax cuts (designed in part to lift the economy out of recession) and profligate spending have since transformed the budget surplus into a record deficit. With neither Democrats nor Republicans professing the political will to raise taxes and cut spending enough to trim it, this deficit is likely to persist for the foreseeable future, even before America’s ever-increasing unfunded liabilities are taken into account.

86 Migration in the European Union

The coming hordes Jan 15th 2004 From The Economist print edition

Fears of migration from east to west

ON ONE side stand economists armed with formulae and tables of data, arguing that migration from the poor countries of central Europe to the rich countries of western Europe will be modest and manageable after ten new members join the European Union in May. On the other stand Eurosceptics, trade unions and some governments, worried that enlargement will bring a rush of migrants chasing jobs and social-security benefits. Almost drowned out are voices from the poor countries themselves, demanding the rights and freedoms of EU membership, but fearing a drain of skilled workers.

Free movement of workers across borders is a basic EU policy. But it poses problems of scale when the EU is gaining ten countries, with a combined population of 75m, that have wage levels and living standards far below the 15 existing member countries (and 380m people). Cyprus and Malta apart, the new members include eight central European countries with an average income per head of only 23% of the EU average in 2001. That figure falls to 18% if Bulgaria and Romania, which hope to join in 2007, are added.

Given such a big income gap, and high unemployment in many of the new countries, the question should perhaps not be why so many workers might want to leave, but why so many might choose to stay. One answer is that prices are lower in central Europe, making those low average incomes worth more like 35-45% of their west European counterparts. But that still leaves plenty of incentive for workers to go overseas, send money home, and come back to spend it later. Already more than 400,000 migrants from central Europe are working legally in the EU, and many others are doing so illegally.

Fears of a big new migration wave from central Europe after enlargement have provoked a policy split among EU governments, already hard-pressed by asylum seekers and illegal immigrants from farther afield. Germany and Austria, which border the new members, oppose a quick opening-up of labour markets. They have secured agreement that EU members can restrict labour inflows from central Europe for up to seven years, although this should not affect students or tourists.

Britain and Ireland are among the countries taking a quite different view. They have promised to open their labour markets immediately, seeing workers from the new countries as a timely source of cheap, skilled labour. Some EU governments have yet to state final positions, though the European Commission hopes they will do so by the end of January. They all have the option to bar workers from central Europe for an initial two years, and to renew this bar for another three years in 2006. A further extension of two years will be possible for countries that still fear “serious disturbances” in labour markets.

87 Recent academic simulations have predicted that as many as 3m-4m people will migrate from central to western Europe in the 25 years after enlargement, about 1% of the present EU population. Roughly half of those will be workers. There will be a first surge of migrants for two or three years, then a falling away (see chart). Based on past trends, at least half the migrants will head for Germany.

Those who think the rate of migration will be higher point to German unification, when over 7% of the population moved from east to west in ten years, despite a huge flow of subsidies from west to east. Those who think it will be lower cite the EU's experience with Spain and Portugal, which joined in 1986. There was no big outflow then: rather the opposite, as strong growth at home attracted Spaniards and Portuguese back from other countries. But when they joined, Spain and Portugal had living standards much closer to the EU average than the countries of central Europe do now. Spanish purchasing power was about two- thirds of the EU average. For Poland, the biggest country in central Europe, the figure is about 40%.

Even diligent and legal migrant workers from central Europe could pose political problems for western European governments, if they come in large enough numbers and seem to price locals out of jobs. But they will still be valuable economically, because they are likely to contribute more in work than they take out in pay.

The bigger worry for rich-country governments concerns migrants in search of state benefits. Central Europe's Roma minorities—about 9% of the population in Slovakia, 5% in Hungary and 3% in the Czech Republic—are a particular cause for concern. The poorest Roma villages, especially in eastern Slovakia, are among the most desperate places in Europe, with no work and little schooling. A flow of Roma migrants claiming political asylum led Britain to reintroduce temporary visas for Slovaks a few years ago. Such barriers will be illegal after EU enlargement.

Yet whatever problems migration may pose, short-term restrictions, such as those proposed by Germany and Austria, will not be a solution. At best they may merely delay or divert flows. A two-year or even five-year delay is not much when set against the 50-90 years that it might take the countries of central Europe to catch up with west European living standards. If the incentive to migrate from central Europe is strong in 2004, it will be strong in 2009—unless western Europe's economies do remarkably badly.

A better way to deter too much movement of people would be through investment in the poorest parts of central Europe, especially improving infrastructure such as roads. This should bring businesses and jobs, making it less likely that people will migrate. That is a good argument for directing eastwards the subsidies that the EU gives to poor regions.

Even so, east-west migration will be a fact of life in the EU for at least the next 30 years. The trick is to make the best use of it. This means fine-tuning benefit systems to shut out short- stay claimants, as Denmark is doing, and improving incentives to work. It means deregulating labour markets so that jobs can be created cheaply but legally for the workers who want them. Migration will be less of a challenge, and more of an opportunity, if it forces such reforms on recalcitrant governments.

American banks

One fewer Jan 15th 2004 | CHICAGO AND NEW YORK From The Economist print edition

Another huge American banking merger

AFTER a brief pause for the recession, America's banks are back to their favourite pastime: buying each other. On January 14th it was announced that Chicago's Bank One, a roll-up of the largest Midwestern banks, had accepted an offer from New York's J.P. Morgan Chase, itself the recent combination of four big institutions, for $58 billion in shares. This deal follows another big merger, that of Bank of America and FleetBoston, announced with much fanfare in October.

The latest combination will be a formidable one, with $1.1 trillion of assets, second in the American banking firmament only to Citigroup (and not that far behind—see chart). It will have 2,300 branches, combining Bank One's Midwestern network with J.P. Morgan's leading franchise in New York and smaller ones in Texas and Arizona. The new group will be a big asset-manager, overseeing $700 billion, and a leading credit-card issuer. The two banks have a one-third combined share of syndicated lending.

As well as combining the partners' strengths, however, the new firm will also have their weaknesses: a gap in investment banking and the threat of competition from innovative upstarts in retail banking—notably in Bank One's home town. Chicago is seeing a heated battle for retail customers' deposits. Washington Mutual, a Seattle bank, has moved into town aggressively in the past year. Last month the boss of Harris Bank, another competitor of Bank One's in Chicago, predicted that nearly half of all bank branches to open in America over the next few years will be in the city.

The deal is clearly a good one for the two principal bosses, J.P. Morgan's Bill Harrison and Bank One's Jamie Dimon. A year ago, Mr Harrison was taking a lot of stick from investors over the slow pace of integration between J.P Morgan and his own Chase Manhattan, following their merger in 2000. Business was poor, especially in investment banking, and the share price was feeble. Now Mr Harrison has pulled off another big deal, taking his

89 institution to within spitting distance of Citigroup, the bank it most resembles in structure and scale.

The merger looks better still for the career of Mr Dimon, who is due to take over from Mr Harrison as chief executive of the new bank in 2006. Having helped Sandy Weill create the modern Citigroup and having been generally seen as Mr Weill's successor, Mr Dimon was purged by his mentor in 1998. He rejected many offers, including some from then- trendy new-economy firms, before taking over Bank One in 2000. Bank One was then reeling, having done one deal too many.

Mr Dimon quickly transformed a dysfunctional management, aided by the willingness of many of Citi's prized executives to flock to his side. Until this week's deal, however, it had seemed that Mr Dimon's resurrection may have run its course. In the days of his partnership with Mr Weill, an acquisition was the usual answer to stagnation. That looked an expensive option after Bank of America, the third- biggest bank in the United States, offered a huge premium for FleetBoston Financial late last year. This pushed up the likely cost of any purchase which Mr Dimon might have been considering.

Now, because Bank One is itself being bought, his shareholders will receive a takeover premium (of about 14%) instead of paying one. In his brief tenure, which spanned a sick economy and a stockmarket bust, Bank One's shares appreciated by two-thirds. Importantly for Chicagoans' self-esteem, the base for the merged bank's retail operation will stay in Illinois.

Nevertheless, there are some question marks over what the merger will achieve. First and foremost, the deal is about scale, especially in retail banking, so there will be few of the easy gains that come from eliminating overlapping operations. Strategically for Morgan, it has the disturbing characteristic of continuing the bank's tendency to follow trends: might it be that Bank of America's purchase of FleetBoston has focused Mr Harrison's mind?

Throughout the late 1990s when corporate finance was faddish, his Chase Manhattan built up its corporate bank at high cost through a series of acquisitions, notably of Hambrecht & Quist, a west-coast specialist in initial public offerings; the Beacon Group, a high level advisory firm; and then J.P. Morgan. The Beacon and Hambrecht deals were both outright disappointments and the marriage of J.P. Morgan and Chase never achieved what was hoped. Now, with retail banking once again in fashion, there has been a change of course. At the very least, a more distinctive strategy would have allowed for less costly deals. Perhaps more importantly, bank trends never seem to last very long, as many firms pursuing the same approach inevitably reduce returns.

Nuts and bolts

Despite this area of doubt, both banks' bosses are considered particularly good at retaining operational capabilities in chaotic times, notwithstanding the turmoil that inevitably follows big deals. Struggling to integrate J.P. Morgan and Chase Manhattan, Mr Harrison nevertheless cut costs quickly when revenues, especially in investment banking, did not

90 meet expectations. During each of the mergers that created his bank, competing institutions formed groups to pick away clients lost in the shuffle, and had little success.

America's banking industry has now seen two big mergers announced within three months. More deals are likely to be in the works as banks seek both scale and broader geographical coverage, as they break out of their old regional constraints. The new J.P. Morgan Chase will still have branches in only 17 states. It is hard to believe that even the biggest banks would not like wider coverage. For the next tier, consisting of the biggest regional banks, the question of whether to buy or sell is becoming more acute all the while. And among America's smaller banks—the country has an impressive total of 8,000 banks—many mergers have been going on, without attracting the headlines generated by the biggest players' deals. Consolidation looks sure to continue. Who's next?

Buttonwood

A banker's delight Jan 20th 2004 From The Economist Global Agenda

American banks are making very big deals and very big—nay record-breaking— profits. But for how much longer?

EVEN casual readers of the financial press will have noticed that another big banking merger was announced last week in America. This latest, between J.P. Morgan Chase and Bank One, will create America’s second-biggest bank by assets, which is to say a very big bank indeed, since the assets concerned amount to some $1 trillion or so. It follows on the heels of another megamerger, announced last October, between Bank of America and FleetBoston, which would have created the second-biggest bank had it not been for this latest deal. Most writers were swept along by the scale of the transaction and the undeniable human drama: Bank One’s boss, Jamie Dimon, was the protégé of Sandy Weill, the (apparently) former head of Citigroup, America’s biggest bank, before he was elbowed out by his mentor. Mr Dimon, it seems, is to come into a handsome inheritance after all, since he will become the chief executive of the new bank when Bill Harrison retires.

All good stuff. But what strikes Buttonwood is something else, albeit connected to this latest wave of coupling: America’s banks are astonishingly, jaw-droppingly profitable. Financial firms now account for a third of all corporate profits, compared with some 18% in 1988, their recent low. On January 20th, Citigroup announced that it made an astonishing $17.9 billion after tax last year—more than any financial institution has ever made—and a raft of other banks announced higher fourth-quarter profits on the same day. If the sector continued to make as much as it did in the third quarter, it would, according to figures compiled by Andrew Smithers, an independent consultant, rake in some $283 billion for the year as a whole—and this now seems a conservative forecast.

91 Why are the banks making so much money, and will they continue to do so? For those to whom reading this column is something of a chore, the answer to the second question is intimately connected to the answer to the first, and can be briefly summarised as “no”.

Banks, as Mr Smithers points out, essentially take two risks: credit risk—the risk that a borrower won’t pay the money back—and what is succinctly dubbed maturity-transformation risk—taking in short-term deposits and lending the money out for a longer term at a higher rate of interest to companies or the government (by buying government bonds). Historically, banks have not been very good at managing either of these risks, which is why there have been so many banking crises in America, and elsewhere, over the years.

But American banks have been especially vulnerable, because until the mid-1990s laws made it very difficult for them to expand across state boundaries. Banks were thus small, even the biggest ones, and undiversified. So a property crisis in New England, say, would have a dramatic (and often fatal) effect on banks that could largely operate only in that region. After the laws were scrapped, banks started to leap into bed with one another. At the end of 1993, there were 10,600 banks in America; by September last year, there were 7,875. This process has not only made banks more diversified and stable, but it has also allowed them to strip out masses of overlapping costs. Bank One grew in exactly this way.

But if banks have been more stable, the environment has also undoubtedly been much kinder to them of late. The fact that hardly any banks have gone bust in recent years (just two went under last year, neither big), even after the popping of one of the biggest stockmarket bubbles in history, is not just a matter of skill. Credit risk has been of fairly minor concern because few borrowers have gone bust. Although a few big, well-known companies folded after the stockmarket fell, banks have in fact had to write off very few bad loans. Charge-offs for corporate lending, for example, peaked in December 2001 at just over $6 billion and have halved since then. They are likely to continue falling, partly because corporate profits have soared, but also because of a renewed surge in investors’ appetite for risk, which has kept many a rocky company afloat. Moreover, consumers have kept spending, which has kept the economy buoyant and problem loans low.

For that, thanks goes mostly to Alan Greenspan and his colleagues at the Federal Reserve, for slashing interest rates to the bone and saying that they will keep them there. Low and falling short-term rates have been a bonanza for banks for another reason, too. The difference between short- and long-term rates, otherwise known as the yield curve, is close to historic highs, even though long-term rates have fallen remorselessly over recent years.

The result is that maturity-transformation risk has paid off handsomely: banks have snaffled up deposits and lent the money on at much higher rates. Better still, the value of the loans or securities in which they have invested (or most of them, anyway) has climbed as long- term rates have fallen. Mortgage-backed securities have been an especially profitable business. At the peak, commercial banks held some $400 billion of such paper.

In such conditions, in other words, bankers would have to be more than usually stupid not to thrive. Sadly, the wonderful times are unlikely to continue. Ten-year Treasury yields are now 4%, which is decidedly odd for an economy that is growing as fast as America’s. If growth peters out, bond yields will fall further but bad loans will rise and the difference between short- and long-term rates will narrow, since there is little scope for the Fed to push short-term rates down further than their current 1%. If growth continues to pick up, on the other hand, bond yields will rise, perhaps sharply, and so will short-term rates, perhaps even more sharply. Since much “restructuring” of corporate balance sheets has been flattered by low interest rates, it would not be entirely surprising if, to add insult to injury, bad loans mounted too.

92 Which is where the latest megadeal comes in. Bizarrely for a developed economy, banking has been a growth business in America over the past decade. Since 1995, the banking component of the S&P 500 has returned 240%, outperforming the overall index by almost 100 percentage points. But banks are having to run very fast indeed to boost profitability. Too fast, perhaps. J.P. Morgan Chase is about to embark on another merger, even though the one that formed it in 2000—J.P. Morgan’s marriage to Chase Manhattan—still looks decidedly uncomfortable. A benign, profitable environment makes most deals look magical, since banks can throw money at problems. Whether the deals will work when things are choppier is quite another matter. But to keep profits up, banks will continue to couple.

Inflated fears, deflated hopes Jan 22nd 2004 From The Economist Global Agenda

The Chinese fear inflation; the Japanese long for it

WILL the year of the monkey be marked by economic mischief? The Chinese celebrated the lunar new year on Thursday January 22nd, gladdened by the news that the economy grew by 9.1% in 2003. But this heartening performance has stoked fears that the Chinese economy is overheating. It wouldn’t be the first time. During the last year of the monkey, in 1992, China’s then leader, Deng Xiaoping, made his famous tour of the south, urging the country to make the most of its new economic liberties. Liberty soon slid into licence, however, and within a year or two the economy was struggling to cope with rampant overinvestment and inflation over 20%.

This year marks an equally troubling anniversary for China’s neighbouring economic giant, Japan. It was ten years ago that the economic superpower fell into a deflationary quagmire from which it has yet to escape. Core consumer prices registered a small increase in October, but fell again in November. The GDP deflator, a broader measure of prices, continues to fall by over 2% a year. While the Chinese authorities are acting smartly to head off inflation, the Japanese authorities are actively seeking it.

Inflation, said Milton Friedman, a Nobel prizewinning economist, is always and everywhere a monetary phenomenon. Maybe so. But Japan has phenomenal amounts of money, and inflation remains always and everywhere elusive. The Bank of Japan is pursuing a policy of “quantitative easing”. It cannot lower the price of money any further—nominal interest rates are already at zero—so it has boosted the quantity of money in the economy instead. Over

93 the past two years, this policy has increased the monetary base by half. On Tuesday, the central bank surprised onlookers by increasing the money supply still further. It now aims to flood the banking system with reserves of ¥30 trillion-35 trillion ($280 billion-330 billion), up from its previous target of ¥27 trillion-32 trillion.

In China too, the money supply is increasing, though not with the central bank’s blessing. To maintain its currency peg, the People’s Bank of China has to create enough yuan to satisfy foreign demand for the currency at the going rate of 8.3 yuan to the dollar. As a result, it is losing its grip on the amount of liquidity in circulation. Broad money is growing by around 20% a year. Bank lending is expanding in step. Investment in plant, equipment and other capital assets is growing at rates not seen since the runaway years of 1993-94. Inflation has edged up, from negative territory a year ago to 3.2% now.

Even so, fears of overheating may be a little overdone. China’s modest inflation can be put down to a disappointing harvest, which raised food prices. There may be shortages in some sectors, such as electricity generation, but there is still much slack to be taken up in the rest of the economy. Labour in particular is never in short supply. Unemployment among those who have left the fields for the cities is thought to be quite high. Underemployment among those who work in loss-making state-owned factories is still higher. To keep the factory workers and peasants happy, China must mobilise labour on a grand scale. Economic growth of 9% or more is not surplus to requirements, because the country’s requirements are so stiff.

China is mobilising capital on an equally grand scale. According to official statistics, its investment rate is around 40% of national income and growing. The fear is that once mobilised, this capital will be mis-allocated. China’s state-owned commercial banks make over 60% of the country’s loans. Past history suggests they do not lend well. With marvellous understatement, the People’s Bank of China admits that the “mechanism of internal control” at these banks “still needs improvement”.

In the meantime, the Beijing authorities have taken to curbing, restricting or rationing the allocation of capital themselves. Investments in steel, cars, aluminium and luxury housing are all subject to new regulations. Last September, the central bank went a step further, raising the reserve requirements for banks in the hope of curtailing lending. The policy seems to be working for now. Bank lending in the final quarter of last year seems to have slowed.

If China’s problems stem from banks too willing to lend, Japan’s stem from banks unwilling to lend at all. Loans in Japan have fallen for 72 months in a row. Banks are reluctant to lend because the bad loans of the past still weigh heavily on their balance sheets; entrepreneurs are reluctant to borrow because demand for their products is weak and the price they can fetch for them falls every year; and, completing the vicious circle, households are reluctant to spend because goods will be cheaper next year. As a result, however much money the Bank of Japan creates, it is not being lent, borrowed or spent.

With spending at home flat, Japan relies more than ever on spending abroad. Indeed, the boom in nearby China may represent its best hope of escaping from its doldrums. Japan’s export-led recovery, now almost two years old, owes much to surging Chinese demand for its products. Morgan Stanley reckons that China accounted for no less than 66% of Japan’s export growth in the first nine months of 2003. In the space of a year, China has been transformed from scapegoat to saviour in Japan’s eyes. In December 2002, Japanese officials publicly rebuked China for exporting deflation around the world. Now, many recognise that it is helping their economy to reflate.

But Japan’s hopes may be thwarted by China’s fears. By taking steps to avert inflation in their own country, the Chinese authorities may halt the return of inflation to Japan. If the

94 Chinese economy slows this year, its appetite for Japan’s exports will wane and its role as an engine of growth in the region will weaken. The Chinese believe that the year of the monkey is capricious and unpredictable. The Japanese may soon believe it too.

Article background Japan's economy Jan 8th 2004

From Economist.com

Japan’s economic slump began with a stockmarket crash in 1989 and hasn’t ended yet, largely because deflation lowers wages and discourages investment. (It also discourages spending—except amongst older consumers.) Many weak corporations, including troubled insurers, hang on stubbornly, thanks to a culture that discourages corporate bankruptcy; they turn to banks, which now carry ¥150 trillion ($1.2 trillion) of bad loans. The government’s traditional solutions have been to keep the yen weak and pour money into public-works projects.

Junichiro Koizumi, the prime minister, promised painful economic reforms in 2001, but so far his efforts have been half-hearted. The government’s new Industrial Revitalisation Corporation, designed to help restructure failing firms, got off to a slow start. Mr Koizumi, Heizo Takenaka, his finance minister, and Toshihiko Fukui, head of the Bank of Japan, are rarely able to work together. An economic upturn has boosted the stockmarket and expectations. In the long run, however, Japan needs reforms: an ageing population will shrink productivity, raise health care costs, and make the bloated and costly public pension system even more so.

Universities

Pay or decay Jan 22nd 2004 From The Economist print edition

If universities are to be truly free and sustainable, most students will have to pay fees

UNIVERSITIES the world over love symbols, from medieval scholastic garb at degree ceremonies to the owls, martlets, chevrons and scrolls of scholastic heraldry. But for many universities, especially in Britain and elsewhere in Europe, a more accurate emblem would include slummy buildings, dog-eared books and demoralised dons. That's why Britain's government is, next week, risking defeat in the House of Commons to bring more private money into the country's universities—and why European and developing countries, now busy expanding higher education, need to think hard about how much government involvement is good for universities.

There are, broadly, two models for running universities. They can be autonomous institutions, mainly dependent on private income, such as fees, donations and investments, or they can be state-financed and (as a result) state-run. America's flourishing universities exemplify the former, Europe's the latter (see article). Britain's government wants to move towards the American model. The subject of next week's rebellion is a bill that would allow English universities (Scotland and Wales are different) to charge up to £3,000 ($5,460) in tuition fees, instead of the current flat-rate £1,125. Students will borrow the money through a state-run loan scheme and pay it back once they are earning enough.

It is a very limited start, laced with sweeteners for students from poor backgrounds. The best universities worry that the maximum fee should be many times higher. But it reflects an important shift in thinking. First, that the new money universities need should come from graduates, rather than the general taxpayer. Second and most crucially, it abandons the egalitarian assumption that all universities are equally deserving.

That is commendable. Just because a course is cheap does not mean it is worthless; the existence of costly ones is not in itself a sign of iniquitous social division. Yet old thinking has deep roots. Bandying phrases such as “excellence for all” and “education for the many not the few”, politicians, especially left-wing ones, want to slap the university-educated label on ever more people, regardless of merit, cost or practicality.

The aspirin theory of university finance

Universities can indeed give the disadvantaged a leg up—but they will do it much better if the state stands back. Micromanaging university admissions, as the British government has been trying to do on grounds of class, with targets, quotas, fines and strictures, risks the same consequences as similar American experiments based on racial preference. It

96 humiliates the talented but disadvantaged, whose success is then devalued; it infuriates the talented who are not deemed underprivileged enough and who feel their merits ignored, and it makes universities do a job they are bound to be bad at.

A good university will need little encouragement to hunt the best talent regardless of class (or race or gender) wherever it can find it. The government may want to subsidise that search, or subsidise loans and bursaries, or provide remedial teaching for borderline candidates. But by far the best route to fairness is not fiddling with the universities, but improving the state school system. When only half the British school population gains five decent exam passes at 16, and only a quarter gain two decent A-levels at 18, it is hardly surprising that the best universities recruit largely from the best schools—those (public and private) attended by the middle class.

Along with mistaken egalitarian assumptions, governments should also ditch another misconception: the utilitarian notion that universities' main merit is their economic usefulness. Amid much blather about the “knowledge economy”, the core of this belief is that more higher education means higher productivity and more wealth. This lies behind the British government's desire (unmatched by the necessary money) to have 50% of the 18-30 age group in university by 2010 and behind much German anxiety about that country's crowded but increasingly second-rate universities.

Alison Wolf, a British economist, terms this the “two aspirin good, five aspirin better” approach to university finance. It is deeply flawed. In reality, there is no proven connection between spending on universities and prosperity, nor can there be. Those rich countries that spend a lot on higher education may do so for the same reasons they subsidise opera: because they like it, rather than because it makes them richer.

This sounds heretical, but should not be very surprising. Just as people differ, so do their educational needs. An intensive three-year academic course may be just the ticket for one person, but a tedious waste of time for another. Indeed, faced with ageing populations, Britain and most European countries arguably should be encouraging their young people to start earning earlier in their lives rather than later.

Graduated differences

Public funding is addictive, and the withdrawal symptoms are painful. But as British dons and politicians struggle with these issues, and their European counterparts ponder whether, one day, they might just have to do something similar, the message for emerging economies like China and India, who are investing heavily in their own systems of higher education, is clear: avoid a nationalised and uniform system, and go for one that is diverse and independent. America's universities have their problems. Inflated tuition fees are a big worry; alumni preference looks unfair. But overall, America's system looks sustainable in a way that the Old World's does not.

In short, the model to strive for is varied institutions charging varied fees. Not all courses need last three years or bring a full honours degree. Some will be longer and deeper, others shorter and shallower. Some universities may specialise as teaching-only institutions, like America's liberal arts colleges. Others may want to concentrate mainly on research. All must have the right to select their intake.

It is better to do some things well rather than everything indifferently. It is because politicians have forgotten this that some of the world's oldest universities risk a future that is a lot less glorious than their past.

Corporate social responsibility

Two-faced capitalism Jan 22nd 2004 From The Economist print edition

Reuters

Corporate social responsibility is all the rage. Does it, and should it, make any difference to the way firms behave?

AT THIS year's gathering of underworked snow-loving corporate chieftains at the World Economic Forum in Davos, Switzerland, anti-capitalist protesters were expected heavily to outnumber the delegates. These rebels against the system could be forgiven for thinking that they have been making progress: they were literally out in the cold this week, but metaphorically speaking they are warming themselves at corporate hearths everywhere. Companies, governments and international organisations pander to them eagerly. Good corporate citizenship is (again) a theme of the Davos celebrations.

One of the biggest corporate fads of the 1990s—less overpowering, no doubt, than dotcom mania, but also longer-lived—was the flowering of “corporate social responsibility” (CSR). The idea that it is not enough for firms to make money for their owners is one that you might expect to be an article of faith among anti-globalists and eco-warriors. Many bosses now share, or say they share, the same conviction.

In a survey of the 1,500 delegates (most of them business leaders) attending the Davos meetings, fewer than one in five of those responding said that profitability was the most important measure of corporate success. Admittedly, even fewer, just 5%, named CSR in its own right as the single most important criterion; but one might add to this the additional 24% who said that the reputation and integrity of the brand, to which good corporate citizenship presumably contributes, matter most. (The quality of the product was the highest-scoring category, with 27%.) When asked to name the leading threat to “security and integrity of the corporate brand”, 38% of the businessmen who responded said

98 “economics/markets”. Evidently, not all the anti-capitalists in Davos are huddled outside the conference rooms.

There's profit in it

CSR, at any rate, is thriving. It is now an industry in itself, with full-time staff, websites, newsletters, professional associations and massed armies of consultants. This is to say nothing of those employed by the NGOs that started it all. Students approaching graduation attend seminars on “Careers in Corporate Social Responsibility”. The annual reports of almost every major company nowadays dwell on social goals advanced and good works undertaken. The FTSE and Dow Jones have both launched indices of socially responsible companies. Greed is out. Corporate virtue, or the appearance of it, is in.

Is this a good thing? Possibly not. From an ethical point of view, the problem with conscientious (as opposed to fake) CSR is obvious: it is philanthropy at other people's expense. As a rule, so far as public companies are concerned, managers do not own the firms they work for. They are entrusted with the care of assets belonging to others, the firm's shareholders. Supporting good causes out of their own generous salaries, bonuses, deferred compensation, options packages and incentive schemes would be admirable; doing it out of income that would otherwise be paid to shareholders is a more dubious proposition. Anyway, is it really for managers and NGOs to decide social-policy priorities among themselves? In a democracy, that is a job for voters and elected politicians.

Advocates of CSR typically respond that this misses the point: corporate virtue is good for profits. And so it may be, on occasion. The trouble is, CSR that pays dividends, so to speak, is unlikely to impress the people whose complaints first put CSR on the board's agenda. So there is a dilemma. Profit-maximising CSR does not silence the critics, which was the initial aim; CSR that is not profit-maximising might silence the critics but is, in fact, unethical.

An unusually persuasive advocate of the view that CSR—or “compassionate capitalism”, as he calls it—benefits shareholders, employees and the needy all at once is Marc Benioff, boss of salesforce.com, a private company (for now) that provides online customer-relationship- management services. In a new book, co-written with Karen Southwick, Mr Benioff argues that corporate philanthropy, done right, transforms the culture of the firm concerned*. “Employees seeking greater levels of fulfilment in their own lives will have to look no further than their workplace.” As well as doing the right thing, the firm will attract and retain better people, and they will work more productively. He makes it seem plausible.

Mr Benioff advocates “the 1% solution”: 1% of salesforce.com's equity, 1% of its profits and 1% of its employees' paid hours are devoted to philanthropy, with workers volunteering their time either to company-run schemes or to charitable activities at their own initiative. His book describes similar projects at many other firms, always underlining their win-win character.

Unlike some advocates of CSR, Mr Benioff says he opposes government mandates to undertake such activities. Compulsion would neutralise the gains for corporate culture, he points out. (He is not averse to tax relief, however, and complains that America's corporate- tax code does too little to encourage his charity.) In any case, if Mr Benioff is right, and CSR done wisely helps businesses succeed, compulsion should not be needed. Companies like salesforce.com and the others discussed in his book will thrive, and the model will catch on by force of example.

Lack of compulsion, however, is exactly what is wrong with current approaches to CSR, say many of the NGOs that first put firms on the spot for their supposedly unethical practices. This week Christian Aid, with Davos in mind, published a report claiming to reveal the true

99 face of CSR†. The charity is “calling on politicians to take responsibility for the ethical operation of companies rather than surrendering it to those from business peddling fine words and lofty sentiments.” (If Christian Aid has no time for lofty sentiments, one wonders, who does?) It regards CSR as a “burgeoning industry...now seen as a vital tool in promoting and improving the public image of some of the world's largest companies and corporations.”

The report features case studies of Shell, British American Tobacco (BAT) and Coca-Cola—all of them, it says, noted for paying lip-service to CSR while “making things worse for the communities in which they work.” Shell, says the report, claims to be a good neighbour, but leaves oil spills unattended to. Its community-development projects are “frequently ineffective”. BAT, it says, claims to give farmers training and protective clothes; contract farmers in Kenya and Brazil say otherwise. Coca-Cola promises to use natural resources responsibly. The report accuses an Indian subsidiary of depleting village wells. So, “instead of talking about more voluntary CSR in Davos, government...should be discussing how new laws can raise standards of corporate behaviour.”

This is a switch. CSR was conjured up in the first place because government action was deemed inadequate: orthodox politics was a sham, so pressure had to be put directly on firms by organised protest. Ten years on, instead of declaring victory, as well they might, disenchanted NGOs like Christian Aid are coming to regard CSR as the greater sham, and are calling on governments to resume their duties. Might this be a sign, Mr Benioff notwithstanding, that CSR has finally peaked? If so, it might be no bad thing. If bosses are no longer to get credit for pandering to their critics, they may as well go back to doing their jobs.

* “Compassionate Capitalism: How Corporations Can make Doing Good an Integral Part of Doing Well.” Career Press, $15.99

† “Behind the Mask: The Real Face of Corporate Social Responsibility.” www.christianaid.org.uk

100

The dollar

Let the dollar drop Feb 5th 2004

From The Economist print edition

Some think the dollar has fallen too far. On the contrary, it has not fallen by enough

THE dollar is the world's dominant currency. Should the world therefore be worried by its recent plunge against other currencies? Plenty of people seem to think so. When central bank governors and finance ministers of the G7 economies meet this weekend in Boca Raton, Florida, the fate of the dollar will be high on their agenda. Since 2001 the dollar has fallen by 33% against the euro and by 15% against the Japanese yen. Currency traders around the globe will scrutinise every word from Boca Raton, looking for a signal that governments might act together to stem the dollar's decline. Many businessmen will be holding their breath as well.

This is understandable. Any shift in currencies produces winners and losers. And yet the real problem facing the world economy is not a suddenly weak dollar, but a dollar which remains, even after its recent decline, too strong. The drop in the greenback was inevitable and should benefit both America and other countries, because it will help to reduce America's vast current-account deficit, which is arguably one of the biggest threats to the global recovery. For the same reason the dollar should, and almost certainly will, fall further. But some countries are not prepared to allow the dollar to fall by enough to complete the necessary adjustment to America's finances.

America's current-account deficit stands at 5% of GDP, and most economists reckon that this percentage needs to be reduced by at least half. That would stabilise the ratio of America's foreign liabilities to GDP, which has surged in recent years. So far the dollar has fallen by 15% in trade-weighted terms against a broad basket of currencies. Nevertheless, after adjusting for inflation, its value is still close to its 30-year average. It may need to fall by another 20% over the next few years if the current-account deficit is to be halved (see article: “Competitive sport in Boca Raton”).

American policymakers seem happy to let the dollar slide. Europeans, however, complain that the burden of adjustment has fallen disproportionately on their currency, the euro. As the euro has soared against the dollar, central banks in Japan, China and other Asian countries have bought dollars to hold down the value of their own currencies. By doing so, they financed over half of America's current-account deficit in 2003. Without that money the dollar would have fallen further.

Missing signals

101 In the short term, Asia might thus be seen as America's saviour. But in the longer term Asian governments are delaying a necessary adjustment by allowing America's deficit to loom large for longer. This is likely to lead to an even bigger and more dangerous build-up of American foreign debt.

The behaviour of Asia's central banks has also blunted the necessary market signals to which even America must, eventually, pay heed. The current-account deficit is a direct, arithmetical reflection of insufficient domestic saving. In particular, America needs to prune its government budget deficit. However, it feels even less reason than usual to do so. Normally, when a government's budget deficit swells so fast (to 4.6% of GDP this year, from a surplus of 2.4% of GDP in 2000) and its currency is falling, investors would demand higher bond yields to compensate them for the increased risk. That penalty gives governments both a warning and an incentive to borrow less. But Asian governments are devouring American Treasury bonds with little regard for the usual risk-return characteristics. As a result, bond yields are being held artificially low, subsidising America's borrowing spree.

This has allowed the Bush administration to point misleadingly to low bond yields as evidence that its budget deficit is not harming the economy, and to think that cutting the deficit is less urgent. President George Bush's plan, set out this week in his budget, to halve the deficit over five years is based on unrealistic assumptions and fantasy accounting (see article). A fiscal stimulus was justified when the American economy was on the brink of a deep recession in 2001, but now that the economy is booming again, borrowing needs to be cut.

Asia's game

In essence, Asian governments are buying American Treasury bonds in order to ensure that Americans can afford to keep spending money on Asian goods. This cannot go on forever. Despite their mercantilist instincts, sooner or later Asia's central banks will have to face the fact that they are holding far too many risky, low-yielding dollars. If they stop buying, it could trigger a sharp fall in the dollar and a jump in bond yields. Delaying the natural adjustment in the dollar and bond yields is likely to mean that, when the inevitable correction comes, it will be much more painful.

If financial markets do turn nasty, then everybody will carry some of the blame. Japan and China will be guilty of trying to block market forces and hence an earlier adjustment in America's trade deficit. With Japan's economy now growing faster than the euro area and its firms' profits surging, Japan can probably afford a stronger yen. Its continuing worry about deflation can be better addressed by printing more money. And China needs to allow its currency to move upwards, not just to help the rest of the world, but also to rebalance its own overheating economy. Without such a rebalancing, inflation or a property boom and bust could destroy growth. The Chinese might find it easier to accept such advice if they are given a seat at the G7 table, where they clearly belong.

The euro area is also far from blameless. Policymakers wring their hands about the “brutal” rise in the euro, yet the euro is still close to fair value against a basket of currencies. If Europeans are worried that a stronger euro will hurt their economies, then the solution is simple: the European Central Bank should cut interest rates to boost demand.

However, America must bear much of the blame for its failure to do anything to curb household and government borrowing and so boost saving. Its easy monetary and fiscal policies are now beginning to look reckless. The dollar's slide has rightly shifted some of the burden of economic adjustment on to other economies. Sooner or later, though, America will have to face up to its own responsibilities, too.

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With seven out of nine, Kerry marches on Feb 6th 2004 From The Economist Global Agenda

By winning five more states this week, John Kerry has bolstered his front-runner status in the race for the Democratic presidential nomination. He has also picked up a valuable endorsement from Dick Gephardt

AS A youngster, John Forbes Kerry sometimes liked to be called by his initials, JFK. Now Mr Kerry seems well on his way to becoming the first senator from Massachusetts since John F. Kennedy to capture the Democratic presidential nomination. On Tuesday February 3rd, Mr Kerry claimed victory in five more states—Delaware, Missouri, Arizona, New Mexico and North Dakota. The closest of these contests was Arizona, where he still overwhelmed his nearest rival, retired general Wesley Clark, by 43% to 27%. Adding to his momentum, he was endorsed this week by Dick Gephardt, a congressman from Missouri who dropped out of the presidential race last month. That may help Mr Kerry make inroads into Mr Gephardt's protectionist mid-western supporters ahead of Michigan's caucuses on Saturday.

The race is not over yet, since Mr Kerry still has only a fraction of the 2,162 Democratic delegates needed to win the nomination in July (see our primer on America’s electoral process). Two of the seven states contested on Tuesday did not fall to Mr Kerry. Senator John Edwards of North Carolina won decisively in South Carolina, the state where he was born. Mr Clark eked out a victory in Oklahoma’s primary with 30% of the vote, beating Mr Edwards by just 1,300 votes. (Mr Kerry came third with 27%.)

Both Mr Clark and Mr Edwards are hoping to build momentum from their one-state victories, but Tuesday’s voting did claim one casualty. Joe Lieberman, the Connecticut senator who was Al Gore’s running mate in the 2000 elections, has dropped his bid after a poor showing across the board. Howard Dean, a former governor of Vermont, has vowed to continue fighting despite not having won any of the states up for grabs on Tuesday, nor either of the previous contests, in Iowa and New Hampshire. Mr Dean did not campaign hard for this week’s seven

103 contests and plans instead to make a stand in Washington's caucuses on Saturday, and Wisconsin's primary on February 17th. But his campaign is almost out of cash—its staff reportedly have not been paid in two weeks—and the end seems near.

As the field dwindles, Mr Edwards may be the biggest remaining threat to Mr Kerry. His Southern charm and populist cry to reclaim America for the have-nots have drawn enthusiastic crowds. Besides winning South Carolina, he has posted strong second-place finishes in Iowa and Oklahoma. But Mr Edwards’ Achilles heel is his inexperience. He is still in his first term in the Senate and held no prior political post. The coming weeks will be crucial in showing whether he can win outside the South. Talk is growing of a Kerry-Edwards ticket, though Mr Kerry (if he becomes the nominee) may look elsewhere, perhaps to Bill Richardson, the Hispanic governor of New Mexico and former ambassador to the United Nations.

President George Bush, of course, lies in wait for the eventual Democratic winner. This week, a USA Today/CNN/Gallup poll postulating a Kerry-Bush contest found Mr Kerry leading Mr Bush by 53% to 46%. But Mr Bush, even more than Mr Kerry, has “not yet begun to fight”. Once the president unleashes his campaign treasury, already well over $100m, many now-straying voters will probably return to the Republican camp. Mr Bush will assert that he is miles ahead of Mr Kerry on national security—saving special scorn for Mr Kerry’s call, after the cold war’s end, to cut the budget of intelligence-gathering agencies. He will also try to peg Mr Kerry as a Massachusetts liberal, of the Michael Dukakis variety (Mr Dukakis was trounced by Mr Bush's father in the 1988 election after being branded wishy-washy). This line of attack may have extra zing following the Massachusetts supreme court's decision on Wednesday to approve gay marriage—making it the most liberal state on the issue, beyond even Vermont's civil unions.

But Mr Bush is vulnerable. America is near-evenly split between right and left, and the division has only been sharpened by the president’s aggressive policies on Iraq and tax cuts. Some of the Democratic primaries, such as South Carolina's, have seen record turnouts; this attests partly to the strong desire to unseat Mr Bush. Voters are still worried about the economy, with job-creation slow and the budget deficit ballooning.

Should Mr Kerry become the Democrats’ nominee, he will probably also play up military service on the campaign trail. Mr Bush sat out the Vietnam war in the Texas National Guard; Mr Kerry went to Vietnam and became a hero. This week Terry McAuliffe, chairman of the Democratic National Committee, accused Mr Bush of being AWOL (absent without leave) during part of his service. The presidential race could soon turn nasty.

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George Bush's budget

An election-year farce Feb 5th 2004 | WASHINGTON, DC From The Economist print edition

Nice glossy brochure, not much fiscal responsibility

ELEVEN days after Congress at last approved a budget for the current fiscal year, which began in October, George Bush presented Congress with a $2.4 trillion budget for the next. Think of it as a campaign brochure, complete with glossy pictures of the president bringing relief to the elderly, restoring the environment and exhorting the young. As a way to unveil the three main themes of Mr Bush's re-election strategy—fighting the war on terror, protecting the “homeland” and getting the credit for a recovering economy—the brochure is a tour de force. As an exercise in fiscal responsibility, it is a charade.

For the armed forces and homeland defence come big proposed increases in spending, up by 7% and 10% respectively. Nothing short of “transformation” is proposed in order to win the war on terror. A Republican Congress is unlikely to begrudge Mr Bush the money.

A bigger problem are those puckerish conservatives who believe that almost any domestic spending by the federal government is wickedness incarnate. This group complains that, since he came to office, Mr Bush has betrayed the vision of Ronald Reagan with a “big-government conservatism” that has increased spending wildly.

In this budget, the president makes his peace with this pinched lot. He proposes that total discretionary spending increases by only 3.9%—less than the rise in average household income. To achieve that, he plans to restrict any increase in discretionary spending not related to homeland security or defence to just 0.5%. Money will be cut for school drop-outs, illiterate prisoners and so on: 65 “major” programmes in all are to be cut, a welcome assault for conservatives on the parasites (Democrats, if they vote at all) on the state. On the other hand, money will be raised for wholesome programmes like one supporting “healthy marriages”. And best of all, as far as the puckerers are concerned, his temporary tax cuts are to be made permanent.

And there is more. While many of the Reagan flame-keepers agree with Dick Cheney that “deficits don't matter”, other Republicans have become increasingly unsettled by a budget deficit now forecast at $520 billion this fiscal year, or over 4.5% of GDP. To this camp, the president promises that spending restraint, by reimposing long-term budget caps, combined

105 with higher revenues from faster economic growth will halve the deficit by 2009. By then, the deficit will be back below its long-run average, as a proportion of GDP.

If this all looks too good to be true, it is. For once, the administration has not fiddled the books by relying on unrealistically high growth rates in the coming years; but it has relied on other fibs. For a start, the budget does not factor in the future costs of keeping soldiers in Iraq and Afghanistan: even Mr Bush's own budget director says costs could be as much as $50 billion for Iraq alone in 2005. Then the usual implausible savings are found from “waste, fraud and abuse”. Third, all the president's cuts are to fall on the one-fifth of the total budget that counts as domestic discretionary spending—hardly likely to happen in an election year.

Mr Bush's most culpable failing lies in his refusal to think beyond the 2009 horizon. Take, first, the tax cuts of 2001 and 2003, which Mr Bush wants to make permanent at a ten-year cost, when other new proposals for tax-free savings schemes are added in, of $1.25 trillion. The cuts may well have provided a welcome economic stimulus at a time when confidence was knocked by recession and terrorist attack. But after 2009, these cuts will equal three- quarters of the total deficit, even by the administration's own numbers.

This matters, because soon after that date, some very predictable things happen, thanks to a demographic bulge as the baby-boom generation reaches retirement. The surplus on government-retirement accounts, which currently subsidises federal spending by over $250 billion a year, will vanish. The costs of Medicare, the health programme for the elderly, will soar. Mr Bush has aggravated the problem by pushing through a Medicare prescriptions law whose ten-year cost has now jumped to $530 billion. The idea that Mr Bush will ever tackle these issues—even in a second term—looks fanciful.

Article background

America's budget deficit Feb 5th 2004 From Economist.com

George Bush's series of tax cuts (designed in part to lift the economy out of recession) and profligate spending have since transformed the budget surplus into a record—and still expanding—deficit. Though the 2005 budget gave lip service to deficit reduction, and promised moderate cuts to discretionary domestic spending, it still ended up in the red to the tune of $520 billion, or about 5% of America's GDP. With neither Democrats nor Republicans professing the political will to raise taxes and cut spending enough to trim it, this deficit is likely to persist for the foreseeable future, even before America’s ever- increasing unfunded liabilities are taken into account.

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Integrating minorities

The war of the headscarves Feb 5th 2004 | EVRY From The Economist print edition

Getty

France and Britain have radically different approaches to ethnic and religious diversity. Each can learn from the other

BY THE grassy banks of the Seine, under a vast white marquee the size of a football pitch, 4,000 sheep are bleating. In the muddy field outside, a makeshift sign has been nailed to a wooden post: “Aid-el-Kebir”. This middling town south of Paris, home to some 15,000 Muslims (nearly a third of its population), is preparing for the Islamic festival of Eid.

The sheep-slaughter, which used to take place in living rooms, has been highly organised. Each family identifies and tags its own sheep. An official Muslim sacrificateur dispatches it, and each family then takes its animal home for the feast. In a country that is battling to protect the separation of religion and state, the entire event has been run by the town hall. “The French must understand that France is changing,” says a local official. “Islam has its place here now.”

Evry is particularly ethnically diverse. Some 40 different creeds, colours, faiths or tongues crowd into the town's rain-streaked tower-blocks. Croissants are on sale at the local boulangerie, mint tea and foufou at the halal butcher, and the “Afro-Coiffure” has skin- whitening cream and hair extensions on special offer. In the local paper, death announcements speak of “Pierre” and “Charles”; the births are of “Moussa” and “Fatih”. Half the town's housing is publicly owned, over three times the French average. Joblessness is

107 high, particularly among young men. “It's not the Bronx,” suggests an official, but some estates “are a bit like a ghetto.”

While the French remain mesmerised by the proposed ban on the Muslim headscarf in state schools, other matters have preoccupied Evry. Last year, for instance, the mayor kicked up a fuss when the Muslim managers of a local Franprix supermarket stopped selling alcohol and pork. Local French shoppers, he argued, could not do without their saucisson and red wine. In vain: the supermarket is now another halal butcher.

In general, however, Evry wears multi-culturalism with confidence. It hosts evenings of Algerian poetry or Malian music. It is home to the biggest mosque in France. A multicultural team of youth workers—“Hamid, Bachir, Souleymane, Claire and Pétroline”—is on hand to get jobless young people back to work, with the help of “positive discrimination”. And ritual slaughter is now an official activity.

Evry illustrates clearly the issues troubling France in dealing with ethnic diversity. At root are difficult questions of identity, social mobility and religious expression. In particular, Islam is challenging the strict form of secularism, known as laïcité, which marks France out from most other western democracies. Under this doctrine, equality before the law of all citizens, regardless of their private beliefs, is supposed to be guaranteed by barring religion from the public arena. Even the “So help me God” intoned by incoming American presidents would be unthinkable in France.

A ban unveiled

Under the version of history which all French schools teach, the rigorously secular character of the state is a hard-won victory against the dark forces of obscurantism, anti-Semitism and authoritarian Catholicism which previously held sway. In theory, the involvement of Evry town hall in sheep-slaughter flies in the face of secularist principle. In practice, it shows increasing pragmatism and accommodation in ordinary French life.

At national level, however, debate has been reduced to a single issue: President Jacques Chirac's proposed ban on the wearing of the Islamic headscarf and other “conspicuous” religious symbols in state schools. Next week parliament will vote on the new law, which enjoys wide cross-party support. After that, further laws to protect secularism in public hospitals and public offices are expected.

Outside France the headscarf ban has caused bafflement and indignation, and not only in the Arab world. Yet French support for the ban remains strong (see chart), and unites unlikely bedfellows. Secularists join ranks with feminists, who are dismayed that daughters now choose to wear the veil their mothers battled to discard. Politically, the ban is seen as a way to take support from the far- right National Front.

It is also regarded as a message to fundamentalist Islamists, whose certainties are seducing disaffected young French Muslims. The government stresses that its new law refers to all religions, but nobody is fooled. How many schoolchildren turn up to class wearing crucifixes of a “manifestly excessive dimension”? “It's not the crucifix or the kippa that is targeted,” insists Khalil Merroun, the rector of the Evry mosque, “but Islam.”

108 Many French people feel deeply uncomfortable about defiant, assertive Islam. France, after all, is home to Europe's biggest Muslim population (outside Turkey): some 5m, next to 3m in Germany and 1.5m in Britain. The country has about 1,600 mosques or prayer halls. Many young French Muslims find no difficulty in balancing private faith with French secularism. But an increasingly vocal minority, many of whom speak no Arabic and freely mix Nike trainers with the hijab, finds such compromise unacceptable.

This ban is widely seen as a test of what obligations modern France is willing to, or can, impose on its ethnically and ideologically diverse citizens. Either it can attempt a compromise, and allow Islam and other ethnic groups and religions a public voice, on condition that they at least pay lip-service to the secular republic. This, crudely, is the position of Nicolas Sarkozy, the outspoken interior minister, who has set up an official body, the French Council of the Muslim Faith, to that end. Or France can continue to try to defend its integrationist tradition and refuse compromise, as Mr Chirac is trying to do with the ban.

For those defending the existing model, the fear is that giving in to one demand will lead to many more. If, for religious reasons, women are allowed separate hours in municipal swimming pools, will the country end up separating whites and blacks? On this argument, there seems nothing to stop France sliding towards communautarisme, a dreaded state of affairs in which ethnic or religious groups could freely segregate themselves and form “states within a state” with their own rules and values. “I refuse to take France in that direction,” Mr Chirac said when announcing the ban. Not least because it leads, in French minds, to Britain's laisser-faire multiculturalism.

Meanwhile, in Finsbury Park

For French observers, the dire consequences of British sloppiness are clear to see in Finsbury Park, an edgy area of north London. There, the local mosque is boarded up with corrugated iron. The storming of the mosque by armed police a year ago, the arrest of seven men suspected of terrorism and the deportation order for its former imam, Abu Hamza al-Masri, confirmed every French fear about Britain's multiculturalism. “I told you so,” was the reaction across the Channel.

Yet Mr Hamza's mosque was a very odd place, not least for its extremism. Far more typical of Islam in Britain is the nearby Muslim Welfare House, which has been overflowing ever since moderate local faithful got fed up with Mr Hamza's excesses. The centre supplies English-language and Arabic lessons, advice on job-seeking, and youth and homework clubs, as well as holding weekly prayers—all with the help of an annual grant from the British government. It not only serves traditional populations of Pakistanis and Bangladeshis, but newer groups of Algerians and Albanians too. In France, this might be regarded as state-sponsored ethnic segregation. At the Muslim Welfare House they consider it integration. “We do the grass-roots job the government can't,” comments an official.

The British model of integration consists, essentially, of not worrying about it. Where the French have an official High Council for Integration, designed to ensure that the process takes place, the British shy away from the term. Ethnic minority groups are not only left alone by the state to practise their faith, language or culture, but are encouraged and subsidised to do so. In one or two schools, the wearing of headscarves has caused trouble; but this is seen as a problem for school governors, not politicians. A vast majority disapproves of headscarf bans for impeccably liberal reasons.

Britain does not use quotas or American-style affirmative-action programmes to enforce multiculturalism. It relies, in part, on the routine acceptance of it, and also on strong laws against discrimination. The onus is now on employers to prove that they have not discriminated, rather than on employees to show that they have been treated unfairly. Fired by a self-interested desire to protect reputation, private companies scramble to adopt

109 “diversity” programmes as a mark of good citizenship. France has none of this. In secularist French theory, the principle of rigorous, colour-blind equality before the law should remove the need for “positive discrimination”.

The British and French models for dealing with diversity have deep roots in history. The French model stems not only from secularism but from the country's revolutionary ideal, which enshrines the equal rights and obligations of citizens as individuals. The model in Britain, which is an assembly of nations, has always allowed a more pragmatic, looser connection to the centre. Moreover, Commonwealth citizens arrived in Britain with the right to vote. Geographical concentration propped up that voting power. So bargaining rights— over the building of mosques, the introduction of halal food in schools, or railway-station signs in Urdu—were won more easily.

These differences acknowledged, is British multiculturalism as wrong-headed as the French suggest? The British model has at least ensured the visibility of ethnic Britons in public life, such as TV news-reading. French television news, by contrast, is almost lily-white. France may celebrate its multi-ethnic national football team; Zinedine Zidane was voted the most admired Frenchman last year. But such exceptions, mostly in arts or sports, stand out. France's emphasis on integration would be more compelling if more of its minorities had become public figures.

In terms of political representation, Britain scores better. At the latest count, there were 12 ethnic-minority members of Parliament and 24 such members of the House of Lords. The French National Assembly contains no Muslims, and the black faces are those from French overseas constituencies. Even the French Socialist Party, with its links to anti-racism movements, has no black deputies.

But surely the British model leads to more isolation and segregation? Britain has highly concentrated minorities. Two entire London boroughs, Brent and Newham, now have a non- white majority. In some primary schools, white faces are non-existent. Yet the French model has not averted segregation. It is hard to measure, because minorities are not monitored. But on certain estates, like those in Evry, white faces are also rare.

Tracking the extremists

Racial tension is harder to judge. Britain was marked by riots in the northern cities of Oldham, Burnley and Bradford in 2001. An official report blamed in part the “parallel lives” and “separation of communities” in the towns. London, however, where a third of the population is now from an ethnic minority, is visibly multi-racial, and the capital has not seen a big race riot for many years.

France, to its credit, has also averted mass race riots. Racial tension, however, shows up in other ways. The far-right National Front, which grabbed second place in the first round of the presidential election in 2002, is expected to do well again in regional elections in March. It campaigns heavily on an anti-immigrant platform. In addition, anti-Semitic attacks in France continue, widely blamed on the influence of Islamic extremism and anti-Zionism.

And what of religious fanaticism? It may be easier to plot, preach and disappear in London than in Paris. Yet intelligence sources suggest that the two countries have comparable, though different, levels of activity. Only last month, six people, including an imam, were arrested in Vénissieux, a suburb of Lyons, on suspicion of terrorism. France acts as an important “supply base” for finance and recruitment to the terrorist front, many of whose members move on to London and thence to Pakistan, Afghanistan and elsewhere. The more the traditional mosques in France are watched, the more the networks disappear into clandestine prayer halls and corner shops. In short, a tradition of integration has not sheltered France from extremism.

110 Where does all this leave the balance sheet? Crudely, the British model seems to produce more social mobility, though perhaps at the price of greater extremist activity and complacency about its entrenched ghettos. The French model may give less space to radicalism, but fails to promote social mobility, and is no guard against ghettos forming. Evry's mayor puts it well when he comments that France is accumulating the disadvantages of British multiculturalism without the advantages.

The difficulty lies in deciding what to do about it. Current policy carries risks. The headscarf ban, designed to strengthen French secularism, could end up threatening it: the ban plays into the hands of Islamist groups, who claim that Islam is being stigmatised. At the same time, Mr Sarkozy's new Muslim council brings its own dangers. The more Muslim leaders once considered extremist co-operate with the government, the more young jobless Muslims could turn to other voices outside the council, such as those behind the recent march against the ban in Paris. Tariq Ramadan, for instance, the Swiss grandson of the founder of the Islamist Muslim Brotherhood, is fast becoming a hero on run-down French housing estates.

Some are beginning to advocate a more radical rethink of the current French model. There are stirrings, for instance, of a public debate on “positive discrimination”, despite Mr Chirac's declaration that such thinking is “unacceptable”. If waiting for individual merit to rise to the top is not working, argues Mr Sarkozy, then some sort of hand-up should be considered. The idea of favouring groups, though, makes the French tie themselves in knots. How do you discriminate in favour of a group when the country doesn't recognise any, and all are equal before the law?

Quietly, practical ways are being found around the theoretical objections. Sciences-Po, a respected college in Paris, lets schoolchildren living in certain “educational priority zones” skip the fiercely competitive entrance exam. Most happen to be non-white. “It's illegitimate to hide behind republican principles and do nothing,” argues Richard Descoings, the college's head. Towns like Evry are finding ways to support Muslim activities and skirt the official ban on state finance and religion. Indeed, Evry's mayor argues that France should explicitly help to finance legitimate mosques, in order to avoid the radicalism that comes in from the Gulf and North Africa. Some 90% of France's 900 or so official and self-proclaimed imams are foreign-trained and sponsored.

Perhaps the most devastating criticism of the rigidity of current French policy was delivered in a recent report from the Institut Montaigne, a think-tank. It talked of France's “rampant ethnic segregation” and “veritable ghettos”. The country, it said, “scarcely recognises itself as a pluri-ethnic nation”. It urged France to “recognise the reality of minorities”, and, most important, to put in place a programme designed to reflect ethnic “diversity”, including positive discrimination.

That common glue

The British, too, are beginning to recognise the drawbacks of their own approach. David Blunkett, the home secretary, is introducing citizenship classes to ensure that Britons can at least speak English and know a little of their history—not hitherto much of a concern. Quite sensibly, there is more talk of the need to strengthen common glue so that differences can continue to flourish. Trevor Phillips, the black head of the Commission for Racial Equality, says he wants to rehabilitate the term “integration”. “People think we tolerate any old nonsense because it's part of their culture: that's nonsense,” he says. “To make the idea of a British Muslim a reality means paying as much attention to “British” as to “Muslim”.

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The future of Japan

Happiness is no laughing matter Feb 5th 2004 From The Economist print edition

Magnum

Japan is going through a complex national identity crisis. That may be no bad thing, says a new book by an American academic Japanologist

Japan Unbound: A THE economy is stalled, but the society is in motion. That is John Volatile Nation's Nathan's own summary of his new book, and it fits the bill Quest for Pride and admirably. Japan is a difficult country to report on and analyse Purpose because things do not change in big, noticeable ways, flagged by By John Nathan set-piece events and announcements, as they often do elsewhere. They change in an incremental process, generally of small steps but which, over time, can add up to big movements. And just such a big movement seems to be taking place.

Mr Nathan, a professor of Japanese cultural studies at the University of California at Santa Barbara, has been observing Japan since the 1960s. Whereas most people look at economic data or the comings and goings of prime ministers, he is more interested in schools, Houghton Mifflin; 271 novels, manga comic books, and the minds of young entrepreneurs pages; $25 and maverick local politicians. In particular, his focus is on whether Japan's famously cohesive, conformist society may be fracturing under the strain of economic stagnation, and on how such strains have been affecting the country's sense of purpose and of national identity.

112 Fractures are what he looks for and fractures are what he finds. On balance, they are neither obviously dangerous nor obviously positive, but they are, as he says, signs of motion which could, in time, lead in unpredictable directions. The most worrying fractures he writes about are in the schools, where violence and truancy have risen remarkably. Old Japan hands shrug wearily at such things, for worries about bullying have long existed but have never really seemed terribly serious. Now, though, Mr Nathan's numbers do make the situation look grave.

Since 1998, youths aged between 14 and 19 have been involved in 50% of all arrests for felonies, including murder. In the first six months of 2000, he says, juveniles (including even younger ones) committed a record 532 killings. In the first 11 months of 2001, juvenile crime increased by 12.5% compared with the previous year, to 920,000 incidents, a post-war high. Truancy is also on the up. A conservative estimate is that 150,000 children between the ages of six and 17 are permanently absent from school; others, says Mr Nathan, assert that the true number is 350,000 children, or 5% of the student population.

Such trends appear to be symptoms of two related phenomena: a widespread feeling of disillusionment, alienation, uncertainty or plain anger, which has spread to children too; and a gradual breakdown of old systems of discipline—part familial, part social, part legal—which appear to prevent schools and parents from dealing effectively with errant children.

Japan is, in short, passing through a national identity crisis. There are plenty of positive aspects to it too, however. One is a considerable increase in the number of actual or budding young entrepreneurs, a trend especially visible in the willingness of high-flyers to leave good, safe jobs in order to set up their own firms. The numbers remain modest, but are nevertheless surprisingly high given the state of the economy in recent years. Another is a new eagerness among popular writers and maverick politicians to try to define and encourage a new national pride.

Mr Nathan picks three particularly interesting cases, two of which combine the roles of politician and popular writer. What is also notable is that he pays virtually no attention to the man keenest to describe himself as a maverick agent of change, namely the prime minister, Junichiro Koizumi. Deeming Mr Koizumi to be essentially part of the establishment, Mr Nathan instead offers profiles of two contrasting outsiders: the now elderly novelist turned politician, Shintaro Ishihara, who is governor of Tokyo and stands for an old- fashioned sort of hard-edged nationalism; and a much younger writer, Yasuo Tanaka, who is governor of Nagano prefecture and advocates a softer, pacifist and hedonistic sort of national identity.

What these two have in common, though, is that both argue that Japan must shake itself free of the too-close and dependent relationship it has had with the United States for the past half century. They do not argue that Japan should define itself by opposition to America but rather that it should be much more independent of it. Mr Nathan's third case, a bestselling cartoonist called Yoshinori Kobayashi, concurs, calling for Japan to stop cringing about its past and about its international status, and to adopt instead what he calls “arrogant-ism”—ie, a strong sense of national pride.

It is not clear where all this will lead: will hard-edged nationalism really take hold, or will it be softer hedonism? And will the current close relationship with America endure for fear of dangers such as North Korea? What is clear, however, is that a lively debate is taking place over that relationship and its effect on national identity, one partly stimulated by the war in Iraq, as has occurred elsewhere in the world, but also one arising from longer-term trends, including economic strains as well as the revival of cultural and economic ties with China.

Occasionally, Mr Nathan seems over-stimulated by his own concerns about America. For instance he claims, without offering any citations or evidence, that “since early in 2003 the

113 United States has been pressuring Japan to arm itself with nuclear weapons and tell the Chinese of its intention as a way of persuading Beijing to get tough with North Korea.” Now that, as we journalists say, would be a story, and if true it is one we have all missed. What is certain is that some mainstream Japanese politicians have become willing to make speeches openly advocating nuclearisation, and perhaps that has been encouraged by their American friends as a way to chivvy the Chinese.

This is a minor cavil, however, in the context of a fascinating book. Japan's society is changing, in complex but seemingly powerful ways, and Mr Nathan brings those ways alive with a wealth of anecdote and insight

114

Blaming everyone but themselves Feb 9th 2004 From The Economist Global Agenda

AT THE weekend, finance ministers and central bankers from the world's seven biggest rich economies came together in Boca Raton, Florida, to Europe’s economy is too give the currency markets a steer. In a joint restrained, say the Americans. statement, they called for “more flexibility” in America’s is too gluttonous, say exchange rates, but frowned on “excess volatility”. the Europeans “Widespread adjustments” should be promoted, they said, but “disorderly movements” avoided. Good to know the world economy is in such decisive hands.

The directions were too nuanced for currency traders to heed. On Monday February 9th, they carried on selling dollars and buying euros as they have been doing, with few interruptions, since early 2002. The Europeans probably deem Monday's trading excessive and disorderly. The Americans, no doubt, consider it flexible and well-adjusted.

In truth, the American and European economies are like ill-matched partners on a see-saw: either can be blamed for throwing the world economy out of balance. The European economy is too puny and restrained, say the Americans; a stronger currency might do it some good. The American economy is overindulging itself, say the Europeans; until it tightens its belt, the dollar will fall. They are both right.

American households and their government are both living beyond their means. The Bush administration will overspend this fiscal year by $521 billion. Its budget for the next fiscal year, unveiled last week, fantasises about halving that deficit by 2009 and dares not look any further forward than that. A more sober (and sobering) examination of America’s fiscal prospects suggests deficits of $400 billion or more until 2009, and worse to come when the baby boomers begin to retire. For the White House, these are problems for the future; specifically, the future that begins after George Bush’s second term ends. But others, such as Robert Rubin, a former treasury secretary, warn that the financial markets, looking forward to deficits as far as the eye can see, may take fright.

The government’s rampant borrowing would be less worrying were it offset by saving in the private sector. In the early 1980s, for example, President Ronald Reagan ran a deficit that was even bigger than Mr Bush’s as a proportion of GDP. But at that time, the private sector (households and corporations combined) was saving far more than it is today, according to calculations by the Levy Economics Institute.

Short of savings of its own, gluttonous America is relying instead on the savings of foreigners. Overseas investors bought $83 billion-worth of American securities in November alone, the latest month for which figures are available. The Europeans fear that this cannot

115 continue. As foreigners tire of American assets, demand for the dollar ebbs. Its fall against the euro has already been “brutal”, in the words of Jean-Claude Trichet, president of the European Central Bank (ECB). Worth more than €1.19 in July 2001, the dollar now fetches fewer than 80 euro cents.

To put an end to this brutality, the Europeans want Mr Bush to rein in the federal deficit. Some might even want Alan Greenspan, chairman of the Federal Reserve, to tighten monetary policy. Mr Greenspan’s counterparts at the Bank of England have already shown him the way: last week they raised interest rates to 4% in the hope of restraining Britain’s indebted consumers. But Mr Greenspan is unlikely to be swayed by the force of their example. He has resolved to be “patient” before raising rates.

Mr Bush, for his part, has an election to fight—and fiscal austerity wins few votes. On the contrary, he will claim that his tax cuts have delivered growth and jobs. They have certainly delivered some of the first, but not much of the second. The economy needs to create more than 140,000 jobs per month just to keep pace with the growth of the labour force. Last month, firms added 112,000 workers to the payrolls; in December, they added just 16,000. This is a poor return on tax cuts that cost the Treasury $195 billion in the 2003 fiscal year. For that money, Mr Bush could have hired 2.5m people to dig holes and another 2.5m to fill them, paying them all America’s average annual wage.

In reply to their critics, the Americans will argue that, in economics, thrift is often a vice and gluttony a virtue. If it were not for America’s overspending, the world economy would stagnate. If Europe is not as over-extended as America, it is only because Europe is not pulling its weight. Its modest recovery in the second half of last year, for example, was export-led, piggy-backing on stronger growth elsewhere. Unless domestic demand picks up, Europe’s “fledgling” recovery may already be past its prime.

The Europeans saw the G7 get-together in Boca Raton as an opportunity to vent their frustration at the rising euro. But the strengthening currency is an opportunity as well as a threat. It gives European consumers more spending power, if only they would use it. By curbing inflation, it also gives Mr Trichet an opportunity to cut interest rates, if only he would take it—he and his colleagues at the ECB held rates steady at a meeting last Thursday. In all, Europe’s problems are more likely to be resolved in Frankfurt than in Florida

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Monday Feb 6 2004. France seeks new G7 signal on currencies By Alan Beattie in Boca Raton, Florida Published: February 6 2004 19:43 | Last Updated: February 6 2004 19:43

The French finance minister on Friday said he would seek a change in the signal that the Group of Seven rich countries would send to currency markets during their meeting this weekend. But economists said any likely change in the G7 communiqué would probably fail to convince investors that the US's benign neglect of the dollar's fall was about to alter.

Speaking in Washington before travelling to Florida, where the meeting of G7 finance ministers and central bank governors is being held, Francis Mer said the G7's previous statement, made in Dubai in September, had been misunderstood by markets.

"We will try to do the maximum together to state that the wording of Dubai does not satisfy anyone and try to hatch a wording or expression that satisfies all of us," he told reporters.

European policymakers were disappointed by the reaction to the Dubai statement, where a call for flexible currencies designed to put pressure on Asian countries to cease holding down their currencies instead drove the euro up against the dollar.

"In Boca Raton, our presentation will have to be different to what it was in Dubai if for no other reason than to show markets that our position was badly expressed or to flesh it out," Mr Mer said on Friday. Referring to the financial markets, he said: "There's such a state of feverishness that we're going to have to try to lower the temperature without cooling down the economy."

The comments suggest that European finance ministers and central bankers will continue to press during the meeting for some language calling for a smooth adjustment or stability in foreign exchange markets.

But currency markets were little moved by the remarks. Investors have largely taken the view that the US will not allow the statement about flexible currencies to be dropped, and will point out to the Europeans that they need to do more to increase growth.

The dollar slid again after a week of losses on Thursday morning, following the release of the soft US payroll jobs data. In early-afternoon US trading, the dollar was down 1.3 cents against the euro at $1.2698, and down 0.31 yen at 105.42 yen.

"These comments are whistling in the wind," said Mark Cliffe, chief economist at ING Financial Markets in London. "Given the European Central Bank's inaction on Friday, the Europeans are essentially going to the Americans empty-handed. If the Europeans aren't helping themselves, the Americans aren't going to help them."

The US has insisted that the focus for the G7 meeting should be the "agenda for growth", a laundry- list of supply-side reforms, including liberalisation and deregulation in the eurozone economies, rather than the usual emphasis on fiscal and monetary policy.

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Monday Feb 6 2004. Corporate Japan hedges against yen rise By Jennifer Hughes in London and Barney Jopson in Tokyo Published: February 6 2004 18:23 | Last Updated: February 6 2004 18:23

Japanese companies and investors are bracing themselves for a further fall in the dollar against the yen following this weekend's G7 meeting.

Yen currency options volatility - a measure of the amount of hedging taking place - has risen to levels not seen since last year's G7 meeting in Dubai.

Then, the group's call for flexibility was interpreted as tacit acceptance of a weaker dollar, which promptly fell from Y114 towards its current three-year lows just above Y105. Options traders are reporting a number of hedges being placed to protect the buyer if the dollar were to fall to Y104 or Y103.

"The trading has been one-way," said Gary Noone, currency analyst at Informa. "People are thinking the G7 won't come out with a strong line against dollar weakness and that this will be seen as a green light to sell dollars."

Last year, average daily turnover in yen-dollar options through brokers reached its highest level since 1996. Banks also reported a rise in interest from small and medium-sized companies.

Sean Callow, currency strategist at IDEAglobal, a consultancy, said a combination of continuing portfolio inflows into Japan and the G7 meeting would only increase volatility.

"By extension this will mean increased hedging activity in the derivatives market."

The Bank of Japan has spent an unprecedented Y27,000bn ($256bn) since the beginning of 2003 in stemming yen appreciation. Despite its actions, the Japanese currency has risen more than 12 per cent.

"There are effectively two forces here," said Julian Knight, head of FX at Fimat UK, the brokerage. "The BoJ is sitting there trying to weaken the yen, while Japanese pension funds and exporters want to buy yen and sell dollars ahead of the March year-end."

Traditionally, Japan's car manufacturers, electronics exporters and machinery makers are the biggest users of hedging to protect their overseas earnings.

Exports to China have surged, and the renminbi's peg to the dollar has provided an added impetus to protect earnings from a rise in the yen's exchange rate.

Sony, the Japanese electronics giant, reckons each Y1 fall in the dollar's value against the yen cuts the net value of its sales by Y30bn and its net profits by Y5bn. This quarter, it is using a budget rate of Y105 compared with Y110 for the previous quarter and Y115 in April last year.

A spokesman said the group had hedged almost 80 per cent of its exposure on a three-month

118 basis.

"We follow the market almost 24 hours every day and when necessary make adjustments," said Sony.

The complications of marking derivatives exposure to market prices in their accounts means many companies are reluctant to use long-term strategies.

Observers said a lot of the rise in hedging after the September meeting in Dubai did not happen until December because hedging strategies can be subject to internal consultation because of the risks they imply.

"In most cases companies don't hedge 100 per cent of their expected exposure - they like to keep room for manoeuvre," said Ichiro Ikeda, vice-president of currency and commodity at JP Morgan Chase in Tokyo. "They don't want to lock in everything because if the dollar goes back up to Y110 they would suffer an opportunity loss."

JP Morgan is forecasting the dollar will fall to Y95 by the end of the year - which would be the yen's strongest level since 1995.

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Monday Feb 8 2004. H H HG7 says currency swings put growth at risk HBy Andrew Balls and Alan Beattie in Boca Raton, Florida HPublished: February 8 2004 11:39 | Last Updated: February 9 2004 10:55 H

HThe dollar weakened on Monday after finance ministers from the world's rich countries reiterated at a meeting this weekend that greater exchange rate flexibility was needed to promote global financial adjustment, but shaded their statement to address European concerns that the eurozone was bearing the brunt of the dollar's decline.

H The statement from the Group of Seven finance ministers and central bank governors said: "Excess volatility and disorderly movements in exchange rates are undesirable for economic growth."

Currency analysts said the statement made little difference to the market perception that the dollar would weaken in the long term.

"The market has taken it as a sign that the dollar's decline is being tolerated," said a trader. "The dollar decline should continue though we expect Europe to start becoming openly ratty about it."

After a sharp jump higher, the US currency steadily weakened and in European trade the euro had risen to $1.2761 - a two-week high - from a low of $1.2605 as markets opened in Asia. The pound reached an 11-year high against the dollar on Monday at $1.8628.

The dollar was steadier against the yen at Y105.6, little changed from last week, when it fell to three-year lows at Y105.25.

The G7 said that more exchange rate flexibility was desirable "for major countries or economic areas that lack such flexibility to promote smooth and widespread adjustments in the international financial system, based on market mechanisms".

In the run-up to the meeting European policymakers had expressed concern about the strength of the euro, and US policymakers sought to focus the meeting on the need to promote stronger economic growth through supply-side reforms.

The Europeans said they were pleased with the changes from the statement made at the previous G7 finance ministers' meeting, held in Dubai, which some investors had interpreted as an invitation to sell the dollar and buy the euro.

The acknowledgement that excessive volatility is undesirable may also warn investors that the dollar's decline against the euro is not a one-way bet.

Marc Chandler, chief currency strategist at HSBC in New York, said: "This is about the most that the market had reasonably expected - a modest clarification of the flexibility clause, and a bone

120 thrown to the Europeans about excess volatility."

With the new emphasis on countries that lacked flexibility, the communiqué implicitly narrowed the focus of the call for greater currency flexibility to Asian countries, particularly China.

Following the meeting, Sadakazu Tanigaki, Japanese finance minister, said the call for flexibility was not aimed at Japan, signalling Tokyo would continue to intervene if necessary to hold down the yen against the dollar.

Marvin Barth, global currency economist at Citigroup, said that, despite the call for flexible exchange rates, he expected Asian countries to continue intervening to stem currency appreciation against the weakening dollar.

"We expect no near-term change in Asian foreign exchange policy as a result of the statement. That implies that the dollar will continue to depreciate against clearly floating currencies," he said.

The G7 also called on Argentina to implement policies in line with its International Monetary Fund programme, saying: "Argentina should engage constructively with its creditors to achieve a high participation rate in its restructuring."

The IMF's rules say it can lend to a country in default only when it is negotiating in "good faith" with creditors. Three G7 members - the UK, Italy and Japan - abstained on the vote to release the latest tranche of IMF loans to Argentina, although the vote went through with US support.

The signal in the communiqué increases pressure on the Argentine finance ministry, whose officials meet the IMF management on Monday to discuss progress. H

121 Monday Feb 9 2004. Japan sees G7 meeting as victory HBy David Pilling in Tokyo HPublished: February 9 2004 10:07 | H

HThe Japanese government on Monday sought to portray the result of Group of Seven finance ministers meeting in Florida as a victory, praising the statement’s warning against excess volatility.

Yasuo Fukuda, chief cabinet secretary, said: “It was good in that it confirmed the shared view that exchange rate stability was important.” H Japan has spent unprecedented amounts on foreign currency intervention with the supposed intention of smoothing out sudden movements, rather than keeping the yen artificially low. Last year, it spent Y20,000bn and in January lavished a further Y7,155bn.

Jesper Koll, economist at Merrill Lynch in Tokyo, agreed with Mr Fukuda’s assessment of the Florida meeting, saying the G7 had “turned Japanese”.

He added: “The new G7 reads exactly like the standard Ministry of Finance forex mantra,” referring to the Florida statement that “excess volatility and disorderly moves are undesirable.”

Zembei Mizoguchi, vice-finance minister for international affairs, signalled Japan’s willingness to keep on intervening, saying: “Foreign exchange rates should reflect economic fundamentals and move in a stable manner…We will act if needed.”

The Japanese government has filled its intervention coffers, giving it the ability to spend three times the Y20,000bn it spent last year.

The yen weakened slightly to Y105.7 to the dollar on Monday from Y105.4 before the Florida meeting. Some Japanese manufacturers have said they would struggle if the yen goes above Y105 to the dollar. But economists say most Japanese companies are efficient enough to survive at Y100 or higher.

Many in the market expect the yen to continue strengthening against the dollar. Since the G7 meeting in Dubai last September when ministers put stress on currency flexibility, the dollar has depreciated 8 per cent again the yen.

Some commentators said a slight drop in the Nikkei 225 stock average on Monday, which fell 0.56 per cent to 10,402, was a reaction to the G7’s reiteration of the desirability of flexible exchange rates.

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Monday Feb 9 2004.

Stress on flexibility 'means pressure on Asia' By Jennifer Hughes, Currencies Correspondent, in London Published: February 9 2004 4:00 | Last Updated: February 9 2004 4:00

Asian currencies could come under greater pressure to appreciate as the dollar continues its broad decline, currency strategists said after the Group of Seven nations fine-tuned their call for "flexibility" in exchange rates.

The group's statement emphasised: "More flexibility in exchange rates is desirable for major countries or economic areas that lack such flexibility to promote smooth and widespread adjustments in the international financial system, based on market mechanisms."

The wording was similar to that from the last meeting in Dubai, but analysts said the new stress on regions that lack flexibility could only mean renewed pressure on Asia. "Asia's ears must have been burning in absentia," said Tony Norfield, head of currency strategy at ABN Amro. Many Asian countries have, like China, pegged their currency to the dollar or, like Japan, intervened in order to maintain export competitiveness. Europeans and others with freely floating currencies have complained this puts the burden of the dollar's decline on them.

"There is no question this is all about Asian nations," said Simon Derrick, currency strategist at Bank of New York who warned the yen might bear the brunt of the market's attention. "The pressure already building on the yen will surely now only be greater."

The dollar has depreciated by about 8 per cent against the yen since the September meeting and last week fell to Y105.25 - its weakest since September 2000. Japan argues that its intervention is designed purely to "smooth" the market and that the yen's appreciation shows it is flexible.

But Ray Attrill, director of research at 4Cast economic consultancy, warned that investors betting on sudden appreciations were likely to lose out.

"The reality remains that action by China on its currency remains a precondition for a broader adjustment of Asian currencies - including the yen," he said.

Japan has already indicated that it will continue to intervene - a move that will probably mean the euro goes higher still.

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Monday Feb 9 2004.

Nikkei slips with investors calm at G7 call By Barney Jopson in Tokyo Published: February 9 2004 4:03 | Last Updated: February 9 2004 7:50

Japanese stocks slipped on Monday but investors were largely untroubled by the G7’s reiterated call for greater exchange rate flexibility.

The Nikkei 225 average closed down 0.6 per cent at 10,402.61 having stayed virtually unchanged during morning trade. The Topix index closed down 0.4 per cent at 1,024.77.

The yen weakened slightly to Y105.7 against the dollar, apparently unaffected by fine tuning of a G7 statement on exchange rates that was interpreted as gentle criticism of Asian countries for holding down their currencies.

Following a weekend meeting, the G7 said more exchange rate flexibility was desirable "for major countries or economic areas that lack such flexibility to promote smooth and widespread adjustments in the international financial system, based on market mechanisms."

Tokyo shares lost ground last week on worries more explicit criticism of Japanese currency intervention could push the yen higher.

Shares in electronics exporters, whose earnings normally suffer when the yen rises, were broadly up.

Sony was up 1.2 per cent at Y4,270, Canon climbed 0.4 per cent to Y5,090 and Toshiba gained 0.5 per cent to Y430.

Matsushita, the maker of Panasonic goods, was up 1.6 per cent at Y1,517 having posted an 8 per cent rise in quarterly profits and lifted its full year forecast on Friday.

Shares in Tokyo Electron gained 0.7 per cent to Y6,960 after the chip equipment maker raised its net profit forecast for the year to March to Y4.5bn from Y1bn.

Automakers put in a more mixed performance, with Nissan virtually flat at Y1,096 but Honda down 0.5 per cent at Y4,430 and Toyota falling 1.1 per cent to Y3,510.

Kanebo shares were boosted by news that the company had received a rival bid for its cosmetics business, which had been lined up for sale to Kao. A bid from Unison Capital, a Japanese private equity firm, pushed Kanebo shares up 10.3 per cent to Y128. Kanebo, however, said it intended to press ahead with the sale to Kao. Kao shares dropped 1.9 per cent to Y2,300.

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Monday Feb 8 2004.

German chancellor faces call for elections Bertrand Benoit in Berlin Published: February 8 2004 18:57 | Last Updated: February 8 2004 18:57

German opposition leaders called for fresh elections on Sunday as senior Social Democrats stepped up their attacks on Gerhard Schröder, the chancellor, after his resignation as Social Democratic party chairman.

The attacks showed Mr Schröder's resignation - a rare admission of defeat for a politician used to prevailing over critics - had profoundly shaken his authority. They also underlined how little of the chancellor's modernising ardour had percolated through the party in his five years as chairman.

In an unprecedented move by a chancellor, Mr Schröder said on Friday he would hand over the chair to Franz Müntefering, parliamentary floor leader. The party's executive endorsed the decision on Saturday ahead of an extraordinary congress on March 21, when it will be ratified.

Instead of silencing critics who had grown louder in recent weeks, the move prompted several SPD officials to suggest that Mr Schröder had reached the end of his political career or that the government should roll back some of his reforms.

Heiko Maas, SPD leader in the state of Saarland, said the chancellor's decision, made last summer, to lead the party into a general election for the third time in 2006 should not be taken for granted. "Who runs will depend on the course of the next two years," Mr Maas told the Bild am Sonntag newspaper, later denying it amounted to a call for a different candidate.

Harald Schartau, party chief in North-Rhine Westphalia, said the government should reconsider planned or recent measures resulting in additional costs for pensioners and medical patients. Wolfgang Thierse, deputy SPD chairman, said there could be "adjustments" to recent healthcare and tax reforms.

Meanwhile, Angela Merkel, leader of the opposition Christian Democratic Union (CDU), told Welt am Sonntag that Mr Schröder's resignation as SPD chairman was "the beginning of the end . . . The best solution would be early elections as soon as possible."

The CDU and the CSU, its Bavarian sister party, enjoy a strong lead in opinion polls but their leaders are deeply divided over policy issues. It is also unclear which of Ms Merkel or Edmund Stoiber, the CSU leader and Bavarian premier, would lead the parties into an early poll.

A Forsa opinion survey showed 59 per cent of respondents against fresh elections, suggesting Mr Schröder's move was seen as a matter for the SPD and not for the nation. Yet Sunday's attacks testified to the difficulty of the task facing Mr Müntefering in restoring order in the party.

SPD officials have blamed Agenda 2010, Mr Schröder's package of social security and labour market reforms adopted shortly before Christmas, for the largest exodus of members since the

125 war and a string of electoral defeats last year. "We are forging ahead with the reforms," Mr Müntefering countered on Sunday. "Agenda 2010 was ratified by two party congresses. We must all accept this. We are not going into reverse gear."

The collapse of the SPD's popularity has been of particular concern in the Länder, where regional SPD organisations and governments will be on the electoral front line with 14 elections due this year.

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Monday Jan 21 2004.

Corporate America awakes from its long sleep

By Dan Roberts in New York

Published: January 21 2004 18:48 | Last Updated: January 21 2004 18:48

From the airport lounge to the restaurants of midtown Manhattan, eavesdropping on corporate America has suddenly become a lot more interesting. After months of nothing but scandals and downsizing, a new mood of confidence can be heard, thanks to soaring company profits and a return of the "can-do" approach to dealmaking and investment.

Stock markets and economists have indicated for some time that US business should put the past behind it and dust down long-forgotten action plans. Yet it took that most traditional of Wall Street signals - the mega-merger - to ram home the message last week, when JP Morgan Chase agreed to buy Bank One for $58bn in stock. Within days, the stalwarts of the mainstream economy were lining up to reinforce the message. General Electric reported a 45 per cent jump in fourth-quarter profits and said a rush of activity in December had led to a 19 per cent increase in orders for this year. IBM signalled the end of the three-year decline in corporate IT spending. And Citigroup set a record for the most profitable company in history, as quarterly earnings doubled to $4.76bn. As if awaking from a long sleep, some sectors are picking up where they left off. Three years ago it was impossible to talk to cellular phone executives without the conversation turning to the likely suitors for smaller operators like AT&T Wireless. This week, New York is full of the same people having the same conversations - simply because "there is a feeling the market will let us do things again". Talk of deals is swirling through the worlds of retailing, consumer goods and banking, too. "There is a sense the corner has finally been turned," says Charles Stonehill, global head of capital markets at Lazard, the private investment bank that advised Bank One. "It's been building for a while, but there is still enormous pressure in certain sectors to achieve consolidation." Yet the "can-do" comeback is more than just the creation of commission-hungry bankers. The recovery in tech spending and business class air travel suggests companies are loosening the purse strings and looking for new ideas on a range of fronts. For many commentators, the explanation can be found in those bullish quarterly earnings statements.

127 "People have focused on problems like jobs, capital spending and inventories for a long time, but I think we only really had one problem - a profit problem," says Jim Paulsen, chief investment officer at Wells Capital, a fund manager based in Minneapolis. What is more, the speed of the turnround in corporate profits may lead to a rapid recovery in activity simply because the natural caution that held back investment during earlier phases of the recovery led to pent-up demand. Much of this translates to straightforward deals and investment projects focused on cost-saving and rationalisation. "A lot of the impetus for deals comes because we are in a world that necessitates scale efficiencies," adds Mr Paulsen. "It is less to do with corporate greed and more to do with surviving in a world of ageing populations, excess supply and not enough demand." Deals such as JP Morgan and Bank One appear staid compared with AOL and Time Warner or Vodafone and Mannesmann. Capital spending may be recovering, but it is in industrial equipment for China or business-outsourcing software for multinationals, rather than the gold rush of 2000. Hence, plenty of seasoned hands are sounding notes of caution about the strength of the recovery in US corporate confidence and the reasons behind it. "Over the last year, there has been an unprecedented amount of [fiscal] stimulus, so it would be really quite extraordinary if there were not some recovery in confidence," says Pete Peterson, chairman of The Blackstone Group and the Federal Reserve Bank of New York. "The trouble is every week we have another scandal . . . More trials are coming up and some are likely to be televised. Meanwhile, the gut issue for many Americans remains executive compensation. This [corporate governance] remains the large unannounced elephant in the room." If this were not enough to damp any irrational exuberance, there is also the lingering worry about global security and the sustainability of the wider US economic recovery. Mr Peterson, who also chairs the Council on Foreign Relations in Washington DC, adds: "Up to now, governance may have had some effect [on corporate risk-taking], but a more relevant consideration is the macro-economic situation and the risk of terrorism." Perhaps it is a sign of the changing times that the big US companies reporting this week blithely passed over the economic threats posed by the US trade and budget deficits. Ken Goldstein, an economist with the Conference Board representing US companies, sums up this new corporate focus on the positive rather than the negative: "The twin deficits may be a big concern in Europe or among politicians, but it is hard to find businessmen here who even talk about it."

USA: déficit budgétaire record à 477 milliards de dollars en 2004 (Congrès) AFP | 26.01.04 | 18h23

Les Etats-Unis vont accuser un nouveau déficit bugétaire record de 477 milliards de dollars cette année, a averti lundi une commission du Congrès.Le déficit budgétaire devrait ensuite revenir à 362 milliards de dollars en 2005, a estimé le Bureau du budget du Congrès (CBO), un organisme bi-partite qui présentait lundi son rapport économique semi-annuel.Les Etats- Unis avaient déjà accusé l'an dernier un déficit budgétaire record de 374 milliards de dollars.

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11.02.2004

Faltan mosqueteros en

Europa

Los edificios de la Unión Europea en Bruselas también cuestan dinero.

En Berlín no tardaron en echar cuentas. Sí se aprueba la propuesta de la Comisión Europea sobre el presupuesto de la Unión, Alemania debería pagar cada año unos seis mil millones euros más a Bruselas.

La respuesta de Berlín a los planes en Bruselas no sorprenden. El ministerio alemán de Finanzas, Hans Eichel, calificó de “poco realista” la propuesta de la Comisión Europea (CE) para el presupuesto de la UE para el periodo 2007-2013, en el que se prevé un techo financiero del 1,24 por ciento del producto nacional bruta (PNB). El marco propuesto por la Comisión Europea “no constituye una política financiera sólida”, agregó el ministerio alemán de Finanzas.

Como si fuese un eco, la misma critica se escuchó también en París. En nombre de la “disciplina presupuestaria”, Francia defendió su propuesta y la de otros cinco países para congelar el presupuesto comunitario. En diciembre pasado, Francia, Alemania, Reino Unido, Holanda, Suecia y Austria, contribuyentes netos de la UE, pidieron congelar en un 1% del PNB el presupuesto comunitario, a pesar de la ampliación de la Unión.

Egoísmos nacionales

Francia y Alemania se encuentran económicamente en aprietos. Los monederos ya no están tan llenos como en el pasado. ¿Cómo puede ser, argumentan los dos, que por un lado Bruselas exija de París y Berlín fuertes recortes en los presupuestos nacionales y por otro lado les pida más dinero para los fondos de la UE? La argumentación franco-germana, a primera vista comprensible y lógica, resulta ser algo hipócrita. La ‘solidez financiera’ y la ‘disciplina presupuestaria’ que Francia y Alemania reclaman de Bruselas es precisamente lo que hace falta en la política financiera nacional de ambos países.

La resistencia en París y Berlín tiene también (pero no sólo) su origen en la frustración por el fracaso de la última cumbre de Bruselas, en la que se debería haber aprobado la Constitución Europea. La criticas se centraron en la postura supuestamente intransigente de España, mayor beneficiario de los fondos europeos, y en Polonia, país que en opinión de muchos analistas se apresuró demasiado en pedir dinero de Bruselas antes de ser miembro del club.

Mucho dinero, pocas nueces

Efectivamente, los planes de la Unión Europea para el futuro son ambiciosos: ampliación con 12 nuevos miembros hasta 2013, una política exterior seria y respetada en el mundo, una política de defensa común, y, como si eso fuese poco, una reestructuración política de la Unión mediante una constitución. Esos planes no se podrán realizar con menos dinero.

Pero una cosa es hablar de las ambiciones y otra cosa son los resultados. En el marco de la política sería más oportuno hablar de la “Desunión Europa” en vez de la Unión Europea. Indudablemente, Bruselas necesita una sólida perspectiva financiera a la altura de retos como la ampliación, la investigación científica o la lucha antiterrorista. Pero a la vez necesita una estructura que trabaje con eficacia y rapidez, guiada por una visión europea para un futuro común.

Sería ilusorio esperar que la Unión Europea se convierta algún día en un club de mosqueteros, siguiendo el lema ‘uno para todos y todos para uno’. Pero un poco más de visión y un poco menos de egoísmo no le vendría mal al viejo continente. Gabriel González

129

07.02.2004

Schröder deja la jefatura del SPD

El canciller alemán confía en superar así las críticas internas.

El canciller alemán, Gerhard Schröder, abandonará la jefatura de la socialdemocracia para concentrarse en las tareas de gobierno y en su programa de reformas, que ha causado divergencias dentro del partido.

La oposición se frota las manos y proclama "el comienzo del fin de este gobierno". La repentina decisión de Gerhard Schröder de abandonar la jefatura del Partido Socialdemócrata Alemán (SPD), seguida por la renuncia de Olaf Scholz al cargo de secretario general, sin duda da cuenta de los problemas de dicha colectividad. Aunque el canciller recurrió a la justificación consabida en estos casos -el deseo de concentrar sus energías en la conducción del gobierno- lo cierto es que no habían pasado inadvertidas las críticas lanzadas desde diversos sectores del partido contra su política.

Quejas internas El jefe de la bancada socialdemócrata de la Baja Sajonia, Sigmar Gabriel, se había quejado públicamente de la baja de popularidad que sufre el SPD, como consecuencias de las reformas que pretende llevar a cabo Berlín. "Los resultados de las encuestas hablan un lenguaje claro", señaló el dirigente regional, apuntando que lo sustancial para los socialdemócratas es si se conseguirá mantener un equilibrio social. "Reformar no significa vaciarle continuamente los bolsillos a la gente", puntualizó Gabriel, quien considera necesario abordar otros temas, como la educación, la familia y la situación de los grupos de bajos ingresos. Otros correligionarios, por su parte, habían demandado una reestructuración del gabinete de gobierno, por estimar que algunas de sus figuras estaban demasiado "gastadas" ante la opinión pública. Sea como fuere, para nadie era un secreto que el partido atraviesa serias dificultades internas. La jefa del SPD de Hesse, Andrea Ypsilanti, llegó a reconocer que la situación era "terrible".

En busca de cohesión En suma, la cúpula socialdemócrata ha tenido que admitir que no logra transmitir adecuadamente su mensaje político, no sólo a la gran masa de la ciudadanía, sino también a parte considerable de sus propias huestes. Schröder, por lo visto, confía en superar el problema entregando la conducción del partido a uno de sus más cercanos: el jefe de la bancada parlamentaria del SPD a nivel federal, Franz Müntefering.Su elección formal habrá de llevarse a cabo en un congreso extraordinario del partido, en marzo. La lealtad de Müntefering está más allá de toda duda; no así su carisma. Y esta cualidad probablemente le haga falta al tratar de restablecer la cohesión interna, lo que implica principalmente derribar las resistencias a los recortes sociales previstos en la agenda de reformas. Sin embargo, se muestra dispuesto a emprender enérgicamente su misión y afirma que, "después del de Papa", el cargo de jefe del SPD es el mejor. Su mensaje es claro: "el partido debe saber que la oposición es parte de la democracia, pero son los otros los que deberían hacer oposición y no nosotros".

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09.02.2004

De la volatilidad de cancilleres y mercados cambiarios

Siempre ha habido tiempos mejores.

Los columnistas europeos comentan hoy los difusos resultados de la reunión celebrada en Boca Ratón (Florida) por los ministros de Finanzas del G-7 y las reacciones tras la renuncia de Schröder a la jefatura del SPD.

Las vagas decisiones del Grupo de los Siete países más industrializados del mundo, reunidos en Boca Ratón, no parecen convencer ni a los mercados ni al diario parisino Les Echos "puesto que no se logró un consenso dentro de la comunidad internacional. Es cierto que los europeos tienen ahora una razón para sentirse más tranquilos. Gracias a que Europa ha seguido una línea de defensa común frente a la política cambiaria estadounidense, Washington ha tenido que reconocer que no sólo el fuerte euro debe llevar la pesada carga del inmenso déficit fiscal de Estados Unidos, máxime cuando en Europa se registran tan bajas tasas de crecimiento. Aún así, y a pesar de que el ministro estadounidense de Finanzas, John Snow, descartó seguir dejando caer el dólar, los mercados no están, del todo, convencidos", concluye Les Echos.

Tapando huecos fiscales Para el cotidiano español El País "la cooperación internacional no está en su mejor momento. La posibilidad de que del G-7 emergiera un rotundo mensaje a los mercados de divisas y un claro compromiso de actuación, que contribuyeran a frenar el abaratamiento del dólar y el encarecimiento de la moneda europea, ha chocado con los intereses estadounidenses. A diferencia de la anterior Administración norteamericana, la de Bush contempla casi con complacencia la depreciación de su moneda, en la medida en que puede favorecer la reducción del abultado déficit comercial de EEUU y neutralizar su pérdida de competitividad. Los intereses de los europeos son opuestos. La excesiva apreciación del euro dificulta la recuperación de las economías más dependientes de las ventas al exterior que son hoy las más debilitadas, en particular Alemania, Francia e Italia. Europa debe asumir que las amenazas a la recuperación de sus principales economías, derivadas de la excesiva depreciación del dólar, han de sortearse mediante actuaciones estrictamente europeas. No tanto con intervenciones de dudosa eficacia en los mercados de divisas, como reduciendo los tipos de interés, intensificando la precaria inversión pública y dándole una dimensión verdaderamente paneuropea, en la dirección propuesta por la Comisión Europea".

¿Qué tan mansos son los socialdemócratas? Tras la decisión del canciller alemán, Gerhard Schröder, de prescindir de la jefatura de su partido socialdemócrata, para el rotativo holandés Algemeen Dagblad "es claro en cuál dirección se moverá ahora la socialdemocracia alemana: hacia la izquierda. Del canciller y jefe del partido socialdemócrata, que ahora tendrá que limitarse a gobernar el país, se dice que ha sido un 'camarada de los gerentes' y que, de todas formas, es más 'liberal' que 'socialista'. Lo que no puede decirse de su sucesor Franz Müntefering. Es muy claro que Schröder ha perdido poder, pero si va, realmente, a perder la cancillería, como vaticina la oposición, depende de que Müntefering logre calmar los exasperados ánimos entre sus propias filas".

131 "La oposición aún no está madura para el poder" El diario Badische Zeitung de Friburgo, se ocupa de las reacciones de la oposición a los cambios en la cúpula de la socialdemocracia alemana y observa que "Westerwelle (liberal) fue el más rápido. Merkel (cristianodemócrata) necesitó más tiempo. Y Stoiber (cristianosocial) necesitó dos días para opinar sobre el tema. Ahora todos entonan la misma canción: ¡nuevas elecciones! Pero no nos engañemos. Los gritos que piden nuevas elecciones arrecian, mientras los peticionarios estén convencidos de que no van ser tomados en serio. El soberano podría llegar a replicar que... ¿para qué elecciones cuando el canciller tendrá ahora más tiempo para hacer su trabajo? Pero hablemos en serio. Aunque las encuestas le dan la delantera a la oposición cristianodemócrata, ni ella misma querrá ahora probar suerte. La oposición alemana no ha recuperado aún la forma como para convertirse en una genuina alternativa del Gobierno rojiverde de Berlín", dice el Badische Zeitung.

08.02.2004

Argentina, euro y dólar: las disyuntivas de Boca Ratón

Los siete países más industrializados del Mundo, reunidos en Boca Ratón (EEUU), no lograron ponerse de acuerdo en cómo estabilizar el dólar, pero sí en presionar a Argentina para que negocie su "monstruosa deuda". La paciencia con Argentina parece habérsele agotado al Grupo de los Siete que instó a Argentina a que "negocie constructivamente" con sus acreedores y a que adopte las políticas que acordó con los organismos multilaterales de crédito. "Hemos concluido que Argentina cumpla sus compromisos con el Fondo Monetario Internacional (FMI) y proceda con las reformas a las que se comprometió", dijo el secretario del Tesoro de Estados Unidos y anfitrión de la reunión del G-7, en la ciudad estadounidense de Boca Ratón, John Snow. "El requisito del FMI es que el país negocie de buena fe con los acreedores", agregó. El texto final del comunicado del G-7, que forman Alemania, Estados Unidos, Gran Bretaña, Canadá, Francia, Italia y Japón, hace "un llamamiento a Argentina a que adopte políticas acordes con su programa con el FMI. Argentina debe negociar constructivamente con sus acreedores para conseguir un alto grado de participación en su reestructuración". Muchos funcionarios del G-7 expresaron en Florida su frustración por la lentitud del país sudamericano en reestructurar su deuda y hacer las reformas a las que se comprometió en septiembre pasado. Argentina responde Por otra parte, cables noticiosos reportan que el gobierno argentino contestó a la petición subrayando que está cumpliendo su pacto con el FMI al tiempo que busca "obtener la participación más amplia posible de acreedores en la reestructuración dentro (...) del objetivo de cumplir con la deuda social interna". Japón, Italia y el Reino Unido estuvieron entre los ocho países de los 24 miembros ejecutivos del directorio del FMI que la semana pasada tomaron la inusual decisión de abstenerse de apoyar a Argentina en la revisión del programa crediticio, "frustrados por la lenta marcha de la reestructuración de la deuda incumplida de 88.000 millones de dólares". Hacia la confrontación La situación entre el FMI y Argentina va hacia una confrontación. "No se pueden tener negociaciones serias cuando los bancos quieren 65 centavos (por cada dólar de los bonos incumplidos) y les ofrecen 10 centavos", dijeron observadores alemanes. Buenos Aires se ha mantenido firme en la oferta que hizo en septiembre a los poseedores de bonos de pagar el 25% de la deuda nominal - una oferta que los analistas consideran equivalente a 10 centavos por dólar en el mejor de los casos, si incluye los intereses vencidos de los últimos dos años. Argentina es uno de los principales deudores del FMI, con el 16% del crédito otorgado por el organismo pendiente de cobro, pero un representante del G-7 dijo que los países ricos están decididos a poner un límite a Buenos Aires, aunque esto derive en un incumplimiento de pagos del país de su deuda con la entidad. Dólar versus euro: la puja continúa Y en la puja por el poderío de las monedas más importantes del mundo los operadores cambiarios lo pensarán ahora dos veces antes de seguir impulsando al dólar a la baja, después de que el G7 advirtiera sobre el daño que provocan los fuertes movimientos cambiarios sobre la economía mundial. Pero también podría comenzar una prolongada batalla entre los gobiernos y los mercados financieros a medida que los operadores

132 evalúan qué define una "volatilidad excesiva" y unos "mercados desordenados". Varios analistas de mercado dijeron que la declaración del G-7 podría haber aumentado la probabilidad de que los bancos centrales intervengan para evitar nuevas caídas del dólar, en especial contra el euro. Pero también dijeron que por sí sola no cambiaría la tendencia de largo plazo de debilitamiento del dólar. Los ministros de Finanzas y los banqueros centrales del G-7 terminaron una serie de encuentros de dos días en Boca Ratón con un tradicional comunicado de cierre que buscó calmar a los mercados cambiarios y ofrecer un bálsamo a los europeos preocupados porque la subida del euro perjudica su crecimiento. "El exceso de volatilidad y los movimientos desordenados en los tipos de cambio son indeseables para el crecimiento económico", dijo el comunicado del G-7. "Seguimos supervisando de cerca los mercados cambiarios y cooperando como es apropiado", agregó. Aumenta riesgo de intervención de Banco Central Europeo En los últimos dos años el dólar ha perdido un 30% contra el euro y alrededor de 20% frente al yen. El G-7 reiteró su pedido de flexibilidad, pero lo expresó de distinta forma, para enfocarse en "los mayores países o áreas económicas que no tienen esa flexibilidad". Esto fue una aparente referencia a los países que atan sus monedas a otras, como China, que vincula la moneda - el yuan - al dólar. También fue una referencia a las naciones que suelen intervenir para afectar a los tipos de cambio. Marcel Kasumovich, un jefe de estrategia cambiaria de Merrill Lynch en Nueva York, dijo que los mercados continuarían impulsando el alza del euro pero que ahora podrían tener que enfrentarse a un mayor riesgo de una intervención del Banco Central Europeo. José Ospina Valencia

22.01.2004

Argentina: ¿vuelve el tango con el FMI?

El próximo 28 de enero se espera que el Fondo Monetario apruebe la revisión del manejo fiscal de Argentina. Analistas alemanes califican a Kirchner como un negociador "duro". Cuenta regresiva para Argentina que espera luz verde del Fondo Monetario Internacional (FMI). Se trata de la primera revisión que el FMI realiza sobre el plan firmado en septiembre, y que está pendiente desde el 17 de diciembre pasado. Crecimiento y superávit Oportunamente, esta semana se dieron a conocer dos variables macroeconómicas que parecen preparar el terreno para que no se repitan las tensiones del pasado entre Argentina y el FMI. Por un lado, Argentina logró en el 2003 un superávit que supera con creces la meta anual exigida por el FMI. Por el otro, el crecimiento entre enero y noviembre del 2003 fue del 8%, en contraste con el mismo período del 2002. Por lo tanto, el Dresdner Bank Lateinamerika (DBLA) de Hamburgo estima una expansión total del 7,8% para el 2003. No es sostenible Pero los expertos siempre advierten que el desafío radica en crecer con "calidad". Aunque la cifra del crecimiento es de gran impacto a primera vista, Günter Köhne del DBLA no cree que sea sostenible. En su informe diario sobre América Latina, el DBLA identifica "al consumo, las exportaciones y las ventajas de altos precios para materias primas, como la soja", como los motores de la expansión del 2003. Es decir, en el fondo Kirchner "no está haciendo sus tareas", dijo el economista Köhne a DW-WORLD, ya que falta el incentivo a las inversiones, que son el agregado que aseguraría un crecimiento continuado en el futuro. Argentina optimista Entretanto, en Argentina dan por descontado que el FMI de su visto bueno a Buenos Aires. Según Köhne, esto también tiene que ver con el hecho de que el Presidente Kirchner condicionó el pago de unos US$ 3.000 millones, que vence el próximo 8 de marzo, a que el Fondo apruebe su gestión de las cuentas públicas.

133 En este sentido, Köhne destaca en DW-WORLD que los antecesores de Kirchner "no fueron tan duros en las negociaciones con los acreedores". Pero aunque en el corto y mediano plazo la estrategia de Kirchner de resultados, sigue sin resolverse el peso de la deuda con los principales acreedores, especialmente Alemania, Italia y Japón. Por lo tanto, y a pesar de cierta tregua anunciada entre Argentina y el FMI, este país sigue robándole el sueño a algunos.

22.01.2004

Davos: la "amenaza" estadounidense

El jefe del FMI, el alemán Horst Köhler, espera que Bush controle su déficit.

Mientras que en Washington, el Presidente George W. Bush alaba su gestión, en Davos, los expertos consideran que el déficit EE.UU. es una amenaza para la economía global. La preocupación no es nueva. Así, el propio Alan Greenspan. Presidente de la Reserva Federal (banco central) estadounidense advirtió a finales del 2002 que "el abandono de la disciplina fiscal elevará las tasas de interés", es decir, veneno para a economía. La economía estadounidense pasó de un superávit fiscal en los últimos años del gobierno de Bill Clinton a un déficit durante los primeros años de Bush, resultado, entre otros de la reducción de impuestos para impulsar la economía y la caída de las recaudaciones debido a la contracción económica del país. En el último año hay que añadir el importante aumento del gasto militar, que también merma las cajas públicas. Pesimismo Jacob A. Frenkel, presidente de Merrill Lynch, parece aislado en estos días, al destacar las virtudes de la economía de EE.UU., como su flexibilidad, y no muestra excesiva preocupación porque la recuperación no vaya acompañada de la creación de empleo. En Davos, Frenkel sostiene que estamos ante "un nuevo paradigma", y dirige una mirada crítica hacia otras regiones, contrastando la fuerte recuperación de esa economía norteamericana con la lentitud de las europeas ante la falta de reformas estructurales. En cambio, Stephen S. Roach, economista jefe de la casa de inversión Morgan Stanley, denunció el enorme endeudamiento privado de EEUU, y criticó que el incremento de la productividad bajo la administración Bush no se haya traducido en aumento del empleo. Según Roach, la "locomotora" estadounidense funciona a base de "humo". Asimismo Lauren D. Tyson, ex asesora económica del anterior presidente de EE.UU., Bill Clinton, y actual decana de la London Business School, fue especialmente crítica con los "desequilibrios estructurales" de su país, y afirmó que los recortes fiscales aplicados por la actual administración republicana no están justificados. También el Fondo se une a la crítica Según los expertos, el deterioro del déficit fiscal estadounidense se debe en gran medida a los recortes fiscales y a un gasto público que multiplica el de anteriores gobiernos. La situación se ha tornado tan alarmante, que resulta difícil encontrar e un economista, que niegue que en los próximos años se pueda agravar la situación. Así, el Fondo Monetario Internacional (FMI) acaba de reiterar una crítica ya formulada en agosto pasado. Charles Collyns, el subdirector del FMI, advierte de la relación negativa entre un déficit en aumento y la pérdida de valor del dólar. Collyns teme que un déficit más grande continúe "ejerciendo presión sobre el

134 dólar, particularmente debido a que el déficit fiscal refleja poco ahorro en vez de inversión". Asimismo, el déficit podría desalentar la inversión privada dentro de los EE.UU., y representar un freno en el horizonte de recuperación a largo plazo. Pero no todo es nubarrones y pesimismo. Desde Davos, Frenkel indica, por ejemplo, que el debilitamiento del dólar puede ser asimismo el comienzo de la solución, una interpretación que incluso comparte con el FMI y con quienes critican la política fiscal de Bush. Como siempre en economía, todo depende de la perspectiva que se asuma.

21.01.2004

Davos y la ética empresarial

El Foro Económico Mundial de Davos comienza bajo el lema "prosperidad y seguridad". Pero, ¿qué pasó con el lema "construir confianza" del 2003? Buenos propósitos que fracasaron ante escándalos como el de Parmalat.

Desde este miércoles, 2.000 invitados, entre ellos presidentes, políticos y líderes empresariales de talla mundial, se reúnen es su cita anual en la exclusiva estación de esquí suiza de Davos. Entre los líderes de empresaa alemanes se destacan Jürgen Hambrecht (BASF), Heinrich von Pierer (Siemens), y Bernd Pischetsrieder (Volkswagen). Ausencias latinoamericanas Mientras que en el 2003 el Presidente de Brasil, Luis Inacio "Lula" da Silva, fue la estrella del Foro, este año el protagonismo lo acaparan el Presidente iraní, Mohamed Jatamí, y el vicepresidente de EE.UU., Dick Cheney. La participación de mandatarios latinoamericanos se limita al ecuatoriano Lucio Gutiérrez, luego de que la cancelación de sus homólogos de Argentina, Chile y Perú decepcionara a los organizadores de este evento. La falta seguridad no habrá sido motivo de la cancelación. Un dispositivo de seguridad sin precedentes (6.500 efectivos y dos aviones interceptores F/A-18, además de sofisticados detectores de metales y radares de vigilancia), se encarga de que reine la calma. Curiosamente, este año no se anunció ninguna manifestación "antiglobalización" en Davos. La mancha de Parmalat Aunque el lema oficial se centre en la seguridad, el escándalo financiero en torno a la lechera italiana Parmalat, coloca un tema que la agenda de estos días no puede eludir. Irónicamente, se trata de la meta propuesta en el Foro del 2003: "construir confianza". En Davos, los expertos recuerdan una vez más la importancia de la ética y responsabilidad social de la empresa. "La empresa se mueve en un entorno donde ya no sólo responde a los trabajadores e inversores sino a la sociedad civil", explica en DW-WORLD el economista Manuel Escudero, del Instituto de Empresa, uno de los principales centros de formación ejecutiva en Europa. ¿Nueva utopía? Hoy en día, hablar de ética empresarial no sería sólo un simple instrumento de marketing. Así por ejemplo, el Pacto Mundial de las Naciones Unidas abarca la responsabilidad social de las empresas, permitiendo un diálogo "transparente que incluye también a la sociedad civil y organizaciones como Amnistía Internacional o Greenpeace", dice Manuel Escudero, quien asimismo preside el capítulo español del Pacto Mundial. Hay mucho trabajo pendiente. Precisamente, según una reciente encuesta del Foro Económico Mundial, las empresas figuran entre las instituciones más desprestigiadas. "No se cuántos escándalos financieros ocurrirán en el futuro, lo que si está claro es que en cuanto a la legitimación futura, las empresas ya no se pueden permitir eso", advierte Escudero. Los planteamientos de quienes están convencidos de poder lograr un equilibrio entre lucro y conciencia social, pueden sonar como una nueva utopía. Manuel Escudero está convencido de que "esta es la nueva realidad del siglo XXI". En este sentido se produce una coincidencia, cuando menos, anecdótica. El primer día en Davos coincide con el inicio juicio por corrupción más sonado en la historia económica de Alemania. En el banquillo de los acusados en el caso "Mannesmann" toma lugar nada menos que Josef Ackermann el director del Deutsche Bank. Ackermann, aun figura en la lista de participantes destacados en el Foro Económico Mundial. Sin duda, la ética empresarial es un tema de candente actualidad

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INTERNATIONAL -- FINANCE FEBRUARY 9, 2004 • Editions: N. America | Europe | Asia |

So "Takeover" Does Translate

Foreigners are after Japanese companies -- with better governance as one result

Back in 1989, legendary Texas oilman and corporate raider T. Boone Pickens Jr. gained notoriety in Tokyo for unmasking Japan Inc.'s rigged stock market and incestuous corporate cross-shareholdings. His Mesa Petroleum owned a 20% stake in Koito Manufacturing, making him the biggest shareholder in the company, which supplied auto parts to Toyota. Naturally, Pickens wanted a seat on the board. But he was told to shove off, enhancing Japan's well- deserved reputation as a wasteland of corporate governance.

Maybe Pickens should try again. On Dec. 19, Steel Partners Japan Strategies LP, a private equity fund run by Wall Street investor Warren G. Lichtenstein, decided it wasn't getting enough return on its investment in Yushiro Chemical Industry Co. Steel Partners owns an 8.9% stake in the machine-oils producer, which, like Koito, is a big Toyota Motor Corp. (TM ) supplier. Lichtenstein didn't just want a board seat, however. He launched a hostile takeover bid, offering $10.80 per share for the rest of the stock.

Lichtenstein's interest highlights how cheap many Japanese stocks are. Before Steel Partners appeared, Yushiro was trading well below its book value of $193 million. That included $100 million in cash, which Steel Partners and other investors thought should be doled out to benefit shareholders or reinvested in operations.

In an earlier time, Yushiro would have rallied its Japanese shareholders to send the gaijin packing. This time, the result was a lot more favorable to investors. Yushiro fended off Steel's offer, but not before a panicked management agreed to increase the company's dividend fourteenfold, to $1.80 a share. Shareholders, including Lichtenstein, were ecstatic. Not only will they get $28 million in cash, but Yushiro's stock has vaulted 54% since mid-December -- raising the company's market cap to $255 million. "The environment in Japan is changing," says a top Steel executive in New York. Steel has also launched a takeover bid for textile maker Sotoh Co. that is still unresolved.

So has Japan Inc. suddenly discovered shareholder value? Well, not quite. Average return on equity for Japanese companies in 2003 was still only 7%, about half the U.S. level and among the lowest in the industrialized world, according to Nikko Citigroup Ltd. (C ). A low ROE translates into low share prices.

ON THE CHEAP. But the pressure is building to improve the numbers. Japanese companies once relied on extensive cross-shareholdings with their banks to keep intruders out. But with sick banks being forced to sell out, about half those shareholdings have been put on the market since 1991.

That has given an opening to foreigners, who last year alone snapped up $70 billion in Japanese equities, with investment funds such as Ripplewood Holdings, Lone Star, and Cerebus picking

136 up distressed banks, manufacturers, and real estate developers on the cheap. Now even Japanese turnaround boutiques such as M&A Consulting Inc., which is run by former bureaucrat Yoshiaki Murakami, are going after mismanaged companies. "Recovery-oriented investors are now recognized as legitimate" among the Japanese public, says Tatsuo Kubota, a Tokyo investment banker. Kubota should know: He works for dealmaker Wilbur L. Ross Jr., who last year teamed up with powerful California Public Employees' Retirement System (CalPERS) pension fund to launch a $200 million fund that will take stakes in companies and agitate for better corporate governance.

Japan certainly has a long way to go before it becomes open territory for corporate takeover artists. Nevertheless, the arrogant attitude Japan Inc. once had toward shareholder activists is looking increasingly like a luxury it cannot afford. So come on back, T. Boone -- the game's starting to get interesting.

By Brian Bremner in Tokyo, with Mara der Hovanesian in New York

137

FEBRUARY 5, 2004 NEWS ANALYSIS

Kerry: Already on the GOP Firing Line His flip-flops, cozy ties with lobbyists, Massachusetts-style liberalism, and newly adopted populism will make tempting targets

Propelled by five big wins in the Feb. 3 round of Democratic primaries and caucuses, Massachusetts Senator John Kerry is steadily advancing on his party's nomination. But even as Kerry gathers momentum, he hears the sound of not-so-distant thunder. That's because President Bush's megabuck reelection campaign is starting to train its big guns his way.

Kerry, of course, must still mop up entrenched resistance, especially from an energized Senator John Edwards (N.C.), who posted an impressive win in South Carolina, and a still-lurking Howard Dean. That means weeks of close combat -- and perhaps some setbacks -- stand between Kerry and the nomination.

MAN FROM "TAXACHUSETTS." Republicans aren't likely to wait until all the delegates have been counted, however. Before the emerging image of Kerry as a populist fighter for working folks takes hold, Republican National Committee Chairman Ed Gillespie and GOP surrogates are trying to paint him as a "Taxachusetts" pol whose values are outside the mainstream. "Kerry is the son of Dukakis," charges senior GOP operative Ron Kaufman. "He's a legitimate Massachusetts liberal, which means he backs policies that only the most left-wing side of the Democratic Party agrees with -- leaving the center-right to us."

The Republicans may have a slog on their hands, though. A new Gallup poll released on Feb. 3 found that when respondents were asked whether Bush or Kerry was most in touch with "problems ordinary Americans face," Kerry -- like Bush the product of wealth, Yale, and the secret Skull & Bones society -- came out on top, 56% to 33%.

Most of the heavy fire against Kerry will commence this spring, when Bush taps a $200 million war chest. The Republicans will rail about Kerry's fondness for tax hikes and for expensive business mandates that will crush a recovering economy. And they'll make the case that the Kerry who lambastes "powerful special interests" is a poseur whose campaign is bankrolled by lobbyists.

"BUNDLED" CONTRIBUTIONS. Indeed, Kerry's benefactors include execs at Goldman Sachs, Citigroup (C ), and AT&T Wireless Services (T ). He has also pulled in plenty of donations from members of his brother Cameron's law firm, Mintz, Levin, Cohn, Ferris, Glovsky & Popeo, which represents many telecom interests. And according to the Center for Responsive Politics, a campaign-reform group, Kerry received more contributions from lobbyists in 2003 (though September) than any other senator -- some $226,450.

On the stump, the senator boasts that he has never taken money from political action committees. But he doesn't need PAC money because he has tapped an organization called the Citizen Soldier

138 Fund, a vehicle for amassing unlimited gifts from unions and lobbyists representing the insurance, banking, and telecom industries. Kerry set up this "shadow committee" -- a so-called 527 -- despite his support for the McCain-Feingold bill, which banned direct donations of soft money.

Kerry has also done favors for wireless outfits and other interests, ranging from arranging entrée with regulators to backing friendly amendments. In some cases, the favors were followed by "bundled" contributions. For instance, Kerry has often sponsored amendments for the Cellular Telecommunications & Internet Assn., only to receive checks from lawyers and lobbyists close to the trade group.

Kerry's staffers say that as a former state prosecutor, he is incorruptible and never trades influence. But the reality is that he is less of a campaign reformer than he makes himself out to be, working the system to his advantage while insisting that tougher rules are needed.

ANTI-CORPORATE FIRE. As for Kerry's new penchant for attacking "Big Oil, big drug companies, big HMOs, and Benedict Arnold CEOs," aides say that some of the anti-corporate fire will fade as he tries to appeal to upscale suburbanites. "This stuff has never been a big part of his talking points in the past," says one strategist close to the campaign. "That's mainly a reflection of the fact that Dean got so hot so early." Bottom line: Kerry has been a sometime New Democrat in the '90s, backing free trade, tech tax breaks, and limits on shareholder lawsuits, and he has left most of the CEO-bashing to fellow Massachusetts Senator Edward M. Kennedy. He may well seek a rapprochement with business after he secures the nomination.

Such a meeting of the minds could prove difficult, however, because Kerry would repeal all but a few middle-class cuts out of Bush's $3 trillion-plus in reductions. Like most of his fellow Dems, Kerry worships at the altar of former Treasury Secretary Robert E. Rubin, insisting that "demand-side" tax breaks for moderate-income people will spur growth faster than the GOP's cuts in marginal rates. In a fall campaign against Bush, Kerry wouldn't have much time for nuances, though. Republicans will tattoo him as a tax-and-spender.

At first glance, Kerry also seems vulnerable to the charge that he is weak on defense. Republicans home in on a series of votes he cast in the '90s, which would have whacked the Pentagon budget to shift money to health care and education. Most troublesome, the senator, who now says U.S. intelligence has to be dramatically bolstered in the wake of September 11, voted in 1994 to slash $2.58 billion from spy budgets.

UNANSWERED QUESTIONS. In 1995, Kerry did indeed vote for a seven-year freeze in defense spending in a bid to free up $34 billion. But there is a pattern to his maneuvers. He has been a persistent foe of big-ticket weapons, such as Star Wars, and favors a cheaper, more nimble, high-tech military.

Kerry's efforts to rein in the CIA were a product of his Vietnam-era revulsion over politicization of intelligence data. But the fact is, he has been a vocal critic of intelligence services and shifted his focus toward enhanced intelligence-gathering after terrorists attacked the U.S. Bottom line: Kerry has a lot of explaining to do -- but has a chestful of medals to deflect some of the criticism.

The harshest attack on Kerry will come over the values divide -- his support for taxpayer-funded abortions, gay civil unions, and gun control, plus his opposition to capital punishment. That means Kerry will have to answer charges that he's on the wrong side of the culture wars.

139

A LIBERAL AND A LAWYER. His challenge is all the more complicated since a new Massachusetts court ruling that gay and lesbian partners must be granted the same right to marriage as heterosexual couples. Although Kerry backs only civil unions, not gay marriage, Republicans will make this a huge wedge issue -- conjuring up lurid images of a "Massachusetts lifestyle" to make the hair stand up on blue-collar necks. Says RNC member Kaufman about a possible Kerry-Edwards ticket: "We get to run against a Massachusetts liberal and an ambulance- chasing lawyer. I like our odds."

Such assaults are nothing compared with what Kerry will face if he blows away remaining contenders on Mega Tuesday, the big Mar. 2 round of primaries. Right now, though, the lanky warrior has other concerns on his mind -- such as fighting off weariness, staying on message, and hustling up money for media buys. The guns of the GOP will have to wait.

By Lee Walczak, with Richard S. Dunham and Lorraine Woellert, in Washington

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DECEMBER 29, 2003

2004 INVESTMENT OUTLOOK -- THE BIG

PICTURE

As The Economy Heats Up, The Market Has A Head Of Steam For 2004

Oscar Wilde once said: "Success is a science. If you have the conditions, you get the result." In 2003, astonishing the naysayers, the conditions were ripe for stock market success -- and those for a continued good performance seem to be in place for 2004. The economy, which began stumbling toward recovery in 2003, should have a standout year and could lay the foundation for another strong year. Instead of the usual election-year policy gridlock, look for the Fed to nudge up rates and for the Administration to push a package of tax cuts aimed at boosting savings. Geopolitical crises, and Iraq, will still pose risks despite the capture of Saddam Hussein. But even if the bull continues to run, success in the year ahead will require more than just showing up.

141

The Easy Money Is Gone, But Next Year Could Still Pay Off If You're Picky

It was a knock-your-socks-off year in the stock market for Mark Ciborowski, 47, head of a real estate management firm in Concord, N.H. He racked up nearly 125% gains by buying mostly small, beaten-down stocks, riding them up steadily as a ski-lift, then jumping out with a tidy profit.

Most investors didn't make such nosebleed returns in 2003, but it's doubtful you'll hear complaints. After three years of the most grisly bear market since the Great Depression, many investors are thrilled to see double-digit gains in their 401(k) and brokerage accounts. Through Dec. 16, the Standard & Poor's 500-stock index was up 22%, the Nasdaq Composite Index popped 44%, and the Dow Jones industrial average -- which recently topped the 10,000 mark -- had risen 21%. In fact, if you weren't in stocks, you're probably feeling like a geek hiding by the punch bowl at the high school prom. Money-market accounts have averaged well under 2% this year, barely keeping up with inflation.

The party's not over, but it may be thinning out a bit. Many strategists think stocks could reap low double-digit gains in 2004, but a repeat of 2003 is highly unlikely. Because stocks have rallied so strongly, many aren't cheap anymore. Besides, interest rates will likely start rising in 2004. Then there are tougher earnings comparisons and a chronically weak dollar, and despite the recent capture of a bedraggled-looking Saddam Hussein, the occupation in Iraq continues. All these factors make Ciborowski merely "cautiously optimistic" about 2004: "The easy money has been made." Still, a 10% gain for 2004 would not be bad at all; in fact, over the past 50 years, that has been the market's average annual return. To best that, investors need to saddle up with stocks poised to benefit from economic recovery.

It's likely that investors' love affair with bonds has gone the way of most courtships spawned on reality-TV shows like Joe Millionaire. If rates rise by as little as 1%, the price of a 10-year Treasury will plunge about 8%. And if you hope the price of your house will continue to outpace the stock market, think again. Rising rates could huff and puff and blow your house value down...or at least sideways.

The good news is there's no question that the economy is building muscle. In the third quarter, gross domestic product grew 8.2% -- the fastest spurt since 1984. A stronger economy will translate into healthy corporate earnings. Analysts estimate that fourth- and first-quarter earnings will come in at about 22% and 13% higher than the same periods a year earlier, according to earnings researcher Thomson First Call (TOC ). For 2004, analysts expect earnings to rise about 12%.

Companies are increasingly flush with cash, and that's likely to fuel earnings. Both operating and free cash flow for the S&P 500 are at their highest in five years, according to StockDiagnostics.com, an equities-research firm. Because earnings tend to lag behind cash flow by about six months, StockDiagnostic's research director, Michael Markowski, thinks stocks will be strong at least through the first half of 2004. "When cash flow starts going up like this, it's telling you that companies have plenty of money to pay down debts and are preparing to make capital expenditures," he says.

142

Market rotation

Although interest rates will likely inch up in 2004, they'll remain very low. John A. Caldwell, portfolio strategies director at McDonald Investments Inc., a division of KeyCorp (KEY ) in Cleveland, says rates have some elbow room. The Federal Reserve focuses on the federal funds rate, at which banks lend to each other overnight, and that is still just 1%, or below the current 1.8% inflation rate. Even so, rates won't rise overnight. Says Caldwell: "The Fed will probably wait until we see more than two consecutive quarters of strong GDP growth and job growth."

Election years, along with the year before them, are usually bullish. According to the Stock Trader's Almanac, the last two years of the 43 Administrations since 1832, including 2003, produced cumulative market gains of 739%, compared with a 228% gain in those Administrations' first two years; average annual gains were 17% vs. 5%. Incumbents tend to pile on economic stimulus in order to spruce up their last two years in office, having applied the bitter medicine, such as tax hikes, earlier. President George W. Bush's 2003 tax cuts, which slashed taxes on dividends and capital gains, provided a booster shot for the market. The effect will likely spill over into 2004. Says Woody Dorsey, a strategist and president of Market Semiotics, a research firm in Castleton, Vt.: "The liquidity boom probably has some tailwind that could take us through the first quarter."

Despite the widening mutual-funds scandal, investors are looking on the sunny side. Our annual BusinessWeek/Harris Poll found that 54% of households think stocks will rise in 2004. That's a big jump from the 41% who thought so a year ago. Mutual-fund flows have held up surprisingly well. Through mid-December, investors poured about $48 billion into equity funds; in 2002 during the same period, they yanked out about $28 billion, according to U.S. Bancorp Piper Jaffray (USB ).

Still, some factors could be a drag on stocks. Beyond unpredictable geopolitical crises or acts of terrorism, the main roadblock in 2004 will likely be valuations. After 2003's run, the median S&P 500 stock is trading at a price-earnings ratio of about 18, based on analysts' estimates of earnings over the next 12 months. That's not exactly cheap, even with rock-bottom interest rates; over the past 50 years, the average p-e for the S&P 500 has been about 15. "The market is fairly to fully valued," says Vincent D. Farrell Jr., chairman of Victory Capital Management. "That means you really have to pick stocks."

For 2004, you'll want to look beyond the many technology equities and small- and micro-cap stocks with lower quality earnings that have been hands-down winners this year. According to a study by Richard Bernstein, chief U.S. and quantitative strategist at Merrill Lynch & Co (MER )., shares of lower-quality companies that lost money over the past decade were up 33% for the year through Nov. 25, beating the 22% gain of top-rated companies whose earnings rose. The catch is that many of these stocks are now overpriced. That's why many experts now favor large caps with solid earnings that have been trading at a discount to the market. Consider energy stocks. "Energy earnings have been phenomenal, but [the group's] performance is the second- worst among 10 sectors," says Bernstein.

Among large caps, companies that have been increasing their dividends, such as General Electric (GE ) and Pfizer (PFE ), could be a good bet. According to S&P, 418 listed companies raised their dividends in the third quarter -- a 40% jump from a year ago. It estimates that dividends for the S&P 500 will rise 10.1% in 2004, compared with an average of just 0.8% over the five years

143 through 2002. Says Philip S. Dow, director of equity strategy at RBC Dain Rauscher Inc. in Minneapolis: "The big story in 2004 will be dividend increases."

Tech stocks that aren't overheated could shine, particularly those of companies that can ramp up production without having to invest more. Some financial companies are still fairly priced relative to their peers, and as takeover deals heat up and investors come back to the market, they could rally. Both high-end and discount retailers look poised for gains. Insurers and pharmaceuticals will likely benefit from recent Medicare reform. High energy prices, coupled with a looming natural-gas shortage, could spark a rally in energy stocks.

Beyond stocks, commodities like nickel and copper should remain durable in 2004. Gold could continue to glitter. Even art could be a portfolio masterpiece.

The bottom line for 2004: To beat the market, you'll need to invest in the best-performing stocks that are trading at low valuations. No, it's not easy. But in this issue we've done some of the spadework for you.

By Marcia Vickers

144

Just One Of Those Do-Nothing Election Years? Not Likely

Usually, not much gets done in Presidential election years: Politicians are too busy positioning themselves ahead of the contest, while Federal Reserve policymakers prefer to stay out of the limelight. But Washington could spring a few surprises in 2004.

This year, political considerations could drive action on a number of fronts. Chairman Alan Greenspan's Federal Reserve could nudge up interest rates at midyear, and lawmakers could pass a parcel of important legislation, including mutual-fund reform and tax cuts aimed at increasing savings.

The central bank has two windows for hiking interest rates: summer 2004, before the election campaign really heats up, or winter 2005, says Laurence H. Meyer, a former Federal Reserve governor who is now with the Center for Strategic & International Studies. If the economy continues to outperform expectations and inflation ticks up, the Fed could tighten at its June or August meetings. But if it hasn't acted by then, it will put off an increase until 2005, well after the election.

Pre-election politics will also shape the tax-cut package that President George W. Bush is expected to roll out. Modeled on a proposal he first made in early 2003, it's likely to call for the creation of new kinds of savings accounts: Savers would have to deposit aftertax dollars, but interest, capital gains, and dividend income earned on them would never be taxed, and the funds could be withdrawn for any purpose. In deference to fiscal conservatives who have criticized the President for the swelling budget deficit, the package will probably be less generous than the 2003 proposal, which would have allowed savers to stash $7,500 a year in such accounts. Chances for passage look good, because Democrats would find it difficult to oppose such a plan in an election year.

With scandal rippling through the mutual-fund industry, Congress is also likely to pass mutual- fund reform legislation in 2004. Already, the House has overwhelmingly approved a bill aimed at improving fee disclosure, beefing up the independence of fund boards, and deterring trading abuses. The version that the Senate will take up early in 2004 is likely to be tougher. The bottom line for investors: added costs, at least initially, as funds scramble to meet the new requirements. But in the long run, the reforms could lead to more competition and lower costs as investors use the extra information to shop around and independent directors demand more from fund managers.

Watch Washington closely next year. What comes out of the nation's capital could have dramatic implications for investors for years to come.

By Rich Miller

145

Fatter Profits -- And Job Growth -- Will Send The Recovery Into High Gear

To hear economic forecasters tell it, the trip from 2003 to 2004 will be like going to sleep in Kansas and waking up in Oz. And it won't be a dream.

After two years of a tepid, hit-or-miss recovery that offered no assurance of better times ahead, all signs now point to a year of strong, well-balanced growth that will generate a lasting upturn. Better balance is the key: between spending gains by businesses and consumers, between rising profits and household incomes, between productivity increases and job growth. Simply put: "Everyone wins," says David W. Berson at Fannie Mae (FNM ).

One big reason is that in 2004 the benefits of the economy's long-run trend of faster productivity growth will shine through. Even as demand sputtered over the past three years of recession and mock recovery, productivity gains were lifting profit margins and the real wages of workers who kept their jobs. Now, amid stronger and more widely based demand, every addition to revenue will create even more profits. And with payrolls rising, each new worker will generate even more purchasing power. "This is the virtuous cycle," says Gail Fosler at the Conference Board Inc.

The business economists in BusinessWeek's survey, on average, expect the economy to grow 4.1% in 2004. That's fast enough to spur enough job growth to cut the jobless rate to 5.6% by yearend from its peak of 6.4%. They expect almost no change in inflation, which will be 1.9% for the year. They also look for the Federal Reserve to be patient in lifting interest rates, most likely not until midyear.

The forecasters are quite confident in their upbeat outlook. Two-thirds expect growth of 4% or better, including BW's Business Outlook editors' forecast of 4.4%. The lowest projection is 2.9%, which only a year ago was close to the consensus expectation for 2003. "With monetary and fiscal policy as aggressive as they have been in history, and with both household and business confidence on the rise, everything is in place for a robust economy with broad-based growth," says Joel L. Naroff of Naroff Economic Advisors.

It's hard to disagree. Strong profits are fueling a rebound in capital spending. New hiring and stock market gains are lifting household incomes, wealth, and confidence. Even the depressed manufacturing sector is stirring to life. Accelerating growth abroad, especially in Asia, and depreciation in the dollar are boosting exports, overseas profits, and U.S. competitiveness -- particularly in Europe, where the dollar has slipped the most. Cash-strapped state and local governments will be winners, too, as stronger growth lifts tax revenues. The capture of Saddam Hussein also may bolster confidence by removing some uncertainty over Iraq and improving stability in the region.

Pent-up demand The biggest difference between 2003 and 2004 is that overall demand will not be as dependent on consumer spending and housing. Consumer buying will moderate as the stimulus from tax cuts and cheaper mortgages wane. But at the same time, "we expect the main growth engine to come from business investment and production," says Gene Huang at FedEx Corp. (FDX ). The combination of stronger demand and the investment bust of the past three years has resulted in

146 pent-up demand for new equipment and insufficient inventories. "Businesses are starting to feel the need to expand in order to take advantage of new opportunities," says Gary Thayer at A.G. Edwards Inc. (AGE ). Outlays for tech gear are already matching the growth rates of the late-'90s boom as companies strive to boost productivity.

But don't expect productivity to repeat its recent surge of 5% over the past year. "Productivity gains will slow, but only from their present elevated levels," says Nariman Behravesh at Global Insight Inc. The good news: If productivity slows to 2% to 3% in the coming year, an economy growing at 4% would be able to generate job growth of 1% to 2%, equivalent to job gains of about 100,000 to 200,000 per month. "Job growth of just over 1%, combined with wage growth near 3%, will give consumers enough spending power to keep them a solid force for economic growth," says Stuart Hoffman at PNC Financial Services Group Inc. (PNC ).

The bright outlook isn't just an American story. Thanks to the dual thrust from the U.S. and China, the global backdrop looks the best in years. "China has jump-started growth throughout Asia and is stimulating exports from all industrialized countries," says Robert Gay at Commerzbank Securities. The U.S. is playing a smaller role as the world's growth engine. Chinese-driven strength in Asia is helping Japan pull out of its abyss, though its growth will continue to be limited by slow progress in restoring the health of its banking sector. The euro zone is also starting to turn up, but its recovery will be constrained by relatively stringent monetary and fiscal policies, by the euro's rise, and by slow progress on labor, pension, and regulatory reforms.

Despite expectations of solid economic growth, forecasters say that, amid so much slack, in terms of unused labor, equipment, and buildings, inflation will be a no-show, allowing the Federal Reserve considerable leeway to keep interest rates low. Nevertheless, the current 1% federal funds rate is far too low to be consistent with the Fed's long-run goal of price stability. At some point, as short-term rates start to inch up, bond yields will rise with them.

"We expect 2004 to be a difficult year for the bond market," says John Ryding at Bear, Stearns & Co. (BSC ). In that regard, the Fed is damned-if-it-does, damned-if-it-doesn't. When the Fed begins to move, long-term rates will rise. If the market thinks the Fed is waiting too long to hike, yields will jump anyway out of worries over inflation. "My fear is that the Fed will be too slow to lift rates," says Ian Shepherdson at High Frequency Economics Ltd. Like nearly all economists, Shepherdson isn't concerned about inflation in 2004, but the danger would come later on.

Is there a Wicked Witch to foil next year's rosy outlook? Fears of terrorism or a Middle East crisis that could cause oil prices to spike are common. But there are new worries. "My biggest concern remains the immense [U.S.] current-account deficit and the risk of a dramatic decline in the dollar," says Lynn Michaelis at Weyerhaeuser Co. (WY ). A sharp plunge in the dollar could bring a retreat in foreign capital so crucial to U.S. growth, along with higher inflation and interest rates. Mounting federal deficits also raise concerns about interest rates.

But that risk goes beyond 2004, and strong growth has a way of lessening other worries, including those over the dollar. For the coming year, forecasters see an economy ready to skip down a yellow brick road of rising demand, fatter profits, and solid job growth.

By James C. Cooper & Kathleen Madigan

147

Winners: Ethan Harris, Top Economic Visionary

The 2003 economic picture was dominated by accelerating growth with a continued drop in inflation -- and thus a very accommodating Federal Reserve. Of all the forecasts for 2003 gathered by BusinessWeek back in December, 2002, Ethan S. Harris, chief U.S. economist at Lehman Brothers Inc. (LEH ), gave the most accurate projections for the year. Close on his heels were Joseph Liro of Stone & McCarthy Research Associates and Wayne D. Angell of Angell Economics. How did Harris and his staff of four economists forecast such a seemingly contradictory mix of rising growth but slowing inflation? "It's spare capacity that determines inflation's trend," he says. "It's not the growth rate per se." By spare capacity, he means the number of unemployed workers and the low rate of production facilities in use, both in the U.S. and globally. If an economy has excess labor and capital, it can't generate the cost and wage pressures that push up inflation. Harris knew the overhang of labor and capacity would influence Fed policymaking as well. That's why he was one of the few economists in the BusinessWeek survey who correctly projected another rate cut by the Fed in 2003 -- although, like most forecasters, he wrongly expected some tightening later on. The Lehman 2003 forecast was also tempered by noneconomic events, from preparation for war to the corporate-governance scandals. These "touchy-feely" factors, as Harris calls them, are hard to model, but they caused executives to delay making business decisions and widened the spread between various interest rates. HARRIS, 47, LIVES IN Westfield, N.J., with his wife, two children, and three cats. In his spare time, he's a student of history and a follower of the Boston Red Sox. Being a long-suffering fan, he says, may have given him "the right level of cynicism" to forecast an economy that disappointed many who wanted faster growth and more jobs in 2003. That disappointment may continue into 2004, according to the Lehman forecast. In Lehman's view, the corporate sector will participate more fully in the recovery while consumers take a spending break, since there is not much pent-up demand among households and there will be no further tax- cut stimulus to boost incomes. Job growth will remain muted, mainly because of high productivity, he says. Harris doesn't see policymakers hiking rates until 2005. "They want a period of healing in the economy," he says. He thinks the Fed will wait until it sees better growth, less risk of deflation, and stronger job growth. Harris' insight into the Fed's thinking may be better than most because he worked at the Federal Reserve Bank of New York for a total of nine years after he earned his doctorate in economics at Columbia University. After such a long stint, he admits, "I've been indoctrinated into the Fed mind-set." He also is able to draw on the advice of Lehman economists abroad and experts in the firm's trading and sales departments. That team effort helps explain why the Lehman forecast was such a winner in 2003. While his beloved Red Sox have developed a knack for snatching defeat from the jaws of victory, Harris has proven himself a major league success. By Kathleen Madigan in New York

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2004: The Economy To Come

We asked 60 business economists for their views of the economists' forecasts for real GDP growth for all of 2004.

2004 annual rate 2003 Q4 to 2004 Q4 2004 Q4 Levels (%)

Real GDP 10-yr. Fed. Quarterly % Change REAL Operating Jobless Treas. Funds I II III IV GDP Profits CPI Rate Yield Rate

CONSENSUS 4.3% 4.2% 4.0% 3.8% 4.1% 11.7% 1.9% 5.6% 5.0% 1.7%

149

Investors Are Bullish All Over Again. It's Not Just Irrational Exuberance

Optimism is back in style. The number of Americans who think stocks will go up in the coming year is back to the bull-market highs of the late 1990s, according to the annual BusinessWeek/Harris Poll. This year, a surprisingly high 54% of the public predicted an up year for the stock market, a statistical tie with the 52% who said so in frothy 1999.

Our poll contains other intriguing insights into the public's current thinking. Real estate -- still Americans' No. 1 investment pick -- is less favored than a year ago, seemingly because people see more opportunity in stocks. Investors have regained confidence in their own stockpicking ability. They're less concerned than last year about terrorism's potential impact on stocks. And they expect strong economic growth in the year ahead. They're realistic, though. Their expectations for long-term returns from stocks remain well below the level of the giddy 1990s. And in the wake of the Wall Street scandals, they're more dubious that small investors can do as well as big ones.

Put the sometimes contradictory answers together, and you get a picture of a public that has been immensely cheered by the stock market rally of the past year but doesn't seem to be dangerously euphoric. The telephone survey of 610 adults, including 312 who said they own stocks, was conducted from Dec. 2 to Dec. 8 by Harris Interactive Inc. (HPOL ). The sampling margin of error is plus or minus 4% for all respondents and plus or minus 5.5% for the subset of stock investor responses. Full results are available at www.businessweek.com.

The 54% of households who think stocks will go up in the coming year was a sharp increase from the 41% who thought so last year. The rise in optimism was even bigger for respondents who own stocks. Among them, 67% expected stocks to go up, compared to 47% a year ago.

It's no surprise that Americans still like real estate, since it's the biggest chunk of most households' assets and housing prices have been strong. What's interesting is that the share of all households making it their top pick fell to 46% from 53% last year, when real estate was seen as a refuge from Wall Street's carnage. The dropoff in real estate's popularity among investors was mirrored by a rebound in mutual funds and stocks, which together were the No. 1 choice of 31% of respondents, up from 19% in 2002.

Investors seem to have been reading the headlines about mutual-fund abuses, judging from the increase (to 50%, from 42%) in the share who disagree that small investors can do as well as big investors in the stock market. On the other hand, many remain convinced that they can beat the pros and their fellow dabblers. An overwhelming 75% are confident that the stocks or mutual funds they pick will beat the market averages. That's up from 64% last year. "It's like what Samuel Johnson said about second marriages -- 'the triumph of hope over experience,"' says Laszlo Birinyi Jr., president of Birinyi Associates Inc., a stock market research firm in Westport, Conn.

Taking terrorism in stride? Despite the mutual-fund scandal, 17% of investors chose mutual funds as the best investment for the coming year, up from 12% last year. Funds also held their own against individual stocks. The

150 28% who plan to invest more in funds in the next six months are little changed from the 31% who say they will invest more in stocks.

Investors may be taking the scandals in stride because the market is still rising. The same thinking could be at work in the attitude toward terrorism. Asked how "terrorism and the war against it" will affect the stock market over the next 12 months, 24% expect a positive effect and 22% expect no effect at all. That's pretty confident for a nation that suffered the September 11 attacks two years ago and continues to lose soldiers to terror attacks in Iraq. Woody Dorsey, president of Market Semiotics, a Castleton (Vt.) investment research firm, speculates that since stocks have shrugged off terror so far, "people have kind of gotten that out of their system. They're inoculated against it." Only 5% of investors -- down from 12% last year -- called a big stock market crash "very likely."

As an experiment this year, we asked people to predict inflation, interest rates, and economic growth in 2004 -- and then compared their answers with those of the professional forecasters in our Economic Survey. Our respondents were even more bullish on growth than the pros. Yet, somewhat inconsistently, they were less worried that interest rates would rise.

The degree of optimism expressed in our poll worries some contrarian analysts. They fear that investors have already acted on their convictions by putting money into the market, so there's not much upside left. When everyone is upbeat, they say, then the market is "priced for perfection." The only possible change then is that some people turn pessimistic and bail out, sending stocks lower. That's certainly what happened in the bear market that began after the high tide of optimism in December 1999. "There is probably an overconfidence factor," says Dorsey. Adds Tobias Levkovich, chief U.S. equity strategist at Smith Barney (C ): "We've seen a move from fear to comfort, probably on the way to greed."

The contrarians could be right. Still, some answers in the poll suggest that investors remain level- headed: Only 5% plan to invest "a lot more" in stocks or mutual funds in 2004. What's more, their expectations for long-run stock returns (capital gains and dividends) are restrained. Fully 61% expect their returns to average under 10% a year, and only 14% are counting on returns of 12% or more. In 1999, by contrast, just 37% expected sub-10% returns and 27% counted on 12% or more per year.

The modest increase in mutual-fund inflows is another sign of level-headedness. Net inflows in the six months through October equaled just 3.7% of average assets, safely below the frothy peak of over 5% in early 2000, according to Levkovich.

Last year, the public was pessimistic -- and wrong. This year it's optimistic. A lot of people are crossing their fingers that this time, the conventional wisdom turns out to be right.

By Peter Coy

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DECEMBER 29, 2003

BW/Harris Poll: Investing In 2004

Methodology: This survey was conducted by telephone within the United States between December 2 to December 8, 2003 among a nationwide cross section of 610 adults who are 18 or older (Sampling error +/- 4.0). Among them 312 respondents were "stock investors" (Sampling error +/- 5.5). An asterisk (*) signifies a value of less than one-half percent. A dash represents a value of zero.

Some questions were asked of all respondents, and others were asked only of stock investors. For some of the questions that were asked of all respondents, it is possible to break out the answers of the subset who own stock. Questions labeled "Base: All Respondents" represent the answers of all 610 adults polled. Questions labeled "Base: Stock Investors" represent answers only of the 312 who said that they own stock.

If you had to choose the ONE investment that you think would be the best to make right now, which would it be?

BASE: ALL RESPONDENTS 1996 1997 1998 1999 2000 2001 2002 2003

REAL ESTATE 25 33 30 30 28 39 53 46

MUTUAL FUNDS 24 21 18 20 21 13 9 10

BANK OR SAVINGS & LOAN DEPOSITS 8 9 11 12 14 7 6 8

COMMON STOCK 10 12 13 13 8 7 5 9

MONEY-MARKET FUNDS 6 6 7 7 8 5 4 3

GOLD OR OTHER PRECIOUS METALS 7 4 4 5 4 5 5 3

GOVERNMENT BONDS 9 5 5 5 5 8 6 7

CORPORATE BONDS 2 4 3 2 1 3 2 1

I DON'T SAVE OR INVEST AT ALL (V) 3 1 3 1 3 4 2 4

NOT SURE (V) 6 5 6 4 7 9 7 9

DECLINE TO ANSWER (V) - - - - * * * *

BASE: STOCK INVESTORS 2002 2003

152 REAL ESTATE 55 46

MUTUAL FUNDS 12 17

BANK OR SAVINGS & LOAN DEPOSITS 3 4

COMMON STOCK 7 14

MONEY-MARKET FUNDS 5 5

GOLD OR OTHER PRECIOUS METALS 5 4

GOVERNMENT BONDS 5 4

CORPORATE BONDS 3 1

I DON'T SAVE OR INVEST AT ALL (V) 1 2

NOT SURE (V) 5 2

DECLINE TO ANSWER (V) - -

Thinking about your household's total assets including real estate, stocks including stock mutual funds, bonds including bond mutual funds, savings instruments, and cash, does your household own any of the following?

BASE: ALL RESPONDENTS Yes No Not sure (v) Decline to Answer (v)

REAL ESTATE 1999 62 34 2 2

2000 59 32 1 8

2001 60 37 3 -

2002 62 36 1 1

2003 63 35 2 1

STOCKS INCLUDING STOCK MUTUAL FUNDS 1999 50 46 2 2

2000 47 42 2 9

2001 47 49 3 *

153

2002 47 50 2 1

2003 47 49 2 1

BONDS INCLUDING BOND MUTUAL FUNDS 1999 28 67 3 2

2000 27 61 4 9

2001 26 69 4 *

2002 28 68 3 1

2003 29 65 4 2

SAVINGS INSTRUMENTS AND CASH 1999 74 23 1 2

2000 67 21 2 10

2001 72 25 2 *

2002 69 29 1 1

2003 67 29 3 2

SOME OTHER ASSET 1999 22 74 2 2

2000 34 55 2 10

2001 34 62 4 1

2002 34 62 3 1

2003 34 61 4 1

BASE: STOCK INVESTORS Yes No Not sure (v) Decline to Answer (v)

REAL ESTATE 2002 79 21 1 -

2003 78 22 - -

154

STOCKS INCLUDING STOCK MUTUAL FUNDS 2002 100 - - -

2003 100 - - -

BONDS INCLUDING BOND MUTUAL FUNDS 2002 46 51 4 -

2003 51 46 3 -

SAVINGS INSTRUMENTS AND CASH 2002 89 11 1 -

2003 88 11 1 *

SOME OTHER ASSET 2002 44 54 2 *

2003 43 54 3 *

Have you bought common stock or shares in a stock mutual fund WITHIN THE PAST YEAR?

BASE: STOCK INVESTORS 1999 2000 2001 2002 2003

HAVE BOUGHT 57 59 53 50 48

HAVE NOT BOUGHT 42 39 46 49 48

NOT SURE (V) 1 1 1 1 4

DECLINE TO ANSWER (V) * 1 * - -

Over the next six months, do you think you will probably invest a lot more in STOCKS, invest somewhat more in STOCKS, reduce your investment in STOCKS somewhat, or reduce your investments a lot?

BASE: STOCK INVESTORS 2003

INVEST A LOT MORE 5

INVEST SOMEWHAT MORE 26

REDUCE SOMEWHAT 16

REDUCE A LOT 11

155

STAY THE SAME (V) 34

I DON'T SAVE OR INVEST AT ALL (V) 4

NOT SURE (V) 4

DECLINE TO ANSWER (V) -

Over the next six months, do you think you will probably invest a lot more in STOCK MUTUAL FUNDS, invest somewhat more in STOCK MUTUAL FUNDS, reduce your investment in STOCK MUTUAL FUNDS somewhat, or reduce your investments a lot?

BASE: STOCK INVESTORS 2003

INVEST A LOT MORE 5

INVEST SOMEWHAT MORE 23

REDUCE SOMEWHAT 19

REDUCE A LOT 13

STAY THE SAME (V) 32

I DON'T SAVE OR INVEST AT ALL (V) 3

NOT SURE (V) 5

DECLINE TO ANSWER (V) -

Over the next year, do you think stocks will go up, stay about the same, or go down?

BASE: ALL RESPONDENTS 1996 1997 1998 1999 2000 2001 2002 2003

GO UP 39 39 37 52 33 52 41 54

STAY ABOUT THE SAME 36 38 34 20 26 25 27 24

GO DOWN 19 16 21 17 23 14 20 11

NOT SURE (V) 6 7 8 10 18 9 12 12

DECLINE TO ANSWER (V) - - - - 1 * * -

156 BASE: STOCK INVESTORS 2002 2003

GO UP 47 67

STAY ABOUT THE SAME 28 21

GO DOWN 16 6

NOT SURE (V) 8 6

DECLINE TO ANSWER (V) * -

Over the next 12 months, how would you rate the chance of another big crash in the stock market -- very likely, somewhat likely, not very likely, or not at all likely?

BASE: ALL RESPONDENTS 1996 1997 1998 1999 2000 2001 2002 2003

VERY LIKELY 12 13 14 15 13 14 17 12

SOMEWHAT LIKELY 35 43 41 37 37 38 39 34

NOT VERY LIKELY 35 31 29 33 35 32 28 37

NOT LIKELY AT ALL 15 10 11 11 7 11 9 12

NOT SURE (V) 3 3 4 4 7 5 6 5

DECLINE TO ANSWER (V) - - - - 1 * * -

BASE: STOCK INVESTORS 2002 2003

VERY LIKELY 12 5

SOMEWHAT LIKELY 39 27

NOT VERY LIKELY 37 52

NOT LIKELY AT ALL 8 10

NOT SURE (V) 3 5

DECLINE TO ANSWER (V) * -

157 In the long run, what sort of total returns (capital gains plus dividends) do you expect the stock market to produce for you -- below 5% a year, 5% to below 10% a year, 10% to below 12% a year, 12% to below 15% a year, or 15 % or higher a year?

BASE: STOCK INVESTORS 1996 1997 1998 1999 2000 2001 2002 2003

BELOW 5% A YEAR 8 4 9 7 7 12 20 15

5% TO BELOW 10% A YEAR 36 27 26 30 33 42 42 46

10% TO BELOW 12% A YEAR 29 30 29 27 25 24 18 19

12% TO BELOW 15% A YEAR 13 19 18 14 12 9 6 7

15% OR HIGHER A YEAR 9 14 17 13 12 7 6 7

NOT SURE (V) 5 5 2 8 10 7 9 5

DECLINE TO ANSWER (V) - - - 2 1 * * -

How confident are you that the stocks or mutual funds you pick will beat the market averages Ð very confident, somewhat confident, not very confident, or not at all confident?

BASE: STOCK INVESTORS 2000 2001 2002 2003

VERY CONFIDENT 17 14 10 15

SOMEWHAT CONFIDENT 62 62 54 60

NOT VERY CONFIDENT 12 14 24 16

NOT AT ALL CONFIDENT 3 5 8 5

NOT SURE (V) 5 4 4 4

DECLINE TO ANSWER (V) 1 * - -

158 Overall, how would you describe the stock market's valuation -- very overpriced, somewhat overpriced, fairly valued, somewhat cheap, or very cheap?

BASE: STOCK INVESTORS 1999 2000 2001 2002 2003

VERY OVERPRICED 12 11 4 8 8

SOMEWHAT OVERPRICED 46 40 29 28 30

FAIRLY VALUED 31 28 39 37 40

SOMEWHAT CHEAP 4 9 17 15 11

VERY CHEAP * 1 3 4 4

NOT SURE (V) 6 11 8 9 7

DECLINE TO ANSWER (V) 1 * * * -

Overall, how would you describe the valuation of international stocks -- very overpriced, somewhat overpriced, fairly valued, somewhat cheap, or very cheap?

BASE: STOCK INVESTORS 1999 2000 2001 2002 2003

VERY OVERPRICED 6 7 5 5 5

SOMEWHAT OVERPRICED 22 23 18 22 29

FAIRLY VALUED 19 17 21 18 20

SOMEWHAT CHEAP 11 10 8 10 6

VERY CHEAP 1 2 2 2 1

NOT SURE (V) 39 41 46 41 38

DECLINE TO ANSWER (V) 2 * 1 1 * Overall, how would you describe the valuation of technology stocks -- very overpriced, somewhat overpriced, fairly valued, somewhat cheap, or very cheap?

BASE: STOCK INVESTORS 2000 2001 2002 2003

VERY OVERPRICED 18 15 14 13

SOMEWHAT OVERPRICED 35 31 32 30

159 FAIRLY VALUED 19 22 22 29

SOMEWHAT CHEAP 6 17 13 11

VERY CHEAP 1 4 5 4

NOT SURE (V) 21 11 14 13

DECLINE TO ANSWER (V) * * * - Do you believe that next year, the stock market will be -- less volatile, about as volatile as this year, or more volatile?

BASE: STOCK INVESTORS 1998 1999 2000 2001 2002 2003

LESS VOLATILE 16 11 24 42 27 34

ABOUT AS VOLATILE AS THIS YEAR 56 54 43 40 49 49

MORE VOLATILE 26 28 24 12 19 14

NOT SURE (V) 2 7 9 6 5 4

DECLINE TO ANSWER (V) - * 1 * * -

How do you think terrorism and the war against it will affect the stock market over the next 12 months -- very positively, somewhat positively, somewhat negatively, very negatively, or will it have no effect at all?

BASE: ALL RESPONDENTS 2001 2002 2003

VERY POSITIVELY 11 14 12

SOMEWHAT POSITIVELY 28 20 20

SOMEWHAT NEGATIVELY 32 38 30

VERY NEGATIVELY 8 12 13

NO EFFECT AT ALL 14 10 18

NOT SURE (V) 7 6 7

DECLINE TO ANSWER (V) * * -

BASE: STOCK INVESTORS 2002 2003

160

VERY POSITIVELY 10 3

SOMEWHAT POSITIVELY 20 21

SOMEWHAT NEGATIVELY 43 34

VERY NEGATIVELY 13 12

NO EFFECT AT ALL 10 22

NOT SURE (V) 4 8

DECLINE TO ANSWER (V) * -

Some people say that small investors can do as well as big investors in the stock market. Do you agree or disagree with this statement? Do you agree strongly, agree somewhat, disagree somewhat, or disagree strongly?

BASE: ALL RESPONDENTS 2002 2003

AGREE STRONGLY 18 16

AGREE SOMEWHAT 34 33

NEITHER AGREE NOR DISAGREE (V) 3 4

DISAGREE SOMEWHAT 25 24

DISAGREE STRONGLY 16 19

NOT SURE (V) 4 3

DECLINE TO ANSWER (V) 1 -

BASE: STOCK INVESTORS 2002 2003

AGREE STRONGLY 17 11

AGREE SOMEWHAT 37 33

NEITHER AGREE NOR DISAGREE (V) 3 4

DISAGREE SOMEWHAT 28 29

161 DISAGREE STRONGLY 14 21

NOT SURE (V) 2 2

DECLINE TO ANSWER (V) * -

What do you think will happen to the INFLATION RATE in the next 12 months? Will it go up, stay the same or go down?

BASE: ALL RESPONDENTS 2003

WILL GO UP 50

WILL STAY THE SAME 36

WILL GO DOWN 11

NOT SURE (V.) 3

DECLINE TO ANSWER (V.) -

BASE: STOCK INVESTORS 2003

WILL GO UP 55

WILL STAY THE SAME 34

WILL GO DOWN 9

NOT SURE (V.) 2

DECLINE TO ANSWER (V.) -

What do you think will happen to INTEREST RATES in the next 12 months? Will they go up, stay the same or go down?

BASE: ALL RESPONDENTS 2003

WILL GO UP 58

WILL STAY THE SAME 30

WILL GO DOWN 10

NOT SURE (V.) 2

162

DECLINE TO ANSWER (V.) *

BASE: STOCK INVESTORS 2003

WILL GO UP 63

WILL STAY THE SAME 26

WILL GO DOWN 10

NOT SURE (V.) 2

DECLINE TO ANSWER (V.) -

What do you think will happen to the ECONOMY in the next 12 months? Will it grow faster than in the past 12 months, will it grow at about the same rate or slower?

BASE: ALL RESPONDENTS 2003

WILL GROW FASTER 31

WILL GROW AT THE SAME RATE 46

WILL GROW SLOWER 21

NOT SURE (V.) 3

DECLINE TO ANSWER (V.) -

BASE: STOCK INVESTORS 2003

WILL GROW FASTER 36

WILL GROW AT THE SAME RATE 47

WILL GROW SLOWER 15

NOT SURE (V.) 2

163

La globalización y sus quejas en 2004

Joseph E. Stiglitz, premio Nobel de Economía, es catedrático de Economía en la Universidad de Columbia; fue presidente del Consejo de Asesores Económicos del presidente Clinton y primer vicepresidente del Banco Mundial. Su libro más reciente es The roaring nineties: A new history of the workld's most prosperous decade. © Project Syndicate, enero de 2004. Traducción de María Luisa Rodríguez Tapia.

EL PAÍS | Opinión - 06-01-2004

El año 2003 fue, en muchos aspectos, un desastre para la globalización. Estados Unidos y su "coalición" de voluntarios emprendieron la guerra de Irak sin el apoyo de la ONU, y la asamblea de la Organización Mundial de Comercio en Cancún -que debía dar el impulso necesario para culminar con éxito la ronda de desarrollo de las negociaciones comerciales- acabó en fracaso. Es muy probable que 2004 sea mejor, tanto para la globalización política como para la economía mundial. Pero no creamos que va a ser un año espectacular.

Los acontecimientos de Irak demuestran el fracaso de los procesos democráticos a escala internacional y la necesidad de reforzarlos. La forma que ha tenido el Gobierno de Bush de afrontar la guerra y la posguerra se ha caracterizado por el mismo unilateralismo visible en su rechazo del Protocolo de Kyoto y el Tribunal Penal Internacional.

En estos dos casos, en los que la decisión colectiva del mundo difería de los deseos de los norteamericanos, el presidente Bush insistió en que Estados Unidos se saliera con la suya. El hecho de que el Gobierno estadounidense mintiera deliberadamente al mundo sobre la existencia de armas de destrucción masiva en Irak, o se dejara arrastrar por su propia retórica, es menos importante que la lección que nos enseña: es peligroso poner un poder excesivo en manos de unos cuantos.

Ahora bien, Estados Unidos está comprendiendo, por fin, que ni siquiera una superpotencia puede garantizar la seguridad en un país ocupado por la fuerza. Podría haberse ganado al pueblo iraquí en los primeros meses de la ocupación, pero, a estas alturas, la acumulación de errores quizá ha condenado dicho esfuerzo al fracaso. Asimismo, se ha dado cuenta de que es necesario condonar la deuda de Irak, para lo que será necesario recuperar la cercanía y la cooperación con países que eran aliados tradicionales de Estados Unidos, pero se opusieron a la guerra.

Estos pasos representan la esperanza de que, en 2004, Estados Unidos adopte una actitud más multilateral en su política exterior. Una esperanza que, sin embargo, se ve debilitada por el hecho de que el Gobierno de Bush excluya de los contratos de reconstrucción a países acreedores como Francia, Alemania y Rusia.

Al mismo tiempo, si se lleva a cabo la "terapia de choque" que proponen los estadounidenses para esa reconstrucción -liberalización económica y privatización inmediatas-, seguramente aumentará el desempleo y se generará más resentimiento. La "terapia de choque" es una estrategia que ha fallado en repetidas ocasiones. En 2004, es muy posible que el mundo vuelva a descubrir los riesgos de depender demasiado de la ideología o el liderazgo de un solo país. Irak sufrirá más que otros, pero las consecuencias se sentirán seguramente en todas partes.

164 Las conversaciones de la OMC en Cancún fueron el otro gran fracaso de la globalización en 2003. Estados Unidos y Europa faltaron a su promesa de que iba a ser una ronda de negociaciones destinada a mejorar las circunstancias de los países en vías de desarrollo. Es más, no lograron restablecer los desequilibrios de las rondas de negociaciones anteriores, que habían empeorado la situación de los países más pobres del mundo.

EE UU y Europa no sólo intentaron imponer sus prioridades comerciales a los países en vías de desarrollo, sino que además siguieron insistiendo en su derecho a mantener los subsidios agrarios y plantearon nuevas exigencias que habrían empeorado todavía más la vida en esos países. Por primera vez, los países en vías de desarrollo se unieron, y las negociaciones fracasaron.

Después de echarse mutuamente la culpa de este fracaso, Estados Unidos y Europa seguirán insistiendo, en 2004, en que quieren reanudar la ronda de desarrollo. Ahora bien, si no se hacen concesiones significativas en agricultura, barreras no arancelarias y derechos de propiedad intelectual, ¿qué pueden ganar los países en vías de desarrollo? Los aranceles sobre los productos industriales en los países avanzados son ya lo suficientemente bajos como para que los países en vías de desarrollo no tengan muchas probabilidades de beneficiarse demasiado, y, en cambio, tienen mucho que perder si se llega a otro acuerdo comercial injusto.

No obstante, los países en vías de desarrollo están aprendiendo varios trucos de Occidente. El pasado mes de noviembre, en Miami, aprobaron una zona de libre comercio de las Américas, que, en realidad, no permite el libre comercio y no va mucho más allá de lo que ya se había acordado en la OMC. En otras palabras, empieza a parecer que cualquier éxito posible en la ronda actual de negociaciones comerciales tendrá que basarse en acuerdos sin sustancia.

La recuperación de la actividad económica en Japón y Estados Unidos es un buen augurio para la economía mundial en 2004, y también lo es que se mantenga la fortaleza de China. Todas las crisis económicas tienen un final, y ya ha llegado el momento de que la economía estadounidense, que comenzó su desplome hace casi cuatro años, empiece a recuperarse. Podría haber empezado antes si el Gobierno de Bush hubiera defendido los recortes fiscales para los pobres y la clase media, y no para los ricos. Pero los recortes fueron de tal dimensión que, aun así, supusieron cierto estímulo. Sin embargo, el coste ha sido enorme: un déficit fiscal gigantesco que pone en peligro el crecimiento futuro.

Ese inmenso déficit fiscal tiene su equivalente en un enorme déficit comercial. El doble déficit ha afectado de forma muy negativa a la confianza de los extranjeros en la salud tradicional de la economía estadounidense y, por tanto, al valor exterior del dólar. Mientras el euro se mantenga fuerte respecto al dólar, el déficit comercial de Estados Unidos se aliviará, pero a costa de hacer que sea todavía más difícil una recuperación firme de Europa.

Por otro lado, cuando se confirme la recuperación, las grandes demandas en materia de préstamos de Estados Unidos y Europa harán, sin duda, que los tipos de interés crezcan en todo el mundo, y eso planteará nuevos problemas a los mercados emergentes, que se encontrarán, una vez más, con un nuevo caso de tener que pagar el precio de los errores estratégicos cometidos en los países industriales avanzados, un nuevo ejemplo de fracaso de la globalización.

165 Le nouvel ordre Internet

. JANVIER 2004

A Genève, durant trois jours, du 10 au 12 décembre 2003, s’est tenu le premier Sommet mondial sur la société de l’information, organisé, à la demande de l’ONU, par l’Union internationale des télécommunications (IUT). C’est un événement majeur (1). Comparable, en matière de technologies de la communication, par son ampleur, ses effets et ses enjeux, à ce que représenta, pour l’environnement, le Sommet de la Terre de Rio en 1992. Internet n’a atteint le grand public qu’il y a moins de dix ans... En si peu de temps, il a chamboulé des pans entiers de la vie politique, économique, sociale, culturelle, associative... Au point qu’on peut désormais parler, à propos de l’état de la communication dans le monde, d’un « nouvel ordre Internet ».

Rien n’est plus comme avant. L’accélération et la fiabilité des réseaux ont changé la manière de communiquer, d’étudier, d’acheter, de s’informer, de se distraire, de s’organiser, de se cultiver et de travailler d’une importante partie des habitants de la planète. Le courrier électronique et la consultation de la Toile placent l’ordinateur au centre d’un dispositif d’échanges (relayé par le nouveau téléphone à tout faire) qui bouleverse tous les secteurs d’activité.

Mais ce formidable chambardement profite surtout aux pays les plus avancés, déjà bénéficiaires des précédentes révolutions industrielles, et aggrave ce qu’on appelle la « fracture numérique », cet abîme qui se creuse entre les nantis en technologies de l’information et tous ceux, les plus nombreux, qui en sont dépourvus. Deux chiffres résument l’injustice : 19 % des habitants de la Terre représentent 91 % des utilisateurs d’Internet. Le fossé numérique redouble et accentue le traditionnel fossé Nord-Sud ainsi que l’inégalité entre riches et pauvres (rappelons que 20 % de la population des pays riches disposent de 85 % du revenu mondial). Si rien n’est fait, l’explosion des nouvelles technologies cybernétiques décrochera définitivement les habitants des pays les moins avancés, et en particulier ceux d’Afrique noire (à peine 1 % des utilisateurs d’Internet, dont très peu de femmes).

Ce problème ne peut laisser indifférents tous ceux qui veulent construire un monde moins inégal. Il a été au centre du sommet de Genève. Pour la première fois, et c’est un signe des transformations en cours, ce sommet de l’ONU associait, aux représentants des Etats, des chefs d’entreprise et des responsables d’organisations non gouvernementales (ONG). Cela n’a d’ailleurs pas bien fonctionné, ces dernières se plaignant d’avoir, en quelque sorte, été marginalisées et d’avoir largement servi d’alibi.

La déclaration finale (2) dissimule à peine l’échec sur les principales questions en débat. En premier lieu, le projet de créer un « fonds de solidarité numérique » n’a pu aboutir, les pays riches ayant refusé de s’engager financièrement. Le président du Sénégal, M. Abdoulaye Wade, qui défend depuis longtemps le principe de ce fonds, a proposé de contourner les Etats et a lancé l’idée d’une contribution volontaire de 1 euro sur l’achat de tout ordinateur dans le monde. D’autres suggèrent d’augmenter de 1centime d’euro chaque communication téléphonique, quelle que soit sa durée, pour favoriser la « cohésion numérique » de la planète.

Autre grand thème de préoccupation : le contrôle exercé sur Internet par de nombreux Etats autoritaires (dont la Chine) et, sous prétexte de lutte contre le terrorisme, le « flicage » de la vie privée des citoyens, via la surveillance de leur activité sur la Toile, dans beaucoup de pays démocratiques (dont les Etats-Unis). Là non plus, pas d’avancée. Au nom de la cyber-sécurité, les Etats n’ont fait aucune concession.

166 Troisième question capitale : le débat sur le mode de régulation et de gestion d’Internet. Pour l’heure, ce sont les Etats-Unis qui en ont la haute main (3). Toutefois, c’est devenu une affaire tellement importante, qui conditionne un nombre si grand de décisions dans toutes les sphères de la vie politique et économique, que Washington accepte d’en discuter. Mais seulement dans le cadre du G8, le consortium des huit puissances qui pilotent le monde...

Au départ, le sommet plaidait en faveur d’une gestion multilatérale d’Internet, transparente et démocratique, avec la pleine participation des gouvernements, du secteur privé et de la « société civile ». Et caressait l’idée, défendue par de nombreux Etats (mais aussi par l’inventeur du World Wide Web, le physicien britannique Tim Berners-Lee), d’en transférer la responsabilité à une instance spéciale des Nations unies. Washington a refusé net. Au prétexte que seule la gestion par le secteur privé garantit qu’Internet reste un outil de liberté...

Toutes ces questions reviendront sur le tapis lors de la seconde mi-temps du sommet, à Tunis, en novembre 2005. En attendant, ne faudrait-il pas lancer, tout de suite, un formidable plan Marshall technologique ?

IGNACIO RAMONET

167

TRIBUNA: PAUL KENNEDY El escándalo de la pobreza mundial

Paul Kennedy es titular de la cátedra Dilworth de Historia en la Universidad de Yale, y autor, entre otros libros, de Auge y caída de las grandes potencias. Traducción de María Luisa Rodríguez Tapia. , 2003.

EL PAÍS | Opinión - 23-01-2004

“Los consumidores, ávidos, vuelven por más", dicen los periódicos al informar sobre la orgía compradora en los centros comerciales de Estados Unidos, que continuó al empezar el nuevo año. Después de todos los regalos comprados en los días anteriores a la conmemoración del nacimiento de Cristo, volvieron a lanzarse a gastar, tentados por los inevitables anuncios de precios rebajados y ofertas especiales.

¿Y por qué no? La economía estadounidense se recupera, las bolsas de todo el mundo han subido, operadores y banqueros vuelven a recibir primas sustanciosas por su forma de colocar el dinero de otras personas, y las empresas de tarjetas de crédito ofrecen un trozo de plástico nuevo cada semana. Comamos, bebamos y seamos felices. Con los codos listos y afilados. Ha habido gente que ha muerto aplastada en la avalancha para entrar en los grandes almacenes esta temporada.

Sólo a un amargado como yo se le ocurre llamar la atención sobre un documento publicado por la Organización Mundial de la Salud una semana antes de Navidad. Es el Informe sobre la Salud Mundial que presenta todos los años el importante organismo de Naciones Unidas, con un mensaje dirigido a todos nosotros. Como es natural, sus palabras quedaron borradas en unos medios de comunicación obsesionados por el cine fantástico, la enfermedad de las vacas locas y las disputas entre los candidatos demócratas a la presidencia. No hubo más que unos pocos medios informativos -Reuters, The Christian Science Monitor- que tuvieran la decencia de prestar seria atención al informe.

El estremecedor mensaje de este informe es que la vida ha ido empeorando, año tras año, para los más pobres. Es cierto que la expectativa de vida ha aumentado sin cesar para los que tienen la fortuna de haber nacido en las sociedades ricas: las mujeres francesas, en la actualidad, tienen una expectativa de vida de 83,5 años, y los hombres australianos, de 77,9 años. También es cierto que ha mejorado en algunos países fundamentales, muy poblados, como China, Brasil y Egipto. No todo es malo, aunque unas sociedades cada vez más envejecidas crean toda una serie de problemas nuevos. Pero es evidente que es mucho mejor ser un pueblo viejo y rico que un pueblo joven y asolado por la enfermedad.

Veamos algunos de los datos que proporciona el informe anual. (Es más, ¿por qué no los pegamos en la puerta de la nevera?). En 14 países africanos, la mortalidad infantil es mayor hoy que en 1990. Sus poblaciones están cada vez más enfermas, a lo que contribuye el hecho de que son más pobres ahora que hace 30 años. En Sierra Leona, de cada 1.000 niños nacidos, más de 300 mueren antes de cumplir cinco años.

En el resumen que hace Reuters del informe de la ONU se lee esta lacónica frase: "Una niña que nazca hoy en Japón tiene una expectativa de vida de 85 años, mientras que otra nacida en Sierra

168 Leona, seguramente, no sobrevivirá más allá de los 36 años". Si este dato tan estremecedor no se nos atraganta es que hemos perdido cualquier sentido de la humanidad y la decencia.

¿Qué debemos hacer con respecto a esta aberración? He estado dándole vueltas a la cuestión del empobrecimiento mundial, no sólo en medio de los excesos consumistas navideños, sino durante décadas de leer la reacción que nos recomiendan los evangelios del Nuevo Testamento y las obras equivalentes en otras tradiciones religiosas y humanísticas. Y lo que más me desconcierta son los distintos mensajes, a menudo contradictorios, de Jesucristo.

Por un lado, Cristo nos enseña que, como no estamos durante mucho tiempo en esta tierra, el verdadero problema lo tienen los ricos: a quienes sufren pobreza y desnutrición se les acogerá en el seno de Abraham, mientras que para los potentados será tan difícil entrar en el cielo como para el camello del proverbio pasar por el ojo de la aguja. Lázaro recibe su recompensa, y el avaro ante cuya puerta yacía Lázaro es expulsado al infierno. ¿Qué solución puede haber más apropiada? La verdad es que, a lo mejor, tenemos que envidiar a los pobres.

Sin embargo, en otros sermones y parábolas de Cristo existe otro mensaje más amplio y persistente: por ejemplo, en las bienaventuranzas o la historia del buen samaritano. En ellos nos insta a socorrer a viudas y huérfanos (que hoy suman decenas de millones en una África arrasada por el sida), dejar en libertad a los que sufren prisión injusta y, sobre todo, ayudar a quienes viven en la pobreza. Para algunos, eso puede significar actos personales de servicio y voluntariado. Para la mayoría es la sugerencia de que, como el buen samaritano, nos rasquemos un poco más los bolsillos. Las transferencias de dinero no van a resolver por sí solas los desastres del mal gobierno y las violaciones de los derechos humanos que han destrozado países como Sierra Leona; pero Dios sabe que, sin la ayuda material, los países arrasados no tienen ninguna oportunidad de construir infraestructuras ni sistemas educativos y de salud. Predicar sobre el imperio de la ley a millones de etíopes hambrientos y, al mismo tiempo, negarse a darles ayuda es pura hipocresía.

Por consiguiente, tengo una propuesta para todos los que se han dado recientemente a las grandes compras: ¿por qué no tranquilizan un poco sus conciencias mediante "diezmos"? Un diezmo era la donación (el tributo) del 10% que se entregaba en concepto de alquiler de la tierra durante la época feudal, o a la Iglesia en la Edad Media, pero podría aplicarse a las sociedades de consumo actuales. Si uno se ha gastado 800 dólares en una nueva pantalla de televisión de gran tamaño, que dedique 80 dólares a la ayuda a los pobres del mundo; 50 dólares por una botella de buen vino significaría un "diezmo" de cinco dólares, y así sucesivamente. Cada uno puede escoger la organización que desee: Oxfam International, CAFOD (organización católica de ayuda al desarrollo), o la que le parezca que hace mejor labor y emplea de forma más adecuada el dinero en los países más pobres. Y no olvidemos que Unicef depende, sobre todo, de las aportaciones voluntarias.

¿Por qué no? Si uno puede permitirse un vídeo nuevo, seguro que puede rascarse un poco más el bolsillo y ayudar a disminuir el espanto de la pobreza mundial. Sería una resolución para el nuevo año mucho mejor que la de empezar la dieta Atkins. El diezmo -al menos para los que viven en Estados Unidos- es desgravable de los impuestos. Y quizá se sientan más a gusto consigo mismos la próxima vez que se monten en su monovolumen para ir de compras al centro comercial.

169 johnelkington.com Journal

Sunday, February 01, 2004

A WEF piece I wrote today. Edited version posted on: http://www.opendemocracy.net on 5 February.

'IT'S THE SYSTEM, STUPID!'

Former Presidents Bill Clinton and Jose Maria Figuieres (©WEF)

Even when jet-lagged, Bill Clinton knows how to hold Davos Man and Woman in the palm of his hand. Count me more or less in their number. Kicking off this year’s World Economic Forum (www.weforum.org) on 21 January, he used language which was to resonate through the rest of that high-octane, high testosterone week. Nothing new there: Google the phrase ‘It’s the Economy, Stupid!’ - the 1992 Clinton-Gore campaign slogan - and you’ll find its echoes everywhere. But now, it seems, Clinton’s implicit message when on the broad range of economic, social and environmental challenges we face is, ‘It’s the System, Stupid!’

Instead of making flying visits to people like the Grameen Bank’s Muhammad Yunus, he suggested, we should bring Yunus – and folk like the property-rights-for-the-poor campaigner Hernando de Soto – in from the cold. Mainstream them. No doubt some corporate bottoms shifted uneasily in their seats at this call for some sort of Third Way revolution, but what exactly was Clinton prescribing, exactly? Sadly, at least in my memory, he was long on concept and short on detail.

170 He was, he said, all for systematic change, but the scale of the challenges we now face requires systemic change. Well, fine, and no doubt he would have won nods from many of those across the road at the ‘Public Eye on Davos’ (www.evb.ch) and, indeed, at the anti-WEF World Social Forum, held this year in Mumbai, India (www.wsfindia.org). But most of these people, I suspect, would have soon parted company with the Davos crowd – even with Clinton - in terms of how much, how far, how fast and at whose expense.

Thinking back, though, it strikes me that it would be easy to over-dramatise the chasm between Davos and Mumbai. The divides are there, of course, but, willingly or not, both sides are in the process of adjusting their mindsets. In fact, this was the third time I had attended the World Economic Forum’s annual summit and I was forcefully struck by just how far both the nature and content of the debate have shifted over the past three years.

At WEF, many once forceful globalizers are now off balance, some even taking part in sessions on corporate social responsibility and sustainable development. It’s not yet a question of ‘Globalizers Anonymous’, but the agenda is a lot more nuanced than it was just a few years back. And, for the most part still in a parallel universe, a growing number of former anti- globalizers are trying on labels like alter-mondialiste and talking in terms of ‘responsible globalisation’.

Several swallows never did make a summer, but the basis for some form of convergence is clearly there. That really wasn’t the case a few years back. The first time I got the call, in 2002, the WEF event was held in New York, in the wake of the 9/11 attacks. The following year, 2003, most of the caravan returned happily to snowy Davos, in Switzerland. This time, though, there were bitter recriminations between America and its allies - who were actively planning for war and those who opposed invasion, with or without UN sanction. One of the sessions I remember best was the one where General Wesley Clark pointed energetically to places on the map of Iraq where the coalition forces expected to be attacked with anthrax and other weapons of mass destruction.

What a difference twelve months can make. This year, by contrast, US Vice-President Dick Cheney was in conciliatory mood. And my overall impression, while British Foreign Secretary Jack Straw drew no cheers for his lacklustre defence of the Iraqi venture, was that most participants were much more interested in what would happen to the US recovery and to the dollar. Most seemed to have little appetite for major changes in the economic architecture.

And something else had changed too, it seemed to me. Looking back, 2002 saw the WEF summit in New York invaded by a fairly considerable number of NGOs and fellow travellers, myself included. The trend evolved further in 2003. On both occasions, demonstrations in the streets outside helped keep the political pot bubbling. You could almost feel the steam percolating up through the floorboards into some of the sessions. This year, by contrast, the security forces choked off most of the protests in and around Davos, and – whether it was a related trend or not – the NGO voices seemed muted.

Behind the scenes, true, there were clashes between WEF officials and some NGOs on the best ways forward. Afterwards, the head of one highly reputable NGO told me that he – they - would not be coming back. I could understand the frustration. A couple of the parallel sessions I attended were surprisingly glib and ill-informed, although in my experience they were the exception. While you hear some of their research partners seethe that the relationship with WEF

171 is pretty one sided, with the Forum claiming most of the credits, it has positioned itself as the most coherent global platform for integrated debate in this area. When I challenged WEF co-CEO Jose Maria Figuieres, a former president of Costa Rica, on the issue of whether the Forum would ever take a stand position on a major policy issue, he stressed that it is essentially neutral in what it does. But, however you judge that claim, it really is leaning into the debate a bit more these days.

This year, for example, the WEF Global Governance Initiative launched its first annual report . And it is surprisingly critical of current efforts to tackle the priority issues identified at the 2000 UN Millennium Summit, in the form of the Millennium Development Goals. Scoring each of seven areas of activity out of a maximum of 10 for 2003, WEF set the numbers such that a ‘0’ means retrogression, whereas a ‘10’ means that “the world – that is, national governments, businesses, civil society and international organizations taken together - essentially did everything needed to be on track to reach the goals.”

The report came up with the following results: peace and security (3), poverty (4), hunger (3), education (3), health (4), environment (3) and human rights (3). Reading the numbers, it struck me that the world really deserves a school report I got some time late in the 1950s: “Sets himself low standards and consistently fails to achieve them.”

Whatever you think of WEF, this is an important contribution. Nor is this the only initiative WEF is helping drive forward in this area. Indeed, one of the reasons the NGOs probably seemed a bit muted to me this year was that the voices of the social entrepreneurs in Davos had been wound up several notches. Convened by the Schwab Foundation (www.schwabfound.org), also founded by WEF founder Klaus Schwab and his wife Hilde, the entrepreneurs came together for the first time at the WEF summit in New York. After a slightly wobbly start, more of them hit the ground running in Davos in 2003 and most really got into their stride this year.

Most social entrepreneurs today are unknown to the general public. Some, like Muhammad Yunus or Bunker Roy of the Barefoot College, may be well known to Bill Clinton and be covered fairly regularly in the international media, but for most of us most of what they do tends to disappear into the background noise. Nor are they guaranteed to succeed. Many of them will fail, some more than once. Such is the life of entrepreneurs, perhaps even more so of social entrepreneurs. But these people have the potential to transform the way in which hundreds of millions of people live, learn and work.

A huge and growing variety of social entrepreneurs are tackling such issues as environmental protection, family planning, the empowerment of women, fair trade, food security, the homeless, HIV/AIDS orphans and youth development. Where markets fail, as they do in relation to many of these issues, social entrepreneurs are working on leapfrog thinking, technology and business models to do the previously undoable. They are not primarily motivated by profit – although many are more than happy to make a profit.

In short, the phrase ‘The impossible takes a little longer’ could have been coined for them. It has been my great good fortune to be in the passenger seat as they began their WEF breakthrough. In 2002, I sat in on the first WEF social entrepreneur session in New York. In 2003, I facilitated the first Davos social entrepreneurs session. And this year, with Pamela Hartigan, who runs the Schwab Foundation, I had the extraordinary privilege of interviewing 15 or so social entrepreneurs for a book we are planning. That’s around a quarter of the Schwab Foundation’s current network - and I emerged supercharged.

172

No wonder Clinton name-checks these people in his speeches. Both he and UN Secretary- General Kofi Annan have every excuse for pleading exhaustion in the wake of their continuous efforts to get these issues onto the political agenda. But an hour with any of these entrepreneurs is like the shot of monkey gland extract that some rich people apparently used to come to Switzerland for. (And, who knows, perhaps some of the Davos crowd still do?)

Whatever, the real question right now is how we can initiate the necessary top-down changes to the market system to help social entrepreneurs bring their bottom-up activities to scale. Maybe it will help if we adopt the ‘It’s the System, Stupid!’ mantra, even sticking it on our fridge doors. But we can all be sure of one thing: only if we are prepared to throw our collective weight behind these extraordinary pioneers can we hope to see evidence of real progress in future Global Governance Initiative scorecards.

http://www.opendemocracy.net/debates/article.jsp?id=6&debateId=28&articleId=1698# From the magic mountain: the World Economic Forum Simon Zadek 29 - 1 - 2004

The annual Davos conference pulsates with brilliant people. Why do so many of their fine ideas dissolve with the winter snow? Simon Zadek, an insider-outsider with attitude, sends a passionate daily diary from the high-altitude conference.

Wednesday 21 January, morning

The countdown

As I edge towards the world’s most elite event, the annual World Economic Forum (WEF) in Davos, I am in low spirits.

It is not the 6am start, the insipid airport coffee, nor even the bright orange, cramped aircraft seats on the Easyjet flight from London’s Gatwick to Zurich. Truth be told, the cause of my depression is the memory of my time at Davos last year listening to the innermost thoughts of the world’s most powerful business people and politicians.

No insult is intended to my conference colleagues. Some of the characters at Davos are amazing; they have achieved incredible things on the back of innovation, energy and vision. The rest? Well, they are in the main average, god-fearing family types who got where they are by being in the right place with the right face – or else by being media- and market-friendly. Almost none of them have horns.

173 And me: how do I fit into this picture? Well, I am one of the Shakespearean “fools”, invited to amuse, surprise and, within moderation, attack, the gathered throng: an insider-outsider with attitude – yet reasonable manners.

So why the depressive bit about last year? Well, the 2003 event was held just before the invasion of Iraq. This coincidence of timing had its highlights; one of them came unexpectedly at the start of a plenary address by the all-too-sincere Colin Powell, when the tradition of offering a standing applause to Great Dignitaries even before they say anything was trashed by no less than 500 non-US participants (a quarter of the total attendees) who made an extraordinary stand against the war by remaining seated and silent whilst the US delegates rose to welcome their own.

But as vivid is the memory of the United States-sponsored swat team – mandated to convince the great and good of the virtues of Bush’s Middle East venture – which swept the location. This advance force proved far more effective than their rival would-be invaders – the civil activists mobilising outside the gate, who succeeded only in adding a perverse form of credibility to the whole event through the cachet-effect of their spectacle.

Wandering off-campus, beyond the ring of steel and firepower surrounding Davos, I joined the alternative People’s Summit in time to hear some of its speakers, as well as debate between feisty social activists and organisations. I confess that it felt much like a throwback to the very early days of The Other Economic Summit (TOES), the antecedent of many of today’s alternative events. Good spirits, centred ethics, and vibrant energy, combined with testimonies from grassroots activists and the more orderly policy-wonkers.

The fact of the World Social Forum (WSF) had somewhat taken the edge from this dissident event, but in other ways made its local aspects all the more enjoyable. Here, I visited WEF’s own version of “village debates”, where dignitaries from the main event spoke in front of the residents of Davos and its environs, along with an assortment of lost souls like me taking a break from the often stifling intensity of the main game. Sadly, this experiment still needed some adjustment, as the opportunity to “educate the people” reduced most of the speakers to something akin to didactic, Victorian-era poorhouse teachers.

On the eve of Davos 2004, all this remains with me. But in the end, my real downer from last year was to do with substance. Attending several sessions on terrorism and security, it quickly became clear that the days of the “liberal mind” were seen as being numbered. “We are here to help You, since You cannot cope with the emerging situation” was the line of the day. Fifty years of liberal democracy had neutralised the citizenry’s ability to think, it seemed.

Tomorrow we get going. More then.

Thursday 22 January, morning

Orgiastic inspiration

Night falls, and hundreds of weary figures dressed in “business casual” can be seen scattered along the snow-decked Davos streets, dragging themselves back to their hotel beds.

174 After only a day, participants in the World Economic Forum are already showing signs of that new millennium disease: stakeholder over-dialogue syndrome (SOS). It takes serious stamina to cope with the sheer volume of ideas, dilemmas and solutions being pumped through the e- wired congress building housing the rump of the conference.

Davos is a giant sandwich. The bulky bread is the hundreds of sessions; the real meat inside is the thousands of one-on-one meetings between the leading players. On the first day, I was a carnivore.

I ate my fill in meetings with Maritta Koch-Weser, until recently head of Earth3000, who walked me through progress made on the revitalised social investment initiative, GEXSI; Kumi Naidoo, executive director of Civicus, who briefed me on his participation in Kofi Annan’s Eminent Persons Panel on the UN’s relations with civil society, for which I am preparing a paper on ‘partnerships and the UN’; Adele Simmons, ex-president of the MacArthur Foundation and now chair of the US-based Fair Labor Association, who brought me up to date on the FLA’s recent successes and ambitions; Augusto Lopez, the director of WEF’s Global Competitiveness programme, talked through possible links with AccountAbility’s recently published Responsible Competitiveness Index that maps the relationship between national competitiveness and corporate responsibility; and Ed Mayo, who runs the National Consumer Council, explained his work in the UK looking at public policy responses to the pensions crisis.

You get the idea. Davos is pulsating with inspirational people and ideas. The whole thing is an orgy of initiative.

Meanwhile the set-piece WEF machinery produced piles of bread. Bill Clinton, a Davos regular, gave the equivalent of a “state of the nation” address. Looking decidedly tired, he entreated the gathered dignitaries to move beyond good initiatives and upgrade their endeavours. He extolled Ernesto Zedillo for ridding Mexico of its one-party state, and celebrated Hernando de Soto as the ‘greatest living economist’ for his work on bringing poor people’s assets into the global market to enable them to raise credit.

Clinton went on to argue that we should appreciate the important critique of the anti- globalisers, whilst recognising that their solution was utterly wrong. He described – with apparent surprise – his difficulties in raising money for health initiatives in developing countries. He warned that his success in bringing down the prices of drugs for HIV/Aids still left them too high for poor people – even if the delivery infrastructure was there, which it clearly isn’t.

His curiously repetitive use of the term ‘systematise’ seemed to be a coded suggestion for taking money from the rich and giving it to the poor, perhaps with an intended dose of structured accountability. All sturdy stuff. One only wondered why Clinton didn’t think of all this, or better still do something about it, when he was still ‘leader of the free world’.

Many participants at Davos spend their evenings at pre-planned dinners with speakers and managed dialogue. I had wanted to go to one on the role of memory in social change, but I was committed to being a speaker elsewhere. There were many options: the tribulations of Argentina, new directions for Georgia, putting a price on health, or even “If you’re happy and you know about it”.

My session was entitled, believe it or not, “Do grassroots organisations need to be ring-

175 fenced?” I had hoped that the American Enterprise Institute might show, and spice up the evening with a gentle rant about how NGOs were stripping us all of our basic right to commercialise. But it was not to be. We were a very moderate crowd, with the likes of Denis Caillaux from Care International; Jeroo Billimoria from the Child Helpline International and the Credibility Alliance; Ernst Ligteringen, CEO of the Global Reporting Initiative; and Mark Moody-Stuart, chair of Anglo-American.

We joined in bemoaning the civil accountability gap, and found common cause in wanting to make sure that NGOs did the right thing for the right reasons, before they were made to do it for the wrong ones.

Tottering out of the dinner at 11pm, I too was one of those night stragglers on the chilly Davos roads, reeling towards my bed after a straight 15 hours’ dialogue. A willing victim of SOS, I fell into a dreamy sleep, building energy for the conversations to come.

Friday 23 January, morning

Words and deeds

Breakfast in Davos: coffee, croissants and globalisation. Social entrepreneurs, business and religious leaders; mix together one part Brooklyn labour activist, one part Russian Chief Rabbi, a senior partner from PricewaterhouseCoopers and a sprinkling of blog entrepreneurs – an extraordinary cross-gathering. Then stand back to enjoy the show.

“It’s OK to be rich,” concludes one tableful. “Consider it a gift from heaven. The challenge is to do something good with it.” “We need to get real,” asserts another. “The challenge is not ‘to include’ the poor…they already have real lives, and real economies. They do not want to be included, just not to be poor.” “Check out my blogs,” suggests a third – waving protocol to remind people that this was, after all, 2004, and no self-respecting leader should be without one.

Breakfast over, we turn to the main show. Brief stopover in the congress hall as Arab leaders debate the possibility of an ‘Arab renaissance’. The opening presentation by an American academic highlights the ‘curse of oil’ inflicted on those who have it, one that creates unequal, rentier societies. Thereafter oil fades gently out of the discussion, and actually is not mentioned by a single presenter for the following hour. The problem, a business leader pronounces, is the region’s loss of competitiveness.

Solutions come thick and thin, but all look remarkably similar – get competitive and enter the global markets. But the political challenge does eventually hit the table, as an instant participant voting system signals that political reform is the heart of the issue. After all, challenges one questioner from the floor, what about democratic reform and the gender rights deficit? The suited, all-male panel is unanimous and unambiguous in stating its commitment to political reform.

In its way this is a strong message from a powerful group of people that includes Gamal Mubarak, head of policy in Egypt (and the president’s son), and the Crown Prince of Bahrain.

176 It makes you wonder...I guess it must be complicated to actually do something.

Snuggled in the back of one of the many shuttle buses moving people between events sprawled across a network of hotels throughout Davos, the gentleman next to me reflects on whether the event is useful. “In 1999, after listening to the dot.com leaders here,” he reflects, “I decided to take my company public. Six months later I sold 10% of my stock. It went up 100% in value in the first day and I became a billionaire overnight. Four months later the bubble popped and I lost exactly the same amount.” Did it make any difference to your life, I enquired. “Oh yes,” he laughed, “my wife and I did a load of shopping between the two dates.”

Lunch is a private event about water, or more specifically the conditions under which privatisation of water management can and should proceed across the world. A code has been drafted under the auspices of the World Economic Forum, and a distinguished group has been assembled to comment.

“Seems somewhat market-focused,” I suggest politely, pointing to the code’s focus on a decent financial return to investment, and an explicit rejection of subsidies linked to a statement that “consumers need to understand the real cost of water”.

“What about a rights-based approach,” I proffer as an innocent alternative, pointing out how this can be consistent with reasonable economic returns. The cat is out of the bag.

The debate heats up as Mary Robinson and others weigh in with powerful arguments linking UN conventions and an eco-system perspective just to complete the picture. The Swiss code- design team listen intently, nodding enthusiastically in response to the probing comments, scribbling furiously, but no doubt wondering how on earth to square these demands with the need to bring water companies to the table.

I am invited to an evening reception at Davos’s Kirchner Museum, hosted by the Canadian government. “How is it,” says one of De Beers’ young Oppenheimers, “that NGOs in the know say we are the heartland of all that is right about the diamond industry, whilst others continue to abuse us in the press?”

I cluck politely, suggesting the analogy that if your beloved partner has betrayed you consistently for 25 years, it might take more than a week in the same bed to build back the trust needed for a meaningful relationship. That does not go down well.

Over canapés, we run into some characters who have come from an NGO-WEF advisory group where the hot topic has been WEF’s decision not to invite Oxfam to Davos this year. “A matter of rotation”, claims WEF, pointing to the bulging sessions and the town’s over-patronised, over-priced hotels. “A political decision”, retort some, with Oxfam excluded “because of their hard-arse anti-corporate campaigning tactics”.

“What is to be done?” I inquire casually, squinting out over the top of my wine glass at the small group of assembled NGO-ites. A bit of this and a bit of that, I eventually gather, from the assorted responses – but essentially not much at all. Civil solidarity is a solitary beast. I wonder who will be excluded next year?

The road to hell is paved with good intentions, we are told. I suspect that Groucho Marx might have responded that if only the opposite were equally true, that the road to heaven was paved

177 with bad intentions, the world would be a far better place.

Saturday 24 January, afternoon

Davos hots up in the cold

Early morning in the congress hall, and Kofi Annan takes us through our paces on the nature of globalisation and the role of business in development. I am impressed by his ability to blend a deeply disturbing view of the world with a motivating optimism and lightness of soul. Like Bill Clinton, however, one senses a deep weariness in him; it has been a particularly hard couple of years for those at the top who care.

“Does corporate responsibility pay?” is the title of a session that I am opening today. “Maybe, sometimes, but not enough to make a real difference,” I begin – before edging my way cautiously from a celebration of leadership of progressive companies towards the need for public policy interventions to ensure that markets reward business for doing good.

An editor from the Economist wades in, reiterating the publication’s long-standing editorial position that corporate responsibility is either a misnomer for good management; a case of mistaken identity; or rank irresponsibility on the part of managers – essentially vanity-spend of someone else’s money.

Curiously, business leaders at the session were at one in resisting what one alluded to dismissively as “old-style, classical economics”. There was a time when the Economist led the march from the right. Today, it is a weird (although still highly profitable) anachronism, campaigning for a style of business that makes neither money nor sense.

It is Friday, and I have been invited to a Shabbat dinner hosted by the Israeli government. I go with a mix of trepidation and fascination. 100 people celebrate the intended moment of peace, what is meant to be a return to the spirit and family. Around the room are ex-prime ministers and Nobel laureates. One of them rises. Softly and with nuance, he offers words laced with optimism and humour. Then the punchline: “it’s all a matter of demography...60 of them are born for every 40 of us. There is very little time. We must act.” Quietly, I leave the room.

Weekend blues as Dick Cheney takes the stage. It is, I am told, only the second time he has left United States shores since taking up his post in the current administration. There is cause to be optimistic, he asserts, citing his sense of the growing democratisation of the Middle East. Another pointless conversation, as believers applaud the happy words while most of us wonder for the future of our children.

On Saturday afternoon, I sit in on a panel discussing the future of the trade round. Fascinating stuff, as a series of global business leaders call for the abandonment of $318 billion of annual agricultural subsidies.

The sense of the meeting is that the Cancun summit failed because it was tuned to fail from the start. In the last trade round, the US and Europe won, and everyone else lost. This time, the ‘others’ – like the G21 group of developing countries – are not willing to see the same result. The US needs to recognise that there are other partners, not ‘others’. Are we seeing a real

178 development round in the making, or more a fear of the collapse of the round – with untold cost to the more dynamic and powerful parts of the business community?

Sunday 25 January, evening

The bottom line

What did I do at the World Economic Forum in Davos this year? After spending a week with the world’s most powerful people, I conclude that the high point was dancing to Hugh Masekela’s uplifting South African music.

What is so astonishing about Davos is that it brought together the best brains and hearts of the world’s business, political and spiritual leaders, covered every conceivable topic under the sun – and yet managed to avoid serious, open debate about what is really happening in the world.

There was no real debate about how today’s American Dream has established an essentially colonial and destructive attitude towards the rest of us; no real debate about the extraordinary loss of civil rights that comes with this new discipline; and no real debate about the utterly cynical behaviour of many business leaders towards their shareholders, let alone workers and communities.

There was, moreover, no real debate about how our leaders show neither remorse nor shame as they defy their citizens and the laws of the land in taking for themselves, and leading their countries (against the clearly-voiced interests of their citizens) to war against others, and ultimately against themselves.

Dick Cheney’s speech spelt it out in words of one syllable. We do it our way, when we want, and how we want. You do it with us, or you are alone, at best. At worst, by abandoning us and making us seem visibly illegitimate, you will earn the status of Enemy – not of al-Qaida, or Saddam, or the evil axis of North Korea or Iran, but of ‘Us’, the United States.

There is only one big difference between last year’s and this year’s Davos. In 2003, people were so shocked with world events that they couldn’t help but show their concerns, their anger towards the US, and their fury towards the corruption within their midst. A year later, the facial muscles and itchy voice-boxes are back under control. The assembled are largely mute, polite, accepting. Even edgy questions are ritualised in how they are asked, and are assured of mildly irrelevant responses. Corridor conversations illuminate the fact that this silence is not born out of lack of information, thoughtfulness, or ethics. But these more noble traits are swept tidily behind masks of pragmatism. Worse still, they are submerged by people’s passivity towards what they know is morally unacceptable and ultimately destructive behaviour from within their ranks.

There are, of course, voices of discontent. Most audible is probably Kofi Annan, conflicted and compromised by and within the UN, but nevertheless softly and clearly amplifying the limits to what is acceptable, and the simple fact of unacceptability. One applauds the leadership shown by Brazil’s President Lula in trade, access to health care and other debates. There are also heartening individual acts of political heroism – from politicians as they resign their briefs in disgust, and professionals as they voice their unwillingness to be associated with barefaced

179 distortions of the truth.

But civil society, in truth, remains largely absent from the conversation in Davos. NGOs are at the table, but seem to have been put into specialised roles, dealing the ‘minor keys’ that do make a difference but in no way challenge the underlying game-plan. What on earth has happened to our civil champions, sparkling but nevertheless unfocused and divided in Mumbai, and silent in Davos?

So take note, Hugh Masekela. The sounds of your trumpet go to the soul, but your words of liberation are sadly out of step with the times. An independent South Africa may indeed be celebrating its 10th birthday, and for this I am happy for you, and us. But your country is growing up in a troubled world, one that has seemingly lost interest in the principles of radical democracy and the freedom of spirit out of which your country’s independence came.

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Comisión 'versus' Ecofin: consecuencias jurídicas y políticas

ANTONIO ESTELLA

EL PAIS | Economía Martes, 3 de febrero de 2004, actualizado a las 13:02

El autor analiza las razones que han movido a la Comisión a recurrir contra el Ecofin por el incumplimiento del Pacto de Estabilidad, y asegura que esos recursos forman parte del juego institucional. A su juicio, ello ayudará a clarificar puntos del citado acuerdo y servirá para una reforma futura.

A pesar de su nombre, el Pacto de Estabilidad es mucho más que un simple pacto político. Efectivamente, el Pacto está compuesto, fundamentalmente, por una resolución del Consejo Europeo, de 17 de junio de 1997, cuya naturaleza jurídica es dudosa, pero también por dos reglamentos del Consejo de la Unión Europea (1466/97 y 1467/97) que, sin duda alguna, constituyen derecho en el sentido más pleno y amplio del término: es decir, vinculan jurídicamente a sus destinatarios, en este caso, los Estados miembros. El "marco" en el que los Estados miembros se mueven a la hora de desarrollar sus políticas sobre déficit excesivos es, pues, un marco claramente jurídico, además de comunitario, lo que significa que los países que forman parte del euro no pueden saltarse a la torera lo que dicen los reglamentos antes señalados ni, por supuesto, lo que dispone el TCE (fundamentalmente, su artículo 104) sobre esta materia; hay que recordar, además, que este último también es derecho, y de rango constitucional, según ha establecido el Tribunal de Justicia en innumerables ocasiones.

Una vez clarificado este punto, sobre el que existe mucha confusión, incluso entre los analistas, podemos pasar a examinar brevemente qué es lo que ha movido a la Comisión Europea a interponer el recurso contra el Ecofin. Mediante una serie de decisiones, el Ecofin constató en 2003 que tanto Francia como Alemania habían incurrido en déficit excesivos, violando lo establecido en el TCE y en el propio Pacto de Estabilidad. En estos casos, el procedimiento previsto en las normas anteriores es el siguiente: si el déficit excesivo persiste, el artículo 104.9º del TCE señala que el Consejo "podrá decidir" que se formule una advertencia al Estado miembro en cuestión para que adopte las medidas oportunas para la corrección del déficit, lo que puede desembocar en la imposición de cuantiosas multas. Pues bien, esencialmente, lo que ha ocurrido en este asunto es que el Ecofin decidió, en una reunión de 25 de noviembre de 2003, "congelar" el desarrollo de este procedimiento, es decir, no formular ninguna advertencia ni a Francia ni a Alemania sobre la necesidad de poner fin a la situación de déficit, a pesar de que la Comisión recomendó que así se hiciera. El recurso que ha interpuesto la Comisión va dirigido justamente a la anulación de esta decisión de "congelación" ("suspensión", es la palabra que el Ecofin emplea exactamente) del procedimiento en caso de déficit excesivo.

Los economistas nos enseñan que solamente se deben hacer predicciones sobre el pasado, y con limitaciones. Esta máxima es de perfecta aplicación al mundo del derecho, por lo que no voy a aventurar aquí cuál va a ser la reacción del Tribunal de Justicia ante la demanda formulada por la Comisión. Solamente señalaré a este respecto que el texto del TCE establece, como he indicado antes, que el Ecofin "podrá decidir" la formulación de una advertencia al Estado deficitario, con lo que parece que estamos ante un acto discrecional y no reglado, es decir: el Ecofin no está obligado a formular dicha advertencia, sino que puede hacerlo si existe una mayoría suficiente en

181 su seno para ello. Independientemente de esta observación, lo que sí podemos hacer es simular los escenarios que se pueden dar a partir de ahora, es decir, una vez interpuesto el recurso. Dichos escenarios son dos: que el Tribunal de Justicia anule la decisión del Ecofin, o que no la anule. Como digo, existen bastantes motivos para pensar que lo que ocurrirá será lo segundo y no lo primero; en cualquier caso, si el Tribunal de Justicia decidiera anular, podrían pasar dos cosas: que anulara la decisión del Ecofin solamente con efectos pro futuro (es decir, a contar desde la fecha de emisión de la sentencia), o que lo hiciera con efectos retroactivos. Si ocurre lo primero, todo dependerá de la situación a la que se haya llegado cuando la sentencia se dicte, pero lo más probable es que, en ese momento, nos encontremos en una circunstancia en la que una sentencia anulatoria con efectos prospectivos tenga escasa eficacia práctica. Sin embargo, la segunda opción es que el Tribunal de Justicia acuerde efecto retroactivo a su sentencia anulatoria. Esto significaría, en términos jurídicos, que el acto del Ecofin se expulsaría del ordenamiento jurídico en el sentido más pleno de esta expresión: es como si el acto anulado nunca se hubiera adoptado. En este caso, entiendo que el procedimiento se debería retomar desde el punto a partir del cual se anuló, lo que podría desembocar en la imposición de la multa a la que me he referido más arriba (incluso aunque la situación de déficit excesivo ya se hubiera corregido en el momento en que se dictara la sentencia). Por otro lado, si se diera el escenario que considero más probable (la no anulación de la decisión del Ecofin), es evidente que todo quedaría como está ahora, aunque sin duda alguna, incluso en este caso, la sentencia del Tribunal de Justicia incluiría importantes elementos aclaratorios que serían de gran utilidad para evitar que contiendas institucionales de estas características se reproduzcan en el futuro.

¿Cuáles serán las consecuencias políticas del recurso de la Comisión? Lo primero que hay que decir a este respecto es que no debemos rasgarnos las vestiduras ante acciones de este tipo: aunque tienen menos repercusión mediática, la Comisión interpone recursos contra el Consejo con relativa frecuencia. Ello forma parte del juego institucional comunitario y nadie lo ve ni con asombro ni con especial preocupación. El recurso de la Comisión es, además, fundamental, porque ayudará a clarificar el sentido de muchos de los "pasos" procedimentales que se establecen en el Pacto de Estabilidad y que no están, a fecha de hoy, suficientemente claros para las instituciones comunitarias. Y, probablemente, dicha aclaración podrá servir de base para modificar, en el futuro, el Pacto de Estabilidad, con el objeto de hacerlo más preciso y riguroso. Aunque existe cierta base para fundamentar en derecho el recurso interpuesto por la Comisión, el problema del Pacto de Estabilidad, y, concretamente, del procedimiento por déficit excesivo, es que el mismo está formulado de una manera tan ambigua que casi todo cabe en él. Si el resultado final de este juego entre la Comisión Europea y el Ecofin es la reforma del Pacto de Estabilidad en aras de su mayor claridad, todos habremos ganado con el recurso de la Comisión: las instituciones comunitarias y, sobre todo, los ciudadanos europeos.

182 Financial integration: Where do we stand?

Speech by Jean-Claude Trichet, President of the European Central Bank, Paris, 3 December 2003

Introduction

Ladies and gentlemen, Pascal described the universe as "a circle whose centre is everywhere and whose circumference is nowhere". This definition can be applied fairly well to euro capital markets, which are global markets as a result of the international use of the euro. As such, they are not grouped around one financial centre alone, or even a single main financial centre, but around a constellation of financial centres spread over the euro area and beyond. Paris is naturally one such centre and I must say that I am delighted to be back here for the first time since my appointment as President of the European Central Bank for this inaugural forum on euro interest rate markets. Although the decentralisation of euro markets is a reality, their segmentation should obviously not be seen as a foregone conclusion. On the contrary, with decentralisation the need to integrate different markets and different financial centres becomes even more pressing, and only through such integration can the single market be a reality. The ECB's and the Eurosystem's interest in the process of financial integration

Therefore, we at the European Central Bank and in the Eurosystem attach great importance to pursuing the process of financial integration in Europe. The main reason why we are so interested in this is because the financial system evidently plays an essential role in the transmission of monetary policy. From this point of view, an efficient and broadly integrated capital market ensures that monetary policy is implemented consistently and effectively. This holds true for the whole financial system, but especially for markets which are directly involved in the conduct of our monetary policy operations: the money market, of course, but also the bond market, since the vast majority of eligible assets which act as collateral in our credit operations are from this market. A high level of financial integration is also desirable in view of our other key tasks, such as promoting the smooth functioning of payment systems or contributing to the maintenance of financial stability. But perhaps the most profound and significant reason for our attachment to pursuing the integration process is that it could raise the non-inflationary growth potential of our economy. This causal relationship is instinctive in that as integration increases, there is a more effective allocation of savings to the most profitable investment plans, while frictions and transaction costs are minimised. In addition to this intuition, the impact of financial integration on the growth potential is now solidly supported by a considerable number of theoretical and empirical studies. And finally, I do not really need to remind you that, in the more general context of the single market, financial integration is the objective of specific European policies that have been prioritised by the European Council. In this context, and in accordance with the obligations assigned to us by the Treaty, it behoves us to support these policies.

183 State of play

Given this background, I should now like to go back to the subject of my speech today by looking at "where we stand". As is always the case, there can be two different viewpoints. The first, which was dominant in the first couple of years following the introduction of the euro, was to highlight the considerable distance we have covered so far. The example most often given is the almost immediate integration of the money market – concerning both the interbank market and the derivatives market – at the beginning of 1999. The remarkable development of the bond market, excluding government securities, is also a result of this integration. Throughout 2002, bond issues from the private sector represented approximately half of all issues, whereas before the introduction of the euro the market was dominated entirely by public issues. Moreover, the beneficial effects of integration have also been felt in the government securities market. If further proof were needed, I could mention the standardisation of issuance methods or even the development of common trading platforms across the euro area. The development of the different components of the MTS group, including of course the EuroMTS platform, is perhaps the best example of this. Furthermore, integration is continuing to advance in areas where it appeared to have been delayed slightly, such as the repo market. Evidence of this progress can be seen in the creation of the EUREPO benchmark index, or in the development of a standardised legal document known as the "European Master Agreement" (EMA). A more pessimistic viewpoint is to highlight the inadequacy, and in particular the apparent slowdown, of the process of financial integration over the past few years. In this regard, we could highlight the level of residual fragmentation of delivery-versus-payment securities settlement systems. In spite of the many consolidation efforts, there are still 20 or so national delivery- versus-payment systems in the European Union today, and roughly as many in the acceding countries set to join the EU next spring. This is not normal. Therefore, the process of integration is already quite remarkable, despite the fact that it is incomplete. However, there are two reasons why, in my view, it would be wrong to interpret this situation pessimistically. First, it should be remembered that the period in which the easiest progress was made in terms of integration naturally came immediately after the changeover to the euro in 1999. As is reasonably logical to expect, what remains to be done is what is most difficult, though not impossible. But, more importantly, as Saint-John Perse once famously wrote, "pessimism is not only a sin against nature, but an error of judgement as much as a desertion" (From "Sur l'optimisme en politique", an article which appeared in the Excelsior journal, 27 February 1935). We should not look at the inadequacy of the process of financial integration, but rather understand the causes of this inadequacy and identify means to remedy it. Two lessons arise from the road travelled so far. The first is that integration can only be achieved if the barriers to cross-border financial activities are effectively abolished. This is the objective set by lawmakers in the Financial Services Action Plan (FSAP), launched by the European Commission in the spring of 1999. 36 of the 42 original measures proposed by the FSAP have now been adopted, and it is reasonable to expect the remaining measures to be adopted before the European parliamentary elections next spring. This is a major undertaking, the importance of which cannot be emphasised strongly enough. The second lesson is that a legislative framework in itself is not sufficient to achieve an effective integration of the market. What this framework produces is a potential. It is then up to the

184 different players involved, whether public or private, to exploit this potential. This is what has been done so far in many domains, and it would be advisable to carry on in this way. With the finalisation of the FSAP, it seems to me that we have therefore reached a key moment in the integration of the European financial system. We have a body of legislation which is coherent and relatively comprehensive at European level. It is quite possible that there will be a need for supplementary legislation in the future. But what should retain people's attention and focus people's energies in the short term is undoubtedly the translation of the measures that have been adopted into realities, as well as the exploitation of the opportunities that these measures create. In a word, what is important is no longer so much the FSAP itself but the strategy to be applied post-FSAP. And it is this last point that I would now like to emphasise. The role of public policies post-FSAP

The adoption of the measures contained in the FSAP obviously does not constitute the end of the public authorities' involvement in the integration process. It is now crucial for the competent authorities to effectively implement at national level the measures adopted at European level in a coherent manner. As was stressed by the Lamfalussy Committee, the capacity of Community legislation to adapt flexibly to constantly evolving markets and the coherence of its application help to alleviate the burden on the financial institutions which are active across the single market. Therefore, as you know, the so-called "Lamfalussy" approach provides for the drafting of technical Community legislation, or "secondary" legislation, which can, if necessary, be amended through a simplified procedure. It also provides for closer cooperation between supervisory authorities in the area of financial regulation and supervision. This method seems to me likely to bring about a truly joint regulation and legislation from the point of view of those who ultimately count, i.e. market players, while fully respecting the principle of subsidiarity. The implementation of the "Lamfalussy approach" offers what may be a unique opportunity to simplify the current regulatory framework while standardising its application. If this approach is adopted in full, it is reasonable to expect that the elaboration of European regulations combined with this strengthened cooperation between competent national authorities would lead to the development of a joint European handbook, an "EU Rulebook", comprising the technical measures applicable in terms of financial regulation. This European rulebook would provide the financial institutions with the reference that they perhaps lack today when they undertake cross- border activities. A second issue on which public authorities are working is related to the supervision of financial institutions. Two strategic objectives should be highlighted here. First, the strengthening of cooperation between competent authorities, in particular between supervisors and central banks, in order to supervise more effectively institutions which operate in several jurisdictions. This would also draw on the efforts at the very heart of the central banks' mission to ensure that financial stability is maintained. This strengthened cooperation would imply an intensified exchange of information, which is, moreover, already under way within the European System of Central Banks, and will also be developed in the context of the new structures created in accordance with the Lamfalussy approach. I should now like to make an aside on the specific nature of the banking system, which is actually a source of particular, systemic risks directly associated with the maturity transformation carried out by banks and with their role in payment systems in particular. Therefore, given our responsibilities, it is essential that the ECB and the national central banks of the Eurosystem are actively involved in the regulatory process. It is just as important for central banks to work

185 closely with the competent authorities in the area of supervision. The memorandum of understanding signed by central banks and banking supervisors on the principles of cooperation in crisis management situations is a perfect illustration of the efforts made in this domain. I should also like to reiterate that financial integration brings about a change in the systemic risk transmission channels, notably as a result of a possible increase in the risks of cross-border contagion and, consequently, a change in the potential sources of financial instability. Given our responsibility in this field, we are paying particularly close attention to these implications of the integration process. The second strategic objective is that it would be preferable if the procedures and obligations associated with banking supervision were to converge further, in order to lighten the burden on the institutions subjected to them. This could be done by means of a joint agreement between competent authorities on some transparent standards to be applied when the measures contained in the "rulebook" that I mentioned a moment ago are being implemented. None of what I have just said detracts from the merits of arrangements under which national authorities are responsible for prudential supervision. Furthermore, the conditions for an in-depth cooperation are being developed precisely to ensure that such a decentralised organisation is still able to achieve the results expected in the context of an integrated financial system. The role of the private sector post-FSAP

The points that I have raised so far form a long list of tasks incumbent upon the public sector to convert into a reality the potential for financial integration resulting from the FSAP. However, this is a responsibility which also behoves the private sector. I would like to say a few words on this point. The first of the private sector's responsibilities is, naturally, to take advantage of the opportunities created by the single market, as you have successfully been doing up to now. If it is up to the authorities to create the environment of trust needed to undertake cross-border activities, it is finally up to you to "convert the try". But there is also another area in which private initiative can, and in my view must, contribute to the process of market integration. This is the area of collective action, which is something I should like to explain in more detail. The rules governing the proper functioning of the financial markets are not only enacted by public authorities. There are a considerable number of rules, perhaps the majority in fact, which are the result of the community of market participants itself. These rules include, for example, quotation conventions, conventions for calculating accrued interest, conventions for delivery versus payment and many other standards used by the market as a whole. What sets these rules apart is the fact that the voluntary adhesion that they create is the result of network externalities. The more people that follow these rules, the more beneficial it is to apply them, not least because of the resulting increase in the number of potential counterparties. However, the use by two groups of market operators of different standards or conventions will constitute a real segmenting factor. Therefore, to my mind, the adoption of common rules, conventions or standards by all market players is one way in which the private sector can, in its own interests, work effectively and together towards achieving greater financial integration. Public authorities can only facilitate collective action in this domain, not replace it. Moreover, the ECB and the national central banks of the Eurosystem have, on many occasions, acted as a facilitator, and we are, of course, willing to continue to help the market along this path if need be.

186 To illustrate this point, I will use the example of the creation of the EONIA when the euro was introduced. This index, which reflects the level of the overnight rate on the interbank market, is not the result of a legislative or regulatory decision, but of coordinated action between money market operators. The European Central Bank is involved in the calculation of this index, but only as a facilitator. The reason I mention the EONIA is because it seems to me that its existence, as well as its adoption as a benchmark on the interest rate swap market, has been an important factor for the integration of this particular market segment. Furthermore, the results are well known by everyone: the market for interest rate swaps indexed on the EONIA is the most liquid and deepest of its kind in the world, and its contribution to managing the interest rate risk of all market players is considerable. Given this amazing success, the question which needs to be asked is therefore whether all potential opportunities for collective action to deepen financial integration have been exploited. Our experience leads us to believe that this is not the case. For example, we could mention the commercial paper market, where the diversity of the conventions used is perhaps greater than is strictly necessary, although a group of market participants has taken the initiative to specifically reduce these differences. In this context, the completion of the FSAP is perhaps also an opportunity not to be missed. If the legal or regulatory obstacles to cross-border activity are eliminated, the adoption of joint standards and conventions through collective action only becomes more desirable and more beneficial. In order for this collective action to become a reality, market associations which are effectively pan-European in their constitution and objective are needed. However, I have the impression that the number of initiatives in this direction are increasing, and I find that a reason to be optimistic about European financial integration. Conclusion

Therefore, the conclusion of the FSAP does not signal the end of the process of financial integration in Europe. It marks the end of a stage, and a decisive stage at that, but one which must be followed by other steps forward. In order to achieve this, a strategy which is just as ambitious and coherent as the one which has been applied up to now must be applied post-FSAP. It will be up to the different players involved in this process, whether public authorities or market players, to jointly develop this strategy over the coming year. In any case, I believe that this strategy should include some of the elements that I have outlined today, namely: First, close attention to coherence between the actions carried out by the various public authorities, as well as between the role of the public sector and the essential role of the private sector. Only will effective interaction between all those involved be likely to lead to even deeper integration. Then, the need for rationalisation and simplification. This can be applied to the area of regulation and supervision, but also to the standards and conventions drawn up by the private sector. Finally, the need for organisation and participation. In order for the policies which have been defined to be put into practice, market players must, in principle, be actively involved and organised effectively with a view to a permanent dialogue with the supervisory authorities in the best possible conditions.

187 Given the statements and initiatives which are appearing it seems to me that a consensus is being formed on these three points. This is the case, for example, for the market infrastructure, where a certain coherence and complementarity can be observed between the various activities in progress. The development of TARGET2 by the Eurosystem in particular, the strategy proposed by the Giovannini group in the area of delivery versus payment and the work carried out on the consolidation of technical platforms used by international central securities depositories based in Europe should all yield tangible results between 2005 and 2008. I would like to see the encouraging signs of a forthcoming acceleration of this process of European financial integration, which is already well advanced. The benefits of everything that has been achieved so far are so outstanding that there can be no doubt that it is in the interests of all concerned to continue determinedly along this road. Ladies and gentlemen, thank you for your attention. http://www.ecb.int/events/

188 Bank of England

News Release www.bankofengland.co.uk 5 February 2004 BANK OF ENGLAND RAISES INTEREST RATES BY 0.25 PERCENTAGE POINTS TO 4.0%

The Bank of England’s Monetary Policy Committee today voted to raise the Bank’s repo rate by 0.25 percentage points. The Committee reviewed monetary and economic developments in the light of its latest quarterly projections for output and inflation, to be published in the February Inflation Report. The world economic recovery has become more broadly based. In the United Kingdom, output growth in the second half of last year was above trend and business surveys point to a further pickup in the first quarter. Household spending and borrowing have been resilient, and the housing market remains strong. Although sterling has appreciated, continued growth above trend means that inflationary pressures are likely to pick up gradually over the next couple of years. Against that background, and despite CPI inflation currently below the 2% target, the Committee judged that an increase of 0.25 percentage points in the repo rate to 4.0% was necessary to keep CPI inflation on track to meet the new target in the medium term. The Committee’s latest inflation and output projections will appear in the Inflation Report to be published on Wednesday 11 February. The minutes of the meeting will be published at 9.30am on Wednesday 18 February. ENDS Note to Editors The previous change in interest rates was an increase of 0.25 percentage points to 3.75% on 6 November 2003.

189 Inflation Report Press Conference Wednesday 11 February 2004 Opening Remarks by the Governor

Over recent months growth in the United Kingdom has been strong. It is expected to remain so. Inflation, on the new CPI measure, has been below the new 2% target for some time, but was expected to move up to exceed the target at the two-year horizon as demand growth pressed on supply capacity. In response to that inflation outlook, the Monetary Policy Committee judged last week that a rise in interest rates was necessary to keep inflation on track to meet the target in the medium term. Signs of further economic recovery are evident in most parts of the industrialised world. At home, GDP growth in the second half of last year was above its historical average. Consumer borrowing and spending have been rising faster than expected, but are likely to slow in the face of decelerating incomes and house prices. For business, the outlook for exports and investment looks brighter than for some considerable time. So a long overdue rebalancing of the economy is now in prospect. There are already some signs of higher inflation to come. The growth rates of money and credit remain at very high levels, and there is evidence of greater cost pressures in the pipeline. Against that, sterling's effective exchange rate rose between the November and February Reports by just over 2%, although it is still below its average level between 2000 and the beginning of last year. The higher level of sterling will offset part of the impact on inflation of faster domestic demand growth. In assessing inflationary pressures, the official GDP data may not be the best guide to the balance between demand and supply in the economy as a whole. GDP includes an estimate of the output of the public sector. That is extremely difficult to measure in sectors such as health and education, and the ONS has commissioned a review by Sir Tony Atkinson. But in evaluating the impact of higher public spending on inflation what matters is not the value of the services provided by the public sector but the opportunity cost of the resources that would otherwise be employed in the private sector. And such a measure of total demand for resources has risen by significantly more than official GDP in both of the past two years, with implications for the degree of spare capacity. The Committee's latest projection for GDP growth, on the assumption that official interest rates remain constant at 4% throughout the two-year forecast period, is shown in Chart 1 (GREEN CHART) on page ii of the Report. Business investment, exports and public expenditure are all expected to help offset, at least in part, the slowdown of consumer spending. The central projection is for growth above its historical average, although slowing a little over the forecast period. This outlook is somewhat stronger than in November. After 44 Inflation Reports, and, for some of you I fear, 44 press conferences, containing projections for RPIX inflation, today marks the start of a new era with the Committee's first projection for inflation on the new CPI measure. The final outturn for RPIX inflation under the old target was, appropriately enough, 2.5%. The new measure starts life at 1.3%, below the new 2% target. The Committee's projection for CPI inflation, again conditional on an official interest rate of 4%, is shown in Chart 2 (RED CHART) on page iii. The central projection rises steadily

190 to reach the target at the two-year horizon, reflecting the growing pressure of demand on supply capacity. Chart 3, also on page iii, shows the Committee's current projection for RPIX inflation. It remains close to 2.5% for most of the forecast period because rising domestically generated inflation is offset by declining house price inflation. This profile is similar to that in the November Report, as can be seen from Charts 6.3 and 6.4 on page 46. The news about stronger demand pressures is broadly offset by the higher level of sterling. Last May I said that the Committee's central view might be described as positively Panglossian. Some of you might think this is equally true of today's projection, with a central view of above- trend growth and low inflation. But it is crucial to bear in mind that, in the central projection, inflation is continuing to rise at the two-year horizon and that the risks, although broadly balanced, are nevertheless considerable in both directions. What this means for policy only time will tell. Central projections rarely materialise - as Dr. Pangloss himself discovered

191 Rubin Gets Shrill

By PAUL KRUGMAN, New York Times, OP-ED COLUMNIST, January 6, 2004

Argentina retained the confidence of international investors almost to the end of the 1990's. Analysts shrugged off its large budget and trade deficits; business-friendly, free-market policies would, they insisted, allow the country to grow out of all that. But when confidence collapsed, that optimism proved foolish. Argentina, once a showpiece for the new world order, quickly became a byword for economic catastrophe.

So what? Those of us who have suggested that the irresponsibility of recent American policy may produce a similar disaster have been dismissed as shrill, even hysterical. (Hey, the market's up, isn't it?) But few would describe Robert Rubin, the legendary former Treasury secretary, as hysterical: his ability to stay calm in the face of crises, and reassure the markets, was his greatest asset. And Mr. Rubin has formally joined the coalition of the shrill.

In a paper presented over the weekend at the meeting of the American Economic Association, Mr. Rubin and his co-authors — Peter Orszag of the Brookings Institution and Allan Sinai of Decision Economics — argue along lines that will be familiar to regular readers of this column. The United States, they point out, is currently running very large budget and trade deficits. Official projections that this deficit will decline over time aren't based on "credible assumptions." Realistic projections show a huge buildup of debt over the next decade, which will accelerate once the baby boomers retire in large numbers.

All of this is conventional stuff, if anathema to administration apologists, who insist, in flat defiance of the facts, that they have a "plan" to cut the deficit in half. What's new is what Mr. Rubin and his co-authors say about the consequences. Rather than focusing on the gradual harm inflicted by deficits, they highlight the potential for catastrophe.

"Substantial ongoing deficits," they warn, "may severely and adversely affect expectations and confidence, which in turn can generate a self-reinforcing negative cycle among the underlying fiscal deficit, financial markets, and the real economy. . . . The potential costs and fallout from such fiscal and financial disarray provide perhaps the strongest motivation for avoiding substantial, ongoing budget deficits." In other words, do cry for us, Argentina: we may be heading down the same road.

Lest readers think that the most celebrated Treasury secretary since Alexander Hamilton has flipped his lid, the paper rather mischievously quotes at length from an earlier paper by Laurence Ball and N. Gregory Mankiw, who make a similar point. Mr. Mankiw is now the chairman of the president's Council of Economic Advisers, a job that requires him to support his boss's policies, and reassure the public that the budget deficit produced by those policies is manageable and not really a problem.

But here's what he wrote back in 1995, at a time when the federal deficit was much smaller than it is today, and headed down, not up: the risk of a crisis of confidence "may be the most important reason for seeking to reduce budget deficits. . . . As countries increase their debt, they wander into unfamiliar territory in which hard landings may lurk. If policymakers are prudent, they will not take the chance of learning what hard landings in [advanced] countries are really like."

192 The point made by Mr. Rubin now, and by Mr. Mankiw when he was a free agent, is that the traditional immunity of advanced countries like America to third-world-style financial crises isn't a birthright. Financial markets give us the benefit of the doubt only because they believe in our political maturity — in the willingness of our leaders to do what is necessary to rein in deficits, paying a political cost if necessary. And in the past that belief has been justified. Even Ronald Reagan raised taxes when the budget deficit soared.

But do we still have that kind of maturity? Here's the opening sentence of a recent New York Times article on the administration's budget plans: "Facing a record budget deficit, Bush administration officials say they have drafted an election-year budget that will rein in the growth of domestic spending without alienating politically influential constituencies." Needless to say, the proposed spending cuts — focused only on the powerless — are both cruel and trivial.

If this kind of fecklessness goes on, investors will eventually conclude that America has turned into a third world country, and start to treat it like one. And the results for the U.S. economy won't be pretty.

193 Sustained Budget Deficits: Longer-Run U.S. Economic Performance and the Risk of Financial and Fiscal Disarray

Paper presented at the AEA-NAEFA Joint Session, Allied Social Science Associations Annual Meetings, The Andrew Brimmer Policy Forum, "National Economic and Financial Policies for Growth and Stability", January 5, 2004

Peter R. Orszag, Senior Fellow, Economic Studies Robert E. Rubin, Office of the Chairman, Citigroup Allen Sinai, Chief Global Economist, Decision Economics, Inc.

Introduction

The U.S. federal budget is on an unsustainable path. In the absence of significant policy changes, federal government deficits are expected to total around $5 trillion over the next decade. Such deficits will cause U.S. government debt, relative to GDP, to rise significantly. Thereafter, as the baby boomers increasingly reach retirement age and claim Social Security and Medicare benefits, government deficits and debt are likely to grow even more sharply. The scale of the nation's projected budgetary imbalances is now so large that the risk of severe adverse consequences must be taken very seriously, although it is impossible to predict when such consequences may occur.

Conventional analyses of sustained budget deficits demonstrate the negative effects of deficits on long-term economic growth. Under the conventional view, ongoing budget deficits decrease national saving, which reduces domestic investment and increases borrowing from abroad.1 Interest rates play a key role in how the economy adjusts. The reduction in national saving raises domestic interest rates, which dampens investment and attracts capital from abroad.2 The external borrowing that helps to finance the budget deficit is reflected in a larger current account deficit, creating a linkage between the budget deficit and the current account deficit. The reduction in domestic investment (which lowers productivity growth) and the increase in the current account deficit (which requires that more of the returns from the domestic capital stock accrue to foreigners) both reduce future national income, with the loss in income steadily growing over time. Under the conventional view, the costs imposed by sustained deficits tend to build gradually over time, rather than occurring suddenly.

The adverse consequences of sustained large budget deficits may well be far larger and occur more suddenly than traditional analysis suggests, however. Substantial deficits projected far into the future can cause a fundamental shift in market expectations and a related loss of confidence both at home and abroad. The unfavorable dynamic effects that could ensue are largely if not entirely excluded from the conventional analysis of budget deficits. This omission is understandable and appropriate in the context of deficits that are small and temporary; it is increasingly untenable, however, in an environment with deficits that are large and permanent. Substantial ongoing deficits may severely and adversely affect expectations and confidence, which in turn can generate a self-reinforcing negative cycle among the underlying fiscal deficit, financial markets, and the real economy:

• As traders, investors, and creditors become increasingly concerned that the government would resort to high inflation to reduce the real value of government debt or that a fiscal

194 deadlock with unpredictable consequences would arise, investor confidence may be severely undermined; • The fiscal and current account imbalances may also cause a loss of confidence among participants in foreign exchange markets and in international credit markets, as participants in those markets become alarmed not only by the ongoing budget deficits but also by related large current account deficits; • The loss of investor and creditor confidence, both at home and abroad, may cause investors and creditors to reallocate funds away from dollar-based investments, causing a depreciation of the exchange rate, and to demand sharply higher interest rates on U.S. government debt; • The increase of interest rates, depreciation of the exchange rate, and decline in confidence can reduce stock prices and household wealth, raise the costs of financing to business, and reduce private-sector domestic spending; • The disruptions to financial markets may impede the intermediation between lenders and borrowers that is vital to modern economies, as long-maturity credit markets witness potentially substantial increases in interest rates and become relatively illiquid, and the reduction in asset prices adversely affects the balance sheets of banks and other financial intermediaries; • The inability of the federal government to restore fiscal balance may directly reduce business and consumer confidence, as the view of the ongoing deficits as a symbol of the nation's inability to address its economic problems permeates society, and the reduction in confidence can discourage investment and real economic activity; • These various effects can feed on each other to create a mutually reinforcing cycle; for example, increased interest rates and diminished economic activity may further worsen the fiscal imbalance, which can then cause a further loss of confidence and potentially spark another round of negative feedback effects.

Although it is impossible to know at what point market expectations about the nation's large projected fiscal imbalance could trigger these types of dynamics, the harmful impacts on the economy, once these effects were in motion, would substantially magnify the costs associated with any given underlying budget deficit and depress economic activity much more than the conventional analysis would suggest. Indeed, the potential costs and fallout from such fiscal and financial disarray provide perhaps the strongest motivation for avoiding substantial, ongoing budget deficits. 3 Conventional analyses of budget deficits also do not put enough emphasis on three other related factors: uncertainty; the asymmetries in the political difficulty of revenue increases and spending reductions relative to tax cuts and spending increases; and the loss of flexibility in the future from enacting tax cuts or spending increases today. Budget projections are inherently uncertain, but such uncertainty does not provide a rationale for fiscal profligacy. The uncertainty surrounding budget projections means that the outcome in the future can be either better or worse than expected today. Such uncertainty can actually increase the incentive for more saving ahead of time—in other words, for more fiscal discipline. In addition, it is much harder for the political system to reduce deficits than to expand them. As a result of this asymmetry, enacting a large tax cut or spending increase today is costly because it reduces the flexibility to adjust fiscal policy to future events. Therefore, large tax cuts or spending increases today carry a cost typically excluded from traditional analysis: They constrain policy-makers' flexibility to respond to unforeseen events in the future.

195 Thus, in our view, to ensure healthy long-run U.S. economic performance, substantial changes in fiscal policy are needed to deal preemptively with the risks stemming from sustained large budget deficits and the economic imbalances they entail. The political system, however, seems unwilling to address the threat posed by future deficits and to make the necessary choices to put the nation on a sustainable fiscal course.4 Failing to act sooner rather than later, though, only makes the problem more difficult to address without considerable instability, raises the probability of fiscal and financial disarray at some point in the future, and runs the risks of further constraining policy flexibility in the future. We emphasize that our focus is on the effects of ongoing, sustained budget deficits. It is important to underscore that temporary budget deficits can be beneficial by providing short-term macroeconomic stimulus when the economy is weak and has considerable unused resources of capital and labor. When necessary to spur a weak economy, policy-makers could employ various fiscal policy programs, each with relative advantages and disadvantages in different contexts. Whatever decisions are made about short-run fiscal policy when the economy is weak, the objective should be budget balance over the business cycle. The next section of this paper presents projections of federal government budget deficits over the next 10 years and thereafter, including baseline projections and sensitivity analysis. Section III presents the conventional view of the effects of federal budget deficits. Section IV discusses the potentially more important financial and economic effects not included in the conventional view. A final section provides some perspectives on approaches for restoring fiscal discipline. © Copyright 2004

Footnotes 1 The conventional view assumes that in the long term, the economy operates at, or near, full employment. 2 The increase in interest rates may also exert a negative influence on aggregate demand through several channels. First, the increase in interest rates reduces investment, which is a component of aggregate demand. Second, the increase in interest rates may directly reduce interest-sensitive consumption, such as on credit-financed durable goods. Third, the increase in interest rates may indirectly reduce consumption, by reducing asset values and therefore household net wealth. 3 As Ball and Mankiw (1995, p.117) argue, "We can only guess what level of debt will trigger a shift in investor confidence, and about the nature and severity of the effects. Despite the vagueness of fears about [these effects], these fears may be the most important reason for seeking to reduce budget deficits." 4 As three leading Washington organizations from across the political spectrum emphasized in a rare joint statement in September 2003, "instead of expressing alarm, many in Washington now argue that escalating deficits do not really matter, that they are self-correcting, that they are unrelated to interest rates or future economic well-being, and that tax cuts will pay for themselves later by spurring economic growth. It would be wonderful if this were true. It is not." Committee for Economic Development, Concord Coalition, and the Center on Budget and Policy Priorities (2003). http://www.brook.edu/views/papers/orszag/20040105.htm

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O C C A S I O N A L P A P E R 227

U.S. Fiscal Policies and Priorities for Long-Run Sustainability

Martin Mühleisen and Christopher Towe, Editors

©2004 International Monetary Fund January 7, 2004 I. Overview: Returning Deficits and the Need for Fiscal Reform U.S. government finances have experienced a remarkable turnaround in recent years. Within only a few years, hard-won gains of the previous decade have been lost and, instead of budget surpluses, deficits are again projected as far as the eye can see. The deterioration has not been restricted to the federal budget but has also taken place at the state and local government levels. As a result, the U.S. general government deficit is now among the highest in the industrialized world, and public debt levels are approaching those in other major industrial countries (Figure 1.1). Although fiscal policies have undoubtedly provided valuable support to the recovery so far, the return to large deficits raises two interrelated concerns. First, with budget projections showing large federal fiscal deficits over the next decade, the recent emphasis on cutting taxes, boosting defense and security outlays, and spurring an economic recovery may come at the eventual cost of upward pressure on interest rates, a crowding out of private investment, and an erosion of longer-term U.S. productivity growth. Second, the evaporation of fiscal surpluses has left the budget even less well prepared to cope with the retirement of the baby boom generation, which will begin later this decade and place massive pressure on the Social Security and Medicare systems. Without the cushion provided by earlier surpluses, there is less time to address these programs' underlying insolvency before government deficits and debt begin to increase unsustainably, making more urgent the need for meaningful reform. The remainder of this section summarizes the IMF staff's assessment of the U.S. fiscal situation,describing both the factors that have contributed to the burgeoning of the deficit and the key policy challenges posed by the impending demographic transition. It ties together subsequent sections on domestic and international implications of current budget policies; long-term prospects for Social Security and Medicare; an intergenerational analysis of long-term fiscal imbalances; the role of energy taxation; effectiveness of spending rules; and state and local government finances.

197

The Fiscal Deficit: Back to Square One The 1990s were marked by significant fiscal consolidation as the economy emerged from the 1991 recession and experienced one of the longest expansions in recent history. As a result, following many years of failed attempts at exerting fiscal discipline, the federal budget—including the Social Security surplus—moved from a deficit of 4½ percent of GDP to surpluses that reached 2½ percent of GDP in FY2000 (Figure 1.2).1 Both macroeconomic developments and policy actions played an important role in achieving this correction. Strong economic growth buoyed tax revenues, and the stock market boom fueled an unprecedented increase in capital gains taxes. Estimates by the Congressional Budget Office (CBO, 2003) suggest that cyclical factors accounted for about 4 percent of GDP of the fiscal improvement between FY1992 and FY2000, just over half the shift in the deficit ratio (see Figure 1.2).2 The balance was achieved through tax increases—including those incorporated in the 1993 Omnibus Budget Reconciliation Act—and the discipline over both mandatory and discretionary spending exerted by the 1990 Budget Enforcement Act.3 Since FY2000, however, the fiscal position has eroded rapidly and, with the deficit expected to exceed 4 percent of GDP in FY2004, essentially all the gains achieved during the earlier decade have disappeared. Again, as Table 1.1 shows, the reasons for this shift include both cyclical and policy factors:4

198

• The 2001 recession and the relatively weak recovery accounted for about half of the budgetary turnaround in FY2002 and FY2003. Sluggish employment growth weighed on personal income tax collections and boosted payments for income support and related programs. In addition, the bursting of the equity bubble sparked a substantial drop in capital gains tax collections, as shown in Figure 1.2, fully reversing the extraordinary increases in collections that had been achieved during the 1990s. • On the policy front, expenditure discipline had already relaxed considerably in the face of prolonged budget surpluses. However, the September 11 attacks and the ensuing war on terrorism, as well as efforts to stimulate the economy, prompted major increases in outlays for defense and homeland security, as well as other programs (Figure 1.3). Altogether, discretionary spending increased from 6¼ percent of GDP in FY2000 to an expected 7¼ percent of GDP in FY2003, accounting for about one-fourth of the overall fiscal turnaround.5 • The remaining one-fourth of the turnaround resulted from tax cuts, which were enacted both to provide a countercyclical boost to the economy and bolster the longer-run supply side of the U.S. economy. The bulk of the measures was contained in the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA), which introduced phased reductions in personal income tax rates and the gradual elimination of the estate tax. Relatively minor additional tax cuts were introduced in 2002, but in 2003, legislation was enacted that accelerated the previously scheduled tax cuts and also added additional elements, including a significant reduction in the tax rate applying to dividends and capital gains (Box 1.1). The major tax cuts (as well as some spending measures) enacted in 2001 and 2003 have been estimated to have cost roughly $1.7 trillion over FY2002–FY2011. However, substantial debate and uncertainty have surrounded these cost estimates, largely reflecting the complicated and nontransparent manner in which the measures have been enacted. For example, some measures are only effective for a short period, while others—such as the elimination of the estate tax—are being phased in so that the fiscal cost will rise in the

199 coming years. Moreover, all tax measures are subject to sunset clauses, which will mean that rates and deductions will—in the absence of policy action—return to pre-2001 levels in 2011 at the latest. However, it is the administration's stated intention to make the tax cuts permanent, which would leave the federal budget deficit roughly 2 percent of GDP above its baseline level by FY2013.

Table 1.1. Factors Explaining the Budget Turnaround (Data relate to unified budget balance including the Social Security surplus)

Billions of U.S. dollars Percent of Total Change

FY2002 FY2003 FY2004–08 FY2002 FY2003 FY2004–08 (lti) (lti)

Office of Management and Bd t(OMB) Budget balance

April 2001 current services 283 334 2,578 ...... bli FY2004 Mid-Session Review -158 -455 -1,455 ...... j ti Change in budget balance -441 -789 -4,034 100 100 100

200 Change in budget balance -441 -789 -4,034 100 100 100

Of which

Economic and technical -284 -418 -1,782 64 53 44 reestimates

War, homeland, and other -63 -193 -723 14 24 18 enacted legislation

Tax relief -93 -177 -1,022 21 22 25

2001 EGTRRA -41 -94 -761 9 12 19

2002 JCWAA -52 -38 19 12 5 0

2003 JGTRRA . . . -45 -280 . . . 6 7

Pending budget proposals . . . -1 -506 . . . 0 13

Congressional Budget Office (CBO)

Budget balance

January 2001 current services 313 359 2,543 ...... baseline

CBO baseline projection, -158 -401 -1,446 ...... August 2003

Change in budget balance -471 -760 -3,989 100 100 100

Of which

Economic and technical -306 -427 -1,871 65 56 47 reestimates

War, homeland, and other enacted legislation -55 -138 -1,185 18 18 30

Tax relief -9 -195 -933 17 26 23

201 2001 EGTRRA 0 -93 -677 8 12 17

2002 JCWAA -1 -40 17 9 5 0

2003 JGTRRA . . . -62 -273 . . . 8 7

Sources: OMB, Mid-Session Review, Budget of the U.S. Government, FY2004 (July 2003); CBO, various publications; and IMF staff calculations. Note: EGTRRA = Economic Growth and Tax Relief Reconciliation Act; JCWAA = Job Creation and Worker Assistance Act; JGTRRA = Jobs and Growth Tax Relief Reconciliation Act.

Box 1.1. Recent U.S. Tax Initiatives Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 Significant tax cuts were legislated as part of the EGTRRA in April 2001. The measures included • a phased reduction in the individual income tax rate over the period 2001–06, with the top rate falling from 39.6 to 35 percent and the 28, 31, and 36 percent rates falling by 3 percentage points; and the creation of a 10 percent bracket for lower incomes, with an increase in the income threshold applicable to this bracket scheduled for 2008; • a gradual elimination of the estate tax by 2010,with increases in exemptions and reductions in rates during 2002–09 and repeal of the tax in 2010; • phased increases in the child tax credit from $500 in 2001 to $1,000 in 2010; • marriage penalty relief, in the form of a phased increase in the standard deduction for married couples filing jointly to twice that for single taxpayers during 2005–09, and a phased increase in the income threshold for the 15 percent rate bracket during 2005–08; • alternative minimum tax (AMT) relief through an increase in exemptions by $2,000 for single taxpayers and $4,000 for joint taxpayers during 2001–04. The 10-year cost of the measures was held to $1.35 trillion by phasing them in gradually and allowing them to expire after 2010 (that is, all tax rates were to revert to their 2001 level by the end of 2010). Job Creation and Worker Assistance Act (JCWAA) of 2002 Additional tax initiatives were included in the economic stimulus package signed into law in March 2002. The package was estimated to cost $97 billion over FY2002–FY2003 and included • an allowance for businesses to take an additional first-year depreciation deduction of 30 percent on certain investments made during the three years after September 10, 2001; • temporal extension of the business loss-carry forward rule from two to five years; • tax cuts for New York City businesses damaged by the September 11 terrorist attacks. Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003 Further tax cuts were proposed in February 2003 as a part of the administration's FY2004 budget. The measures were estimated to cost a cumulative $1.3 trillion over FY2004–13, and included • an economic growth package that would bring forward to 2003 the previously scheduled reductions in marginal tax rates, increases in the child tax credit, and marriage penalty relief; li i t th d bl t ti f di id d d id t t i ti f b i

202 eliminate the double taxation of dividends; and provide temporary tax incentives for businesses investment (at a cost of $726 billion over 10 years); • other tax incentives, including measures to encourage saving, charitable giving, and health care; unemployment insurance reform; and tax simplification (at a cost of $114 billion); • permanent extension of expiring tax provisions,including the 2001 cuts (at a cost of $588 billion). The economic growth package was passed in the form of JGTRRA in May 2003, while other budget proposals were not legislated as of September 2003. However, JGTTRA contained only parts of the administration's growth package. Dividends were not fully excluded from personal income tax, and some measures were made subject to sunsets in order to contain the total cost to $350 billion through FY2013. The package consisted of the following: • the tax rate on capital gains was lowered to 15 percent from 20 percent and was also applied to dividends. The 10 percent rate applied to capital gains of low-income households was to be reduced in phases to zero percent by 2008. These measures would expire after 2008; • the tax rate reductions scheduled for 2004 and 2006 were brought forward to 2003. However, the rates would still revert to pre-2001 levels after 2010. The expansion of the 10 percent income bracket scheduled for 2008 was brought forward to 2003 but is set to expire after 2007; • marriage penalty relief was brought forward to 2003 but set to expire after 2004; • the child tax credit was increased from $600 to $1,000 in 2003 and 2004, reverting to $500 in 2011; • AMT exemption levels were increased in 2003–05 by $4,000 for single taxpayers and $8,000 for married taxpayers filing joint returns, reverting to previous levels thereafter; • the annual deduction for small business investment was increased to $100,000 with expanded eligibility, and the first-year depreciation for some capital expenses was raised to 50 percent, with both measures expiring after 2004.

Costs and Consequences of Tax Cuts and Deficits The sharp erosion in the fiscal position and the recent emphasis on tax cuts have revived a long-standing debate about the extent to which fiscal deficits crowd out private investment, and whether tax cuts, by improving economic incentives, can significantly boost the economy's supply side. The current administration has played an active role in this debate.6 It has emphasized that tax cuts would carry important longer-run supply-side benefits that could help mitigate their budgetary cost. The administration has also stressed that the

203 federal deficit and debt-to-GDP ratios that are projected over the coming 5–10 years are "manageable" and remain well below the peak levels recorded in the 1980s and early 1990s. There is little doubt that significant macroeconomic gains could be reaped from reforms of the U.S. tax code, with the Council of Economic Advisers (CEA, 2003) citing estimates of potential gains in the range of 2–6 percent of GDP. The tax system places a disproportionate burden on personal and corporate incomes, compared with a consumption- based tax system, discourages labor market participation and saving, and is, hence, economically less efficient. The administration's 2003 proposals were viewed as a significant move toward a consumption-based tax system, because the initial package of measures announced in February would have lowered marginal income tax rates, eliminated the double taxation of dividends, and significantly expanded the extent to which income earned on saving would have been tax free. Moreover, tax reform that simplified the system could also yield significant gains, given that the multitude of tax deductions and exemptions have imposed considerable administrative and other costs. As noted in CEA (2003), taxpayers are required to spend roughly 3 billion hours a year dealing with federal tax matters, and overall compliance costs are estimated at around 10 percent of total federal tax revenues.It remains an open question whether the tax cuts adopted since early 2001 will have significant supply-side benefits: Although the cuts in income tax rates will—at the margin—improve incentives to work, the labor participation rate is already high, and empirical studies do not suggest that it is highly tax elastic (Angrist, 1991; Blundell, Duncan, and Meghir, 1998).7 • Moreover, in their final form, the tax measures appear to have taken only modest steps toward shifting the tax burden from income to consumption. Although tax rates on dividends and capital gains were lowered, the administration was not successful in eliminating the double taxation of corporate income or expanding the deductibility of saving from income. • Moreover, there is considerable academic debate about the likely magnitude of any supply-side benefits from reducing taxes on dividends. For example, it has recently been argued that the effect on capital spending would be minimal, especially because increased dividend payouts could reduce funds available for new capital spending (e.g., Gale and Orszag, 2003). • The measures also did little to address the complexity of the U.S. tax system. A number of the originally proposed simplifications did not pass, including on tax- preferred savings instruments. Indeed, in many respects the legislation appeared to have only added to the complexity of the system, for example, by using phase-ins and sunsets to obscure the true budget cost and expanding the number of tax preferences. The modest efficiency gains that might arise from the recent tax cuts will also have to be weighed against the effects of a prolonged period of fiscal weakness. As shown in Figure 1.4, the FY2004 budget is expected to result in deficits well into the next decade—a substantial deterioration compared with the January 2002 current services baseline, which saw a return to budgetary surpluses around 2007.Although the deficit ratio is expected to narrow somewhat as the economy recovers in coming years, there are important reasons to worry that these projections may still prove optimistic (Figure 1.5). The strict limits on discretionary spending that have been assumed may be difficult to sustain, especially because of pressures to increase outlays on defense and homeland security, as yet undefined supporting policies for ensuring that limits on other discretionary programs are adhered to,

204 and reduced pressure to maintain spending discipline as a result of the expiration of the Budget Enforcement Act (BEA).8 Also, there are significant uncertainties about tax revenue projections. Notably, the official budget projections do not take into account the costs of reforming the Alternative Minimum Tax (AMT), and are predicated on the assumption that the recent (and still not fully understood) sharp drop in personal tax revenue will be largely reversed.9 With U.S. fiscal deficits expected to persist into the foreseeable future, will any supply-side benefits be outweighed by the effect of weaker public saving on interest rates and investment? The Council of Economic Advisers (2003) argued strongly that these potential offsetting effects would be minimal. However, the estimates surveyed in Section II generally suggest that the short-term stimulus stemming from the FY2004 budget proposals is likely to wane in several years, with higher deficits beginning to crowd out private investment and dampen output thereafter. In one simulation, for example, the tax cuts would eventually lower U.S. productivity—in terms of labor output per hour—by ½ percent in the long run.

Global Issues Although U.S. fiscal policy has undoubtedly provided valuable support to the global economy in recent years, large U.S. fiscal deficits also pose significant risks for the rest of the world. Simulations reported in Section II suggest that a 15 percentage point increase in the U.S. public debt ratio projected over the next decade would eventually raise real interest rates in industrial countries by an average of ½–1 percentage point. Higher borrowing costs abroad would mean that the adverse effects of U.S. fiscal deficits would spill over into global investment and output. Moreover, against the background of a record-high U.S. current account deficit and a ballooning U.S. net foreign liability position, the emergence of twin fiscal and current account deficits has given rise to renewed concern. The United States is on course to increase its net external liabilities to around 40 percent of GDP within the next few years— an unprecedented level of external debt for a large industrial country (IMF, 2003b). This trend is likely to continue to put pressure on the U.S. dollar, particularly because the current account deficit increasingly reflects low saving rather than high investment. Although the dollar's adjustment could occur gradually over an extended period, the

205 possible global risks of a disorderly exchange rate adjustment, especially to financial markets, cannot be ignored. Episodes of rapid dollar adjustments failed to inflict significant damage in the past, but with U.S. net external debt at record levels, an abrupt weakening of investor sentiments vis-à-vis the dollar could possibly lead to adverse consequences both domestically and abroad.10 Long-Run Insolvency of Social Security and Medicare From a long-term perspective, higher U.S. fiscal deficits are especially worrisome because of the precarious financial position of the Social Security and Medicare systems. Although U.S. demographics compare relatively favorably with most other industrialized nations (see discussion in Section III), both systems are projected to run sizable deficits about a decade from now when the baby boom generation enters its peak retirement years, and accumulated surpluses are exhausted 10–20 years thereafter. The Social Security system is under pressure as a result of both the declining fertility rate— which (unlike in many other countries) is somewhat offset by higher immigration—and increases in longevity. As a result, the dependency ratio—the ratio of retirees to the working-age population—is projected to rise from 20 percent at present to around 40 percent by the middle of the century. This implies that payroll tax revenues will decline while social security spending is expected to roughly double as a proportion of GDP (Figure 1.6). The financial position of the Medicare and Medicaid systems is considerably worse, given the rapid growth of health care costs and the modest share of benefits that is covered by individual contributions. Medicare expenditures are projected to grow almost threefold relative to GDP over the next five decades, and considerable increases are also likely in the case of Medicaid.11 The projected sharp increase in expenditures, relative to contributions, and the rapid increase in health care costs mean that the Social Security and Medicare systems are highly under funded. Unless steps are taken to adjust contribution rates and benefits, the programs will fall into deficit in the next two decades and have to be supported by growing transfers out of the federal general fund. IMF staff simulations of the rapid increase of federal debt that would result—which are similar to those presented by the CBO and the administration's FY2004 budget—are shown in Figure 1.7.

Official estimates place the net present value of the programs' unfunded actuarial liability at around 160 percent of current GDP, if measured over a 75-year horizon.12 But even these

206 estimates understate the financial problems facing these programs because, in the absence of policy action, the programs will be running large cash flow deficits past this projection horizon. Moreover, closing the fiscal gap can be accomplished through a variety of policy measures (e.g., tax hikes, spending cuts, and so on) and at varying speed, both of which have different implications that are not captured by typical actuarial measures. These considerations have led to a renewed emphasis on estimates of the fiscal gap, which take into account longer horizons and the intergenerational transfers that are involved. Section IV presents estimates of the U.S. fiscal imbalance using an intergenerational accounting framework that encompasses the entire federal fiscal system over an infinite horizon. The results suggest that the fiscal imbalance is as high as $47 trillion, nearly 500 percent of current GDP, and that closing this fiscal gap would require an immediate and permanent 60 percent hike in the federal income tax yield, or a 50 percent cut in Social Security and Medicare benefits. The analysis also illustrates that this gap is associated with a severe intergenerational imbalance, with the burden on future generations increasing further if corrective measures are delayed. The Policy Challenge To restore a sustainable position, U.S. fiscal policy must refocus on two key objectives. The first is to adopt a clear and credible policy framework to achieve a balanced budget (excluding the Social Security surplus) over the cycle. The second is to pursue the reforms needed to place the Social Security and Medicare systems on a sound financial footing. Restoring Budget Balance Balancing the budget, excluding Social Security, has been an underlying goal of U.S. fiscal policy since at least 1985, when this objective was enshrined in the Gramm-Rudman- Hollings legislation. It is also an objective that the current administration has endorsed in the past—for example, the FY2002 budget was committed to saving the entire Social Security surplus, allowing almost all outstanding federal debt to be repaid over 10 years. The focus on balanced budgets is grounded in the realization that today's Social Security surpluses represent an accumulation of contributions by program participants that need to be saved to fund future retirement benefits. With the approaching retirement of the baby boom generation, reestablishing a balanced U.S. federal deficit is becoming increasingly urgent. Achieving this objective over a 5–10- year period would leave the government debt ratio more than 10 percent of GDP lower in 2013 than at present and provide much-needed room for designing and implementing the reform of entitlement programs in advance of the demographic shock (see Figure 1.7 for an illustration). Returning to a balanced budget would also help ensure that the eventual adjustment of the U.S. current account deficit is orderly and rests on stronger national saving rather than weaker U.S. investment and growth.13 How large a fiscal adjustment would be needed to meet this objective? The CBO's August 2003 baseline suggests that the effort would need to be significant. For example, assuming that the recent tax cuts are made permanent, amendments to the Medicare system are implemented, and steps are taken to address the reform of the Alternative Minimum Tax system, the unified budget deficit would fall to around 1½ percent of GDP in 2013. This measure still includes the surplus of the Social Security Trust Fund, however, which is classified as an "off-budget" item in the U.S. fiscal accounts. Once this surplus is excluded, the budget deficit, and the measures needed for balance, would be over 3 percent of GDP.14 However, these estimates assume that extremely strict limits on discretionary spending—

207 which keeps spending constant in real terms—are maintained for 10 years, and even larger shortfalls can be envisaged. Given the magnitude of this adjustment, it would seem likely that both revenue measures and sustained spending restraints would need to be considered. On the revenue side, allowing the tax cuts to expire would yield around 2 percent of GDP, including the associated interest saving, but any revenue effort would also need to look for opportunities to expand the tax base. Recent CBO publications have illustrated that substantial revenues could be derived from reducing corporate and personal income tax preferences—including corporate tax shelters and mortgage interest deductibility. Section V suggests that energy taxes, which are comparatively light in the United States, could help meet the administration's environmental objectives while also providing substantial support for fiscal consolidation. These measures would have to go hand-in-hand with a tightening of expenditure discipline, which weakened significantly with the emergence of surpluses in the late 1990s. In recent years, geopolitical considerations and the war on terrorism have compounded spending pressures, but these and other spending priorities will need to be weighed carefully if the adjustment burden is not to fall more heavily on the revenue side. To support efforts to rein in public spending, greater weight could be given to reintroducing and strengthening the budget rules contained in the Budget Enforcement Act (BEA), which expired in October 2002. The international and U.S. experience is that fiscal adjustment tends to be more effective if it is based on formal rules embedded in a fiscal policy framework with clearly defined medium- and long-term objectives, similar to the fiscal responsibility legislation adopted by a number of industrial countries. Such a framework— and the political consensus that would surround it—could help provide policy-makers with an appropriate basis for facing the difficult trade-offs in the period ahead. A similar conclusion has been reached by a recent IMF report on U.S. fiscal transparency, which generally praised the high degree of transparency in the United States but noted a lack of clarity in the longer-term direction of its fiscal policy (Box 1.2). Fiscal responsibility legislation could also help guard against using accounting devices that obscure the true cost of measures and lead to loss of credibility, as appears to have been the case in recent years. Section VI shows that the caps on discretionary outlays and pay-as-you-go (PAYGO) requirements contained in the BEA strongly contributed to the successful fiscal consolidation in the United States during the 1990s. Although the BEA's constraints were increasingly circumvented just prior to its expiration, Section VI suggests a range of options for further strengthening these types of budget rules.

Box 1.2. Fiscal Transparency in the United States During November 2002–February 2003, a staff team conducted a review of fiscal transparency in the United States in relation to the IMF's Code of Good Practices on Fiscal Transparency (IMF, 2003a). The principal conclusions of that review are as follows: • The United States is fully compliant with most elements of the Fund's Code of Good Practices on Fiscal Transparency and sets best practice standards in many areas. The U.S. Constitution provides a strong and well-tested framework that clearly defines the roles of the executive and legislative branches in fiscal management. The Congress plays a central role in shaping the budget, which ensures a highly open process. State and local governments also have clearly defined fiscal responsibilities, operating independently from the federal government, and are subject to market discipline. Budget documentation is easily accessible to the public, timely, comprehensive, and reliable, and it excels in its scope and quality of analysis.

208 • Nevertheless, there remains a lack of clarity about the longer-term direction of fiscal policy. This partly reflects the sheer size of the federal government and the complexity of the congressional budget process. Major efforts have been made over the past three decades to put in place a legal framework to strengthen this aspect of the budget process. However, with the expiration of the Budget Enforcement Act (BEA), the failure of Congress to pass a budget resolution for FY2003, and the recent uncertainty regarding the permanence of tax cuts and the costs of the war in Iraq, budget decisions do not seem presently guided by clear medium- and long-term fiscal policy objectives. • Budget responsibility legislation to replace the BEA could help provide a basis for a more systematic incorporation of longer-term considerations into the budget process. Building on existing budget requirements and practices, such a budget framework could require the specification and justification of medium-term fiscal targets as part of the President's budget; a budget report on long-term fiscal policy; discretionary spending caps and pay-as-you-go (PAYGO) requirements for mandatory spending and revenue; and clearer procedures for specifying and disclosing key budget assumptions (e.g., with respect to expiring legislation). • Fiscal transparency could be strengthened in a number of additional ways: reporting an internationally comparable measure of the budget balance to supplement the unified budget presentation; providing an overview of state and local government finances as part of the federal budget presentation; annually assessing the costs and risks associated with the quasi-fiscal activities; including a comprehensive statement on fiscal risks in budget documents; reconsidering the legal basis for tax expenditure reporting; ensuring that audit reports of agencies by the General Accounting Office (GAO) are followed up, possibly by a standing public accounts committee that reports to Congress; increasing the emphasis on program performance; and paying greater attention to the full cost of providing government services.

Reforming Entitlement Programs Although the impact of population aging will not be felt fully until well into the next decade, and public debt ratios are not expected to rise before 2020, the long lead times required in reforming pension and health insurance programs suggest that policy actions need to be taken well in advance. For example, the 1983 reform of the Social Security system raised the normal retirement age from 65 to 67, but to allow workers to adjust their saving and retirement plans, the increase was scheduled to be phased in over a 25-year period, beginning only in 2002. At this stage, relatively modest changes would still appear to be sufficient to close projected pension shortfalls. For example, an immediate 2 percentage point hike in the Social Security payroll tax could be sufficient to close the system's 75-year actuarial liability. However, payroll taxes in the United States are already high and further increases would tend to be regressive and could adversely affect incentives to hire labor. Other options include measures to stem the growth of benefits, including by indexing the calculation of pension benefits to the consumer price index (CPI) rather than wages, further increasing the normal retirement age, or reducing the benefits for early retirement. In general, however, the longer such decisions are delayed, the larger and more painful the required adjustments will be. Privatizing Social Security could, in principle, provide a framework for addressing the system's unfunded liability, but would still require either cuts in benefits or hikes in premiums, as well as an explicit recognition of the liabilities that the system has already accrued. Moreover, the higher returns that might be earned from personal retirement accounts would have to be weighed against the increased exposure of retirement savings to market fluctuations, which would likely require the government to still provide a minimum safety net for retirees. Questions have also been raised about the administrative costs that would have to be borne in managing small accounts, and the challenge of designing a

209 system that discourages workers from withdrawing excessive amounts at retirement and imposing a burden on the rest of the system. Medicare reform is even more critical. The Medicare trust fund begins to run into deficit in 2016, and the unfunded actuarial liability (in net present value terms) has been estimated at 130 percent of current GDP. This raises the question of whether it would have been prudent to defer an extension of benefits, including to cover prescription drugs, until credible measures to address the system's longer-term financial problems are established. Indeed, the broader weakness of the U.S. health care system—which has left health care spending the highest among OECD countries (relative to GDP), without a commensurately high ranking in public health indicators (see Figure 1.8)—suggests that more sweeping reforms of the system may be needed.

State and Federal Fiscal Relations A review of the U.S. fiscal situation would be incomplete without considering the relatively sharp deterioration of state and local government finances in recent years. In aggregate, this sector accounts for close to half of general government spending, raising concern that expenditure cutbacks on the state and local levels could offset some of the stimulus provided by the federal government. This issue is addressed in Section VII, which reviews the principal causes of the state and local fiscal crisis and attempts to quantify its macroeconomic implications. Rising deficits have been caused both by shrinking corporate and personal income tax revenues and by sharp increases in cyclical and health-related spending—in part reflecting tax cuts and more generous benefit levels granted during the boom years of the 1990s. With budget reserves being increasingly eroded, further adjustment measures will be needed. However, the aggregate size of local and state government cutbacks is estimated to be only a small fraction of the overall stimulus provided by the federal government, and their macroeconomic impact is likely to remain small. Concluding Remarks Meaningful reforms of entitlement programs such as Social Security and Medicare tend to require long lead times, given their impact on intergenerational income distribution and politically controversial nature. To reach broad-based agreement on such reforms, fiscal resources are often required to smooth the transition and ensure that reform measures can be implemented over a politically acceptable time horizon. Only a few years ago, the

210 conditions for movement on these fronts seemed to be in place in the United States, with the demographic shock still half a generation away and government debt set to be all but eliminated within a decade. Since then, however, a combination of cyclical, geopolitical, and policy factors have erased a decade's worth of fiscal consolidation, just a short time before the retirement of the baby boom generation begins. The discussion in this and subsequent sections suggests that the U.S. fiscal problem is still manageable, and there remains a window of opportunity for reform. However, the experience of recent decades has shown that fiscal consolidation is difficult to achieve and perhaps even more difficult to hold on to. Therefore, the room for maneuver is narrowing quickly. References Angrist, J., 1991, "Grouped-Data Estimation and Testing in Simple Labor-Supply Models," Journal of Econometrics, Vol. 47, No. 2/3, pp. 243–66. Blundell, R., A. Duncan, and C. Meghir, 1998, "Estimating Labor Supply Responses Using Tax Reforms," Econometrica, Vol. 66, No. 4, pp. 827–62. Congressional Budget Office (CBO), 2003, The Budget and Economic Outlook: Fiscal Years 2004–2013 (Washington: U.S. Government Printing Office). Council of Economic Advisers (CEA), 2003, Economic Report of the President, February 2003 (Washington: U.S. Government Printing Office). Gale, W.G., and P.R. Orszag, 2003, "The Administration's Proposal to Cut Dividend and Capital Gains Taxes," Tax Notes (Washington: Urban Institute, Brookings Institution), January. Available via Internet: www.taxpolicycenter.org/commentary/taxnotes.cfm. Gross, D.B., and N.S. Souleles, 2001, "Do Liquidity Constraints and Interest Rates Matter for Consumer Behavior? Evidence from Credit Card Data," NBER Working Paper No. 8314 (Cambridge, Massachusetts: National Bureau of Economic Research). Gruber, J., and E. Saez, 2000, "The Elasticity of Taxable Income: Evidence and Implications," NBER Working Paper No. 7512 (Cambridge, Massachusetts: National Bureau of Economic Research). International Monetary Fund, 2003a, United States: Report on the Observance of Standards and Codes—Fiscal Transparency Module, IMF Staff Country Report No. 03/243 (Washington: International Monetary Fund). ———, 2003b, World Economic Outlook, September 2003: Public Debt in Emerging Markets (Washington: International Monetary Fund). Leidy, M., 1998, "A Postmortem on the Achievement of Federal Fiscal Balance," in United States: Selected Issues, IMF Staff Country Report No. 98/105 (Washington: International Monetary Fund). Office of Management and Budget (OMB), 2003a, Budget of the U.S. Government, Fiscal Year 2004 (Washington: U.S. Government Printing Office). ——— , 2003b, Mid-Session Review, Budget of the U.S. Government, FY2004 (Washington: U.S. Government Printing Office), July.

1The U.S. fiscal year runs from October through September.

211 2The calculation of cyclical factors has been complicated by the sharp increase in capital gains tax revenues during the stock market boom of the 1990s. The CBO does not treat these revenues as a cyclical factor, but they clearly need to be excluded for identifying policy-related factors. Hence, Figure 1.2 includes a cyclically adjusted balance that has been corrected for the deviation of capital gains tax revenues from their historical average. 3Some studies have suggested a lesser contribution from cyclical factors, partly reflecting difficulties in distinguishing cyclical effects from structural shifts in the economy. For example, Leidy (1998) found that only about 20–25 percent of the fiscal improvement between FY1992 and FY1997 was caused by the cycle. He estimated that roughly half the turnaround was accounted for by tax measures and another one-fourth by reductions in discretionary spending relative to GDP. 4Both the Office of Management and Budget and the CBO regularly present a decomposition of changes in the budget balance into cyclical and other factors. 5Discretionary spending is controlled by annual appropriations acts. Mandatory spending is provided by permanent law and does not require annual appropriations to ensure the continuation of spending. 6See, for example, the discussion in OMB (2003a). 7At the same time, the short-term demand effect of the tax cuts is likely to have been limited by the fact that higher-income households tend to derive most of the income gains from tax reform (Gruber and Saez, 2000) but generally have a lower marginal propensity to consume than lower-income households (e.g., Gross and Souleles, 2001). 8For example, the administration's $87 billion supplemental to cover the costs of ongoing military operations and reconstruction in Afghanistan and Iraq was about twice the size expected at the time the staff projections underlying Figure 1.5 were made. 9The AMT is a parallel income tax system with fewer exemptions, deductions, and rates than the regular income tax (e.g., personal exemptions and the standard deduction are not allowed under the AMT). It was enacted to limit the extent to which high-income taxpayers can reduce their tax liability by using preferences in the regular tax code. Due to increases in nominal income, the number of tax returns subject to the AMT is projected to increase from 4 million in 2004 to 33 million in 2010. 10In a March 2003 speech, delivered at a Bank of France symposium, Federal Reserve Chairman Alan Greenspan remarked on the U.S. current account deficit: "There are limits to the accumulation of net claims against an economy that persistent current account deficits imply. The cost of servicing such claims adds to the current account deficit and, under certain circumstances, can be destabilizing." 11Cost increases for Medicaid are less strongly driven by demographic developments, since benefits are provided to all low-income households independent of age. 12OMB, 2003a, Chapter 3. This estimate assumes that current assets of the Social Security Trust Fund will be used to cover future pension benefits. 13Federal Reserve Chairman Greenspan also made this point in his February 2002 speech to the National Summit on Retirement Savings. 14The Social Security surplus reflects an accumulation of assets that is—in principle—matched by future obligations to retirees. For this reason, U.S. policymakers and other analysts have often focused on measures of the fiscal balance that exclude the Social Security surplus. http://www.imf.org/external/pubs/nft/op/227/index.htm

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Testimony of Chairman Alan Greenspan Federal Reserve Board's semiannual Monetary Policy Report to the Congress Before the Committee on Financial Services, U.S. House of Representatives February 11, 2004 Mr. Chairman and members of the Committee, I am pleased to be here today to present the Federal Reserve's Monetary Policy Report to the Congress.

When I testified before this committee in July, I reported that conditions had become a good deal more supportive of economic expansion over the previous few months. A notable reduction in geopolitical concerns, strengthening confidence in economic prospects, and an improvement in financial conditions boded well for spending and production over the second half of the year. Still, convincing signs of a sustained acceleration in activity were not yet in evidence. Since then, the picture has brightened. The gross domestic product expanded vigorously over the second half of 2003 while productivity surged, prices remained stable, and financial conditions improved further. Overall, the economy has made impressive gains in output and real incomes; however, progress in creating jobs has been limited.

Looking forward, the prospects are good for sustained expansion of the U.S. economy. The household sector's financial condition is stronger, and the business sector has made substantial strides in bolstering balance sheets. Narrowing credit risk spreads and a considerable rally in equity prices have reduced financing costs and increased household wealth, which should provide substantial support for spending by businesses and households. With short-term real interest rates close to zero, monetary policy remains highly accommodative. And it appears that the impetus from fiscal policy will stay expansionary, on net, through this year. These circumstances all should spur the expansion of aggregate demand in 2004. At the same time, increases in efficiency and a significant level of underutilized resources should help keep a lid on inflation.

In retrospect, last year appears to have marked a transition from an extended period of subpar economic performance to one of more vigorous expansion. Once again, household spending was the mainstay, with real personal consumption spending increasing nearly 4 percent and real outlays on residential structures rising about 10 percent. Last year's reductions in personal income tax rates and the advance of rebates to those households that were eligible for the expanded child tax credit boosted the growth of real disposable personal income. The very low level of interest rates also encouraged household spending through a variety of channels. Automakers took advantage of low interest rates to offer attractive incentive deals, buoying the purchase of new vehicles. The lowest home mortgage rates in decades were a major contributor to record sales of existing residences, engendering a large extraction of cash from home equity. A significant part of that cash supported personal consumption expenditures and home improvement. In addition, many households took out cash in the process of refinancing, often using the proceeds to substitute for higher-cost consumer debt. That refinancing also permitted some households to lower the monthly carrying costs for their homes and thus freed up funds for

213 other expenditures. Not least, the low mortgage rates spurred sales and starts of new homes to very high levels.

These developments were reflected in household financing patterns. Home mortgage debt increased about 13 percent last year, while consumer credit expanded much more slowly. Even though the ratio of overall household debt to income continued to increase, as it has for more than a half-century, the rise in home and equity prices enabled the ratio of household net worth to disposable income to recover to a little above its long-term average. The low level of interest rates and large volume of mortgage refinancing activity helped reduce households' debt-service and financial-obligation ratios a bit. And many measures of consumer credit quality improved over the year, with delinquency rates on consumer loans and home mortgages declining.

A strengthening in capital spending over 2003 contributed importantly to the acceleration of real output. In the first quarter of the year, business fixed investment extended the downtrend that began in early 2001. Capital spending, however, ramped up considerably over the final three quarters of 2003, reflecting a pickup in expenditures for equipment and software. Outlays for high-tech equipment showed particular vigor last year. Even spending on communications equipment, which had been quite soft in the previous two years, accelerated. A growing confidence of business executives in the durability of the expansion, strong final sales, the desire to renew capital stocks after replacements had been postponed, and favorable financial conditions all contributed to the turnaround in equipment spending.

By contrast, expenditures on nonresidential structures continued to contract on balance, albeit less rapidly than in 2001 and 2002. High vacancy rates for office buildings and low rates of capacity utilization in manufacturing evidently limited the demand for new structures. Inventory investment likewise failed to pick up much momentum over the year, as managers remained cautious. Firms finished 2003 with lean inventories relative to sales, an encouraging sign for the expansion of production going forward.

To a considerable degree, the gathering strength of capital spending reflects a substantial improvement in the financial condition of businesses over the past few years. Firms' profits rose steeply during 2003 following smaller gains in the previous two years. The significantly stronger cash flow generated by profits and depreciation allowances was more than adequate to cover rising capital expenditures in the aggregate. As a result, businesses had little need to borrow during 2003. For the nonfinancial business sector as a whole, debt is estimated to have grown just 3-1/2 percent.

Firms encountered very receptive conditions in longer-term credit markets in 2003. Interest rate spreads on both investment-grade and speculative-grade bond issues narrowed substantially over the year, as investors apparently became more confident about the economic expansion and saw less risk of adverse shocks from accounting and other corporate scandals. Corporate treasurers took advantage of the attractive market conditions by issuing long-term debt to lengthen the maturities of corporate liabilities.

As a consequence, net short-term financing was extremely weak. The stock of business loans extended by banks and commercial paper issued by nonfinancial firms declined more than $100 billion over the year, apparently owing to slack demand for short-term credit rather than to a constriction in supply. Interest-rate spreads on commercial paper, like those on corporate bonds, were quite narrow. And although a Federal Reserve survey indicates that banks had continued to tighten lending conditions early in the year, by the second half, terms and standards were being

214 eased noticeably. Moreover, responses to that survey pointed to a lack of demand for business loans until late in the year.

Partly as a result of the balance-sheet restructuring, business credit quality appears to have recuperated considerably over the past few years. Last year, the default rate on bonds fell sharply, recovery rates on defaulted issues rose, the number of rating downgrades moderated substantially, and delinquencies on business loans continued to decline. The improved balance sheets and strong profits of business firms, together with attractive terms for financing in open markets and from banks, suggest that financial conditions remain quite supportive of further gains in capital spending in coming quarters.

The profitability of the business sector was again propelled by stunning increases in productivity. The advance in output per hour in the nonfarm business sector picked up to 5-1/4 percent in 2003 after unusually brisk gains in the previous two years. The productivity performance of the past few years has been particularly striking in that these increases occurred in a period of relatively sluggish output growth. The vigorous advance in efficiency represents a notable extension of the pickup that started around the mid-1990s. Apparently, businesses are still reaping the benefits of the marked acceleration in technology.

The strong gains in productivity, however, have obviated robust increases in business payrolls. To date, the expansion of employment has significantly lagged increases in output. Gross separations from employment, two-fifths of which have been involuntary, are about what would be expected from past cyclical experience, given the current pace of output growth. New hires and recalls from layoffs, however, are far below what historical experience indicates. To a surprising degree, firms seem able to continue identifying and implementing new efficiencies in their production processes and thus have found it possible so far to meet increasing orders without stepping up hiring.

In all likelihood, employment will begin to grow more quickly before long as output continues to expand. Productivity over the past few years has probably received a boost from the efforts of businesses to work off the stock of inefficiencies that had accumulated in the boom years. As those opportunities to enhance efficiency become scarcer and as managers become more confident in the durability of the expansion, firms will surely once again add to their payrolls.

A consequence of the rapid gains in productivity and slack in our labor and product markets has been sustained downward pressure on inflation. As measured by the chain-weighted price index for personal consumption expenditures excluding food and energy, prices rose less than 1 percent in 2003. Given the biases in such indexes, this performance puts measured inflation in a range consistent with price stability--a statutory objective of the Federal Reserve and a key goal of all central banks because it is perceived as a prerequisite for maximum sustainable economic growth.

The recent performance of inflation has been especially notable in view of the substantial depreciation of the dollar in 2003. Against a broad basket of currencies of our trading partners, the foreign exchange value of the U.S. dollar has declined about 13 percent from its peak in early 2002. Ordinarily, currency depreciation is accompanied by a rise in dollar prices of imported goods and services, because foreign exporters endeavor to avoid experiencing price declines in their own currencies, which would otherwise result from the fall in the foreign exchange value of the dollar. Reflecting the swing from dollar appreciation to dollar depreciation, the dollar prices of goods and services imported into the United States have begun

215 to rise after declining on balance for several years, but the turnaround to date has been mild. Apparently, foreign exporters have been willing to absorb some of the price decline measured in their own currencies and the consequent squeeze on profit margins it entails.

Part of exporters' losses, however, have apparently been offset by short forward positions against the dollar in foreign exchange markets. A marked increase in foreign exchange derivative trading, especially in dollar-euro, is consistent with significant hedging of exports to the United States and to other markets that use currencies tied to the U.S. dollar. However, most contracts are short-term because long-term hedging is expensive. Thus, although hedging may delay the adjustment, it cannot eliminate the consequences of exchange rate change. Accordingly, the currency depreciation that we have experienced of late should eventually help to contain our current account deficit as foreign producers export less to the United States. On the other side of the ledger, the current account should improve as U.S. firms find the export market more receptive.

* * *

Although the prospects for the U.S. economy look quite favorable, we need to remind ourselves that all forecasts are projections into an uncertain future. The fact that most professional forecasters perceive much the same benign short-term outlook that is our most likely expectation provides scant comfort. When the future surprises, history tells us, it often surprises us all. We must, as a consequence, remain alert to risks that could threaten the sustainability of the expansion.

Besides the chronic concern about a sharp spike in oil or natural gas prices, a number of risks can be identified. Of particular importance to monetary policy makers is the possibility that our stance could become improperly calibrated to evolving economic developments. To be sure, the Federal Open Market Committee's current judgment is that its accommodative posture is appropriate to foster sustainable expansion of economic activity. But the evidence indicates clearly that such a policy stance will not be compatible indefinitely with price stability and sustainable growth; the real federal funds rate will eventually need to rise toward a more neutral level. However, with inflation very low and substantial slack in the economy, the Federal Reserve can be patient in removing its current policy accommodation.

In the process of assessing risk, we monitor a broad range of economic and financial indicators. Included in this group are a number of measures of liquidity and credit creation in the economy. By most standard measures, aggregate liquidity does not appear excessive. The monetary aggregate M2 expanded only 5-1/4 percent during 2003, somewhat less than nominal GDP, and actually contracted during the fourth quarter. The growth of nonfederal debt, at 7-3/4 percent, was relatively brisk in 2003. However, a significant portion of that growth was associated with the record turnover of existing homes and the high level of cash-out refinancing, which are not expected to continue at their recent pace. A narrower measure, that of credit held by banks, also grew only moderately in 2003. All told, our accommodative monetary policy stance to date does not seem to have generated excessive volumes of liquidity or credit.

That said, as we evaluate the risks to the economy, we also assess developments in financial markets. Broad measures of equity prices rose 25 percent in 2003, and technology stocks increased twice as quickly. The rally has extended into this year. And as I noted previously, credit spreads on corporate bonds have narrowed considerably, particularly for speculative-grade issues. This performance of financial markets importantly reflects investors' response to robust

216 earnings growth and the repair of business balance sheets over the past few years. However, history shows that pricing financial assets appropriately in real time can be extremely difficult and that, even in a seemingly benign economic environment, risks remain.

The outlook for the federal budget deficit is another critical issue for policymakers in assessing our intermediate- and long-run growth prospects and the risks to those prospects. As you are well aware, after a brief period of unified budget surpluses around the beginning of this decade, the federal budget has reverted to deficits. The unified deficit swelled to $375 billion in fiscal 2003 and appears to be widening considerably further in the current fiscal year. In part, these deficits are a result of the economic downturn and the period of slower growth that we recently experienced, as well as the earlier decline in equity prices. The deficits also reflect fiscal actions specifically intended to provide stimulus to the economy, a significant step-up in spending for national security, and a tendency toward diminished restraint on discretionary spending. Of course, as economic activity continues to expand, tax revenues should strengthen and the deficit will tend to narrow, all else being equal. But even budget projections that attempt to take such business-cycle influences into account, such as those from the Congressional Budget Office and the Office of Management and Budget, indicate that very sizable deficits are in prospect in the years to come.

As I have noted before, the debate over budget priorities appears to be between those advocating additional tax cuts and those advocating increased spending. Although some stirrings in recent weeks in the Congress and elsewhere have been directed at actions that would lower forthcoming deficits, to date no effective constituency has offered programs to balance the budget. One critical element--present in the 1990s but now absent--is a framework of procedural rules to help fiscal policy makers make the difficult decisions that are required to forge a better fiscal balance.

The imbalance in the federal budgetary situation, unless addressed soon, will pose serious longer-term fiscal difficulties. Our demographics--especially the retirement of the baby-boom generation beginning in just a few years--mean that the ratio of workers to retirees will fall substantially. Without corrective action, this development will put substantial pressure on our ability in coming years to provide even minimal government services while maintaining entitlement benefits at their current level, without debilitating increases in tax rates. The longer we wait before addressing these imbalances, the more wrenching the fiscal adjustment ultimately will be.

The fiscal issues that we face pose long-term challenges, but federal budget deficits could cause difficulties even in the relatively near term. Long-term interest rates reflect not only the balance between the current demand for, and current supply of, credit, they also incorporate markets' expectations of those balances in the future. As a consequence, should investors become significantly more doubtful that the Congress will take the necessary fiscal measures, an appreciable backup in long-term interest rates is possible as prospects for outsized federal demands on national saving become more apparent. Such a development could constrain investment and other interest-sensitive spending and thus undermine the private capital formation that is a key element in our economy's growth prospects.

Addressing the federal budget deficit is even more important in view of the widening U.S. current account deficit. In 2003, the current account deficit reached $550 billion--about 5 percent of nominal GDP. The current account deficit and the federal budget deficit are related because the large federal dissaving represented by the budget deficit, together with relatively

217 low rates of U.S. private saving, implies a need to attract saving from abroad to finance domestic private investment spending.

To date, the U.S. current account deficit has been financed with little difficulty. Although the foreign exchange value of the dollar has fallen over the past year, the decline generally has been gradual, and no material adverse side effects have been visible in U.S. capital markets. While demands for dollar-denominated assets by foreign private investors are off their record pace of mid-2003, such investors evidently continue to perceive the United States as an excellent place to invest, no doubt owing, in large part, to our vibrant market system and our economy's very strong productivity performance. Moreover, some governments have accumulated large amounts of dollar-denominated debt as a byproduct of resisting upward exchange rate adjustment.

Nonetheless, given the already-substantial accumulation of dollar-denominated debt, foreign investors, both private and official, may become less willing to absorb ever-growing claims on U.S. residents. Taking steps to increase our national saving through fiscal action to lower federal budget deficits would help diminish the risks that a further reduction in the rate of purchase of dollar assets by foreign investors could severely crimp the business investment that is crucial for our long-term growth.

The large current account deficits and the associated substantial trade deficits pose another imperative--the need to maintain the degree of flexibility that has been so prominent a force for U.S. economic stability in recent years. The greatest current threat to that flexibility is protectionism, a danger that has become increasingly visible on today's landscape. Over the years, protected interests have often endeavored to stop in its tracks the process of unsettling economic change. Pitted against the powerful forces of market competition, virtually all such efforts have failed. The costs of any new protectionist initiatives, in the context of wide current account imbalances, could significantly erode the flexibility of the global economy. Consequently, creeping protectionism must be thwarted and reversed.

* * *

In summary, in recent years the U.S. economy has demonstrated considerable resilience to adversity. It has overcome significant shocks that, in the past, could have hobbled growth for a much longer period than they have in the current cycle. As I have noted previously, the U.S. economy has become far more flexible over the past two decades, and associated improvements have played a key role in lessening the effects of the recent adverse developments on our economy. Looking forward, the odds of sustained robust growth are good, although, as always, risks remain. The Congress can help foster sustainable expansion by taking steps to reduce federal budget deficits and thus contribute to national saving and by continuing to pursue opportunities to open markets and promote trade. For our part, the Federal Reserve intends to use its monetary tools to promote our goals of economic growth and maximum employment of our resources in an environment of effective price stability.

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Release Date: January 28, 2004

For immediate release

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 1 percent.

The Committee continues to believe that an accommodative stance of monetary policy, coupled with robust underlying growth in productivity, is providing important ongoing support to economic activity. The evidence accumulated over the intermeeting period confirms that output is expanding briskly. Although new hiring remains subdued, other indicators suggest an improvement in the labor market. Increases in core consumer prices are muted and expected to remain low.

The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation.

Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Ben S. Bernanke; Susan S. Bies; Roger W. Ferguson, Jr.; Edward M. Gramlich; Thomas M. Hoenig; Donald L. Kohn; Cathy E. Minehan; Mark W. Olson; Sandra Pianalto; and William Poole.

2004 Monetary policy

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Remarks by Governor Susan Schmidt Bies At the Bond Market Association's Legal and Compliance Conference, New York, New York February 4, 2004 Enterprise-wide Compliance Programs

Introduction I want to thank the Bond Market Association for the opportunity to speak to you this afternoon. Given the evolution of the financial markets and financial services industry and the unfortunate events that some firms have recently encountered, comprehensive and robust management of legal and reputational risks is becoming more essential. The agenda for this conference reflects many of the concerns that have been raised over the past two years regarding legal and reputational risks in general, and conflicts of interest, the adequacy of public disclosures, and the transparency of accounting in particular.

I know that we all hoped that with the new year we could put behind us the corporate governance shortcomings and financial restatements of the past several quarters. Unfortunately, the news about Parmalat demonstrates that we are not yet out of the woods and that corporate governance problems are not limited to the United States, but are a global issue. Financial firms are facing losses and possible legal and reputational risks in connection with their dealings with this company. The industry still has a lot of work to do in managing risks, and this conference is an excellent step toward addressing important risk- management issues in the context of the compliance function.

In addition to sponsoring this timely conference, the Bond Market Association has been at the forefront of myriad initiatives relating to risk management and compliance. One especially important initiative has been the association's participation with other industry groups in establishing the Joint Market Practices Forum. The forum's first initiative has been to articulate a statement of principles regarding the handling and use of material, nonpublic information by credit market participants. The statement of principles fulfills a number of objectives. The most critical, in my view, is the promotion of fair and competitive markets in which inappropriate use of material, nonpublic information is not tolerated. At the same time, the statement allows lenders to effectively manage credit- portfolio activities to facilitate borrower access to more-liquid and more-efficient sources of credit. This recognizes that the liquidity and efficiency of our financial markets are related directly to the integrity of, and public confidence in, those markets.

The forum's statement of principles also provides a number of meaningful recommendations, some of which have already been adopted by the major participants in the credit derivatives market. The statement and recommendations have sparked much- needed discussion and helped identify issues, such as conflicts of interest and insider

220 trading, that may arise in connection with credit portfolio management. These are important steps toward improving the risk-management environment, and I commend you for voluntarily taking the initiative.

One aspect of the forum's statement that I would particularly like to applaud is its focus on controls and compliance across the consolidated organization, because that focus ties directly to my remarks today. Specifically, I would like to discuss the need for financial services firms to develop enterprise-wide compliance programs for legal and reputational risk management. As financial firms continue to grow more complex and add new products, services, and activities--all of which are natural and positive market developments--they need to have a process to facilitate the evolution of the culture of compliance across the organization.

I am first going to discuss the importance of an enterprise-wide approach to risk management and identify some particular areas in which an integrated approach can improve internal controls. Then I will talk about how compliance and internal audit can foster effective risk management.

Enterprise-wide Risk-Management Framework

What do I mean by an enterprise-wide compliance program? I would define it as an integral part of an overall risk-management framework that is adopted by an entity's board of directors and senior management and is applied in setting a strategy throughout a firm. As you may know, the Committee of Sponsoring Organizations of the Treadway Commission, or COSO, is in the process of finalizing an enterprise-wide risk-management framework that is expected to be published later this year. The principles the new COSO document espouses transcend functional areas, and I expect that it will be an important contribution to the ongoing discussion of how risk management can be strengthened across different types of organizations and functional areas.

For those of you not familiar with the COSO framework, let me briefly explain that an enterprise-wide risk-management framework identifies potential events that may affect the entity and establishes how the organization will manage its risk given the firm's risk appetite and strategic direction. In an enterprise-wide risk-management framework, managers are expected to evaluate at least annually the risks and controls within their scope of authority and to report the results of this process to the chief risk officer and the audit committee of the board of directors.

In evaluating risks, managers need to consider both current and planned or anticipated operational and market changes and identify the risks arising from those changes. Once risks have been identified comprehensively, assessed, and evaluated as to their potential impact on the organization, management must determine the effectiveness of existing controls and develop and implement additional appropriate mitigating controls where needed.

The robustness and effectiveness of these controls must be evaluated independently, soon after the control structure is established, so that any shortcomings can be identified promptly and corrected. Risk assessments initiated early in the planning process can give the firm time to implement mitigating controls and conduct a validation of the quality of those controls before launching the product. Strong internal controls and governance require

221 that these assessments be done by an independent group. One of the weaknesses that we have seen is that management delegates both the development and the assessment of the internal control structure to the same risk-management, internal audit, compliance, or legal division. Instead, it is important to emphasize that line management has the responsibility for identifying risks and ensuring that the mitigating controls are effective, and that the assessments should be done by a group independent of that line organization.

An enterprise-wide approach also can integrate the risk assessment of functions that have traditionally been managed in "silos." Conflicts can arise in many different areas and functions of the firm, including sales and research. Conflicts can also occur when compensation structures create incentives inconsistent with prudent risk management or when the bottom line for the current quarter is unduly emphasized without adequate consideration of the risk being taken to accomplish those results. The potential for these conflicts to arise must be addressed squarely by senior management, and appropriate controls must be in place to manage and mitigate conflicts.

A culture of compliance should establish--from the top of the organization--the proper ethical tone that will govern the conduct of business. In many instances, senior management must move from thinking about compliance chiefly as a cost center to considering the benefits of compliance in protecting against legal and reputational risks that can have an impact on the bottom line. It is important to note that the board of directors and senior management of financial firms are responsible for setting the "tone at the top" and developing the compliance culture that has been discussed at this conference. The board and senior management are obligated to deliver a strong message to others in the firm about the importance of integrity, compliance with the law, and overall good business ethics. They also need to demonstrate their commitment through their individual conduct and their response to control failures. The message and corresponding conduct should empower line staff to elevate ethical or reputational concerns to appropriate levels of management without fear of retribution.

Reputational and legal risks pose major threats to financial services firms because the nature of their business requires maintaining the confidence of customers, creditors, and the general marketplace. Importantly, legal and reputational risk can negatively affect the profitability, and ultimately the viability, of a financial firm.

Enterprise-wide Compliance Program

A strong compliance program is an integral part of the risk-management function. For the reasons I will discuss, the best practice in complex financial firms is to conduct risk management on an enterprise-wide basis. As a result, compliance activities should be managed on an enterprise-wide basis as well.

Traditional risk management has focused on quantifiable risks, such as credit and market risks. Recent events have demonstrated the need for greater focus on the risks that are harder to quantify--that is, operational, legal, and reputational risks. Indeed, legal and reputational risks are significant risks facing some financial firms today. The compliance area is critically important in identifying, evaluating, and addressing legal and reputational risks. Given the significance of these risks, a strong enterprise-wide compliance program is a necessity for complex financial firms. A well-executed compliance program can also

222 highlight operational problems.

As an integral part of an enterprise-wide risk management, an enterprise-wide compliance program looks at and across business lines and activities of the organization as a whole to consider how activities in one area of the firm may affect the legal and reputational risks of other business lines and the enterprise as a whole. It considers how compliance with laws, regulations, and internal policies, procedures, and controls should be enhanced or changed in response. This approach is in marked contrast to the silo approach to compliance, which considers the legal and reputational risks of activities or business lines in isolation without considering how those risks interrelate and affect other business lines. The silo approach to compliance has prevailed for far too long in financial firms. We are overdue for a paradigm shift to an enterprise-wide compliance structure as we also shift to enterprise-wide risk management.

Why is an enterprise-wide compliance program so important? Recently, in an interview with The Wall Street Journal, the independent board chairman of a prominent mutual fund company involved in the market-timing scandal identified as one of the firm's compliance breakdowns the bifurcation of compliance responsibilities within the firm. That is, no one had the 25,000-foot view of what was happening across the organization, and this led to internal control shortcomings that were not identified and to opportunities for employees to take unfair advantage of other market participants. Moreover, the compliance function did not have the status and perceived importance it should have had. The company's board reportedly has installed a board-level compliance officer in response to a review of the circumstances surrounding the control deficiencies. This addition helps to ensure that the board, the group that is ultimately responsible for risk management, can assess the quality and robustness of compliance across the organization.

Enterprise-wide compliance programs incorporate controls that include transaction approval and monitoring procedures in all relevant functional areas. They also provide all decisionmakers with complete and comprehensive information about the proposed transaction. Involving all relevant functional areas and decisionmakers allows for an enhanced review of a transaction, one that considers the impact of the transaction across the consolidated organization. As a result, compliance is conducted on a comprehensive, holistic basis and not in silos. Involving all functional areas and decisionmakers also focuses attention on all the relationships a client may have across the organization, allowing identification of conflicts of interest or other sources of legal and reputational risks.

Viewing compliance across the organization's different functions minimizes the potential for legal and reputational risks to be overlooked. As a result, compliance policies, procedures, and controls are less likely to be inadequate. For example, conflict-of-interest policies and controls may be inadequate if risk management in the traditional credit function does not also consider the activities being conducted in the trading and sales areas.

An enterprise-wide compliance program helps management and the board understand where the legal and reputational risks in the organization are concentrated, provides comparisons of the level and changing nature of risks, and identifies those control processes that most need enhancement. This process, in turn, can facilitate analysis of whether the legal and reputational risks taken in a particular part of the organization are appropriate. Of course, the ability to assess legal and reputational risks across the enterprise depends heavily on the quality and timeliness of information. The compliance function must ensure that controls

223 and procedures capture the appropriate information to allow senior management and the board to better perform their risk management functions.

The enterprise-wide compliance function should look at what is being reported to the board, the audit committee, and senior management regarding new or changed processes, procedures, and controls. Is there an effective mechanism for reporting control failures or limit exceptions? How are these exceptions pursued for follow-up action, and how are corrective actions communicated back to the board or management? Importantly, the compliance function should have a direct line to the general counsel through which it can report concerns and needed improvements to processes and controls.

The focus on an enterprise-wide approach to compliance does not mean that the organization cannot leverage off of specific business-line compliance functions. Indeed, it is very important to retain business-line compliance functions because they are staffed by individuals who understand the activities being conducted and know where control breakdowns have occurred in the past. For example, the compliance function for a trading operation requires staff with detailed understanding of the back office, the middle office, and the front office. The enterprise-wide compliance approach supplements this business- line-specific view of compliance with a big-picture approach at the corporate level that encompasses and has access to all lines of business and operational areas. It incorporates the various business-line compliance reviews in assessing the robustness and adequacy of enterprise-wide legal and reputational risk management, and it ensures that significant issues are brought to the attention of senior global compliance officers as appropriate.

The enterprise-wide view is particularly important when functions cross business lines and management lines of responsibility. When business lines or managers share responsibility for compliance, specific duties and chains of accountability need to be established at the line-management level and overseen by the person ultimately responsible for compliance across the organization.

An enterprise-wide compliance program is also dynamic, constantly assessing new legal and reputational risks when new business lines or activities are added or existing activities are altered. Constant reassessment of risks and controls and communication with the business lines is necessary to avoid a compliance program that is operating on autopilot and does not proactively respond to change in the organization.

The Role of the New-Product Approval Process

The compliance program is an important participant in the new-product approval process, along with other relevant parties, including credit risk, market risk, operations, accounting, legal, audit, and senior line management. Compliance personnel should have an active voice in determining whether a particular activity or product constitutes a new product requiring review and approval. New products include products or services being offered to, or activities being conducted for the first time in, a new market or to a new category of customers or counterparties. For example, a product traditionally marketed to institutional customers that is being rolled out to retail customers (hedge funds, for instance) generally should be reviewed as a new product. In addition, significant modifications to products, services, and activities or their pricing warrant review as a new product. Even small changes in the terms of products or the scope of services or activities can greatly alter their risk profiles and justify review as a new product. When in doubt about whether a product,

224 service, or activity warrants review as a new product, financial firms should err on the side of conservatism and route the proposal through the new-product approval process. Cutting short a new-product review because of a rush to deliver a new product to market, or because of performance pressures, increases the potential for serious legal and reputational risk.

The determination of whether a new or modified activity requires additional compliance processes, procedures, or controls is clearly the province of the compliance staff. It involves the interaction of business-line compliance staff with personnel responsible for enterprise- wide risk management. Once these processes, procedures, or controls are designed, compliance personnel should help ensure that those controls are implemented effectively and are a comprehensive response to the legal and reputational risks posed.

The Role of Internal Audit

Just as the compliance area performs an independent review of the firm's activities and business lines, the compliance program also needs to be reviewed independently. Internal audit has the responsibility to review the enterprise-wide compliance program to determine if it is accomplishing the firm's stated objectives, and if it is adequately and appropriately staffed, in light of growth, changes in the firm's business mix, new customers, strategic initiatives, reorganizations, and process changes. Internal audit should evaluate the firm's adherence to its own compliance and control processes and assess the adequacy of those processes in light of the complexity and legal and reputational risk profile of the organization.

It should be obvious that internal audit, like the compliance program, needs to be staffed with personnel who have the necessary skills and experience to report on compliance with financial institution policies and procedures. Internal audit should test transactions to validate that business lines are complying with the firm's standards and report the results of that testing to the board or audit committee, as appropriate.

Structured Transactions

There are "lessons learned" from the legal and reputational risks that some financial firms faced in structuring transactions for Enron and WorldCom, among others. Those legal and reputational risks require a focus on appropriateness assessments, the enforceability of netting and collateral agreements, undocumented customer assurances, insurance considerations, and potential IRS challenges.

Assessments of the appropriateness of a transaction for a client traditionally have required firms to determine if the transaction is consistent with the financial sophistication, financial condition, and investment policies of the customer. Given recent events, it is appropriate to raise the bar on appropriateness assessments in the approval process for complex structured transactions by taking into account the business purpose and economic substance of the transaction.

When firms provide advice on, arrange, or actively participate in a complex structured finance transaction, they may assume legal and reputational risks if the end-user enters into the transaction for improper purposes. Firms should have effective and consistent policies and procedures that require a thorough review of the business purposes and economic substance of the transaction by all relevant functional areas and an assessment of any legal

225 or reputational risks posed by the transaction. In instances that present heightened legal or reputational risk, the policies and procedures should require a review, by appropriate senior management, of the customer's business relationship with the firm. Of course, these policies and procedures need to be supported and enforced by a strong tone at the top and a firm- wide culture of compliance.

Conclusion The evolution of the financial markets and the number of significant governance issues recently faced by complex financial firms clearly underscore the need to view risk management on an enterprise-wide basis. An integral part of a robust legal and reputational risk-management function is a strong compliance program. For such programs to be effective in complex financial institutions, compliance must be addressed on an enterprise- wide basis.

226

Remarks by Chairman Alan Greenspan Economic flexibility Before the HM Treasury Enterprise Conference, London, England (via satellite) January 26, 2004

As the Great Depression of the 1930s deepened, John Maynard Keynes offered an explanation for the then-bewildering series of events that was to engage economists for generations to come. Market systems, he argued, contrary to the conventional wisdom, did not at all times converge to full employment. They often, in economists' jargon, found equilibrium with significant segments of the workforce unable to find jobs. His insight rested largely on certain perceived rigidities in labor and product markets. The notion prevalent in the 1920s and earlier--that economies, when confronted with unanticipated shocks, would quickly return to full employment--fell into disrepute as the depression festered. In its place arose the view that government action was required to restore full employment.

More broadly, government intervention was increasingly seen as necessary to correct the failures and deficiencies viewed as inherent in market economies. Laissez-faire was rapidly abandoned and a tidal wave of regulation swept over much of the world's business community. In the United States, labor practices, securities issuance, banking, agricultural pricing, and many other segments of the American economy, fell under the oversight of government. With the onset of World War II, both the U.S. and the U.K. economies went on a regimented war footing. Military production ramped up rapidly and output reached impressive levels. Central planning, in one sense, had its finest hour. The pattern of production and distribution depended on plans devised by a small, elite group rather than responding to the myriad choices of consumers that rule a market economy.

The ostensible success of wartime economies operating at full employment, in contrast to the earlier frightening developments of the depression years, thwarted a full dismantlement of wartime regimens when hostilities came to an end. Wage and price controls, coupled with rationing, lingered in many economies well into the first postwar decade. Because full employment was no longer perceived as ensured by the marketplace, government initiatives promoting job growth dominated the postwar economic policy framework of the Western democracies. In the United States, the Congress passed, and the President signed, the "Employment Act of 1946."

However, cracks in the facade of government economic management emerged early in the postwar years, and those cracks were to continue widening as time passed. Britain's heavily controlled economy was under persistent stress as it vaulted from one crisis to another in the early postwar decades. In the United States, unbalanced macroeconomic policies led to a gradual uptrend in the rate of inflation in the 1960s. The imposition of wage and price controls in the 1970s to deal with the problem of inflation proved unworkable and ineffective. The notion that the centrally planned Soviet economy was catching up with the West was, by the early 1980s,

227 increasingly viewed as dubious, though it was not fully discarded until the collapse of the Berlin Wall in 1989 exposing the economic ruin behind the iron curtain.

The East-West divisions following World War II engendered an unintended four-decades-long experiment in comparative economic systems, which led, in the end, to a judgment by the vast majority of policymakers that market economies were unequivocally superior to those managed by central planning. Many developing nations abandoned their Soviet-type economic systems for more market-based regimes.

But even earlier in the developed world, distortions induced by regulation were more and more disturbing. In response, starting in the 1970s, American Presidents, supported by bipartisan majorities in the Congress, deregulated large segments of the transportation, communications, energy, and financial services industries. The stated purpose was to enhance competition, which was increasingly seen as a significant spur to productivity growth and elevated standards of living. Assisting in the dismantling of economic rigidities was the seemingly glacial, but persistent, lowering of barriers to cross-border trade and finance.

As a consequence, the United States, then widely seen as a once great economic power that had lost its way, gradually moved back to the forefront of what Joseph Schumpeter, the renowned Harvard professor, called "creative destruction," the continuous scrapping of old technologies to make way for the innovative. In that paradigm, standards of living rise because depreciation and other cash flows of industries employing older, increasingly obsolescent, technologies are marshaled, along with new savings, to finance the production of capital assets that almost always embody cutting-edge technologies. Workers, of necessity, migrate with the capital.

Through this process, wealth is created, incremental step by incremental step, as high levels of productivity associated with innovative technologies displace lesser productive capabilities. The model presupposes the continuous churning of a flexible competitive economy in which the new displaces the old.

The success of that strategy in the United States confirmed, by the 1980s, the earlier views that a loosening of regulatory restraint on business would improve the flexibility of our economy. Flexibility implies a faster response to shocks and a correspondingly greater ability to absorb their downside consequences and to recover from their aftermath. No specific program encompassed and coordinated initiatives to enhance flexibility, but there was a growing recognition, both in the United States and among many of our trading partners, that a market economy could best withstand and recover from shocks when provided maximum flexibility.

Developments that enhanced flexibility ranged far beyond regulatory or statutory change. For example, employers have long been able to legally discharge employees at modest cost. But in the early postwar years, profitable large corporations were dissuaded from wholesale job reduction. Contractual inhibitions, to be sure, were then decidedly more prevalent than today, but of far greater importance, our culture in the aftermath of depression frowned on such action. Only when bankruptcy threatened was it perceived to be acceptable.

But as the depression receded into history, attitudes toward job security and tenure changed. The change was first evidenced by the eventual acceptance by the American public of President Reagan's discharge of federally employed air traffic controllers in 1981 when they engaged in an illegal strike. Job security, not a major concern of the average worker in earlier years, became a significant issue especially in labor negotiations. By the early 1990s, the climate had so changed

228 that laying off workers to facilitate cost reduction had become a prevalent practice. Whether this seeming greater capacity to discharge workers would increase or decrease the level of structural unemployment was uncertain, however. In the event, structural unemployment decreased because the broadened freedom to discharge workers rendered hiring them less of a potentially costly long-term commitment.

The increased flexibility of our labor market is now judged an important contributor to economic resilience and growth. American workers, to a large extent, see this connection and, despite the evident tradeoff between flexibility and job security, have not opposed innovation. An appreciation of the benefits of flexibility also has been growing elsewhere. Germany recently passed labor reforms, as have other continental European nations. U.K. labor markets, of course, have also experienced significant increases in flexibility in recent years.

Beyond deregulation and culture change, innovative technologies, especially information technology, have been major contributors to enhanced flexibility. A quarter-century ago, companies often required weeks to unearth a possible inventory imbalance, allowing production to continue to exacerbate the excess. Excessive inventories, in turn, necessitated a deeper decline in output for a time than would have been necessary had the knowledge of their status been fully current. The advent of innovative information technologies has significantly foreshortened the reporting lag, enabling flexible real-time responses to emerging imbalances.

Deregulation and the newer information technologies have joined, in the United States and elsewhere, to advance financial flexibility, which in the end may be the most important contributor to the evident significant gains in economic stability over the past two decades.

Historically, banks have been at the forefront of financial intermediation, in part because their ability to leverage offered an efficient source of funding. But too often in periods of severe financial stress, such leverage brought down numerous, previously vaunted banking institutions, and precipitated a financial crisis that led to recession or worse. But recent regulatory reform coupled with innovative technologies has spawned rapidly growing markets for, among many other products, asset-backed securities, collateral loan obligations, and credit derivative default swaps.

Financial derivatives, more generally, have grown throughout the world at a phenomenal rate of 17 percent per year over the past decade. Conceptual advances in pricing options and other complex financial products, along with improvements in computer and telecommunications technologies, have significantly lowered the costs of, and expanded the opportunities for, hedging risks that were not readily deflected in earlier decades. The new instruments of risk dispersion have enabled the largest and most sophisticated banks in their credit-granting role to divest themselves of much credit risk by passing it to institutions with far less leverage. Insurance companies, especially those in reinsurance, pension funds, and hedge funds continue to be willing, at a price, to supply this credit protection, despite the significant losses on such products that some of these investors experienced during the past three years.

These increasingly complex financial instruments have contributed, especially over the recent stressful period, to the development of a far more flexible, efficient, and hence resilient financial system than existed just a quarter-century ago. One prominent example was the response of financial markets to a burgeoning and then deflating telecommunications sector. Worldwide borrowing by telecommunications firms in all currencies amounted to more than the equivalent of one trillion U.S. dollars during the years 1998 to 2001. The financing of the massive

229 expansion of fiber-optic networks and heavy investments in third-generation mobile-phone licenses by European firms strained debt markets.

At the time, the financing of these investments was widely seen as prudent because the telecommunications borrowers had very high valuations in equity markets, which could facilitate a stock issuance, if needed, to pay down bank loans and other debt. In the event, of course, prices of telecommunications stocks collapsed, and many firms went bankrupt. Write- downs were heavy, especially in continental Europe, but unlike in previous periods of large financial distress, no major financial institution defaulted, and the world economy was not threatened. Thus, in stark contrast to many previous episodes, the global financial system exhibited a remarkable ability to absorb and recover from shocks.

* * *

The most significant lesson to be learned from recent economic history is arguably the importance of structural flexibility and the resilience to economic shocks that it imparts. The more flexible an economy, the greater its ability to self-correct in response to inevitable, often unanticipated, disturbances and thus to contain the size and consequences of cyclical imbalances. Enhanced flexibility has the advantage of being able to adjust automatically and not having to rest on policymakers' initiatives, which often come too late or are misguided.

I do not claim to be able to judge the relative importance of conventional stimulus and increased economic flexibility to our ability to weather the shocks of the past few years. But it is difficult to dismiss improved flexibility as having played a key role in the U.S. economy's recent relative stability. In fact, the past two recessions in the United States were the mildest in the postwar period. The experience of Britain and many others during this period of time have been similar.

* * *

I do not doubt that the vast majority of us would prefer to work in an environment that was less stressful and less competitive than the one with which we currently engage. The cries of distress amply demonstrate that flexibility and its consequence, rigorous competition, are not universally embraced. Flexibility in labor policies, for example, appears in some contexts to be the antithesis of job security. Yet, in our roles as consumers, we seem to insist on the low product prices and high quality that are the most prominent features of our current frenetic economic structure. If a producer can offer quality at a lower price than the competition, retailers are pressed to respond because the consumer will otherwise choose a shopkeeper who does. Retailers are afforded little leeway in product sourcing and will seek out low-cost producers, whether they are located in Guangdong province in China or northern England.

If consumers are stern taskmasters of their marketplace, business purchasers of capital equipment and production materials inputs have taken the competitive paradigm a step further and applied it on a global scale.

From an economic perspective, the globe has indeed shrunk. Not only have the costs of transporting goods and services, relative to the total value of trade, declined over most of the postwar period, but international travel costs, relative to incomes, are down, and cross-border communications capabilities have risen dramatically with the introduction of the Internet and the use of satellites. National boundaries are less and less a barrier to trade as companies more and more manufacture in many countries and move parts and components across national boundaries

230 with the same ease of movement exhibited a half century ago within national economies. A consequence, in the eyes of many, if not most, economists, world per capita real GDP over the past three decades has risen almost 1-1/2 percent annually, and the proportion of the developing world's population that live on less than one dollar per day has markedly declined.

Yet globalization is by no means universally admired. The frenetic pace of the competition that has characterized markets' extended global reach has engendered major churnings in labor and product markets.

The sensitivity of the U.S. economy and many of our trading partners to foreign competition appears to have intensified recently as technological obsolescence has continued to foreshorten the expected profitable life of each nation's capital stock. The more rapid turnover of our equipment and plant, as one might expect, is mirrored in an increased turnover of jobs. A million American workers, for example, currently leave their jobs every week, two-fifths involuntarily, often in association with facilities that have been displaced or abandoned. A million, more or less, are also newly hired or returned from layoffs every week, in part as new facilities come on stream.

Related to this process, jobs in the United States have been perceived as migrating abroad over the years, to low-wage Japan in the 1950s and 1960s, to low-wage Mexico in the 1990s, and most recently to low-wage China. Japan, of course, is no longer characterized by a low-wage workforce, and many in Mexico are now complaining of job losses to low-wage China.

In developed countries, conceptual jobs, fostered by cutting-edge technologies, are occupying an ever-increasing share of the workforce and are gradually replacing work that requires manual skills. Those industries in which labor costs are a significant part of overall costs have been under greater competition from foreign producers with lower labor costs, adjusted for productivity.

This process is not new. For generations human ingenuity has been creating industries and jobs that never before existed, from vehicle assembling to computer software engineering. With those jobs come new opportunities for workers with the necessary skills. In recent years, competition from abroad has risen to a point at which developed countries' lowest skilled workers are being priced out of the global labor market. This diminishing of opportunities for such workers is why retraining for new job skills that meet the evolving opportunities created by our economies has become so urgent a priority. A major source of such retraining in the United States has been our community colleges, which have proliferated over the past two decades.

We can usually identify somewhat in advance which tasks are most vulnerable to being displaced by foreign or domestic competition. But in economies at the forefront of technology, most new jobs are the consequence of innovation, which by its nature is not easily predictable. What we in the United States do know is that, over the years, more than 94 percent of our workforce, on average, has been employed as markets matched idled workers seeking employment to new jobs. We can thus be confident that new jobs will displace old ones as they always have, but not without a high degree of pain for those caught in the job-losing segment of America's massive job-turnover process.

* * *

The onset of far greater flexibility in recent years in the labor and product markets of the United

231 States and the United Kingdom, to name just two economies, raises the possibility of the resurrection of confidence in the automatic rebalancing ability of markets, so prevalent in the period before Keynes. In its modern incarnation, the reliance on markets acknowledges limited roles for both countercyclical macroeconomic policies and market-sensitive regulatory frameworks. The central burden of adjustment, however, is left to economic agents operating freely and in their own self-interest in dynamic and interrelated markets. The benefits of having moved in this direction over the past couple of decades are increasingly apparent. The United States has experienced quarterly declines in real GDP exceeding 1 percent at an annual rate on only three occasions over the past twenty years. Britain has gone forty-six quarters without a downturn.

Nonetheless, so long as markets are free and human beings exhibit swings of euphoria and distress, the business cycle will continue to plague us. But even granting human imperfections, flexible economic institutions appear to significantly ameliorate the amplitude and duration of the business cycle. The benefits seem sufficiently large that special emphasis should be placed on searching for policies that will foster still greater economic flexibility while seeking opportunities to dismantle policies that contribute to unnecessary rigidity.

Let me raise one final caution in this otherwise decidedly promising scenario.

Disoriented by the quickened pace of today's competition, some in the United States look back with nostalgia to the seemingly more tranquil years of the early post-World War II period, when tariff walls were perceived as providing job security from imports. Were we to yield to such selective nostalgia and shut out a large part, or all, of imports of manufactured goods and produce those goods ourselves, our overall standards of living would fall. In today's flexible markets, our large, but finite, capital and labor resources are generally employed most effectively. Any diversion of resources from the market-guided activities would, of necessity, engender a less-productive mix.

For the most part, we in the United States have not engaged in significant and widespread protectionism for more than five decades. The consequences of moving in that direction in today's far more globalized financial world could be unexpectedly destabilizing.

I remain optimistic that we and our global trading partners will shun that path. The evidence is simply too compelling that our mutual interests are best served by promoting the free flow of goods and services among our increasingly flexible and dynamic market economies.

232

Remarks by Chairman Alan Greenspan Before the Bundesbank Lecture 2004, Berlin, Germany January 13, 2004 Globalization has altered the economic frameworks of both developed and developing nations in ways that are difficult to fully comprehend. Nonetheless, the largely unregulated global markets do clear and, with rare exceptions, appear to move effortlessly from one state of equilibrium to another. It is as though an international version of Adam Smith's "invisible hand" is at work.

One key aspect of the recent globalization process is the apparent persistent rise in the dispersion of current account balances. Although for the world as a whole the sum of surpluses must always match the sum of deficits, the combined size of both, relative to global gross domestic product (GDP), has grown markedly since the end of World War II. This trend is inherently sustainable unless some countries build up deficits that are no longer capable of being financed. Many argue that this has become the case for America's large current account deficit.

There is no simple measure by which to judge the sustainability of either a string of current account deficits or their consequence, a significant buildup in external claims that need to be serviced. In the end, the restraint on the size of tolerable U.S. imbalances in the global arena will likely be the reluctance of foreign country residents to accumulate additional debt and equity claims against U.S. residents. By the end of 2003, net external claims on U.S. residents had risen to approximately 25 percent of a year's GDP, still far less than net claims on many of our trading partners but rising at the equivalent of 5 percentage points of GDP annually. However, without some notion of America's capacity for raising cross-border debt, the sustainability of the current account deficit is difficult to estimate. That capacity is evidently, in part, a function of globalization since the apparent increase in our debt-raising capacity appears to be related to the reduced cost and increasing reach of international financial intermediation.

The significant reduction in global trade barriers over the past half century has contributed to a marked rise in the ratio of world trade to GDP and, accordingly, a rise in the ratio of imports to domestic demand. But also evident is that the funding of trade has required, or at least has been associated with, an even faster rise in external finance. Between 1980 and 2002, for example, the nominal dollar value of world imports rose 5-1/2 percent annually, while gross external liabilities, largely financial claims also expressed in dollars, apparently rose nearly twice as fast.1

This observation does not reflect solely the sharp rise in the external liabilities of the United States that has occurred since 1995. Excluding the United States, world imports rose about 2-3/4 percent annually from 1995 to 2002; external liabilities increased approximately 8 percent. Less-comprehensive data suggest that the ratio of global debt and equity claims to trade has been rising since at least the beginning of the post-World War II period, though

233 apparently at a more modest pace than in recent years.2

From an accounting perspective, part of the increase in the ratio of world gross claims to trade in recent years reflects the continued marked rise in tradable foreign currencies held by private firms as well as a very significant buildup of international currency reserves of monetary authorities. Rising global wealth apparently has led to increased demand for diversification of portfolios by including greater shares of assets denominated in foreign currencies.

More generally, technological advance and the spread of global financial deregulation has fostered a broadening array of specialized financial products and institutions. The associated increased layers of intermediation in our financial systems make it easier to diversify and manage risk, thereby facilitating an ever-rising ratio of both domestic liabilities and assets to GDP and gross external liabilities to trade.3 These trends seem unlikely to reverse, or even to slow materially, short of an improbable end to the expansion of financial intermediation that is being driven by cost-reducing technology.

Uptrends in the ratios of external liabilities or assets to trade, and therefore to GDP, can be shown to have been associated with the widening dispersion in countries' ratios of trade and current account balances to GDP to which I alluded earlier.4 A measure of that dispersion, the sum of the absolute values of the current account balances estimated from each country's gross domestic saving less gross domestic investment (the current account's algebraic equivalent), has been rising as a ratio to aggregate GDP at an average annual rate of about 2 percent since 1970 for the OECD countries, which constitute four-fifths of world GDP.

The long-term increase in intermediation, by facilitating the financing of ever-wider current account deficits and surpluses, has created an ever-larger class of investors who might be willing to hold cross-border claims. To create liabilities, of course, implies a willingness of some private investors and governments to hold the equivalent increase in claims at market- determined asset prices. Indeed, were it otherwise, the funding of liabilities would not be possible.

With the seeming willingness of foreigners to hold progressively greater amounts of cross- border claims against U.S. residents, at what point do net claims (that is, gross claims less gross liabilities) against the United States become unsustainable and deficits decline? Presumably, a U.S. current account deficit of 5 percent or more of GDP would not have been readily fundable a half-century ago or perhaps even a couple of decades ago.5 The ability to move that much of world saving to the United States in response to relative rates of return would have been hindered by a far lower degree of international financial intermediation. Endeavoring to transfer the equivalent of 5 percent of U.S. GDP from foreign financial institutions and persons to the United States would presumably have induced changes in the prices of assets that would have proved inhibiting.

* * *

There is, for the moment, little evidence of stress in funding U.S. current account deficits. To be sure, the real exchange rate for the dollar has, on balance, declined about 15 percent broadly and roughly 25 percent against the major foreign currencies since early 2002. Yet inflation, the typical symptom of a weak currency, appears quiescent. Indeed, inflation

234 premiums embedded in long-term interest rates apparently have fluctuated in a relatively narrow range since early 2002. More generally, the vast savings transfer has occurred without measurable disruption to the balance of international finance. Certainly, euro area exporters have been under considerable pressure, but in recent months credit risk spreads have fallen, and equity prices have risen, throughout much of the global economy.

* * *

To date, the widening to record levels of the U.S. ratio of current account deficit to GDP has been, with the exception of the dollar's exchange rate, seemingly uneventful. But I have little doubt that, should the rise in the deficit continue, at some point in the future further adjustments will be set in motion that will eventually slow and presumably reverse the rate of accumulation of net claims on U.S. residents. How much further can international financial intermediation stretch the capacity of world finance to move national savings across borders?

A major inhibitor appears to be what economists call "home bias." Virtually all our trading partners share our inclination to invest a disproportionate percentage of domestic savings in domestic capital assets, irrespective of the differential rates of return. People seem to prefer to invest in familiar local businesses even where currency and country risks do not exist. For the United States, studies have shown that individual investors and even professional money managers have a slight preference for investments in their own communities and states. Trust, so crucial an aspect of investing, is most likely to be fostered by the familiarity of local communities. As a consequence, home bias will likely continue to constrain the movement of world savings into its optimum use as capital investment, thus limiting the internationalization of financial intermediation and hence the growth of external assets and liabilities.6

Nonetheless, during the past decade, home bias has apparently declined significantly. For most of the earlier postwar era, the correlation between domestic saving rates and domestic investment rates across the world's major trading partners, a conventional measure of home bias, was exceptionally high.7 For OECD countries, the GDP-weighted correlation coefficient was 0.97 in 1970. However, it fell from the still elevated 0.96 in 1992 to less than 0.8 in 2002. For OECD countries excluding the United States, the recent decline is even more pronounced. These declines, not surprisingly, mirror the rise in the differences between saving and investment or, equivalently, of the dispersion of current account balances over the same years.

The decline in home bias doubtless reflects, in part, vast improvements in information and communication technologies that have broadened investors' scope to the point that foreign investment appears less exotic and risky. Moreover, there has been an increased international tendency for financial systems to be more transparent, open, and supportive of strong investor protection.8 Accordingly, the trend of declining home bias and expanding international financial intermediation will likely continue as globalization proceeds.

* * *

It is unclear at what point the rising weight of U.S. assets in global portfolios will impose restraint on world current account dispersion. When that point arrives, what do we know about whether the process of reining in our current account deficit will be benign to the

235 economies of the United States and the world?

According to a Federal Reserve staff study, current account deficits that emerged among developed countries since 1980 have risen as high as double-digit percentages of GDP before markets enforced a reversal.9 The median high has been about 5 percent of GDP.

Complicating the evaluation of the timing of a turnaround is that deficit countries, both developed and emerging, borrow in international markets largely in dollars rather than in their domestic currency. The United States has been rare in its ability to finance its external deficit in a reserve currency.10 This ability has presumably enlarged the capability of the United States relative to most of our trading partners to incur foreign debt.

* * *

Besides experiences with the current account deficits of other countries, there are few useful guideposts of how high America's net foreign liabilities can mount. The foreign accumulation of U.S. assets would likely slow if dollar assets, irrespective of their competitive return, came to occupy too large a share of the world's portfolio of store of value assets. In these circumstances, investors would seek greater diversification into nondollar assets. At the end of 2002, U.S. dollars accounted for about 65 percent of central bank foreign exchange reserves, with the euro second at 19 percent. Approximately half of the much larger private cross-border holdings were denominated in dollars, with one-third in euros.

More important than the way that the adjustment of the U.S. current account deficit will be initiated is the effect of the adjustment on both the U.S. economy and the economies of our trading partners. The history of such adjustments has been mixed. According to the aforementioned Federal Reserve study of current account corrections in developed countries, although the large majority of episodes were characterized by some significant slowing of economic growth, most economies managed the adjustment without crisis. The institutional strengths of many of these developed economies--rule of law, transparency, and investor and property protection--likely helped to minimize disruptions associated with current account adjustments. The United Kingdom, however, had significant adjustment difficulties in its early postwar years, as did, more recently, Mexico, Thailand, Korea, Russia, Brazil, and Argentina, to name just a few.

Can market forces incrementally defuse a worrisome buildup in a nation's current account deficit and net external debt before a crisis more abruptly does so? The answer seems to lie with the degree of flexibility in both domestic and international markets. By flexibility I mean the ability of an economy to absorb shocks, stabilize, and recover. In domestic economies that approach full flexibility, imbalances are likely to be adjusted well before they become potentially destabilizing. In a similarly flexible world economy, as debt projections rise, product and equity prices, interest rates, and exchange rates could change, presumably to reestablish global balance.

The experience over the past two centuries of trade and finance among the individual states that make up the United States comes close to that paradigm of flexibility, especially given the fact that exchange rates among the states have been fixed and, hence, could not be part of an adjustment process. Although we have scant data on cross-border transactions among the separate states, anecdotal evidence suggests that over the decades significant apparent

236 imbalances have been resolved without precipitating interstate balance-of-payments crises. The dispersion of unemployment rates among the states, one measure of imbalances, spikes during periods of economic stress but rapidly returns to modest levels, reflecting a high degree of adjustment flexibility. That flexibility is even more apparent in regional money markets, where interest rates that presumably reflect differential imbalances in states' current accounts and hence cross-border borrowing requirements have, in recent years, exhibited very little interstate dispersion. This observation suggests either negligible cross- state-border imbalances, an unlikely occurrence given the pattern of state unemployment dispersion, or more likely very rapid financial adjustments.

* * *

We may not be able to usefully determine at what point foreign accumulation of net claims on the United States will slow or even reverse, but it is evident that the greater the degree of international flexibility, the less the risk of a crisis.11 The experience of the United States over the past three years is illustrative. The apparent ability of our economy to withstand a number of severe shocks since mid-2000, with only a small, temporary decline in real GDP, attests to the marked increase in our economy's flexibility over the past quarter century.12

In evaluating the nature of the adjustment process, we need to ask whether there is something special in the dollar's being the world's primary reserve currency. With so few historical examples of dominant world reserve currencies, we are understandably inclined to look to the experiences of the dollar's immediate predecessor. At the height of sterling's role as the world's currency more than a century ago, Great Britain had net external assets amounting to some 150 percent of its annual GDP, most of which were lost in World Wars I and II. Early post-World War II Britain was hobbled with periodic sterling crises, as much of the remnants of Empire endeavored to disengage themselves from heavy reliance on holding sterling assets as central bank reserves and private stores of value. The experience of Britain's then extensively regulated economy, harboring many wartime controls well beyond the end of hostilities, testifies to the costs of structural rigidity in times of crisis.

* * *

Should globalization be allowed to proceed and thereby create an ever more flexible international financial system, history suggests that current imbalances will be defused with little disruption. And if other currencies, such as the euro, emerge to share the dollar's role as a global reserve currency, that process, too, is likely to be benign.

I say this with one major caveat. Some clouds of emerging protectionism have become increasingly visible on today's horizon. Over the years, protected interests have often endeavored to stop in its tracks the process of unsettling economic change. Pitted against the powerful forces of market competition, virtually all such efforts have failed. The costs of any new protectionist initiatives, in the context of wide current account imbalances, could significantly erode the flexibility of the global economy. Consequently, it is imperative that creeping protectionism be thwarted and reversed.

The question of whether globalization will be allowed to proceed rests largely on the judgment of whether greater economic freedom, and the often frenetic competition it encourages, is deemed by leaders in societies to enhance the interests, one hopes the long- term interests, of their populations. Such broad judgments in the end determine how

237 societies are governed.

The reasons that some economies prosper and others sink into long-term stagnation consequently has been the object of intense interest in recent decades. Agreement is growing among economic analysts and policymakers that those economies that have been open to cross-border trade have, in general, prospered. Those economies that chose to eschew such trade have done poorly. Most economists have long stipulated that, for a society based on a division of labor to prosper, the exchange of goods and services must be subject to a rule of law--specifically, to laws protecting the rights of minorities and property. Presumably to be effective such arrangements must be perceived as just by an overwhelming majority of a society. Thus, a rule of law arguably requires democracy.

Clearly, ideas shape societies and economies. Indeed, I have maintained over the years that the most profoundly important debate between conflicting theories of optimum economic organization during the twentieth century was settled, presumably definitively, here more than a decade ago in the aftermath of the dismantling of the Berlin Wall. Aside from the Soviet Union itself, the economies of the Soviet bloc had been, in the prewar period, similar in many relevant respects to the market-based economies of the west. Over the first four decades of postwar Europe, both types of economies developed side by side with limited interaction. It was as close to a controlled experiment in the viability of economic systems as could ever be implemented.

The results, evident with the dismantling of the Wall, were unequivocally in favor of market economies. The consequences were far-reaching. The long-standing debate between the virtues of economies organized around free markets and those governed by centrally planned socialism, one must assume, is essentially at an end. To be sure, a few still support an old fashioned socialism. But for the vast majority of previous adherents it is now a highly diluted socialism, an amalgam of social equity and market efficiency, often called market socialism. The verdict on rigid central planning has been rendered, and it is generally appreciated to have been unqualifiedly negative. There was no eulogy for central planning; it just ceased to be mentioned, and a large majority of developing nations quietly shifted from socialism to more market-oriented economies.

Europe has accepted market capitalism in large part as the most effective means for creating material affluence. It does so, however, with residual misgivings.

The differences between the United States and continental Europe were captured most clearly for me in a soliloquy attributed to a prominent European leader several years ago. He asked, "What is the market? It is the law of the jungle, the law of nature. And what is civilization? It is the struggle against nature." While acknowledging the ability of competition to promote growth, many such observers, nonetheless, remain concerned that economic actors, to achieve that growth, are required to behave in a manner governed by the law of the jungle and are hence driven to an excess of materialism.

In contrast to these skeptics, others, especially in the United States, believe the gains in material wealth resulting from market-driven outcomes facilitate the pursuit of broader values. They support a system based on voluntary choice in a free marketplace. The crux of the largely laissez-faire argument is that, because unencumbered competitive markets reflect the value preferences of consumers, the resulting price signals direct a nation's savings into those capital assets that maximize the production of goods and services most

238 valued by consumers. Incomes earned from that production are determined, for the most part, by how successfully the participants in an economy contribute to the welfare of consumers, the presumed purpose of a society's economy.

Clearly, not all activities undertaken in markets are civil. Many, though legal, are decidedly unsavory. Violation of law and breaches of trust do undermine the efficiency of markets. But the legal foundations and the discipline of the marketplace are sufficiently rooted in a rule of law to limit these aberrations. It is instructive that despite the egregious breaches of trust in recent years by a number of America's business and financial leaders, productivity, an important metric of corporate efficiency, has accelerated.

* * *

On net, most economists would agree that vigorous economic competition over the years has produced a significant rise in the quality of life for the vast majority of the population in market-oriented economies, including those at the bottom of the income distribution. The highly competitive free market paradigm, however, is viewed by many at the other end of the philosophical spectrum, especially among some here in Europe, as obsessively materialistic and largely lacking in meaningful cultural values. Those that still harbor a visceral distaste for highly competitive market capitalism doubtless gained adherents with the recent uncovering of much scandalous business behavior during the boom years of the 1990s.

But is there a simple tradeoff between civil conduct, as defined by those who find raw competitive behavior demeaning, and the quality of material life they, nonetheless, seek? It is not obvious from a longer-term perspective that such a tradeoff exists in any meaningful sense.

During the past century, for example, economic growth created resources far in excess of those required to maintain subsistence. That surplus, even in the most aggressively competitive economies, has been in large measure employed to improve the quality of life along many dimensions. To cite a short list: (1) greater longevity, owing first to the widespread development of clean, potable water and later to rapid advances in medical technology; (2) a universal system of education that enabled greatly increased social mobility; (3) vastly improved conditions of work; and (4) the ability to enhance our environment by setting aside natural resources rather than having to employ them to sustain a minimum level of subsistence. At a fundamental level, Americans, for example, have used the substantial increases in wealth generated by our market-driven economy to purchase what many would view as greater civility.

* * *

The collapse of the Soviet empire, and with it central planning, has left market capitalism as the principal, but not universally revered, model of economic organization. Nevertheless, the vigorous debate on how economies should be organized in our increasingly globalized society and what rules should govern individuals' trading appears destined to continue.

239 Footnotes

1. Gross liabilities include both debt and equity claims. Data on the levels of gross liabilities have to be interpreted carefully because they reflect the degree of consolidation of the economic entities they cover. Were each of our fifty states considered as a separate economy, for example, interstate claims would add to both U.S. and world totals without affecting U.S. or world GDP. Accordingly, it is the change in the gross liabilities ratios that is the more economically meaningful concept.

2. For the United States, for example, the ratio of external liabilities to imports of goods and services rose from nearly 1-1/2 in 1948 to close to 2 in 1980. The comparable ratios for the United Kingdom can be estimated to have been in the neighborhood of 2-1/2 or lower in 1948 and about 3-3/4 in 1980.

3. For the United States, for example, even excluding mortgage pools, the ratio of domestic liabilities to GDP rose at an annual rate of 2 percent between 1965 and 2002. For the United Kingdom, the ratio of domestic liabilities to GDP increased 4 percent at an annual rate during the 1987-2002 period.

4. If the rate of growth of external assets (and liabilities) exceeds, on average, the growth rate of world GDP, under a broad range of circumstances the dispersion of the change in net external claims of trading countries must increase as a percentage of world GDP. But the change in net claims on a country, excluding currency valuation changes and capital gains and losses, is essentially the current account balance. Of necessity, of course, the consolidated world current account balance remains at zero.

Theoretically, if external assets and liabilities were always equal, implying a current account in balance, the ratio of liabilities to GDP could grow without limit. But in the complexities of the real world, if external assets fall short of liabilities for some countries, net external liabilities will grow until they can no longer be effectively serviced. Well short of that point, market prices, interest rates, and exchange rates will slow, and then end, the funding of liability growth.

5. It is true that estimates of the ratios of the current account to GDP for many countries in the nineteenth century are estimated to have been as large as, or larger, than we have experienced in recent years. However, the substantial net flows of capital financing for those earlier deficits were likely motivated in large part by specific major development projects (for example, railroads) bearing high expected rates of return. By contrast, diversification appears to be a more salient motivation for today's large net capital flows. Moreover, gross capital flows are believed to be considerably greater relative to GDP in recent years than in the nineteenth century. (See Alan M. Taylor, "A Century of Current Account Dynamics," Journal of International Money and Finance, 2002, 725-48, and Maurice Obstfeld and Alan Taylor, "Globalization and Capital Markets," NBER Working Paper 8846, March 2002.)

6. Without home bias, the dispersion of world current account balances would likely be substantially greater.

7. See Martin Feldstein and Charles Horioka, "Domestic Saving and International Capital

240 Flows," The Economic Journal, June 1980, 314-29.

8. Research indicates that home bias in investment toward a foreign country is likely to be diminished to the extent that the country's financial system offers transparency, accessibility, and investor safeguards. See Alan Ahearne, William Griever, and Frank Warnock, "Information Costs and Home Bias" Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 691, December 2000.

9. Caroline Freund, "Current Account Adjustment in Industrialized Countries," Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 692, December 2000.

10. Less than 10 percent of aggregate U.S. foreign liabilities are currently denominated in nondollar currencies. To have your currency chosen as a store of value is both a blessing and a curse. Presumably, the buildup of dollar holdings by foreigners has provided Americans with lower interest rates as a consequence. But as Great Britain learned, the liquidation of sterling balances after World War II exerted severe pressure on its domestic economy.

11. Although increased flexibility apparently promotes resolution of current account imbalances without significant disruption, it may also allow larger deficits to emerge before markets are required to address them.

12. See Alan Greenspan, remarks before a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30, 2002.

241

Remarks by Governor Donald L. Kohn At the Federal Reserve Bank of Atlanta's Public Policy Dinner, Atlanta, Georgia January 7, 2004

The United States in the World Economy No public policy issues facing the United States today in the economic realm are more important or prominent than those that touch on our place in the world economy. The greater attention to global economic issues is partly just a natural byproduct of the increasing interdependencies of all national economies. But this focus has been accentuated of late by the potential effects of two trends that have intensified in recent years. One is the emergence of several developing countries--most prominently China and India--as global economic forces and the consequent reorganization of production processes and change in the nature and location of jobs here and abroad. The second is our burgeoning trade and current account deficits and the possibility that they cannot be sustained at these levels. Like most interesting policy issues, these are difficult and complex, and they therefore carry a considerable risk that policy prescriptions will be ineffective or even counterproductive.*

The two developments are related, but only to a limited and indirect extent. Importantly, they arise from very different underlying sources. Job reorganization results from the integration of China and other developing countries into the world economy. The increase in our current account deficit has numerous roots, including, most prominently, stronger growth here than in our trading partners. But trade and exchange rate relationships with emerging-market economies are a small part of the story. The deficit does mean that the United States has been spending more than we produce, and the rest of the world has done the opposite.

Because they have different causes, these developments have different public policy implications. Their implications for Federal Reserve policy are indirect. We cannot affect the pace of job restructuring nor correct the current account deficit, and that limitation is important to understand. Nonetheless, how these phenomena evolve and how they are addressed are critical background factors for us as we conduct monetary policy. They can influence the balance of aggregate supply and demand and the functioning of the economy-- its flexibility and resiliency and its capacity to advance standards of living.

Let's look at these developments separately.

Job Restructuring

I think it is useful to look at job restructuring as the adaptation to a much larger development--a huge increase in global productive capacity.

The major increase in global productivity has two main causes. The first is the spreading recognition in recent decades, reinforced by the collapse of the Soviet Union, that market economies work best--that responses to market signals by private parties trying to make

242 profits and raise standards of living are far more effective and efficient than government- directed allocation of resources. Hence not only countries in Eastern Europe, where governments were overturned, but also China and India, where political stability has been maintained, have been shifting toward economic systems that place greater reliance on market transactions among private parties. This trend is unleashing huge productive potential.

The shift to market-based systems has been interacting with a second force--a heightened pace of technological change, especially the declining cost of generating and transmitting information. We can see the effects of technological change here at home, where it has considerably boosted the growth rate of productivity since the mid-1990s. Globally, cheaper access to more information has eased the integration and coordination of geographically diverse production processes. This development has opened up opportunities to transfer production to locations in which the work can be accomplished less expensively, and the trend toward market-based economies has multiplied the number of feasible locations.

This type of shifting has been occurring in manufacturing for a long time in response to technical innovation and economic development. But what seems to be different is that, because of the new applications of information technology and telecommunications, an increasing variety of services that used to be attached to a particular business location can be carried out anywhere in the world. For example, call centers have moved to India and elsewhere. Routine back office accounting work such as handling accounts receivable is also shifting overseas and becoming centralized for global corporations. Many types of routine programming can be carried out around the clock, handed off from time zone to time zone by e-mail.

The interaction of these forces has led to a major restructuring of production processes--at home and abroad--and a redistribution of these processes and associated jobs geographically around the globe. It is a beneficial development that will raise standards of living everywhere. In the newly emerging economies, of course, hundreds of millions of people now have a chance to escape grinding poverty. But the benefits will be felt in the industrial world as well.

Workers in the United States and other advanced economies will need to shift toward industries specializing in the types of goods and services we produce relatively more efficiently. Typically, production of these goods and services involve more complex processes, often those that are more rooted in the higher knowledge and skills of our workers. As workers shift to higher value-added employment, real wages will rise commensurately.

In addition, U.S. residents are getting access to less costly goods produced abroad. As a consequence, more toys appeared under the Christmas tree, and we have a greater choice of inexpensive clothes. I would guess that the less well-off among us probably benefit disproportionately from the availability of many of the types of less-expensive goods coming in from abroad. They are better able to clothe and feed their families and have more income available for other necessities, such as housing and medical care.

International trade is not a zero sum game in which one country's gains are another country's loss. By specializing in what they do best, workers in all countries can be winners. Even if one country can be more efficient at producing all goods and services than another,

243 each will gain by specializing in what it does relatively better. This is the result of what economists call comparative advantage. Increased trade should redistribute jobs, but it should not create or destroy jobs in the aggregate over the long run. Long-run levels of employment are determined by the available supply of labor and the flexibility of the labor market. Keeping employment reasonably close to its long-term, sustainable level is the job of macroeconomic policy--especially monetary policy.

To be sure, individuals do get hurt in the transition, but within a country gains should exceed losses over the longer run. Unfortunately, from a political perspective, the gains are often widely disbursed, accrue over time, and are hard to measure whereas the losses are concentrated and palpable. Those whose jobs are restructured face a difficult adjustment. Even if it is possible, climbing the value-added chain may not be easy, and the dislocations are costly for those involved. People often are unemployed for a considerable time, and a significant portion end up settling for jobs that pay less than the one they left. Trying to protect those particular jobs through tariffs or quotas on imported goods may help those workers who face loss, but that protection will likely prove temporary and will reduce the standard of living for the country as a whole.

When considering public policy responses to job restructuring, we must keep the pace of change in perspective and remember the flexibility and resiliency of our labor and product markets. Indeed, economists cannot even agree on whether job restructuring has accelerated. One study finds that, since the early 1980s, job loss has had a much larger structural component; another study fails to find any such trend.1 Manufacturing employment has been in a long-term downtrend for decades, likely because of the substantial advances in productivity as well as the rising preference for services in an increasingly wealthy country. We should also recall that the shifting of some jobs to Japan in the 1980s and to East Asia and Mexico in the 1990s aroused considerable concern. These developments did not prevent a drop in the unemployment rate to a thirty-year low in the late 1990s. Moreover, the new jobs have not been lower paying. Higher productivity growth has meant that, on average, real wages and compensation rose substantially in the second half of the 1990s and have continued to increase in the past few years, albeit more slowly, despite the recent recession and jobless recovery.

One difficulty of assessing trends in job restructuring in recent years has been the weak cyclical position of the economy. We must not confuse nor conflate cyclical and structural issues, especially when thinking about policy implications. A lot of today's pain in manufacturing and in the overall economy is cyclical--a consequence of inadequate demand, not of a shift of jobs to other countries. Because this business cycle was led by capital goods both in its boom and bust stages, manufacturing has been especially hard hit over the last few years. In fact, until the economy comes much closer to full employment, we will not be able to isolate the structural issues with any confidence.

Authorities here and abroad have the tools to get economies back to high levels of employment and production, even as we adjust to higher productivity growth and shifting production processes. Getting economies on track seems to be requiring unusually accommodative fiscal and monetary policies--but these policies finally appear to be bearing fruit.

Indeed, over time, high productivity growth here and rising productive capacity abroad can increase demand for goods and services even more than they increase supply. We saw

244 considerable strength in demand in the United States in the 1990s, when productivity accelerated, and we are beginning to see it in China, where rising demand for imports is eroding the country's large trade surplus and boosting the economies of some of its trading partners. People experiencing much brighter economic prospects will want much more in the way of consumer goods. Businesses here and in China will need capital equipment to expand, and no country does a better job of producing sophisticated capital equipment than does the United States.

The key to easing adjustment for the individuals affected is training and education. We must do a better job of giving our current workers and the next generations the skills needed to grab the highly productive, knowledge-based jobs to which demand will continue to shift. I cannot tell you exactly in what sectors or industries these jobs will be; government is not good at picking winners and losers. The market system will sort that out and, in the process, will signal our workers as to which skills are becoming more highly valued. Government needs to make sure that the opportunities and resources are available for obtaining those skills.

I recognize that, unfortunately, not every country always plays by the rules. Some job restructuring occurs not because of relative efficiencies but because of subsidies of certain industries or discrimination against foreign goods. We need to work together with all countries to eliminate impediments, wherever they might be, to realizing the benefits of the global increase in productive capacity.

It would be counterproductive to increase protectionist measures, which in effect would reduce the flexibility of our economy, lock people into inferior jobs, and end up raising costs for consumers--especially those among us who can least afford to pay more.

The Trade and Current Account Deficits

Our current account deficit has been growing both in dollar terms and relative to the size of our economy, reaching 5 percent of GDP last year. This is a record for us; when the deficit approached this magnitude in the past, markets had generally already begun to adjust to reduce it.2

The deficit reflects the fact that spending in the United States exceeds what we produce. We meet the extra demand by importing more than we export. We pay for the added imports by using the savings of people in other countries--that is, they lend us money to buy their goods and services.

Using more goods and services than one produces is not a bad deal. We could do so indefinitely, provided that foreigners were willing to continue increasing their loans and investments in the United States. Even then, of course, we would have ever-rising debts to service, and foreigners would own a growing proportion of our capital stock. We have indeed become a large net debtor in global capital markets, but so far, the net servicing of the debt has been very small.

For quite a while, global investors seemed willing to increase the proportion of the total assets they hold as claims on the United States, denominated in dollars. Through the 1990s and into the early 2000s foreigners expected returns here to be so high that they willingly sent us larger and larger amounts of savings--in effect, financing a goodly part of our

245 investment boom. The strong demand for dollar assets was evidenced by a rising exchange rate, which in turn fed the increase in the current account and trade deficits.

This point is important to keep in mind. We did not seek to run a current account deficit, nor did we make policy mistakes that brought it on. The current account and trade deficits became so large mostly because we had a more-dynamic, faster-growing economy than everyone else had--one with a higher expected return on investment, which induced a rising demand for dollar claims on our increasingly productive capital stock.

But although the U.S. economy continues to be far more vigorous than most others, foreign investors may be becoming less willing to finance the gap between what we spend and what we produce. With the current account deficit climbing, that gap is growing fast--evidently faster than the appetite for U.S. assets. Private capital flows into the United States have ceased expanding rapidly. Governments--especially those of Japan and China--have taken up the slack by purchasing U.S. assets, but the shortfall in the desire to supply savings to fund our deficit has been reflected in a significant drop in the dollar on foreign exchange markets since early 2002.

It is to be expected, at least for economies with exchange rates that truly float, that a shortfall of demand for a country's assets will be reflected at first primarily in the exchange rate. The lower exchange rate in turn stimulates exports and damps imports, and so the current account deficit and the associated need for foreign capital are also reduced, matching the lower appetite of foreign investors.

To date, this adjustment process has not been a problem for the United States. Because we are operating with spare capacity in our factories and labor markets, higher exports and lower imports are fine. They help boost U.S. production to more fully utilize labor and capital and should not add to sustained inflation pressures, even with import prices moving a little higher and competitive pressure on import-competing industries easing a bit.

Some have feared that lagging demand for our assets would show up in lower prices for the assets themselves--that is, in increases in bond yields and declines in equity prices--as well as in lower exchange rates. However, for the most part, these assets are traded in highly liquid markets, where even large decreases in demand can be accommodated with very small changes in prices. In such markets, interest rates and equity prices tend to reflect investors= perceptions of fundamentals such as expected inflation, profits, risk, and real growth. In fact, over recent months, as the dollar has continued to drop, equity prices have risen, and yields on corporate bonds are unchanged to a little lower. To be sure, foreign authorities have acquired a large quantity of dollar assets, but their purchases tend to be concentrated in Treasury and agency securities, not in privately issued equity or debt.3

The global economy does face a potential longer-term structural issue. If investors are reaching a point at which assets denominated in U.S. dollars are becoming as large a share of their portfolios as they see appropriate, our trade deficit will need to shrink. We will not be able to call so much on an increasing share of world saving to finance our spending, and that spending will need to match our production much more closely. At the Federal Reserve we will continue to work to foster a full employment level of production, one as high as the economy can generate on a sustainable, noninflationary basis. Relative to that level of production, demand or spending in the United States will need to be considerably more restrained on both domestic and foreign goods, and more U.S. production will need to be

246 exported abroad. This fact--this implication of the simple arithmetic of smaller trade and current account deficits--raises important policy questions for both the United States and the rest of the world.

In the United States the tough questions are just what kind of spending will feel the brunt of the restraint and to what extent will production have to shift to accommodate a new mix of spending. In particular, without added doses of foreign saving, we are going to need to generate more of our own if we wish to fund high levels of business investment in capital goods and household purchases of new houses and durable goods. If we do not increase our saving, investment will have to be cut back. We can get that savings from the private sector by decreasing consumption relative to income or from the public sector by decreasing spending relative to taxes.

In that context, the prospect of large federal government deficits stretching out into the future looks worrisome. In the second half of the 1990s, we had both foreign and government savings to finance investment; a few years from now we may have less of the former and none of the latter--indeed, the government sector is projected to be a net user of savings not a net supplier. The fiscal stimulus of the past few years has been quite helpful in promoting recovery, but we do need to consider the longer-term implications of the policies put in place.

If the fiscal path does not change, unless private savings rise considerably to compensate, interest rates will be higher than they otherwise would be to ration the scarcer savings, and we will have slower growth in the capital stock and in the number of houses and autos. Slower growth in the capital stock means slower growth in productivity and in our economic potential. Constraints on trend growth would be a concern at any time, but they are especially so over the coming years. We are on the cusp of a wave of retirements, which will leave a smaller workforce to generate the goods and services those of us looking forward to retirement will consume even as we contribute less and less to their production. We need to be saving and investing to build our economic potential and to alleviate the burden on our children and grandchildren.

This is not a task for monetary policy. In the long run, monetary policy cannot do anything about the current account deficit or about the lack of savings from government policy or private choices. Our manipulation of the overnight interest rate helps to keep the overall economy in balance--promoting price stability and production at the economy's potential. But on the Federal Open Market Committee Jack and I can do nothing to promote savings other than to provide a stable backdrop for private decisions. Promoting savings is a job for fiscal and tax policy.

If our trade and current account deficits move toward balance, foreign economies will face the questions of how to replace the demand that will no longer be coming from the United States and to reallocate production to a new mix of spending. The U. S. current account will not correct in isolation. The United States has been, in effect, exporting its demand overseas, supporting economic activity in foreign economies by importing more goods and services than we export. If our imports fall and exports rise, just the opposite will occur in the rest of the world. As our domestic demand is restrained relative to production, demand elsewhere will have to increase to foster global high employment.

How that is to be achieved is an open question: Structural reforms that improve the

247 flexibility of the labor force and production and that foster growth abroad are a desirable way to contribute to better global balance, but macroeconomic policy adjustments to promote more domestic demand may also be required. It is simply not possible for all countries to enjoy stimulus from net exports; some countries will need to be net importers, especially if the United States no longer fills that role. And so my two issues become related. The development strategies of countries such as China and other Asian nations, to be successful, must be compatible with the pattern of adjustment in global demand that is required by the consumption, saving, and investment decisions made by market participants everywhere.

Conclusion The global economy seems to be facing major adjustments in several dimensions simultaneously. Successful adaptation to changing circumstances will require flexibility on several fronts. No one can anticipate how events will unfold--the evolving geography and technology of the production of goods and services, the shifting balances between spending and producing as current accounts change. My fear is that poorly formed diagnoses and incorrect policy prescriptions will have unintended adverse consequences for our economy. Any elements of rigidity--in exchange rates, in labor and product markets, in quotas and tariffs on international trade--limit the channels through which the adjustment process can work. Rigidity concentrates stresses, increases the risk of market disruptions, impedes economic resiliency, and limits the world's ability to realize the full potential of the rise in global productivity to lift standards of living.

Footnotes

* The views are my own and do not necessarily represent the views of other members of the Federal Open Market Committee or the Board.

1. Erica L. Groshen and Simon Potter, "Has Structural Change Contributed to a Jobless Recovery?" Federal Reserve Bank of New York, Current Issues in Economics and Finance, vol. 9, no. 8, August 2003. On the Federal Reserve Bank of New York web site. Ellen R. Rissman, "Can Sectoral Labor Reallocation Explain the Jobless Recovery?" (680KB PDF) Federal Reserve Bank of Chicago, Chicago Fed Letter: Essays on Issues, no. 197, December 2003. On the Federal Reserve Bank of Chicago web site.

2. Caroline Freund, "Current Account Adjustment in Industrialized Countries,"FRB: IFDP paper - number 692 Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 692, December 2000.

3. As Chairman Greenspan has argued, increased liquidity in financial markets, greater willingness of investors to look at opportunities outside their home countries, and enhanced flexibility of economies all suggest less pressure than in the past to correct large current account deficits in a short period and greater likelihood that any such adjustment will be smooth. See Alan Greenspan, remarks at the Twenty-first Annual Monetary Conference, cosponsored by the Cato Institute and The Economist, Washington, D.C., November 20, 2003. http://www.federalreserve.gov/boarddocs/speeches/2004/20040107/default.htm

248

Remarks by Vice Chairman Roger W. Ferguson, Jr. At the Meetings of the American Economic Association, San Diego, California January 4, 2004

Lessons from Past Productivity Booms As we are all well aware, the United States has been enjoying significantly faster productivity growth for the past eight years or so than it did over the preceding two decades. Since 1995, labor productivity has risen at an average annual rate of about 3 percent, up from an average annual rate of around 1-1/2 percent between 1973 and 1995. And in the past two years alone, output per hour has increased more than 5 percent per year.

The significance of the improvement since 1995 can hardly be overstated, even after taking into account the cyclical component of the most recent quarters. If productivity were to continue to improve at an average annual rate of 3 percent, the standard of living in the United States would double roughly every twenty-four years. If, on the other hand, productivity growth were to revert to an average annual pace of 1-1/2 percent, a doubling in the standard of living would occur only every forty-seven years. Many observers-including some economists-argue that the present era of robust trend productivity growth will soon come to an end. Others are more optimistic and argue that the potential gains to productivity from the technological advances associated with the computer revolution are far from complete.1 Because productivity growth is critical to economic welfare, assessing the likelihood of these alternative outcomes is of considerable interest.

In thinking about this issue, it is worth recognizing that periods of strong trend productivity growth, although perhaps novel to many of us, are not new to the U.S. economy. In fact, three earlier periods seem to stand out from the historical record as especially worthy of further scrutiny for the lessons they may offer regarding the current episode: a period in the late 1800s from roughly the end of the Civil War to around 1890; the decade or so between the end of World War I and the onset of the Great Depression; and the period from about 1950 to the early 1970s.2

Of particular note is that in at least two of the earlier episodes, heightened productivity growth lasted for an extended period-roughly twenty years or so. Thus, one objective in examining these previous productivity booms is to see whether we can glean any insights into the best ways to sustain the current episode of strong productivity growth. To be sure, each period mentioned can be associated with particular advances in technology, implying that technological progress is a necessary component of trend productivity growth. But significant technological advances were also evident in periods when productivity growth was less robust. Thus, a natural question to ask is whether other complementary factors- including aspects of the labor market, of the business environment, or of government policies-combine to render technological change especially potent or help to foster the transmission of technological change into real gains in the efficiency of the production process.

249 Similarly, examining the historical record may shed light on the sustainability of the current boom. Do productivity booms simply run out of steam and die natural deaths? Or are they cut short by economic imbalances, exogenous shocks, or detrimental government policies? And, if the latter, are these cessations inevitable?

At the outset, I should note that this lecture is co-authored with William Wascher, who is a member of the staff at the Board of Governors. To provide a roadmap of where we intend to go, I want to start by setting out some basic facts about previous periods of strong productivity growth in the United States. I will, of course, begin with some numbers. But I also want to discuss some of the technological innovations that contributed to these productivity booms and about the supportive roles played by changes in the organization of American businesses and the structure of financial markets, and by the U.S. education system. Finally, I will spend some time on the lessons that we think can be learned from what, in many ways, are striking similarities across the three previous episodes and the current one.

Identifying Previous Productivity Booms

I should also note at this point that even the basic facts about economic growth, not to mention the interpretation of those facts, are sometimes subject to considerable debate. Some of these disagreements undoubtedly result from the lack of consistent information on U.S. productivity before data from the Bureau of Labor Statistics (BLS) became available in 1948. For this earlier period, we use data developed in the early 1960s by John Kendrick, who constructed estimates of GDP consistent with the prevailing definitions in the National Income and Product Accounts going back to the 1870s (which had as their basis estimates made by Simon Kuznets in the 1940s).3 These estimates are often cited as the best available measure of U.S output and productivity growth for that period. Although subsequent researchers-notably Balke and Gordon (1989) and Romer (1989)-have refined these estimates in different ways, the additional refinements focus primarily on the cyclical properties of output and do not significantly alter the qualitative statements about long-run growth made here. A number of economic historians-most notably Robert Gallman-have estimated U.S. GDP for the period before the Civil War.4 However, given that their estimates are surely less reliable than those for the later, more industrialized period, we have elected to limit the focus of this lecture to the post-Civil War period.

These caveats aside, average growth rates of productivity over various periods are presented in the table. We will focus on labor productivity (the first column) because that measure is the best indicator of improvement in the nation's standard of living. For the entire period from 1870 to 2003, labor productivity has risen at an average rate of around 2 percent per year. However, productivity growth has not proceeded in a steady fashion. We have chosen time periods for our analysis that smooth through the business cycle, which is a significant source of shorter-term changes in rates of productivity growth. More important for this discussion is the variation in labor productivity growth that has occurred over longer stretches of time, with periods of robust growth interspersed with periods of more modest productivity gains.

Using the Kendrick data as a guide and recognizing that the choice of any particular period is somewhat subjective, we take as the first episode of strong productivity growth-or productivity boom, if you will-roughly the period from 1873 to 1890. During this period, labor productivity rose more than 2-1/2 percent per year, a rate thought to be considerably

250 higher than the average growth experienced over the first 100 years of the United States.5 An important element of the analysis of this and other periods is the decomposition of output per hour into its underlying sources, including the contributions of multifactor productivity, capital deepening, and labor quality. In this regard, Kendrick's decomposition suggests that labor productivity growth in the late 1800s was fueled importantly by capital investment.6

During the next three decades, from 1890 to 1917, the growth rate of labor productivity slowed to an average pace of only 1-1/2 percent per year, with modest rates of growth both in the capital stock and in multifactor productivity. The United States then enjoyed a relatively brief spurt in productivity until about 1927, with labor productivity rising about 3- 3/4 percent per year and multifactor productivity up around 2 3/4 percent per year. This productivity boom was led by the expansion of the automobile industry and robust productivity gains in manufacturing more generally. Productivity growth was markedly slower through the Great Depression and World War II, largely reflecting a lack of capital deepening. Multifactor productivity rose at a relatively solid pace-albeit not as fast as earlier in the century-despite the weak economy during much of that period.

Productivity growth since World War II is more familiar to us and is based on more reliable data-those constructed as part of the multifactor productivity program at the BLS. According to these data, labor productivity rose at an annual rate of close to 3 percent from 1948 to 1973-a period sometimes referred to as the golden age of productivity growth. During this period, productivity accelerated across a broad range of industries, and both capital deepening and gains in multifactor productivity contributed to the strong pace of growth. The productivity slowdown of the 1970s and 1980s is also well known to us, and its possible causes have been the subject of much research. Labor productivity growth slowed to an average pace of 1.4 percent per year over this period, while multifactor productivity growth fell to a pace of 0.4 percent, the slowest pace of any of the periods shown on the table. Finally, labor productivity growth has averaged about 3 percent at an annual rate since 1995, with higher rates of both capital deepening and multifactor productivity growth contributing to the pickup.

Sources of Past Productivity Booms: Technological Change

Although the productivity booms of the past century and a quarter obviously differed in many respects, each episode can readily be associated with the introduction of one or more new technologies. The boom after the Civil War, for instance, appears to have had its genesis in technological improvements that increased the flexibility of production and reduced transportation costs, which allowed firms to take advantage of economies of scale in production and distribution.

In particular, the widespread introduction of steam engines and machinery driven by new sources of energy enabled firms to move away from sources of waterpower and closer to areas where inputs-including labor and raw materials-were more readily available. The Midwest-where sources of waterpower were less abundant but coal was more abundant- benefited greatly from this development, and indeed within a few decades became known as the "industrial heartland" of the United States. This regional shift in economic activity is illustrated by a sharp rise in the share of personal income generated in the Midwest between 1840 and 1880 (from 20 percent to 35 percent), and the commensurate decline in the share

251 of income generated in the Northeast (from 43 percent to 31 percent).7

The increase in the importance of railroad transportation also helped raise productivity growth in the second half of the nineteenth century.8 Improved methods of steel production- notably, the Bessemer process, and later, Siemens's open hearth method-enabled railroads to lay longer-lasting steel track rather than iron track. And the growth of telegraphy enabled railroads to better coordinate the movement of trains over a wider area. As a result, railroads expanded their geographic coverage significantly after the Civil War: From 1860 to 1890, the number of main track miles operated by railroad companies more than quintupled, from 31,000 miles to 167,000 miles, while the number of freight cars in operation jumped from 185,000 to more than 1 million.9

The expansion of the railroads drove transportation costs sharply lower and allowed a significant increase in market size. Whereas, in 1830, the transportation of goods from New York to Chicago had required three weeks even during the warmer months of the year, by 1870, it could be accomplished in three days any time of the year.10 In addition, the construction of new rail lines in western states opened those markets to a wide range of East Coast and Midwest manufacturers. Moreover, some of the benefits of the productivity improvements in the railroad industry were passed on to producers in the form of lower costs of transporting goods. Freight rates fell from 2-1/4 cents per ton-mile in 1860 to less than 1 cent per ton-mile by 1890. As a result, the quantity of goods transported by rail increased sharply, from about 12 billion ton-miles in 1870 to 80 billion ton-miles in 1890.11

Another major technological advance in the mid-1800s was the telegraph. Besides aiding the expansion of railroads by improving the coordination of rail traffic, the telegraph sharply reduced the costs of communicating in many other industries. And judging from the rapid growth in its use-the number of messages handled rose from about 9 million in 1870 to nearly 56 million in 1890-the telegraph undoubtedly contributed to better decisionmaking and higher productivity throughout the economy.12

Agriculture also was increasingly mechanized in the decades immediately after the Civil War, though the change was not as impressive as in the industrial sector. The abundance of land in western states limited the interest among farmers in raising land productivity. However, labor services were more difficult to obtain, so farmers were quite willing to invest in labor-saving machinery. As a result, the better plows, seed drills, reapers, and threshers developed by manufacturers were in high demand by farmers, and the amount of labor required to farm an acre of land fell sharply for many crops.13

In the productivity boom of the early twentieth century, the chief technological innovation was most likely the spread of electrification to the factory floor. As Paul David and others have extensively documented, the use of electric motors in the production process increased substantially in the first quarter of the century.14 In particular, the amount of mechanical energy derived from electric motors rose from 475,000 horsepower in 1899 to nearly 34 million horsepower in 1929, and the fraction of overall factory horsepower produced with electricity rose from less than 5 percent to more than 80 percent over that period.15

A major benefit of electric motors was that they enabled each machine in a factory to be powered by its own motor. This allowed manufacturing plants to be organized in a way that maximized the efficient movement of materials rather than the efficient transmission of power, and it facilitated the spread of continuous processing techniques and the assembly

252 lines made popular by Henry Ford. Indeed, as electric power became less costly-aided by a steep reduction in regulated electricity rates after World War I-its use increased sharply, and factory productivity rose significantly. By one estimate, productivity growth in the manufacturing sector as a whole rose about 5-1/2 percent per year between 1919 and 1929.16

Of course, other technological innovations also contributed to productivity growth during this period. Notable among them were the telephone-which by the 1920s had largely replaced the telegraph; the internal combustion engine, the use of which in motorized vehicles led to sizable productivity gains in the transportation and agriculture sectors; and a variety of technological advances in machine tools. In addition, the early 1900s were characterized by the first wave of office automation equipment, including the portable typewriter and adding and duplicating machines. These machines improved the efficiency of a wide range of management and accounting tasks, and the demand for such equipment rose quite sharply between 1900 and the late 1920s. Indeed, in real terms, business investment in office equipment increased from about $50 million (in 1929 dollars) in 1899 to nearly $500 million in 1929, with a particularly large jump evident in the 1920s.17

The productivity gains of the 1950s and 1960s, in part, had their roots in the technological innovations arising out of research sponsored by the military during World War II.18 For example, although research advances in synthetic polymerization chemistry (most notably, the introduction of catalytic cracking in the processing of crude oil) were made in the 1920s and 1930s, the synthetic rubber program launched during the war led to mass production of the first synthetic polymer from petroleum-based feedstocks. Similarly, production of polyethylene, a petrochemical-based plastic discovered in the 1930s, jumped sharply in the 1940s because of its widespread use in military equipment. And, the military's need for large stocks of penicillin led to a production process for it that turned out to have applicability to a wide range of pharmaceuticals.

The commercialization of these wartime innovations sharply increased the number of products made wholly or partly from newly developed plastic polymers and other synthetic materials. The use of polyethylene, for example, grew sharply after the war, while additional technological advances isolated new forms of synthetics and further reduced production costs for chemicals and pharmaceuticals. Overall, production in the rubber and plastic products industry rose nearly 7 percent per year between 1947 and 1970, while the output of the chemical products industry rose more than 8 percent annually over the same period.19

Two other notable technological advances during this period were the invention of the transistor in 1947 and the use of the jet engine in commercial aircraft. Commercial applications of the transistor, initially in solid state consumer electronic products, were stimulated by improvements in the fabrication process (in 1954) and by the introduction of the integrated circuit (in 1958). With the rise in demand, semiconductor production jumped markedly, rising nearly 20 percent per year during the 1960s.20 Similarly, the introduction of the Boeing 707 in 1958 sharply reduced the time and cost of transporting passengers and freight. In particular, according to estimates by Gordon (1992), productivity in the commercial airline industry rose 7 percent per year during the 1960s, well above the rate of labor productivity growth for the economy as a whole.21

For purposes of comparison, the technological origins of the more recent computer

253 revolution also bear a brief mention. Obviously, the invention of the transistor and the development of the mainframe computer were precursors of the technological advances that contributed to the current productivity boom. However, the real drivers of the productivity gains in the 1990s were the related high-tech innovations of the 1970s and 1980s, including the personal computer, fiber optics, wireless communications, and the Internet.

Many of the recent technological innovations have significantly altered how firms interact with their customers, in ways that have raised the productivity of the economy. In the retail sector, the Internet stores made popular by Amazon.com have been adopted by nearly all large retail chains; in banking, it is now routine for customers to pay bills online; and for airlines, Internet reservations and e-tickets are the norm. Moreover, throughout the goods economy, from manufacturing to retailing, innovations in inventory management practices made possible by new technologies have substantially reduced costs.

An important point about technological change is that, in most cases, the invention of the technologies that stimulated the productivity growth in these boom periods took place well before the productivity gains were realized. For example, the steam engine was invented in the 1700s, well before it had any measurable effect on the production process in the United States. Similarly, railroads were being built in the 1840s, and the first electric power plant was built in 1882. And as we all know, the absence of a significant contribution to productivity growth from computers, which were first introduced in 1945, was a puzzle to many economists as late as the mid-1990s.

What then facilitated the translation of these innovations into gains in productivity? At one level, the delay reflected the challenges of developing commercial applications for the new technologies. The lag from a new invention to a new product or process was sometimes quite long because of the additional scientific research required to demonstrate its practicality. In addition, in many cases, new technologies diffused into the capital stock relatively slowly. Replacing older machines with equipment that embodied the new technologies was often not immediately profitable, and thus firms frequently took some time before making the capital investments required to take full advantage of technological progress.

Sources of Past Productivity Booms: Organizational Change

A careful examination of past productivity booms also points to substantial changes in business practices and in the organization of firms as a key factor enabling businesses to achieve the potential productivity gains associated with new technologies.22 In many cases, these organizational changes went hand in hand with the technological advances-the changes both being made possible by the new technologies and being necessary to achieve the additional productivity associated with the use of these technologies.

For example, before the Civil War, most businesses were either sole proprietorships or partnerships serving local markets and consisted of small shops employing skilled workers involved in each aspect of the production process. At the same time that the spread of railroads lowered transportation costs and increased the size and number of potential markets, the greater availability of steam power enabled manufacturers to set up factories to take advantage of economies of scale in production. As a result, the optimal firm size rose substantially in many industries. In the cotton industry, for example, the median firm size (measured as the annual value of gross production in 1860 dollars) rose from $31,000 in

254 1850 to nearly $100,000 in 1870; similarly, in the iron industry, median firm size rose from $24,000 in 1850 to more than $200,000 in 1870.23 In addition, large wholesalers (and later, retailers) emerged to take advantage of increased distributional efficiencies to sharply reduce the costs of moving commodities and manufactured goods from the farm or factory to retailers' shelves.

These larger enterprises typically had to confront communications challenges not faced by smaller businesses. In particular, effective internal information flows were often crucial to the success of firms producing or distributing large volumes of inputs and outputs. The telegraph and the railroad-based postal service made prompt communication over great distances possible. But firms also had to set up hierarchical management systems to control the production process and to coordinate the flow of goods across the distribution system in order to take advantage of the economies of scale presented by technological change.

Advances in production processes in the early 1900s led to new challenges and opportunities for business organization. As noted above, the diffusion of the electric motor throughout the factory increased the use of continuous-process methods and the assembly line and thus accelerated the trend toward mass production. In addition, as early as the 1880s, manufacturers had begun to integrate forward into distribution; one noteworthy example was the meatpacking industry, in which firms purchased refrigerated rail cars that allowed shipment of beef from centralized slaughterhouses to branch houses that served local markets. The advances in mass production techniques and the increasing complexity of many manufactured products led firms in other industries to integrate forward not only into distribution but also into retailing; this vertical integration reduced transactions costs even more and further increased the optimal size of firms. Indeed, many of the large corporations that arose at this time-Ford, General Motors, and General Electric, for example-are still with us today.

The vertical integration of these large corporations, in turn, led to a greater emphasis on nonproduction activities.24 To compete in retail markets, firms needed to understand what products consumers wanted and to enable consumers to associate specific products with a particular firm; in addition, firms needed to establish accounting systems to keep track of a wider range of activities. As a result, marketing and advertising departments arose within large corporations, as did accounting departments. Also, with large corporations now more sensitive to their market share and their cost advantage over their competitors, they began to develop applied research departments to foster innovations in their industries.

After World War II, changes in the organization of the firm took two forms. The first was an increasing tendency by corporate managers to split the firms' operations into separate divisions, each with its own manufacturing and marketing departments. This multidivisional approach was well suited to the technological changes of the 1940s and 1950s, as many innovations during that period led to the manufacturing of diverse product lines by a single company, DuPont and Monsanto being key examples.25

This multidivisional structure also turned out to be an effective method of handling corporate operations in different geographic areas; and indeed, the second major organizational innovation during this period was the rise of the multinational corporation. After World War II, new trade agreements and efforts to revitalize Europe and Japan allowed American firms to make significant inroads into foreign markets. To handle these long-distance operations more easily, corporations often set up foreign subsidiaries that

255 could adapt quickly to changing circumstances in the host country's marketplace. By one estimate, such multinational corporations accounted for nearly 35 percent of total U.S. corporate assets by 1966.26

Organizational structure during the productivity boom of the late 1990s has, in some respects, shifted away from the large corporations that dominated the U.S. economy during much of the twentieth century. To be sure, the marketplace in many industries is still dominated by large, well-established firms. And in some industries-the financial services sector comes to mind-recent technological innovations have, if anything, increased the scale of business. But in other industries, intense global competition has motivated many corporations to narrow their focus to core production-related activities and to outsource other functions. Increasingly, these supporting firms are providing their services from overseas, taking advantage both of lower labor costs there and of the revolution in communications.

At the same time, much of the rapid technological innovation in this period has occurred outside the large corporate sector, and the success of that innovation has boosted the pace at which new ventures are being created. For example, more than 700,000 new businesses were incorporated each year, on average, in the 1990s, about double the pace of the 1970s.27 Of course, as we know from the dot-com experience, many of these firms failed. However, many others either grew or were bought by larger firms better able to market and distribute the most promising innovations.

Sources of Past Productivity Booms: Financial Market Change

A third major ingredient in promoting the productivity gains associated with technological innovation has been a complementary set of innovations in the financial sector that have changed the financial landscape in ways that were especially appropriate to the predominate form of business organization in each period.28

For example, before the Civil War, most nonfinancial business investment was financed internally with retained earnings, with capital provided by family or friends, or through partnerships formed with other proprietors. The chief exceptions were the canals and railroads, which were actively issuing stocks and bonds in the 1850s.29 With the need for greater capital investments and the sharp increases in the scale of operations of many firms after the Civil War, however, businesses in other industries also began to look more toward external sources of financing.

The main sources of funding in the decades after the Civil War were debt and preferred stock.30 Debt often took the form of secured loans, in large part because investors were concerned about the informational asymmetries they faced in evaluating the bankruptcy risk of particular firms. In addition, the owners of many firms often preferred financing with debt rather than common stock because they did not want to see their equity diluted or their control of the enterprise diminished. Similarly, preferred stock, which reduced bankruptcy risk but did not dilute the equity of the owners of the firm, was often used when assets were insufficient to secure the loan. Thus, despite the prevalence of information problems, financial intermediaries were able to provide firms with external sources of funds, making possible the rapid buildup in the capital stock that took place in the late 1800s. For example, the total value of bank loans rose from less than $1 billion in 1870 to more than $6 billion in the early 1890s, a notable increase in nominal value during a time when, if anything, the

256 aggregate price level was falling.31

In contrast, the years after World War I were characterized by an increase in the importance of equity markets. At the New York Stock Exchange alone, the volume of stock sales rose from 186 million shares in 1917 to more than 1 billion shares in 1929.32 And, by one estimate, the number of individuals holding stock increased from 500,000 in 1900 to 10 million by 1930.33

The rise in the public's interest in common stock occurred for several reasons. First, and probably most importantly, the profitability of large corporations during the early 1900s was accompanied by an expanding middle and upper class that wanted to take part in the economic gains associated with the introduction of new technologies such as the internal combustion engine and the electric motor. As the main way to share in these capital gains was to purchase some ownership in those corporations, these individuals increasingly looked to invest their savings in the stock market.

At about the same time, the informational problems that had constrained interest in common stock through the early 1900s were being reduced. Rising demand from investors in the late 1800s for information about railroad companies had led to the proliferation of newsletters watching developments in that industry, and similar publications soon sprang up to provide information on other traded securities. These newsletters eventually evolved into ratings agencies covering a wide range of individual corporations, with Moody's issuing the first bond ratings in 1909. Although these agencies' ratings focused on corporate bond issues, many also provided economic forecasting services and more detailed information about the relative risk of specific companies. In addition, with a greater recognition of the need to address investors' concerns about risk, more public companies regularly issued audited financial statements.34

Interest in common stock was also boosted by the tendency to imbue them with characteristics similar to those associated with debt, with which investors were more familiar. For example, businesses frequently attempted to establish steady dividend streams in order to boost investors' confidence about the future profitability of the firm and encourage holdings of their securities. Finally, the marketing of securities to the household sector became more aggressive in the 1920s, led by investment trusts-which offered investors a means of diversifying individual portfolios-and retail brokerage firms.

Given the relative prosperity of the post-World War II period, nonfinancial corporations were able to generate significant increases in internal funds. Even so, the growth of investment spending over this period noticeably outpaced the rise in retained earnings, and thus these corporations turned to the capital markets to fill the widening gap. In response, both bond and equity issuance rose rapidly in absolute terms, and the ratio of external financing to overall capital spending increased from an average of around 30 percent in the late 1940s to more than 40 percent in the early 1970s.35

There were two specific developments in financial markets during this period that bear mentioning. First, the late 1950s and 1960s saw the rise of the Eurodollar market-a market for U.S. dollar deposits and loans outside the United States, and at least initially in Europe. Although the origin and early development of the Eurodollar market is attributed, in part, to a desire by holders of dollars to avoid U.S. regulations, including the Regulation Q interest rate ceilings, that market subsequently became a useful source of short-term financing-

257 complementary to the commercial paper market-for large corporations seeking alternatives to more costly domestic commercial bank loans.36 Second, the 1950s and 1960s were characterized by a sharp rise in the importance of large institutional investors-especially pension funds-in the stock and bond markets. This rise, coupled with the growth of mutual funds and brokerage houses, enabled smaller investors (either explicitly or implicitly) to further diversify their portfolios.

More recently, financial markets have continued to evolve to meet the financing needs of the business sector and the concerns of investors. In particular, in response to the proliferation of start-up businesses and, for many firms, a riskier economic environment, financial intermediaries have expanded the range of financing alternatives available to businesses and have made marked improvements in quantifying and managing risk.

For larger lower-rated corporations that have significant default risk, the expansion of the so-called junk bond market has offered the capability to raise funds even when other sources of financing were less available. For example, junk bond issuance rose from about $11 billion in 1984 to more than $100 billion in 2001, while the par value of outstanding junk-rated debt has increased from less than $100 billion in the mid 1980s to nearly $700 billion today.37

For smaller and yet-riskier firms, venture capital and initial public offerings have been important sources of financing. For example, venture capital investments, which were negligible in the early 1980s, rose to more than $100 billion in 2000, although they have since dropped back.38 Similarly, initial public offerings for nonfinancial companies (excluding spinoffs and leveraged buyouts) exploded from less than $5 billion per year in the late 1980s to roughly $30 billion in 2000.39

In terms of managing risk, many large financial institutions have, over the past decade, increasingly adopted internal credit-risk models to improve their ability to assess in real time the riskiness of their portfolios. In addition, financial-market innovations, including securitizations, credit derivatives, and an improved secondary loan market, have allowed these institutions to better manage their exposure to such risks. These improvements in risk management may help to explain why financial institutions weathered the recent economic downturn so well relative to their difficulties in previous recessions.

Sources of Past Productivity Booms: Human Capital Accumulation

The fourth ingredient underlying the productivity booms of the past involves labor input- specifically, the availability of a workforce capable of bringing to fruition the possibilities opened up by the technological innovations. Technological advances have not increased the demand for all skill sets equally. For example, the shift in manufacturing production from artisanal shops in the mid-1800s to factories after the Civil War led to a disproportionate increase in the demand for unskilled labor to operate the new machines. But, as I noted earlier, increases in the optimal size of firms and the growth of businesses dedicated to mass distribution and mass production also increased the demand for workers who could perform clerical and managerial tasks. Indeed, the percent of men who were employed in white- collar occupations rose from less than 5 percent in 1850 to nearly 18 percent by 1900.40

The demand for white-collar workers continued to increase in the early twentieth century with the further expansion in corporate size and the new focus on activities outside

258 traditional production. In particular, these additional activities required a new set of managers to control and coordinate the diverse functions of the corporation and an increase in clerical workers to process the increased flow of information associated with vertical integration. As a result, nonproduction workers as a share of the total labor force rose from 6-1/2 percent in 1880 to nearly 25 percent by 1930.41

Moreover, contrary to what had been true earlier, manufacturing firms that were using more advanced technologies in the early 1900s also tended to hire more-capable and more highly educated workers. In particular, in the 1920s, the industries that were more likely to employ high-school-educated blue-collar workers tended to be the same industries that were further along in adopting the new technologies, suggesting that the basic reading and mathematics skills acquired in high schools were valued by firms in these industries. That wage levels in these industries tended to be higher than for the manufacturing sector as a whole is a further indication that they employed workers with more skills.42

Similarly, throughout the rest of the twentieth century, skilled labor and new technologies appeared to be complements in production. The 1950s and 1960s saw a significant increase in the share of the workforce in professional and technical occupations, with especially rapid growth among engineers and technicians.43 And the 1980s and 1990s saw a rise in the wage premium for higher-skilled workers, as well as a sharp increase in the demand for workers with computer-related skills. In contrast, lower-skilled workers have suffered in recent years from competitive pressures that are related in part to the outsourcing of low- skilled jobs abroad.

The institution of universal education in the United States has allowed our workforce to adapt to the changing skill requirements of the economy. In the late 1800s, school enrollment rates among children held steady at about 50 percent and high school graduation rates remained below 5 percent, a pattern consistent with the absence of a significant wage premium for educated labor. However, as the premium for education widened in the early 1900s, enrollment rates in secondary schools increased steadily, and the high school graduation rate rose to more than 25 percent by the late 1920s. Similarly, partly reflecting rising demand for college-educated labor in the 1950s and 1960s, the percentage of 18 to 24 year olds enrolled in college rose from about 14 percent in 1950 to roughly 25 percent in 1970.44

After stagnating in the 1970s and 1980s, college enrollment rates among youths began to rise again in the 1990s, reflecting a further widening in the skill premium for workers with a college degree. Moreover, enrollments at community colleges increased about 30 percent between 1985 and 2000, and the percent of adults attending an education program rose from 33 percent in 1991 to 45 percent in 1999, with a particularly large increase evident for the unemployed.45 These changes likely reflect, in part, efforts by lesser-skilled adults to retool their skills.

In sum, the productivity booms of the past seem to have involved four key ingredients: technological innovation; the willingness and ability of owners and corporate managers to reengineer the internal organization of their firms to take maximum advantage of those innovations; complementary innovations in the financial sectors specifically tailored to the forms of business organization predominating at the time; and the availability of a workforce sufficiently educated to actualize the potential implicit in the technological innovations. From the standpoint of economic policy, we undoubtedly stand to learn a

259 number of valuable lessons from these similarities, but let me touch on a few that I think are particularly important.

Lessons from Past Productivity Booms

First, many of the technological innovations associated with past productivity booms were general purpose technologies (GPTs) with widespread applicability. Such technologies have operated through a variety of channels, raising productivity not only in production, but also in distribution and business practices. In many cases-railroads and computers, for example- the productivity improvements were initially most pronounced in the production of the capital equipment embodying the new technologies. In particular, Fishlow (1966) estimates that multifactor productivity in the railroad industry rose nearly 4 percent per year, on average, between 1840 and 1900, as compared with increases of around 1 percent per year for the economy as a whole. And, Oliner and Sichel (2002) estimate that since 1990, efficiency gains in the production of high-tech equipment have accounted for about half of overall multifactor productivity growth in the nonfarm business sector. In addition, such general purpose technologies typically draw in substantial amounts of new investment capital. For example, Fishlow (2000) points out that in the 1870s, investment in transportation facilities amounted to more than 15 percent of capital formation. Similarly, in 2003, investment in high-tech equipment as a share of overall business fixed investment stood at 42 percent, up from 19 percent in 1980.46

The importance of general purpose technologies raises the question of whether governments should attempt to stimulate the development of particular GPTs, perhaps through some type of industrial policy. To be sure, government intervention has, at times, contributed to specific technological innovations. Government support in the 1800s-through federal land grants and state and local aid-was one source of financing for railway construction in the 1850s and after the Civil War. Military support for chemical research that focused on developing new materials during World War II obviously contributed to productivity gains in the private sector in the 1950s and 1960s. And, the Department of Defense supported the development in the 1960s of the ARPANET, the predecessor of the Internet of today.

However, many, if not most, of the general purpose technologies of the past two centuries have had their genesis in the private sector. The steam engine, the electric motor, and the computer were developed and diffused through the economy largely as a result of the profit opportunities afforded by those new technologies. And, even for railroads, external financing came primarily from private domestic or foreign sources; estimates place the proportion of government funding in nominal investment by railroad companies at less than 10 percent after the Civil War.47

In the United States, the government has contributed most effectively to technological change by promoting an economic, financial, and legal environment that is conducive to innovation and to the diffusion of new technologies. Federal funding of basic research, often in research universities or federal laboratories, obviously comprises an important part of this contribution. However, another key component of this environment has been the protection of intellectual property rights. Patent laws in the United States have encouraged innovation by attempting to strike a careful balance-allowing the inventors of new technologies to reap the benefits of their innovations, while at the same time encouraging the timely diffusion of new technologies and limiting the damage from monopoly power.48 In the past, patent laws have primarily emphasized protection of the new technologies or

260 production processes associated with invention. Given that recent innovations have, to an increasing extent, encompassed the transformation of electronic data to create new methods of business practices, the challenge today is to ensure that such innovations are afforded the appropriate degree of protection-ensuring that innovators are rewarded for their ideas but not granting them so wide a range of territory in the property-rights battlefield that they acquire a stranglehold on the economy and, perversely, are allowed to choke off the innovation that they helped create.49

Similarly, allowing businesses the flexibility to reorganize their operations in ways that permitted them to take maximum advantage of new technologies has been instrumental in translating technological innovations into higher productivity in all four episodes. Likewise, U.S. labor markets have been quite effective at reallocating the workforce in response to technological changes. Of course, some government regulation of business and labor markets is absolutely essential, but such regulatory policies must be designed taking account not only of perceived advantages but also of economic costs. For example, it seems clear in retrospect that the deregulation of a number of industries in the 1970s and 1980s, such as airlines, trucking, financial services, and natural gas, ultimately provided an important boost to productivity growth by allowing businesses in those industries to operate with fewer constraints and more flexibility.50

In a different vein, one must note the ongoing debate about whether protectionist measures- such as tariffs and quotas-might also be helpful in raising long-run productivity growth by encouraging the diffusion of new technologies into the domestic capital stock. For example, the tariffs that protected domestic markets from foreign competition in the 1800s are viewed by some observers as having provided manufacturers the opportunity to expand more rapidly.51 However, even then, the American economy benefited considerably from free trade in intellectual property by exploiting technologies that had been invented abroad. Moreover, the experience of other periods of American history demonstrates that protectionist measures are not an effective means of promoting the diffusion of technology in a more developed economy. The detrimental economic effects associated with the passage of the Smoot-Hawley tariffs in 1930 provide one important example. And, in the post-World War II period, the relaxation of trade restrictions opened up important foreign markets to the new products being developed by U.S. corporations. More generally, the United States has, over time, consistently and successfully responded to competitive pressures from abroad, often through technological innovations that create new markets and opportunities.

Another lesson from past productivity booms is that the willingness of investors to hold securities is crucial for firms to raise the working capital they need to take advantage of the productivity potential of new technologies. For instance, as I noted earlier, the information problems of the late 1800s and early 1900s constrained interest in common stock, and this reluctance by investors to hold equity presumably raised the overall cost of capital. Similarly, unless the corporate governance issues of the past few years are aggressively addressed, the damage to the financial intermediation process will undoubtedly result in a higher cost of capital. In this regard, prudent regulation of financial markets is extremely important, and a crucial aspect of this regulation has been the requirement that firms provide information that is extensive, accurate, and interpretable in a straightforward manner.

Government involvement in providing broad access to education has also played an

261 important role in stimulating economic growth by continually improving the ability of the workforce to adapt to technical change. In the past, a basic facility for reading and arithmetic were essential to workers in a wide range of occupational settings, and American schools effectively provided these skills to our youths. In the economy of the future, the educational requirements of the population will be even greater. Not only will workers need basic skills in math and language, but they also will increasingly require knowledge of basic and applied science-as well as the ability to acquire new skills when required by their jobs. As a result, continued public recognition of the value of education as well as ongoing efforts to ensure widespread access to a high caliber of schooling at all levels will be indispensable.

Of course, I would be remiss if I did not also comment on the importance of sound macroeconomic policies in promoting long-run economic growth. Evidence clearly points to a correlation between low inflation and strong productivity growth. And while it is difficult to identify a strong causal relationship between a healthy economy and productivity, a couple of casual empirical observations are suggestive of a link. First, the number of patent applications tends to be higher in good economic times than during recessions.52 If patenting is a valid measure of technological change, such a correlation suggests that innovation is stimulated by healthy economic conditions. Second, and perhaps more important, business fixed investment-and thus the diffusion of new technologies through renewal of the capital stock-is likely to be better maintained in an economic environment characterized by the robust profit opportunities and lower uncertainties afforded by sustainable economic growth and low inflation.

Why Do Productivity Booms End?

To complete my discussion, I want to turn briefly to the question of why periods of strong trend productivity growth come to an end. Several hypotheses have been put forth, including (1) that successful new technologies eventually lead to financial imbalances and overinvestment associated with excess optimism, (2) that periods of strong productivity growth eventually run out of steam as the productivity-increasing opportunities associated with new technologies are exhausted, and (3) that exogenous shocks bring an end to boom periods.

Although elements of these three hypotheses can be seen in the past episodes of productivity booms, no clear pattern emerges. Regarding the first hypothesis, support can be found in the soaring stock prices of the late 1870s, the 1920s and the late 1990s, which in all three cases were coincident with a period of very rapid productivity growth and were followed (eventually) in the first two cases by a collapse in stock prices and economic depression. In contrast, the steady rise in equity values during the 1960s did not appear to be associated with the emergence of any significant financial imbalance, and the subsequent decline in stock prices in the mid-1970s may owe importantly to the failure of economic policy to react to the changing dynamics of the economy and thus to control inflation. Similarly, in certain industries-most notably automobiles and electric utilities-a speculative rise in capital spending during the 1920s arguably did result in a significant overbuilding of capacity by the end of that decade. But such instances are more difficult to find in the late 1800s and in the 1960s. And, while there does appear to have been an overinvestment in high-tech and telecommunications equipment in the late 1990s, the recent productivity data certainly do not suggest that this overinvestment has ended the current productivity boom.

The hypothesis that productivity booms end when innovation and technical change levels

262 off is difficult to test for the 1800s and early 1900s because of a lack of data. Arguments along this line, which surfaced to explain the productivity slowdown of the 1970s, pointed to the deceleration in the growth of research and development (R&D) spending in the late 1960s as evidence. However, Griliches (1988) has argued convincingly that this shortfall in R&D spending was not of sufficient magnitude to contribute very much to the productivity slowdown. But, even if the notion that technological innovations are eventually exhausted is valid, we have no evidence that this is as yet a significant risk to the current productivity boom. Both industrial R&D and patent applications have risen rapidly in recent years, suggesting that innovation-and the potential productivity gains associated with technological progress-will likely remain an important source of economic growth in the United States in coming years.

Finally, some role for exogenous shocks is also evident in past episodes, depending on how broadly one defines an exogenous shock. The 1973 oil shock is perhaps is the most convincing example, although the extent to which this ended the "golden era" is still the subject of much discussion. In addition, the bank panic of 1893 is viewed by some as an important contributor to the depression of the 1890s; however, whether this event is an exogenous shock or an indication of earlier economic excess (as in 1929) is debatable. Of course, we have also experienced significant exogenous shocks in recent years-including 9/11, the Iraq conflict, and a variety of corporate scandals. It is encouraging that the economy seems to have successfully weathered these recent shocks with no significant harm to productivity growth.

Conclusion All of us as government economists, policymakers, and citizens have a stake in learning the lessons from past productivity booms. As I have said, productivity improvements translate directly into improvements in the standard of living. Economists will continue to debate the relative importance of various factors underlying productivity growth. But our experience in the United States clearly suggests that periods of relatively rapid trend productivity growth are characterized by innovations in technology that are accompanied by changes in organizational structure and in business financing arrangements and by investments in human capital. Productivity booms in the United States have been of varying duration, but we have seen two of them last as long as twenty years. We do not know definitively what brings these booms to an end. In our experience, however, periods of elevated increases in trend productivity are best fostered in an environment of economic and personal freedom and government policies that are focused on erecting sound and stable macroeconomic conditions that are most conducive to private-sector initiative.

U.S. Productivity Growth, 1873-2003 (Average annual percent change)

Period Labor Multifactor Capital deepening 1873-2003 2.02 1.33 0.73

Episode I 2.6 0.9 1.7 1873-90

263 Episode I 2.6 0.9 1.7 1873-90 1890-1917 1.5 0.8 0.7 Episode II 3.8 2.8 1.0 1917-27 1927-48 1.8 1.7 0.1 Episode III 2.9 1.9 1.0 1948-73 1973-95 1.4 0.4 1.0 Episode IV 2.92 1.03 1.63 1995-2003

1. Includes changes in labor composition. 2. Based on data through 2003:Q3. 3. Based on data through 2001. Source: Kendrick (1961) and U.S. Bureau of Labor Statistics.

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Footnotes

267 1. For a recent assessment of the new economy, see Martin Baily's Distinguished Lecture on Economics in Government (Baily 2002).

2. Others will undoubtedly disagree with this taxonomy. Robert Gordon (2000), for example, argues that the historical record of productivity growth in the United States is best seen as one big "wave" that begins its rise in the late 1800s and tapers off in the late 1960s and early 1970s. And from a standpoint of technological advance, that characterization may well be appropriate. But for assessing the diffusion of technology and the forces that contributed to the speed of the diffusion, a focus on narrower periods of labor productivity booms is arguably more appropriate.

3. See Kendrick (1961) and Kuznets (1946).

4. See, for example, Gallman (1966) and Rhode (2002).

5. This estimate of productivity growth is the change from Kendrick's estimate of the average level of productivity in the 1870s to the level of productivity in 1890.

6. Decompositions of productivity growth before 1948 are the subject of some debate, and thus estimates of multifactor productivity for these earlier periods should probably be viewed as less reliable than are the estimates of labor productivity.

7. Easterlin (1961).

8. How much the railroad contributed to economic growth in the late nineteenth century is the subject of some disagreement. See, for example, David (1969), Fishlow (2000), and Fogel (1979).

9. U.S. Census Bureau (1997), Series Q321, and Fishlow (1966).

10. See Paullin (1932). Before the railroads, goods were transported by canals, which often did not operate during the winter.

11. Estimates of track construction, freight rates, and ton-miles transported are taken from Fishlow (1966 and 2000).

12. U.S. Census Bureau (1997), Series R48.

13. See Atack, Bateman, and Parker (2000).

14. See, for example, David (1990) and Mowery and Rosenberg (2000).

15. U.S. Census Bureau (1997), Series P70.

16. Kendrick (1961), p. 152.

17. See Cortada (1993), figure 3.1.

268 18. This section draws from Mowery and Rosenberg (2000).

19. Board of Governors of the Federal Reserve System, Indexes of Industrial Production. By comparison, overall manufacturing IP rose about 4-1/2 percent per year from 1947 to 1970.

20. Board of Governors of the Federal Reserve System, Indexes of Industrial Production.

21. Of course, the invention and commercial use of the airplane itself was a technological innovation that predated the jet engine. In particular, the introduction of commercial air travel in the late 1920s represented a substantial improvement over existing forms of passenger transportation. The estimates of Gordon (1992) show that productivity in airline transportation rose about 7 percent per year between 1935 and 1959 as well.

22. Chandler (1977) provides a detailed discussion of such changes.

23. Atack (1986).

24. This section draws from Galambos (2000).

25. Baskin and Miranti (1997).

26. U.S. Bureau of Economic Analysis (1966).

27. U.S. Census Bureau (2001).

28. This section draws from Baskin and Miranti (1997) and White (2000).

29. Chandler (1977).

30. As Fishlow (2000) notes, an exception to this were railroad companies, which sold sizable amounts of common stock to investors seeking large capital gains following the completion of new construction projects.

31. U.S. Census Bureau (1997), Series X581.

32. U.S. Census Bureau (1997), Series X531.

33. Hawkins (1963).

34. Miranti (2001).

35. Board of Governors of the Federal Reserve System, Flow of Funds Accounts36. See Johnston (1982) and Kindleberger (1993). Although no direct data on the size of the Eurodollar market are available, flow of funds data indicate that foreign holdings of U.S. corporate bonds rose from about $500 million in the mid-1950s to about $2 1/2 billion in 1970.

37. Based on data from Thompson Financial Securities Data Corporation and Moody's

269 Investors Service.

38. PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association, MoneyTree Survey.

39. Thompson Financial Securities Data Corporation.

40. Margo (2000), pp. 215-16.

41. Beniger (1986).

42. See Goldin and Katz (1998).

43. U.S. Census Bureau (1997), Series D233-D682.

44. U.S. Census Bureau (1997), Series H433, H701. The increase in college enrollments during this period likely was also boosted by the use of college deferments during the Vietnam War.

45. U.S. Department of Education, Digest of Education Statistics. Owing to data limitations, this measure includes adults enrolled in personal development programs. In 1999, for which more detailed information is available, roughly one-third of adults were participating in post-secondary education or career-related courses.

46. Fishlow (2000) and Mowery and Rosenberg (2000) also note the importance of intersectoral linkages between new technologies and other industries. In the nineteenth century, for example, the construction of railroads had backward linkages to the coal, iron and steel, and machinery industries and forward linkages to the distribution sector. Likewise, in the twentieth century, the innovations in electricity, chemistry, and the development of the internal combustion engine led both to widespread productivity improvements in mature industries and the creation of new industries.

47. Fishlow (2000).

48. Engerman and Sokoloff (2000). Some observers have also emphasized that technological diffusion can be effectively achieved through the sharing of information or collective invention. See Meyer (2003), who points to the technological improvements in steel production in the 1800s and in personal computers in the 1970s as examples of such networking gains.

49. For a discussion of patent policy in the context of financial market innovations, see Ferguson (2003).

50. See Winston (1998) for a summary of the evidence.

51. There is considerable debate on this issue. See Lipsey (2000) for a brief summary.

52. Engerman and Sokoloff (2000) point out that the growth in patenting was especially high in the 1850s and 1880s, both periods of rapid economic growth. Similarly, Griliches (1990) finds a positive coefficient on real GDP growth in a regression relating the growth in

270 patent applications to changes in real GDP and gross private domestic investment for the period 1880 to 1987. Geroski and Walters (1995) find a similar result for the United Kingdom.

271

Paper by Governor Ben S. Bernanke and Vincent R. Reinhart, Director, Division of Monetary Affairs* Presented at the Meetings of the American Economic Association, San Diego, California January 3, 2004 Governor Ben S. Bernanke presented identical remarks at the International Center for Monetary and Banking Studies Lecture, Geneva, Switzerland on January 14, 2004

Conducting Monetary Policy at Very Low Short-Term Interest Rates Can monetary policy committees, accustomed to describing their plans and actions in terms of the level of a short-term nominal interest rate, find effective means of conducting and communicating their policies when that rate is zero or close to zero? The very low levels of interest rates in Japan, Switzerland, and the United States in recent years have stimulated much interesting research on this question, and some has been applied in the field. Moreover, their minds concentrated by the possibility of having the policy rate pinned at zero, central bankers have responded flexibly, making changes in their operating procedures and communications strategies. Our purpose in this paper is to give a brief progress report and overview of current thinking on the conduct of monetary policy when short-term interest rates are very low or even zero.1

Monetary policy works for the most part through financial markets. Central bank actions are designed in the first instance to influence asset prices and yields, which in turn affect economic decisions and thus the evolution of the economy. When the short-term policy rate is at or near zero, the conventional means of effecting monetary ease--lowering the target for the policy rate--is no longer feasible, but monetary policy is not impotent. In this paper we will discuss three alternative (but potentially complementary) monetary strategies for stimulating the economy that do not involve changing the current value of the policy rate. Specifically, these alternatives involve (1) providing assurance to financial investors that short rates will be lower in the future than they currently expect, (2) changing the relative supplies of securities (such as Treasury notes and bonds) in the marketplace by shifting the composition of the central bank's balance sheet, and (3) increasing the size of the central bank's balance sheet beyond the level needed to set the short-term policy rate at zero ("quantitative easing"). In the final section, we briefly discuss the macroeconomic costs and benefits of very low interest rates, an issue that bears on the question of whether the central bank should take the policy rate all the way to zero before undertaking some of the alternatives we describe. I. Shaping Interest-Rate Expectations The pricing of long-lived assets, such as long-term bonds and equities, depends on the entire expected future path of short-term interest rates as well as on the current short-term rate. Prices and yields of long-lived assets are important determinants of economic behavior because they affect incentives to spend, save, and invest. Thus, a central bank may hope to affect financial markets and economic activity by influencing financial market participants' expectations of future short-term rates. Important recent research has examined this potential channel of influence in fully articulated models based on optimizing behavior; see Michael Woodford (2003, chapter 6), Lars Svensson (2001), and Gauti Eggertson and Woodford (2003). This literature suggests that, even with the

272 overnight nominal interest rate at zero, a central bank can impart additional stimulus by offering some form of commitment to the public to keep the short rate low for a longer period than previously expected. This commitment, if credible, should lower yields throughout the term structure and support other asset prices.

In principle, the central bank's policy commitment could take either of two forms: unconditional and conditional. An unconditional commitment is a pledge by the central bank to hold short-term rates at a low level for a fixed period of calendar time. In this case, additional easing would take the form of lengthening the period of policy commitment. However, given the many shocks that the economy is heir to, as well as other imponderables that affect the outlook, a policymaking committee might understandably be reluctant to tie its hands by making an unconditional promise, no matter how nuanced, about policy actions far into the future. An alternative strategy is to make a conditional policy commitment, one that links the duration of promised policies not to the calendar but to the evolution of economic conditions. For example, policy ease could be promised until the committee observes sustained economic growth, substantial progress in trimming economic slack, or a period of inflation above a specified floor.

In practice, central banks appear to appreciate the importance of influencing market expectations about future policy. For example, in May 2001, with its policy rate virtually at zero, the Bank of Japan promised that it would keep its policy rate at zero for as long as the economy experienced deflation--a conditional policy commitment. More recently, the Bank of Japan has been more explicit about the conditions under which it would begin to raise rates; for example, it has been specified that a change from deflation to inflation that is perceived to be temporary will not provoke a tightening.2 In the United States, the August 2003 statement of the Federal Open Market Committee that "policy accommodation can be maintained for a considerable period" is another example of commitment. The close association of this statement with the Committee's expressed concerns about "unwelcome disinflation" implied that this commitment was conditioned on the assessment of the economy. The conditional nature of the commitment was sharpened in the Committee's December statement, which explicitly linked continuing policy accommodation to the low level of inflation and the slack in resource use.3 More generally, in recent years central banks have devoted enormous effort to improving their communications and transparency; a major benefit of such efforts should be a greater ability to align market expectations of policy with the policymaking committee's own intentions.

Of course, policy commitments can influence future expectations only to the extent that they are credible. Various devices might be employed to enhance credibility; for example, the central bank can make securities purchases or issue financial options that make it quite costly, in financial terms, to renege on its commitments (Clouse et al., 2003). An objection to this strategy is that it is not entirely clear why a central bank, which has the power to print money, should be overly concerned about its financial gains and losses. Eggertsson and Woodford (2003) point out that a government can more credibly promise to carry out policies that raise prices when (1) the government debt is large and not indexed to inflation and (2) the central bank values the reduction in fiscal burden that reflationary policies will bring (for example, because it may reduce the future level of distortionary taxation). Ultimately, however, the central bank's best strategy for building credibility is to ensure that its deeds match its words, thereby building trust in its pronouncements. The requirement that deeds match words has the consequence that the shaping of market expectations is not an independent instrument of policy in the long run. II. Altering the Composition of the Central Bank's Balance Sheet

Central banks typically hold a variety of assets, and the composition of assets on the central bank's

273 balance sheet offers another potential lever for monetary policy. For example, the Federal Reserve participates in all segments of the Treasury market, with most of its current asset holdings of about $670 billion distributed among Treasury securities with maturities ranging from four weeks to thirty years. Over the past fifty years, the average maturity of the Federal Reserve System's holdings of Treasury debt has varied considerably within a range from one to four years. As an important participant in the Treasury market, the Federal Reserve might be able to influence term premiums, and thus overall yields, by shifting the composition of its holdings, say from shorter- to longer-dated securities. In simple terms, if the liquidity or risk characteristics of securities differ, so that investors do not treat all securities as perfect substitutes, then changes in relative demands by a large purchaser have the potential to alter relative security prices. (The same logic might lead the central bank to consider purchasing assets other than Treasury securities, such as corporate bonds or stocks or foreign government bonds. The Federal Reserve is currently authorized to purchase some foreign government bonds but not most private-sector assets, such as corporate bonds or stocks.)

Perhaps the most extreme example of a policy keyed to the composition of the central bank's balance sheet is an announced ceiling on some longer-term yield below the prevailing rate. This policy entails (in principle) an unlimited commitment to purchase the targeted security at the announced price. (To keep the overall size of its balance sheet unchanged, the central bank would have to sell other securities in an amount equal to the purchases of the targeted security.) Obviously, such a policy would signal strong dissatisfaction on the part of the policymaking committee with current market expectations of future policy rates.

Whether policies based on manipulating the composition of the central bank balance sheet can be effective is a contentious issue. The limited empirical evidence generally suggests that the degree of imperfect substitutability within broad asset classes, such as Treasury securities, is not great, so that changes in relative supplies within the range of U.S. experience are unlikely to have a major impact on risk premiums or term premiums (Reinhart and Sack, 2001). If this view is correct, then attempts to enforce a floor on the prices of long-dated Treasury securities (for example) could be effective only if the target prices were broadly consistent with investor expectations of future values of the policy rate. If investors doubted that rates would be kept low, the central bank would end up owning all or most of those securities. Moreover, even if large purchases of, say, a long-dated Treasury security were able to affect the yield on that security, the policy may not have significant economic effects if the targeted security became "disconnected" from the rest of the term structure and from private rates, such as mortgage rates.

Yet another complication affecting this type of policy is that the central bank's actions would have to be coordinated with the central government's finance department to ensure that changes in debt- management policies do not offset the attempts of the central bank to affect the relative supplies of securities. According to James Tobin, the Federal Reserve's failure to coordinate adequately with the Treasury was the undoing of "Operation Twist" in 1963 (Tobin, 1973, pp. 32-33).

Despite these objections, we should not fail to note that policies based on changing the composition of the central bank's balance sheet have been tried in the United States. From 1942 to 1951, the Federal Reserve enforced rate ceilings at two and sometimes three points on the Treasury yield curve. This objective was accomplished with only moderate increases in the Federal Reserve's overall holdings of Treasury securities, relative to net debt outstanding; moreover, there is little evidence that the targeted yields became "disconnected" from other public or private yields. The episode is an intriguing one, but unfortunately the implications for current policy are not entirely straightforward. We know that, by 1946, the Federal Reserve System owned almost nine-tenths of the (relatively small) stock of Treasury bills, suggesting that at the short end, the ceiling on the bill

274 rate was a binding constraint. In contrast, the Federal Reserve's relative holdings of longer-dated Treasury notes and bonds fell over the period, although the rate ceilings at these longer maturities were not breached until inflation pressures led to the Fed-Treasury Accord and the abandonment of the pegging policy in 1951. The conventional interpretation is that long-run policy expectations must have been consistent with the ceilings at the more distant points on the yield curve. Less clear is the extent to which the pegging policy itself influenced those policy expectations. Probably the safest conclusion about policies based on changing the composition of the central bank's balance sheet is that they should be used only to supplement other policies, such as an attempt (for example, through a policy commitment) to influence expectations of future short rates. This combined approach allows the central bank to enjoy whatever benefits arise from changing the relative supplies of outstanding securities without risking the problems that may arise if the yields desired by the central bank are inconsistent with market expectations. III. Expanding the Size of the Central Bank's Balance Sheet Besides changing the composition of its balance sheet, the central bank can also alter policy by changing the size of its balance sheet; that is, by buying or selling securities to affect the overall supply of reserves and the money stock. Of course, this strategy represents the conventional means of conducting monetary policy, as described in many textbooks. These days, most central banks choose to calibrate the degree of policy ease or tightness by targeting the price of reserves--in the case of the Federal Reserve, the overnight federal funds rate. However, nothing prevents a central bank from switching its focus from the price of reserves to the quantity or growth of reserves. When stated in terms of quantities, it becomes apparent that even if the price of reserves (the federal funds rate) becomes pinned at zero, the central bank can still expand the quantity of reserves. That is, reserves can be increased beyond the level required to hold the overnight rate at zero--a policy sometimes referred to as "quantitative easing." Some evidence exists that quantitative easing can stimulate the economy even when interest rates are near zero; see, for example, Christina Romer's (1992) discussion of the effects of increases in the money supply during the Great Depression in the United States.

Quantitative easing may affect the economy through several possible channels. One potential channel is based on the premise that money is an imperfect substitute for other financial assets (in contrast to the view discussed in the previous section that emphasizes the imperfect substitutability of various nonmoney assets). If this premise holds, then large increases in the money supply will lead investors to seek to rebalance their portfolios, raising prices and reducing yields on alternative, non-money assets. Lower yields on long-term assets will in turn stimulate economic activity. The possibility that monetary policy works through portfolio substitution effects, even in normal times, has a long intellectual history, having been espoused by both Keynesians (Tobin, 1969) and monetarists (Brunner and Meltzer, 1973). Recently, Javier Andres, J. David Lopez-Salido, and Edward Nelson (2003) have shown how these effects might work in a general equilibrium model with optimizing agents. The practical importance of these effects remains an open question, however.

Quantitative easing may also work by altering expectations of the future path of policy rates. For example, suppose that the central bank commits itself to keeping reserves at a high level, well above that needed to ensure a zero short-term interest rate, until certain economic conditions obtain. Theoretically, this action is equivalent to a commitment to keep interest rates at zero until the economic conditions are met, a type of policy we have already discussed. However, the act of setting and meeting a high reserves target is more visible, and hence may be more credible, than a purely verbal promise about future short-term interest rates. Moreover, this means of committing to a zero interest rate will also achieve any benefits of quantitative easing that may be felt through non-

275 expectational channels.

Lastly, quantitative easing that is sufficiently aggressive and that is perceived to be long-lived may have expansionary fiscal effects. So long as market participants expect a positive short-term interest rate at some date in the future, the existence of government debt implies a current or future tax liability for the public. In expanding its balance sheet by open-market purchases, the central bank replaces public holdings of interest-bearing government debt with non-interest-bearing currency or reserves. If the open-market operation is not expected to be reversed too quickly, this exchange reduces the present and future interest costs of the government and the tax burden on the public. (Effectively, this process replaces a direct tax, say on labor, with the inflation tax.) Auerbach and Obstfeld (2003) have analyzed the fiscal and expectational effects of a permanent increase in the money supply along these lines. Note that the expectational and fiscal channels of quantitative easing, though not the portfolio substitution channel, require the central bank to make a credible commitment to not reverse its open-market operations, at least until certain conditions are met. Thus, this approach also poses communication challenges for monetary policy makers.

Japan once again provides the most recent case study. In the past two years, current account balances held by commercial banks at the Bank of Japan have increased about five-fold, and the monetary base has risen to almost 30 percent of nominal GDP. While deflation appears to have eased in Japan recently, it is difficult to know how much of the improvement is due to monetary policy, and, of the part due to monetary policy, how much is due to the zero-interest-rate policy and how much to quantitative easing. The experience of the United States with quantitative policies is limited to the period 1979 to 1982, when the Federal Reserve targeted nonborrowed reserves. Of course, nominal interest rates were not close to zero at that time. The U.S. experience does suggest, however, that the demand for reserves may be sufficiently erratic that the effects of quantitative policies may be intrinsically hard to calibrate. IV. Sequencing and the "Costs" of Low Interest Rates The forms of monetary stimulus described above can be used once the overnight rate has already been driven to zero or as a way of driving the overnight rate to zero. However, a central bank might choose to rely on these alternative policies while maintaining the overnight rate somewhat above zero. For example, monetary policy makers might attempt to influence market expectations of future short rates as an alternative to changing the current setting of the overnight rate. Another possibility is to try to affect term premiums, expectations of future rates, or both, by changing the composition of securities held by the central bank. (Unlimited expansion of the total volume of securities held by the central bank is not compatible, of course, with a positive overnight rate.) The appropriate sequencing of policy actions depends on the perceived costs associated with very low or zero overnight interest rates, as well as on operational considerations and estimates of the likely effects of alternative combinations of policies on the economy.

What costs are imposed on society by very low short-term interest rates? Observers have pointed out that rates on financial instruments typically priced below the overnight rate, such as liquid deposits, shares in money market mutual funds, and collateralized borrowings in the "repo" market, would be squeezed toward zero as the policy rate fell, prompting investors to seek alternatives. Short-term dislocations might result, for example, if funds flowed in large amounts from money market mutual funds into bank deposits. In that case, some commercial paper issuers who have traditionally relied on money market mutual funds for financing would have to seek out new sources, while banks would need to find productive uses for the deposit inflows and perhaps face changes in regulatory capital requirements. In addition, liquidity in some markets might be affected; for example, the incentive for reserve managers to trade federal funds diminishes as the overnight rate falls, probably

276 thinning brokering in that market.

In thinking about the costs associated with a low overnight rate, one should bear in mind the message of Milton Friedman's classic essay on the optimal quantity of money (Friedman, 1969). Friedman argued that an overnight interest rate of zero is optimal, because a zero opportunity cost of liquidity eliminates the socially wasteful use of resources to economize on money balances. From this perspective, the costs of low short-term interest rates can be seen largely as adjustment costs, arising from the unwinding of schemes designed to make holding transactions balances less burdensome. These costs are real but are also largely transitory and have limited sectoral impact. Moreover, to the extent that the affected institutions have economic functions other than helping clients economize on money balances (for example, if some money market mutual funds have a comparative advantage in lending to commercial paper issuers), there is scope for repricing that will allow these services to continue to be offered. Thus there seems to be little reason for central banks to avoid bringing the policy rate close to zero if the economic situation warranted. A quite different argument for engaging in alternative monetary policies before lowering the overnight rate all the way to zero is that the public might interpret a zero instrument rate as evidence that the central bank has "run out of ammunition." That is, low rates risk fostering the misimpression that monetary policy is ineffective. As we have stressed, that would indeed be a misimpression, as the central bank has means of providing monetary stimulus other than the conventional measure of lowering the overnight nominal interest rate. However, it is also true that the considerable uncertainty that surrounds the use of these alternative measures does make the calibration of policy actions more difficult. Moreover, given the important role for expectations in making many of these policies work, the communications challenges would be considerable. Given these risks, policymakers are well advised to act preemptively and aggressively to avoid facing the complications raised by the zero lower bound. REFERENCES Andres, Javier; López-Salido, J. David and Nelson, Edward. "Tobin's Imperfect Asset Substitution in Optimizing General Equilibrium," presented at the JMCB/Federal Reserve Bank of Chicago James Tobin Symposium, November 14-15, 2003. Auerbach, Alan J. and Obstfeld, Maurice. "The Case for Open-Market Purchases in a Liquidity Trap." Working paper, University of California, Berkeley, 2003 Bernanke, Ben. "Deflation: Making Sure 'It' Doesn't Happen Here." Remarks before the National Economists' Club, Washington, DC, November 21, 2002. Bernanke, Ben. "Some Thoughts on Monetary Policy in Japan." Address to the Japan Society of Monetary Economics, Tokyo, May 31, 2003. Brunner, Karl and Meltzer, Allan. "Mr. Hicks and the 'Monetarists'," Economica, February 1973, 40(157), pp. 44-59. Clouse, James; Henderson, Dale; Orphanides, Athanasios; Small, David H. and Tinsley, P.A. "Monetary Policy When the Nominal Short-Term Interest Rates Is Zero." Topics in Macroeconomics, 2003, 3(1), article 12, pp. n.a. Eggertsson, Gauti and Woodford, Michael. "The Zero Bound on Interest Rates and Optimal Monetary Policy." Brookings Papers on Economic Activity, 2003, (1), pp. 139-233. Friedman, Milton. The Optimum Quantity of Money and Other Essays. Chicago: Aldine, 1969. Reinhart, Vincent and Sack, Brian. "The Economic Consequences of Disappearing Government

277 Debt." Brookings Paper on Economic Activity, 2000, (2), pp. 163-209. Romer, Christina. "What Ended the Great Depression?" Journal of Economic History, December 1992, 52(4), pp. 757-84. Svensson, Lars E. O. "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap." Monetary and Economic Studies, Special Edition, February 2001, 19, pp. 277-312. Tobin, James. "A General Equilibrium Approach to Monetary Theory." Journal of Money, Credit, and Banking, February 1969, 1(1), pp. 15-29. Tobin, James. The New Economics One Decade Older. Princeton, NJ: Princeton University Press, 1974. Woodford, Michael. Interest Rates and Prices: Foundations of a Theory of Monetary Policy. Princeton, NJ: Princeton University Press, 2003. Footnotes * Board of Governors of the Federal Reserve System, Washington, D.C. We have benefited from the research of, and many discussions with, numerous colleagues. However, the views expressed here are our own and not necessarily shared by anyone else in the Federal Reserve System. 1. See Bernanke (2002) and Clouse et al. (2003) for earlier discussions of these issues. 2. For a recent appraisal of monetary policy options in Japan, see Bernanke (2003 3. 2003 FOMC statements and minutes.

NBER 2002 Japan Conference: A Summary of the Papers Remarks by Nobuyuki Nakahara, former board member of the Bank of Japan (BOJ) I was initially reluctant to give a public speech so soon, less than six months after my term as board member expired in March 2002. But here I am, because my old friend from Harvard days, Albert Ando, was scheduled to chair the session and also because of the insistence of one of the organizers (Fumio Hayashi). It is a real pleasure to speak to this audience nonetheless. First let me introduce myself. I did graduate study at Harvard. I am a member of the Mont Pelerin Society, as well as a life member of the Royal Economics Society. The annual prize awarded by the Japanese Economic Association (the Japanese equivalent of the John Bates Clark Medal) bears my name as founder. Before serving on the BOJ's board, I was the CEO of Tonen, a major Japanese oil refining company. Now let me go straight to the issue of monetary policy. My view has been clear and consistent: the Japanese economic situation is more serious than commonly supposed and the BOJ should be more aggressive in easing. You can see this from my press conference remarks on the very first day of my term on April 1, 1998, and the proposals for policy directives I put forth at numerous BOJ policy board meetings. Let me elaborate by focusing on several major turning points in the decisionmaking by the policy board. The belated rate cut of September 1998 At board meetings starting with the June 12, 1998 meeting, I proposed to cut the overnight call rate (the Japanese equivalent of the federal funds rate). At each of those meetings, my rate cut proposal was voted down. The argument against the cut was to wait and see the effect of the fiscal stimulus package announced in late April. I argued then, and repeatedly thereafter, that monetary and fiscal policy should be synchronized in their implementation.

278 On September 9, 1998 the board made a 180-degree turn and voted to cut the rate to 0.25 percent, precisely the level I had proposed in the previous board meeting. The start of the zero-interest rate policy (ZIRP) in February 1999 Despite the rate cut, the Japanese economy showed no sign of recovery. My proposal from November 1998 on was to cut the overnight rate further. On February 12, 1999 I took a further step and proposed a directive calling for quantitative easing by setting the overnight rate as low as possible, initially at 0.10 percent and then at lower levels. The governor's proposal at that board meeting -- namely, to set the overnight rate initially at 0.15 percent and then lower -- made no reference to quantitative easing. Nevertheless, it was obviously a step in the right direction, so I voted for it. I think the quantitative easing that actually took place in late February to early March contributed greatly to the rapid recovery of stock prices and the subsequent economic recovery. The monetary base targeting with inflation targeting The proposal that I put forth beginning on February 25, 1999 had two components: to set an inflation target and to set a target for a specific amount of excess reserves consistent with a 10 percent -- and subsequently higher -- growth rate of the monetary base. My proposal was voted down repeatedly. The removal of the ZIRP on August 11, 2000 At a board meeting in November 1999, I was the first to point out that a recovery was underway. Nonetheless, I believed that further easing was needed and stuck to my proposal of the base-and-inflation targeting, because the deflation gap was still substantial. The majority view of the board was more optimistic, and became even more so in the spring of 2000. On August 11, 2000 the governor proposed to end the ZIRP by raising the overnight rate to 0.25 percent. The government's request to postpone the vote, after a heated discussion about the nature of BOJ independence, was rejected by the board, with the only assenting vote coming from myself. Regarding the governor's proposal to end the ZIRP, I cast a dissenting vote. I stuck to my position in all subsequent meetings by dissenting to the board's decision to maintain the 0.25 percent rate. The introduction of quantitative targeting on March 19, 2001 With falling prices and output, it became clear that the termination of the ZIRP was a grave mistake. In February, the board reversed its course by a cut of the overnight rate to 0.15 percent, the level that prevailed in the initial phase of the ZIRP. Finally, on March 19, 2001 it voted for quantitative easing. For the first time in its 120-year history, the BOJ decided to do what it had been saying was impossible, namely, to target reserves instead of the overnight rate. The policy directive also stipulated that this policy last until the CPI inflation rate becomes zero or positive. This is not genuine inflation targeting, because neither the upper bound nor the time horizon is specified. Nevertheless, the directive incorporated the fundamental change that I had been advocating all along. The board finally came through. I was deeply moved. The reserve target remained too low The degree of quantitative easing since the regime change of March 19, 2001, however, was not enough because the adopted reserve target of 5 trillion yen is the minimum amount required to maintain zero interest rates. This is just a ZIRP in disguise! My proposal to raise the target well above that amount was voted down repeatedly. The majority view of the board is none other than the so-called BOJ doctrine: that a central bank should act passively, supplying reserves merely to accommodate demand. Hence their insistence, which later

279 proved plain wrong, that there is a unique level of reserves consistent with zero interest rates and that a central bank cannot increase the supply of reserves over and above that upper bound. But again, the board turned around my way and increased the target to the 10 to 15 trillion yen range in December 2001 (I cast a dissenting vote because the target should be a level, not a range, and because the range was far too wide). Thanks to the increased reserve target, the monetary base, which grew 14 percent on year-on-year basis in September 2001, picked up its pace and grew 36 percent in April 2002. Regrettably, the growth rate since then has been declining (about 25 percent in September, and 20 percent in December 2002). So, despite initial resistance, most components of my proposal eventually were incorporated in the board's directive. Let me conclude with my current view on monetary policy. First, the BOJ should adopt the rest of my proposal, namely inflation targeting and more active and aggressive easing, particularly when excessive bank lending has rapidly been corrected. Second, the quantitative easing should proceed continuously, without letups. The quarter-to- quarter growth rate of the base should be about 5 to 6 percent. Third, to end current deflation, there should be an accord between the government and the BOJ to engineer a monetization of government deficits needed to finance additional government spending that would raise the productivity of the Japanese economy. That is, the government should increase spending and the BOJ should match it by conducting an open-market purchase of an amount equal to the increased spending.

280

Remarks by Governor Ben S. Bernanke At the Meetings of the American Economic Association, San Diego, California January 3, 2004

Fedspeak There was a time when central bankers did not talk to the public. Montagu Norman, the Governor of the Bank of England for a quarter of a century after the First World War and a highly influential figure in his time in central banking circles, was notorious for his reclusiveness, both personal and professional. According to his biographer, Norman lived by the maxim, "Never explain, never excuse" (Boyle, 1967, p. 217). Norman was hardly unique. Central bankers long believed that a certain "mystique" attached to their activities; that making monetary policy was an arcane and esoteric art that should be left solely to the initiates; and that letting the public into the discussion would only usurp the prerogatives of insiders and degrade the effectiveness of policy.

In contrast to this tradition of secrecy, central banks around the world have become noticeably more open and transparent over the past fifteen years or so. Policymaking committees have adopted various mechanisms to enhance their communication with the public, including more informative policy announcements, post-meeting press conferences, expanded testimony before the legislature, the release of the minutes of policy meetings, and the regular publication of reports on monetary policy and the economy.

This increased openness is a welcome development, for many reasons. Perhaps most important, as public servants whose policy actions affect the lives of every citizen, central bankers have a basic responsibility to give the public full and compelling explanations of the rationales for those actions. Besides satisfying the principle of democratic accountability, a more open policymaking process is also likely to lead to better policy decisions, because engagement with an informed public provides central bankers with useful feedback in the form of outside views and analyses. Yet another benefit of full and timely release of information about policy decisions and their rationales is a reduced risk that market-sensitive information will dribble out through inappropriate channels, giving unfair advantage to some financial market participants.

Admittedly, for many central banks, including the Federal Reserve, progress toward greater transparency has come in halting steps and not without trepidation. For example, the decision to announce changes in the target for the federal funds rate immediately after meetings of the Federal Open Market Committee (FOMC) was implemented only in phases and after considerable soul-searching by FOMC members. In retrospect, however, I think that most central bankers, both in the United States and abroad, would agree that greater openness has been beneficial to central banks as institutions and for the advancement of their policy objectives.

Although the presumption today is that--absent compelling reasons to the contrary--central

281 banks should strive for transparency, some basic questions about what, how, and to what end central banks should communicate with the public remain decidedly open. In my talk today I will put aside broader considerations such as democratic accountability and consider these questions as they bear on the ability of central banks to make monetary policy more effective and to improve macroeconomic performance. Before proceeding, I should emphasize that the views I will express today are not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee.

Why Central Bank Communication Matters for Policy Effectiveness

Can central bank talk--Fedspeak, in the vernacular of the U.S. media and financial markets-- make monetary policy more effective and improve economic outcomes? To see why communication may be an integral part of good monetary policymaking, recall that the Federal Reserve directly controls only a single short-term interest rate, the overnight federal funds rate. Relative to the enormous size of global financial markets, the market for federal funds--the market in which commercial banks borrow and lend reserves on a short-term basis--is insignificant. Control of the federal funds rate is therefore useful only to the extent that it can be used as a lever to influence more important asset prices and yields--stock prices, government and corporate bond yields, mortgage rates--which in turn allow the Fed to affect the overall course of the economy.

Of course, basic financial theory implies that a link does exist between short-term interest rates, such as the federal funds rate, and longer-term rates, such as Treasury bond yields and mortgage rates. In particular, longer-term yields should depend in part on market expectations about the future course of short-term rates. For example, with the current setting of the funds rate held constant, any arriving news that leads bond market participants to expect higher future values of the funds rate will tend to raise bond yields and lower bond prices. The link between long-term bond yields and market expectations of future monetary policy actions is familiar to all financial-market participants and has been well supported by recent empirical research. For example, Antulio Bomfim has demonstrated that the shape of the term structure of Treasury yields can be effectively described by a two-factor model, in which the first factor corresponds to the current setting of the funds rate and the second factor closely approximates medium-term monetary policy expectations (Bomfim, 2003).

The fact that market expectations of future settings of the federal funds rate are at least as important as the current value of the funds rate in determining key interest rates such as bond and mortgage rates suggests a potentially important role for central bank communication: If effective communication can help financial markets develop more accurate expectations of the likely future course of the funds rate, policy will be more effective (in a precise sense that I will explain further soon), and risk in financial markets should be reduced as well.

It is worth emphasizing that the predictability of monetary policy actions has both short-run and long-run aspects. A central bank may, through various means, improve the market's ability to anticipate its next policy move. Improving short-term predictability is not unimportant, because it may reduce risk premiums in asset markets and influence shorter- term yields. But signaling the likely action at the next meeting is not sufficient for effective policymaking. Because the values of long-term assets are affected by the whole trajectory of expected short-term rates, it is even more vital that information relevant to estimating that trajectory be communicated. As I will argue later, this can usually be done only by

282 providing information about the central bank's objectives, assessment of the economy, and policy strategy.

Communication, Asymmetric Information, and Learning

Ideally, what should central bank communication try to achieve? In an important analysis of the issue of central bank transparency, my FOMC colleague William Poole laid out a benchmark case in which the potential benefits of communication would be fully realized (Poole, 2003). In this benchmark case, the central bank has well-defined objectives and pursues regular and systematic policies consistent with those objectives. More important for our purposes, in this idealized world, financial markets are highly efficient and well informed. In particular, financial-market participants have access to all the information that the central bank uses in making policy decisions. Let us call the premise that the central bank has no significant information advantage over the private sector the assumption of symmetric information.

If the conditions of systematic policymaking, financial-market efficiency, and symmetric information all held, then one might hope that the economy would converge to a rational expectations equilibrium, in which participants in financial markets would need only to analyze incoming, publicly available economic data to make efficient forecasts of future Federal Reserve actions.1 In this benchmark case, there would be no marginal benefit to central bank communication, beyond whatever was necessary to support this equilibrium in the first place.

Of course, to describe this idealized benchmark case is to recognize that it is at best an approximate description of the economy in which we live. In practice, financial-market participants generally do not have as much information as monetary policymakers do about a number of key inputs to policymaking, including the policymakers' own objectives, their (possibly implicit) model of the economy and the monetary transmission mechanism, their assessment of the economic situation (including both forecasts and the risks to the forecast), and their policy strategy. To the extent that this asymmetry of information between the central bank and the financial markets is quantitatively important--and I will present some evidence on this point shortly--financial markets will not price bonds and other assets efficiently (relative to the information possessed by the central bank), and scope may exist for central bank communication to improve the effectiveness of monetary policy and the overall performance of the economy.

A skeptic might argue that noise and other sources of pricing inefficiency pervade the financial markets, so that improving the predictability of monetary policy is of limited importance in practice, except perhaps to a few brokers and traders. To the contrary, there is good reason to believe that information asymmetries between the central bank and financial markets may matter a great deal for economic welfare. A theoretical basis for this view is provided by the lively recent literature on adaptive learning and monetary policy. This work has shown that, when the public does not know but instead must estimate the central bank's reaction function and other economic relationships using observed data, we have no guarantee that the economy will converge--even in infinite time--to the optimal rational expectations equilibrium.2 In general, the problem is that the public's learning process itself affects the behavior of the economy--for example, as when expectational errors by bond traders affect interest rates and thus a wide range of economic decisions. The feedback effect of learning on the economy, this literature has shown, can in principle lead to

283 unstable or indeterminate outcomes. More generally, the dynamic behavior of an economy with asymmetric information and learning may be radically different from the behavior of the same economy in the optimal rational expectations equilibrium.

A particularly interesting analysis of the implications of learning for monetary policy and central bank communication has been provided in a series of papers by Athanasios Orphanides and John C. Williams (2003a, 2003b). Orphanides and Williams study model economies in which the public is assumed to know the general nature of the economy's underlying structure but not the precise quantitative magnitudes describing that structure. Specifically, these authors consider a model in which the public is assumed to know the form of the equation describing the dynamic behavior of inflation but not the parameters of that equation, which depend on the (unobserved by the public) objectives and preferences of the central bank. Orphanides and Williams assume that, to learn the parameters of the process that generates inflation, people must apply standard statistical methods to observed data on inflation and other macroeconomic variables.

Obviously, in assuming that people know the true economic structure with certainty, and that they infer the underlying parameters of that structure using formal statistical methods, Orphanides and Williams and others in this literature are attributing much greater knowledge and sophistication to the public than exist in the real world. Nevertheless, the behavior of their model economies with learning can be quite different from that of the rational expectations analogue, in which the public is assumed to have full and symmetric information. For example, these authors show that the economy with learning is prone to episodes of stagflation, or combinations of high inflation and low output. The logic is as follows: When people are learning about the inflation process, an increase in inflation that would be only temporary and would leave expectations unaffected in a rational expectations world, may instead lead the public to infer that the long-run average rate of inflation is higher than previously thought. The rise in the public's inflation expectations affects wage- and price-setting and other economic decisions and thus raises actual inflation. In a vicious cycle, the higher rate of realized inflation further increases inflation expectations, forcing the central bank to tighten policy. The result is inflation that is unnecessarily high and output that is unnecessarily low.

Several insights come from this and other contributions to the literature on adaptive learning in macroeconomics. First, the fact that the public must learn about underlying economic relationships changes the nature of the optimal monetary policy. In general, with learning, the central bank's optimal policy involves exerting a tighter control on inflation than it might otherwise exert, to avoid the possibility that inflation expectations will drift randomly higher (or lower). Thus, this approach formalizes the idea that a central bank should work actively to "anchor" inflation expectations within a narrow range. Second, efficient policy in this world requires that policymakers pay attention to information (for example, from surveys) about the public's expectations of inflation and other variables; if these appear not to be converging toward the desired levels, then a policy response may be warranted.3 Finally, and most important for my purpose today, communication by the central bank may play a key role in helping improve economic performance. For example, in the models analyzed by Orphanides and Williams, the provision of information by the central bank about its long-run inflation objective or its economic forecasts generally leads to more favorable policy tradeoffs and better economic outcomes.

The work on adaptive learning by Orphanides and Williams and others is largely

284 theoretical, but in my view it is highly relevant to understanding modern U.S. monetary history. A leading example is the stagflationary period of the 1970s, in which astute observers recognized that high and unstable public expectations of inflation, themselves generated by poor macroeconomic policies that allowed inflation to get out of control, greatly increased the complexity and cost of restoring stability.4 More recently, Marvin Goodfriend (1993) has identified several instances of what he calls "inflation scares," apparently autonomous increases in inflation expectations that raised long-term bond yields and forced a tightening of monetary policy that could have been avoided if expectations had been better anchored. The view that adaptive learning and asymmetric information are crucial to understanding recent monetary history is apparently shared by the developers of the Federal Reserve's primary econometric model, the FRBUS model, which relies heavily on these assumptions (Brayton et al., 1997). Simulations of that model suggest both that adaptive learning is needed to explain the observed responses of the financial market and the economy to monetary policy actions, and that asymmetric information and adaptive learning lead systematically to inferior macroeconomic outcomes, as implied by the work of Orphanides and Williams and others.

Of course, the situation in the United States is much better today than in the 1970s; both inflation and inflation expectations are much more stable, and better economic outcomes have been the result. But is there still scope for improvement? I will present some evidence to suggest that there is and then conclude by discussing how communications policies could help anchor and stabilize the system more firmly.

Evidence on the Effectiveness of Fed Communication

In the past decade, the Federal Reserve has taken a number of significant steps toward increased transparency, including announcing decisions about the federal funds rate promptly after FOMC meetings, indicating first a policy "bias" and then a "balance of risks" assessment in post-meeting statements, and making the minutes of policy meetings publicly available (with a lag of about eight weeks). Members of the FOMC have also made greater use of vehicles such as testimony and speeches to convey their assessments of the economy and their policy inclinations to the public. How effective have these efforts been?

I earlier distinguished between short-run and long-run predictability of policy. Fairly strong evidence supports the conclusion that the short-run predictability of policy has increased in recent years. For example, Joe Lange, Brian Sack, and William Whitesell (2003) have shown that, since the late 1980s and early 1990s, monetary policy actions over short horizons have been predicted increasingly well by financial instruments such as three- and six-month Treasury bills and federal funds futures contracts. These authors attribute at least part of this improvement to greater transparency on the part of the Federal Reserve. Poole, Rasche, and Thornton (2002) reach a similar conclusion.5

However, the more important question is whether the Federal Reserve has improved the ability of the public to forecast its policies at long horizons. Long-horizon forecastability of policy has a number of dimensions, of course. One that has received particular attention in the literature, and which is closely related to theoretical models that assume adaptive learning, is the question of whether the public is able to infer the Federal Reserve's implicit long-run inflation objective.6 Uncertainty about this objective bears directly on the market's ability to price long-term assets, as well as on the capacity of wage- and price-setters to strike efficient long-term agreements and of firms and households to make long-term

285 economic plans.

Various types of evidence bear on this question. For example, some recent research has considered expectations of inflation and other variables as measured by surveys. One clear finding is that, as inflation has come under control and has stabilized in the United States in recent years, long-term inflation expectations have stabilized as well, suggesting reduced uncertainty about the Fed's ultimate inflation objective. For example, a cross-country study of inflation expectations by staff of the European Central Bank found that, since 1990, both the average level of expected inflation and the volatility of reported expectations of inflation in the United States have declined, the latter quite significantly (especially since 1999).7 However, as an aside, it is interesting that both surveys and the inflation compensation priced into the yields on indexed bonds suggest that today long-term inflation expectations in the United States remain in the vicinity of 2-1/2 to 3 percent, above the range of inflation that many observers believe to represent the FOMC's implicit target. Possibly, this observation indicates an ongoing process of adaptive learning.

A subtler issue is the degree to which inflation expectations in the United States are anchored. Specifically, to what extent would inflation expectations rise if actual inflation increased for some reason? To address this question, Andrew Levin, Fabio Natalucci, and Jeremy Piger (2003) examined U.S. private-sector forecasts of inflation since 1994. They found that medium- and long-term forecasts of inflation in the United States are strongly correlated with three-year moving average of lagged inflation, a finding that suggests that inflation expectations are not entirely anchored but are instead subject to adaptive learning. As a supporting piece of evidence, Levin, Natalucci, and Piger show that, compared to other industrial countries, shocks to inflation tend to be relatively persistent in the United States, an implication of models with adaptive learning.8

Bond markets provide fertile ground in which to search for evidence on the importance of adaptive learning and the degree to which expectations are well anchored. For example, Refet Gurkaynak, Brian Sack, and Eric Swanson (2003) show that distant forward rates (e.g., the implied one-year forward rate ten years in the future) move significantly in response to the unexpected components of both monetary policy decisions and a number of macroeconomic data releases. Because they do not find the same result for inflation-indexed securities (that is, real forward rates do not respond to policy or data surprises), they conclude that long-term expectations of inflation must not be tightly anchored in the United States. Kevin Kliesen and Frank Schmid (2003) support these findings by showing directly that ten-year inflation expectations, as derived from inflation-indexed bonds, respond significantly to policy surprises as well as to the unexpected components of macroeconomic data releases.9

Interesting work by Sharon Kozicki and Peter Tinsley (2001a, 2001b) bears directly on the importance of asymmetric information and learning in financial markets. Kozicki and Tinsley incorporate alternative specifications of the evolution of inflation expectations in a standard model of the term structure (see Campbell, Lo, and MacKinlay, 1997). Kozicki and Tinsley show that by far the best fit is obtained when inflation expectations are modeled as evolving by adaptive learning, in which inflation expectations adjust slowly to actual inflation. When inflation expectations are modeled this way, and only when they are modeled this way, the expectations theory of the term structure performs well and estimated term premiums are relatively small. In related research, Glenn Rudebusch and Tao Wu (2003) show empirically that a two-factor model of the term structure can be closely linked

286 to monetary policy fundamentals, but only on the assumption that the medium-term inflation expectations held by market participants are time-varying. All the cited findings apply to recent data, as well to earlier observations. The evidence for asymmetric information and adaptive learning, at least in regard to the Fed's inflation objective, thus seems quite strong.

Implications for Central Bank Communication

So far I have discussed why central bank communication is important for financial market efficiency and good macroeconomic performance, and I have presented a few pieces of evidence that suggest that asymmetry of information between the Federal Reserve and the public may be an important phenomenon. What implications does all this have for the communication policies of the Fed?

In an ideal world, the Federal Reserve would release to the public a complete specification of its policy rule, relating the FOMC's target for the federal funds rate to current and expected economic conditions, as well as its economic models, data, and forecasts. Using this information, financial-market participants would be able to forecast future values of the policy rate and efficiently price long-term bonds and other assets. Unfortunately, as stressed by Poole (2003) as well as by Chairman Greenspan (2003) in his talk at the most recent Jackson Hole conference, specifying a complete and explicit policy rule, from which the central bank would never deviate under any circumstances, is impractical. The problem is that the number of contingencies to which policy might respond is effectively infinite (and, indeed, many are unforeseeable).

While specifying a complete policy rule is infeasible, however, there is much that a central bank can do--both by its actions and its words--to improve the ability of financial markets to predict monetary policy actions. With respect to actions, the central bank should behave in as systematic and as understandable a way as possible, given the macroeconomic and financial environment. That is, although monetary policy cannot be made by a mechanical rule, policy can and should have "rule-like" features. Obviously, the more systematic and the more consistent with a few basic principles the conduct of monetary policy becomes, the easier it will be for the public to understand and predict the Fed's behavior.10 However, because the world is complex and ever changing, policy actions alone, without explanation, will never be enough to provide the public with the information it needs to predict policy actions. Words are also necessary.

What then should the Fed talk about? In general, the research I have discussed today suggests that the central bank should do what it can to make information symmetric, providing the public to the extent possible with the same information that the FOMC uses in making its decisions.11 More specifically, the strongest implication of the adaptive learning literature is that the Fed should be as explicit as possible about its policy objectives. Without clear information about policy objectives, the public's problem of predicting future monetary policy actions becomes extremely difficult. For example, without this information, it would be hard for the public to know whether an unexpected policy move signals a change in the policymakers' objectives, a change in their economic outlook, or both. As also suggested by the adaptive learning literature, a potential advantage of having an explicit objective for inflation in particular is that it may help to anchor the public's expectations.12

287 Besides its policy objectives, the central bank can make other useful information available to the public, including its economic forecasts, its assessment of the economic risks, and (if possible) the models or analytical frameworks that underlie its diagnosis of the economy. The Federal Reserve currently provides information on each of these elements. For example, the so-called "central tendency" forecasts of the FOMC are released twice a year, as part of the Chairman's semiannual testimony before Congress; the statements following FOMC meetings provide some assessment of the perceived risks to the forecast; and the active research programs conducted at the Board and the Reserve banks, including publications and conferences, provide observers insights into the underlying analytical frameworks that inform monetary policymaking.

We should continue to seek improvement in each of these areas. For example, FOMC forecasts might be released more frequently and for a longer horizon. Additional variables could be forecasted, notably core inflation, a key factor in FOMC policy decisions. More controversially, the FOMC might consider forecasting future values of the short-term interest rate, as is currently done by the Reserve Bank of New Zealand. The difficulty would be to make clear that an interest-rate forecast is not the same as a policy commitment. The use of "fan charts" to indicate the range of uncertainty would be helpful in this regard; and indeed, providing more information about the range of uncertainty for all FOMC forecasts would be a useful innovation.

In my talk today I have often adopted the common convention of speaking of the central bank as if it were a single actor. In reality, policymaking at most central banks is done by a committee. In the United States, nineteen people (twelve of whom get to vote at any given meeting) have seats at the FOMC table. The diversity of views and opinions likely to exist among the members of a large committee create further challenges for effective communication. However, vehicles do exist to help convey the breadth of opinion on the Committee. For example, the minutes of FOMC meetings describe the range of viewpoints and many of the key considerations underlying policy decisions. In my view, releasing these minutes more promptly than is now done would provide useful and more timely information for the public. Although at times it feels cacophonous, the willingness of FOMC members to present their individual perspectives in speeches and other public forums provides the public with useful information about the diversity of views and the balance of opinion on the Committee.

Other possibilities for improved transparency may exist. Importantly, as we think about these, we should not simply take the view that more information is always better. Indeed, irrelevant or badly communicated information may create more noise than signal; and some types of information provision--an extreme example would be televising FOMC meetings-- risk compromising the integrity and quality of the policymaking process itself. Rather, the key question should be whether the additional information will improve the public's understanding of the Fed's objectives, economic assessments, and analytical framework, thus allowing them to make better inferences about how monetary policy is likely to respond to future developments in the economy. Communication that meets this criterion will lead to better monetary policy and better economic performance.

REFERENCES Bernanke, Ben (2003a). "A Perspective on Inflation Targeting," at the Annual Washington Policy Conference of the National Association for Business Economics, Washington D.C.,

288 March 25. Bernanke, Ben (2003b). "Panel Discussion," at the Twenty-Eighth Annual Policy Conference: Inflation Targeting: Problems and Prospects, Federal Reserve Bank of St. Louis, St. Louis, Missouri, October 17. Bomfim, Antulio (2003). "Monetary Policy and the Yield Curve," Board of Governors of the Federal Reserve System, Finance and Economics Discussion Series 2003-15 (February). Boyle, Andrew (1967). Montagu Norman: A Biography. London: Cassell. Brayton, Flint, Eileen Mauskopf, David Reifschneider, Peter Tinsley, and John Williams (1997). "The Role of Expectations in the FRB/US Macroeconomic Model," Federal Reserve Bulletin, 83 (April), pp. 227-45. Bullard, James, and Kaushik Mitra (2002). "Learning about Monetary Policy Rules," Federal Reserve Bank of St. Louis working paper 2000-001E, revised January 2002. (424 KB PDF on the Federal Reserve Bank of St. Louis web site) Campbell, John, Andrew Lo, and A. Craig MacKinlay (1997). The Econometrics of Financial Markets. Princeton N.J.: Princeton University Press. Castelnuovo, Efrem, Sergio Nicoletti-Altimari, and Diego Rodriguez Palenzuela (2003). "Definition of Price Stability, Range and Point Inflation Targets: The Anchoring of Long- Term Inflation Expectations," in European Central Bank, Background Studies for the ECB's Evaluation of Its Monetary Policy Strategy, Frankfurt. Erceg, Christopher, and Andrew Levin (2003). "Imperfect Credibility and Inflation Persistence," Journal of Monetary Economics, 50, pp. 915-44. Evans, George W., and Seppo Honkapohja (2001). Learning and Expectations in Macroeconomics. Princeton, N.J.: Princeton University Press. Evans, George W., and Seppo Honkapohja (2003a). "Adaptive Learning and Monetary Policy Design," working paper, University of Oregon and University of Helsinki/Bank of Finland. Evans, George W., and Seppo Honkapohja (2003b). "Expectations and the Stability Problem for Optimal Monetary Policies," Review of Economic Studies, forthcoming. Goodfriend, Marvin (1993). "Interest Rate Policy and the Inflation Scare Problem, 1979- 1992," Federal Reserve Bank of Richmond, Economic Quarterly, 1 (Winter), pp. 1-23. (on the Federal Reserve Bank of Richmond web site) Greenspan, Alan (2003). "Monetary Policy Under Uncertainty," at the symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 29. Gurkaynak, Refet S., Brian Sack, and Eric Swanson (2003). "The Excess Sensitivity of Long-Term Interest Rates: Evidence and Implications for Macroeconomic Models," Board of Governors of the Federal Reserve System, Finance and Economics Discussion Series 2003-50 (November). Kliesen, Kevin and Frank Schmid (2003). "Monetary Policy Actions, Macroeconomic Data Releases, and Inflation Expectations," Federal Reserve Bank of St. Louis, working paper. Kohn, Donald (2003). "Comment on Goodfriend, 'Inflation Targeting in the United States?', in Ben Bernanke and Michael Woodford, eds., Inflation Targeting. Chicago: University of

289 Chicago Press for NBER, forthcoming. Kohn, Donald, and Brian Sack (2003). "Central Bank Talk: Does It Matter and Why?" Board of Governors of the Federal Reserve System, Finance and Economic Discussion Series 2003-55 (November). Kozicki, Sharon, and Peter Tinsley (2001a). "Term Structure Views of Monetary Policy Under Alternative Models of Agent Expectations," Journal of Economic Dynamics and Control, 25 (January), pp. 149-84. Kozicki, Sharon, and Peter Tinsley (2001b). "Shifting Endpoints in the Term Structure of Interest Rates," Journal of Monetary Economics, 47 (June), pp. 613-52. Lange, Joe, Brian Sack, and William Whitesell (2003). "Anticipations of Monetary Policy in Financial Markets," Journal of Money, Credit, and Banking, 35 (December, part 1), pp. 889-910. Levin, Andrew, Fabio Natalucci, and Jeremy Piger (2003). "The Macroeconomic Effects of Inflation Targeting," working paper, Board of Governors of the Federal Reserve, October. Orphanides, Athanasios, and John C. Williams (2003a). "Imperfect Knowledge, Inflation Expectations, and Monetary Policy," forthcoming in Ben Bernanke and Michael Woodford, eds., Inflation Targeting, Chicago: University of Chicago Press for NBER. Orphanides, Athanasios, and John C. Williams (2003b). "Inflation Scares and Forecast- Based Monetary Policy," Board of Governors of the Federal Reserve System, Finance and Economics Discussion Series 2003-41 (August). Poole, William (2003). "Fed Transparency: How, Not Whether," Federal Reserve Bank of St. Louis, Review, 85 (November/December), pp. 1-8. (252KB PDF on the Federal Reserve Bank of St. Louis web site) Poole, William, Robert Rasche, and Daniel Thornton (2002). "Market Anticipations of Monetary Policy Actions," Federal Reserve Bank of St. Louis, Review, 84 (July/August), pp. 65-94. (253 KB PDF on the Federal Reserve Bank of St. Louis web site) Rudebusch, Glenn and Tao Wu (2003). "A Macro-Finance Model of the Term Structure, Monetary Policy, and the Economy," Federal Reserve Bank of San Francisco working paper 2003-17, September. (541KB PDF on the Federal Reserve Bank of San Francisco web site) Sack, Brian (2003). "A Monetary Policy Rule Based on Nominal and Inflation-Indexed Treasury Yields," Board of Governors of the Federal Reserve System, Finance and Economics Discussion Papers 2003-7.

Footnotes 1. As my discussion later will make clear, convergence to a full rational expectations equilibrium may also require that the economy's underlying structure be "learnable" by both the central bank and the public. 2. See Evans and Honkapohja (2003a) for a survey of relevant results. Evans and Honkapohja (2001) provide an extensive analysis of macroeconomic models with learning. Kaushik and Mitra (2002) argue that central banks should restrict themselves to policies that are "learnable" by the public.

290 3. Evans and Honkapohja emphasize this point in a series of papers; see, for example, Evans and Honkapohja (2003b). Sack (2003) provides evidence that U.S. monetary policy does respond to inflation expectations, as measured by the yields on nominal and inflation- indexed Treasury securities. 4. Erceg and Levin (2003) model the disinflation process of the early 1980s using the assumption that the public learns optimally about inflation. They show that learning and the consequently slow adjustment of inflation expectations help to explain the severe economic contraction of the period. 5. Kohn and Sack (2003) studied the effect of the release of post-meeting FOMC statements on the term structure and found that the release of statements generated a response in short- term interest rates (up to two years' maturity), independent of the effects of any accompanying policy actions. They interpret this finding as supporting the view that statements contain information (over and above that inherent in the policy action) for near- term monetary policy. Of course, a fortiori, their findings are also evidence against the view that information relevant to monetary policy is approximately symmetric. 6. The working assumption here is that U.S. monetary policy is conducted "as if" there were a numerical inflation objective, even though there is no explicit agreement on the FOMC as to what that objective should be. 7. Castelnuovo, Efrem, Sergio Nicoletti-Altimari, and Diego Rodriguez Palenzuela (2003). Kohn (2003) notes that the volatility of long-term inflation expectations in the United States has declined and is similar to that of industrial countries, including those that formally target inflation. 8. For example, the model of Erceg and Levin (2003) has that implication. 9. Some care must be taken when using inflation-indexed bonds to measure inflation expectations, however. These bonds were introduced in the United States relatively recently, and the secondary market remains less liquid that those for other Treasury securities. Changes in measured inflation compensation drawn from this market may thus sometimes reflect changes in liquidity or risk premiums as well as changes in market expectations of inflation. 10. "Rule-like" policies may also improve the central bank's credibility and ability to commit to future actions. 11. Note that this suggestion brings us full circle back to Poole's (2003) benchmark case of rational expectations and symmetric information, discussed earlier. 12. See Bernanke (2003a, 2003b) for discussions of the case for an explicit long-run objective for inflation.

291

Remarks by Chairman Alan Greenspan At the Meetings of the American Economic Association, San Diego, California January 3, 2004

Risk and Uncertainty in Monetary Policy

This morning I plan to sketch the key developments of the past decade and a half of monetary policy in the United States from the perspective of someone who has been in the policy trenches. I will offer some conclusions about what I believe has been learned thus far, though I suspect, as is so often the case, the passing of time, further study, and reflection will deepen our understanding of these developments. This is a personal statement; I am not speaking for my current colleagues on the Federal Open Market Committee (FOMC) or the many others with whom I have served over these many years.1

* * *

The tightening of monetary policy by the Federal Reserve in 1979, then led by my predecessor Paul Volcker, ultimately broke the back of price acceleration in the United States, ushering in a two-decade long decline in inflation that eventually brought us to the current state of price stability.

The fall in inflation over this period has been global in scope, and arguably beyond the expectations of even the most optimistic inflation fighters. I have little doubt that an unrelenting focus of monetary policy on achieving price stability has been the principal contributor to disinflation. Indeed, the notion, advanced by Milton Friedman more than thirty years ago, that inflation is everywhere and always a monetary phenomenon is no longer a controversial proposition in the profession. But the size and geographic extent of the decline in inflation raises the question of whether other forces have been at work as well.

I am increasingly of the view that, at a minimum, monetary policy in the last two decades has been operating in an environment particularly conducive to the pursuit of price stability. The principal features of this environment included (1) increased political support for stable prices, which was the consequence of, and reaction to, the unprecedented peacetime inflation in the 1970s, (2) globalization, which unleashed powerful new forces of competition, and (3) an acceleration of productivity, which at least for a time held down cost pressures.

I believe we at the Fed, to our credit, did gradually come to recognize the structural economic changes that we were living through and accordingly altered our understanding of the key parameters of the economic system and our policy stance. The central banks of other industrialized countries have grappled with many of the same issues.

But as we lived through it, there was much uncertainty about the evolving structure of the

292 economy and about the influence of monetary policy. Despite those uncertainties, the trauma of the 1970s was still so vivid throughout the 1980s that preventing a return to accelerating prices was the unvarying focus of our efforts during those years.

In recognition of the lag in monetary policy's impact on economic activity, a preemptive response to the potential for building inflationary pressures was made an important feature of policy. As a consequence, this approach elevated forecasting to an even more prominent place in policy deliberations.

* * *

After an almost uninterrupted stint of easing from the summer of 1984 through the spring of 1987, the Fed again began to lean against increasing inflationary pressures, which were in part the indirect result of rapidly rising stock prices. We had recognized the risk of an adverse reaction in a stock market that had recently experienced a steep run-up--indeed, we actively engaged in contingency planning against that possibility.

In the event, the crash in October 1987 was far more traumatic than any of the possible scenarios we had identified. Previous planning was only marginally useful in that episode. We operated essentially in a crisis mode, responding with an immediate and massive injection of liquidity to help stabilize highly volatile financial markets. However, most of our stabilization efforts were directed at keeping the payments system functioning and markets open. The concern over the possible fallout on economic activity from so sharp a stock price decline kept us easing into early 1988. But the economy weathered that shock reasonably well, and our easing extended perhaps longer than hindsight has indicated was necessary.

That period was followed by a preemptive tightening that brought the federal funds rate close to 10 percent by early 1989. In the summer of that year, we sensed enough softening of activity to warrant beginning a series of rate reductions. However, the weakening of demand already under way, some pullback of credit by lenders, and the spike in oil prices associated with Iraq's invasion of Kuwait were sufficient to produce a marked contraction of activity in the fall of 1990. But perhaps aided by our preemptive action, the recession was, to then, the mildest in postwar history.

However, the recovery also was more modest than usual, in large measure because of the notable financial "headwinds" that confronted businesses. Those headwinds were primarily generated by the constriction of credit in response to major losses at banks, associated with real-estate and foreign lending, coupled with a crisis in the savings and loan industry that had its origins in a serious maturity mismatch as interest rates rose. With their access to managed funds threatened and the quality of their loan portfolio--and hence their capital-- uncertain, these depositories were most reluctant to lend.

Policy eased gradually but persistently to counter the effects of these developments, with the funds rate falling to 3 percent by September 1992, its lowest level since the early 1960s. The uptilt to the term structure of interest rates in a generally low interest rate environment restored bank profitability and, eventually, bank capital. The credit crunch slowly lifted.

By early 1994, as the headwinds of financial restraint abated, it became clear that underlying price pressures were again building. If we had left those pressures unchecked,

293 we would have put at risk some of the hard-won gains that had been achieved over the preceding decade and a half. So, starting from a real federal funds rate that was close to zero, a preemptive tightening was initiated. The resulting rise in the funds rate of 300 basis points over twelve months apparently defused those nascent inflationary pressures.

Though economic activity hesitated in early 1995, it soon steadied, confirming the achievement of a historically elusive soft landing. The success of that period set up two powerful expectations that were to influence developments over the subsequent decade. One was the expectation that inflation could be controlled over the business cycle and that price stability was an achievable objective. The second expectation, in part a consequence of more stable inflation, was that overall economic volatility had been reduced and would likely remain lower than it had previously.

Of course, these new developments brought new challenges. In particular, the prospect that a necessary cyclical adjustment was now behind us fostered increasing levels of optimism, which were manifested in a fall in bond risk spreads and a rise in stock prices. The associated decline in the cost of equity capital further spurred already developing increases in capital investment and productivity growth, both of which broadened impressively in the latter part of the 1990s.

The rise in structural productivity growth was not obvious in the official data on gross product per hour worked until later in the decade, but precursors had emerged earlier. The pickup in new bookings and order backlogs for high-tech capital goods in 1993 seemed incongruous given the sluggish economic environment at the time. Plant managers apparently were reacting to what they perceived to be elevated prospective rates of return on the newer technologies, a judgment that was confirmed as orders and profits continued to increase through 1994 and 1995. Moreover, even though hourly labor compensation and profit margins were rising, prices were being contained, implying increasing growth in output per hour.2

As a consequence of the improving trend in structural productivity growth that was apparent from 1995 forward, we at the Fed were able to be much more accommodative to the rise in economic growth than our past experiences would have deemed prudent. We were motivated, in part, by the view that the evident structural economic changes rendered suspect, at best, the prevailing notion in the early 1990s of an elevated and reasonably stable NAIRU. Those views were reinforced as inflation continued to fall in the context of a declining unemployment rate that by 2000 had dipped below 4 percent in the United States for the first time in three decades.

Notions that prevailed for a time in the 1970s and early 1980s that even high single-digit inflation did not measurably impede economic growth were gradually abandoned as the evidence of significant benefits of low inflation became increasingly persuasive. Moreover, the variance of GDP growth markedly lessened as inflation tumbled from its double-digit high in the early 1980s. To preserve these benefits, we engaged in our most recent preemptive tightening in early 1999 that brought the funds rate to 6-1/2 percent by May 2000.

Our goal of price stability was achieved by most analysts' definition by mid-2003. Unstinting and largely preemptive efforts over two decades had finally paid off. Throughout the period, a key objective has been to ensure that our response to incipient changes in

294 inflation was forceful enough. As John Taylor has emphasized, in the face of an incipient increase in inflation, nominal interest rates must move up more than one-for-one.3

* * *

Perhaps the greatest irony of the past decade is that the gradually unfolding success against inflation may well have contributed to the stock price bubble of the latter part of the 1990s.4 Looking back on those years, it is evident that technology-driven increases in productivity growth imparted significant upward momentum to expectations of earnings growth and, accordingly, to stock prices.5 At the same time, an environment of increasing macroeconomic stability reduced perceptions of risk. In any event, Fed policymakers were confronted with forces that none of us had previously encountered. Aside from the then- recent experience of Japan, only remote historical episodes gave us clues to the appropriate stance for policy under such conditions. The sharp rise in stock prices and their subsequent fall were, thus, an especial challenge to the Federal Reserve.

It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization--the very outcomes we would be seeking to avoid.

In fact, our experience over the past two decades suggests that a moderate monetary tightening that deflates stock prices without substantial effect on economic activity has often been associated with subsequent increases in the level of stock prices.6 Arguably, markets that pass that type of stress test are presumed particularly resilient. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble while preserving economic stability is almost surely an illusion.7

Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies "to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."8

* * *

During 2001, in the aftermath of the bursting of the bubble and the acts of terrorism in September 2001, the federal funds rate was lowered 4-3/4 percentage points. Subsequently, another 75 basis points were pared, bringing the rate by June 2003 to its current 1 percent, the lowest level in 45 years. We were able to be unusually aggressive in the initial stages of the recession of 2001 because both inflation and inflation expectations were low and stable. We thought we needed to be, and could be, forceful in 2002 and 2003 as well because, with demand weak, inflation risks had become two-sided for the first time in forty years.

There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences rather than the bubble itself has been successful. Despite the stock market plunge, terrorist attacks, corporate scandals, and wars in Afghanistan and Iraq, we experienced an exceptionally mild recession--even milder than that of a decade earlier. As I discuss later, much of the ability of the U.S. economy to absorb these sequences of shocks resulted from notably improved structural flexibility. But highly aggressive monetary ease was doubtless also a significant contributor to stability.9

295 * * *

The Federal Reserve's experiences over the past two decades make it clear that uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape. The term "uncertainty" is meant here to encompass both "Knightian uncertainty," in which the probability distribution of outcomes is unknown, and "risk," in which uncertainty of outcomes is delimited by a known probability distribution. In practice, one is never quite sure what type of uncertainty one is dealing with in real time, and it may be best to think of a continuum ranging from well-defined risks to the truly unknown.

As a consequence, the conduct of monetary policy in the United States has come to involve, at its core, crucial elements of risk management. This conceptual framework emphasizes understanding as much as possible the many sources of risk and uncertainty that policymakers face, quantifying those risks when possible, and assessing the costs associated with each of the risks. In essence, the risk management approach to monetary policymaking is an application of Bayesian decisionmaking.

This framework also entails devising, in light of those risks, a strategy for policy directed at maximizing the probabilities of achieving over time our goals of price stability and the maximum sustainable economic growth that we associate with it. In designing strategies to meet our policy objectives, we have drawn on the work of analysts, both inside and outside the Fed, who over the past half century have devoted much effort to improving our understanding of the economy and its monetary transmission mechanism. A critical result has been the identification of a relatively small set of key relationships that, taken together, provide a useful approximation of our economy's dynamics. Such an approximation underlies the statistical models that we at the Federal Reserve employ to assess the likely influence of our policy decisions.

However, despite extensive efforts to capture and quantify what we perceive as the key macroeconomic relationships, our knowledge about many of the important linkages is far from complete and, in all likelihood, will always remain so. Every model, no matter how detailed or how well designed, conceptually and empirically, is a vastly simplified representation of the world that we experience with all its intricacies on a day-to-day basis.

Given our inevitably incomplete knowledge about key structural aspects of an ever- changing economy and the sometimes asymmetric costs or benefits of particular outcomes, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decisionmakers then need to reach a judgment about the probabilities, costs, and benefits of the various possible outcomes under alternative choices for policy.

A policy action that is calculated to be optimal based on a simulation of one particular model may not, in fact, be optimal once the full extent of the risks surrounding the most likely path is taken into account. In general, different policies will exhibit different degrees of robustness with respect to the true underlying structure of the economy.

For example, policy A might be judged as best advancing the policymakers' objectives, conditional on a particular model of the economy, but might also be seen as having relatively severe adverse consequences if the true structure of the economy turns out to be

296 other than the one assumed. On the other hand, policy B might be somewhat less effective in advancing the policy objectives under the assumed baseline model but might be relatively benign in the event that the structure of the economy turns out to differ from the baseline. A year ago, these considerations inclined Federal Reserve policymakers toward an easier stance of policy aimed at limiting the risk of deflation even though baseline forecasts from most conventional models at that time did not project deflation; that is, we chose a policy that, in a world of perfect certainty, would have been judged to be too loose.

As this episode illustrates, policy practitioners operating under a risk-management paradigm may, at times, be led to undertake actions intended to provide insurance against especially adverse outcomes. Following the Russian debt default in the autumn of 1998, for example, the FOMC eased policy despite our perception that the economy was expanding at a satisfactory pace and that, even without a policy initiative, it was likely to continue doing so.10 We eased policy because we were concerned about the low-probability risk that the default might trigger events that would severely disrupt domestic and international financial markets, with outsized adverse feedback to the performance of the U.S. economy.

The product of a low-probability event and a potentially severe outcome was judged a more serious threat to economic performance than the higher inflation that might ensue in the more probable scenario. That possibility of higher inflation caused us little concern at the time, largely because increased productivity growth was resulting in only limited increases in unit labor costs and heightened competition, driven by globalization, was thwarting employers' ability to pass through those limited cost increases into prices. Given the potential consequences of the Russian default, the benefits of the unusual policy action were judged to outweigh its costs.

Such a cost-benefit analysis is an ongoing part of monetary policy decisionmaking and causes us to tip more toward monetary ease when a contractionary event, such as the Russian default, seems especially likely or the costs associated with it seem especially high.

The 1998 liquidity crisis and the crises associated with the stock market crash of 1987 and the terrorism of September 2001 prompted the type of massive ease that has been the historic mandate of a central bank. Such crises are precipitated by the efforts of market participants to convert illiquid assets into cash. When confronted with uncertainty, especially Knightian uncertainty, human beings invariably attempt to disengage from medium to long-term commitments in favor of safety and liquidity. Because economies, of necessity, are net long--that is, have net real assets--attempts to flee these assets cause prices of equity assets to fall, in some cases dramatically. In the crisis that emerged in the autumn of 1998, pressures extended beyond equity markets. Credit-risk spreads widened materially and investors put a particularly high value on liquidity, as evidenced by the extraordinarily wide yield gaps that emerged between on-the-run and off-the-run U.S. Treasuries.

The immediate response on the part of the central bank to such financial implosions must be to inject large quantities of liquidity--or as Walter Bagehot put it, describing such policies of the Bank of England more than a century ago, in a panic the Bank should lend at very high rates of interest "to all that bring good securities quickly, freely, and readily."11 This was perhaps an early articulation of a crisis risk management policy for a central bank.

* * *

297 The economic world in which we function is best described by a structure whose parameters are continuously changing. The channels of monetary policy, consequently, are changing in tandem. An ongoing challenge for the Federal Reserve--indeed, for any central bank--is to operate in a way that does not depend on a fixed economic structure based on historically average coefficients. We often fit simple models only because we cannot estimate a continuously changing set of parameters without vastly more observations than are currently available to us. Moreover, we recognize that the simple linear functions underlying most of our econometric structures may not hold outside the range in which adequate economic observations exist. For example, it is difficult to have much confidence in the ability of models fit to the data of the moderate inflations of the postwar period to accurately predict what the behavior of the economy would be in an environment of aggregate price deflation.

In pursuing a risk-management approach to policy, we must confront the fact that only a limited number of risks can be quantified with any confidence. And even these risks are generally quantifiable only if we accept the assumption that the future will, at least in some important respects, resemble the past. Policymakers often have to act, or choose not to act, even though we may not fully understand the full range of possible outcomes, let alone each possible outcome's likelihood. As a result, risk management often involves significant judgment as we evaluate the risks of different events and the probability that our actions will alter those risks.

For such judgment, policymakers have needed to reach beyond models to broader--though less mathematically precise--hypotheses about how the world works. For example, inferences about how market participants and, hence, the economy might respond to a monetary policy initiative may need to be drawn from evidence about past behavior during a period only roughly comparable to the current situation.

Some critics have argued that such an approach to policy is too undisciplined--judgmental, seemingly discretionary, and difficult to explain. The Federal Reserve, they conclude, should attempt to be more formal in its operations by tying its actions solely, or in the weaker paradigm, largely, to the prescriptions of a simple policy rule. Indeed, rules that relate the setting of the federal funds rate to the deviations of output and inflation from their respective targets, in some configurations, do seem to capture the broad contours of what we did over the past decade and a half. And the prescriptions of formal rules can, in fact, serve as helpful adjuncts to policy, as many of the proponents of these rules have suggested. But at crucial points, like those in our recent policy history--the stock market crash of 1987, the crises of 1997-98, and the events that followed September 2001--simple rules will be inadequate as either descriptions or prescriptions for policy. Moreover, such rules suffer from much of the same fixed-coefficient difficulties we have with our large-scale models.

To be sure, sensible policymaking can be accomplished only with the aid of a rigorous analytic structure. A rule does provide a benchmark against which to assess emerging developments. However, any rule capable of encompassing every possible contingency would lose a key aspect of its attractiveness: simplicity. On the other hand, no simple rule could possibly describe the policy action to be taken in every contingency and thus provide a satisfactory substitute for an approach based on the principles of risk management.

As I indicated earlier, policy has worked off a risk-management paradigm in which the risk and cost-benefit analyses depend on forecasts of probabilities developed from large

298 macromodels, numerous submodels, and judgments based on less mathematically precise regimens. Such judgments, by their nature, are based on bits and pieces of history that cannot formally be associated with an analysis of variance.

Yet, there is information in those bits and pieces. For example, while we have been unable to readily construct a variable that captures the apparent increased degree of flexibility in the United States or the global economy, there has been too much circumstantial evidence of this critically important trend to ignore its existence. Increased flexibility is a likely source of changing structural coefficients.

Our problem is not, as is sometimes alleged, the complexity of our policymaking process, but the far greater complexity of a world economy whose underlying linkages appear to be continuously evolving. Our response to that continuous evolution has been disciplined by the Bayesian type of decisionmaking in which we have engaged.

* * *

While all, no doubt, would prefer that it were otherwise, there is no way to dismiss what has to be obvious to every monetary policymaker: The success of monetary policy depends importantly on the quality of forecasting. The ability to gauge risks implies some judgment about how current economic imbalances will ultimately play out.

Thus, both econometric and qualitative models need to be continually tested. The first signs that a relationship may have changed is usually the emergence of events that seem inconsistent with our hypotheses of the way the economic world is supposed to behave. The anomalous rise in high-tech capital goods orders in 1993, to which I alluded earlier, is one such example. The credit crunch of the early 1990s is another.

The emergence of inflation targeting in recent years is an interesting development in this regard. As practiced, it emphasizes forecasts, but within a more rule-like structure that skews monetary policy toward inflation containment as the primary goal. Indeed, its early applications were in high-inflation countries where discretionary monetary policy fell into disrepute.

Inflation targeting often originated as a fairly simple structure concentrating solely on inflation outcomes, but it has evolved into more-discretionary forms requiring complex judgments for implementation. Indeed, this evolution has gone so far that the actual practice of monetary policy by inflation-targeting central banks now closely resembles the practice of those central banks, such as the European Central Bank, the Bank of Japan, and the Federal Reserve, that have not chosen to adopt that paradigm.

In practice, most central banks, at least those not bound by an exchange rate peg, behave in roughly the same way. They seek price stability as their long-term goal and, accounting for the lag in monetary policy, calibrate the setting of the policy rate accordingly. Central banks generally appear to have embraced a common model of the channels through which monetary policy functions, although the specifics and emphasis given to those channels vary according to our particular circumstances. All banks ease when economic conditions ease and tighten when economic conditions tighten, even if in differing degrees, regardless of whether they are guided by formal or informal inflation targets.

299 As yet unresolved is whether the mere announcement that a central bank intends to engage in inflation targeting increases the credibility of the central bank's inclination to maintain price stability and, hence, assists in the anchoring of inflation expectations. The Bank of England's recent experiences may be encouraging in this regard. But, presumably, we will not know for sure the significance of formal inflation targeting as a tool until the world economy is subjected to shocks of sufficient magnitude to assess the differential performance of those who do not employ formally announced inflation targets. To date, inflation has fallen for formal targeters, but it has fallen for others as well.

* * *

Under the rubric of risk management are a number of specific issues that we at the Fed had to address over the past decade and a half and that will likely resurface to confront future monetary policymakers.

Most prominent is the appropriate role of asset prices in policy. In addition to the narrower issue of product price stability, asset prices will remain high on the research agenda of central banks for years to come. As the ratios of gross liabilities and gross assets to GDP continue to rise, owing to expanding domestic and international financial intermediation, the visibility of asset prices relative to product prices will itself rise. There is little dispute that the prices of stocks, bonds, homes, real estate, and exchange rates affect GDP. But most central banks have chosen, at least to date, not to view asset prices as targets of policy, but as economic variables to be considered through the prism of the policy's ultimate objective.

* * *

As the transcripts of FOMC meetings attest, making monetary policy is an especially humbling activity. In hindsight, the paths of inflation, real output, stock prices and exchange rates may have seemed preordained, but no such insight existed as we experienced it at the time. In fact, uncertainty characterized virtually every meeting, and, as the transcripts show, our ability to anticipate was limited. From time to time the FOMC made decisions, some to move and some not to move, that we came to regret.

Yet, during the last quarter century, policymakers managed to defuse dangerous inflationary forces and dealt with the consequences of a stock market crash, a large asset price bubble, and a series of liquidity crises. These events did not distract us from the pursuit and eventual achievement of price stability and the greater economic stability that goes with it.

As we confront the many unspecifiable dangers that lie ahead, the marked improvement in the degree of flexibility and resilience exhibited by our economy in recent years should afford us considerable comfort.12 Assuming that it will persist, the trend toward increased flexibility implies that an ever-greater part of the resolution of economic imbalances will occur through the actions of business firms and households. Less will be required from the risk-laden initiatives of monetary policymakers.

Each generation of policymakers has had to grapple with a changing portfolio of problems. So while we eagerly draw on the experiences of our predecessors, we can be assured that we will confront different problems in the future. The innovative technologies that have helped us reap enormous efficiencies will doubtless present us with challenges that we

300 cannot currently anticipate.

We were fortunate, as I pointed out in my opening remarks, to have worked in a particularly favorable structural and political environment. But we trust that monetary policy has meaningfully contributed to the impressive performance of our economy in recent decades.

Footnotes

1. I, nonetheless, wish to thank my colleagues David Stockton, David Wilcox, Don Kohn, Ben Bernanke, and John Taylor, for their many suggestions and reminiscences. Return to text

2. That growth was showing through in gross income per hour. An increasingly negative statistical discrepancy was masking the rise in productivity as measured by the official data that relied on gross product per hour. As I indicated in the fall of 1994, "we are observing . . . [an] opening up of margins . . . But unit labor costs apparently have been so well contained by productivity gains at this stage that cost pressures have not flowed into final goods prices." (FOMC transcripts, September 27, 1994, pg. 37) Return to text

3. See, for example, "A Half-Century of Changes in Monetary Policy," John B. Taylor, remarks delivered at the conference in honor of Milton Friedman, November 8, 2002, pp 9- 10, manuscript, Department of the Treasury. Return to text

4. It is notable, that in the United States, surges in price-earnings ratios, a presumed essential characteristic of an equity price bubble, are not observed with elevated inflation expectations. Return to text

5. But, as the Federal Reserve indicated in congressional testimony in July 1999, "... productivity acceleration does not ensure that equity prices are not overextended. There can be little doubt that if the nation's productivity growth has stepped up, the level of profits and their future potential would be elevated. That prospect has supported higher stock prices. The danger is that in these circumstances, an unwarranted, perhaps euphoric, extension of recent developments can drive equity prices to levels that are unsupportable even if risks in the future become relatively small. Such straying above fundamentals could create problems for our economy when the inevitable adjustment occurs." Testimony of Alan Greenspan before the Committee on Banking and Financial Services, U.S. House of Representatives, July 22, 1999. Return to text

6. For example, stock prices rose following the completion of the more than 300 basis point rise in the federal funds rate in the twelve months ending in February 1989. And during the year beginning in February 1994, when the Federal Reserve again raised the federal funds target 300 basis points, stock prices initially flattened. But as soon as that round of tightening was completed, prices resumed their marked upward advance. From mid-1999 through May 2000, the federal funds rate was raised 150 basis points. However, equity price increases were largely undeterred during that period despite what now, in retrospect, was the exhausted tail of a bull market. Stock prices peaked in March 2000, but the market basically moved sideways until September of that year.

Such data suggest that nothing short of a sharp increase in short-term rates that engenders a

301 significant economic retrenchment with all its attendant risks is sufficient to check a nascent bubble. Certainly, 300 basis points proved inadequate to even dent stock prices in 1994. Return to text

7. Some have asserted that the Federal Reserve can deflate a stock-price bubble--rather painlessly--by boosting margin requirements. The evidence suggests otherwise. First, the amount of margin debt is small, having never amounted to more than about 1-3/4 percent of the market value of equities; moreover, even this figure overstates the amount of margin debt used to purchase stock, as such debt also finances short sales of equity and transactions in non-equity securities. Second, investors need not rely on margin debt to take a leveraged position in equities. They can borrow from other sources to buy stock. Or, they can purchase options, which will affect stock prices given the linkages across markets.

Thus, not surprisingly, the preponderance of research suggests that changes in margins are not an effective tool for reducing stock market volatility. It is possible that margin requirements inhibit very small investors whose access to other forms of credit is limited. If so, the only effect of increasing margin requirements is to price out of the market the very small investor without addressing the broader issue of stock price bubbles.

If a change in margin requirements were taken by investors as a signal that the central bank would soon tighten monetary policy enough to burst a bubble, then there might be the appearance of a causal effect. But it is the prospect of monetary policy action, not the margin increase, that should be viewed as the trigger. In a similar manner, history tells us that "jawboning" asset markets will be ineffective unless backed by action. Return to text

8. Op. cit. Return to text

9. Some have argued that, as a consequence of the 1995-2000 speculative episode, long- term imbalances remain, having been only partly addressed since early 2001, the peak of the post-bubble business cycle. For example, large residues of household and external debt are perceived as barriers to future growth. But in the past, imbalances that led to business contractions were rarely fully reversed before the subsequent economic upturn began. Presumably they were fully reversed in later periods, or they continued to fester, but not by enough to halt economic growth.

Even if imbalances still persist in our current environment, the business decline that began in March 2001 came to an end in November of that year, according to the National Bureau of Economic Research. We experienced tepid recovery until the second half of last year, when GDP accelerated considerably. Hence, when the next recession arrives, as it inevitably will, it will be a stretch to attribute it to speculative imbalances of many years earlier. Return to text

10. See minutes of the FOMC meeting of September 29, 1998. Return to text

11. Walter Bagehot, Lombard Street: A Description of the Money Market, (Orion Editions, 1873) p. 85. Return to text

12. See testimony of Alan Greenspan before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, February 11, 2003. Return to text

302 Remarks by Governor Ben S. Bernanke At the Meetings of the American Economic Association, San Diego, California January 4, 2004

Monetary Policy and the Economic Outlook: 2004 The turn of the year is the traditional time to review the high and low points of the year just past and to contemplate the challenges that lie ahead in the year just begun. In that spirit, I will provide a brief progress report on the economic recovery, as well as some remarks on the evolution of monetary policy. As always, the views I will express are my own and are not to be attributed to my colleagues on the Board of Governors or the Federal Open Market Committee.1

It is beginning to appear that 2003 was a watershed year for the American economy, following what had been, on many dimensions, a subpar performance for the better part of three years. Though officially the recession lasted only eight months, from March to November 2001, a period of economic underperformance began with the sharp decline in stock prices and business investment in mid-2000 and continued through the months leading up to the Iraq war this past spring. To a degree that is unusual for postwar recessions, the economic weakness of the period was most apparent in the business sector, even as consumer spending and residential construction remained robust. Businesses radically pared their spending on new capital goods and cut the ratio of inventory stocks to sales to historical lows. In an effort to restore profitability in an environment of weak demand and nonexistent pricing power, businesses also worked hard to improve efficiency and cut costs. These efforts have paid off in terms of remarkable increases in productivity, but, together with insufficient growth in aggregate demand, they also contributed to a significant decline in employment. Like the aftermath of the 1990-91 recession, the two years since the recession trough in November 2001 have been described as a "jobless recovery." Indeed, the lag between the recovery in output and the recovery in employment has been significantly greater this time than it was after the 1990-91 downturn.

Monetary policy was deployed to support the weakening economy, as the Federal Open Market Committee (FOMC) aggressively cut rates in 2001 and has continued its policy of accommodation since then. Fiscal policy, including two rounds of tax cuts, has also been highly stimulative. However, despite some early promise, initially the upturn proved halting and erratic. Policymakers and private-sector economists recognized early on that a balanced recovery would require willingness on the part of the business sector to begin investing and hiring again, but forecasts of improved business sentiment repeatedly proved wrong, or at least premature. In some sectors, such as nonresidential construction and communications, capital overhangs and capital misallocation, the result of the earlier boom, reduced both the need and the financial capacity to invest. Importantly, the economy was also hit by a succession of shocks--notably the September 11, 2001, terrorist attacks, the corporate governance and accounting scandals of the summer of 2002, and the Iraq war in the spring of 2003--each of which created new uncertainties and left its mark on business confidence.

303 Despite all this adversity, there could never have been any doubt that the diversified and resilient U.S. economy, assisted by ample monetary and fiscal stimulus, would eventually stage a comeback. After several false starts, it now appears that that comeback began in earnest in the summer of 2003. As you know, the third quarter of the year displayed near- record levels of real economic growth, in the vicinity of 8 percent at an annual rate, and growth appears to have continued strong in the fourth quarter of 2003. The most heartening aspect of this vigorous expansion is that, finally, the business sector appears to have emerged from its funk. Corporate investment has been strong, particularly in equipment and software, and there are some recent signs that both inventory investment and hiring have begun to pick up.

Of course, downside risks to the economy remain: The recovery in capital investment may prove less durable than it now appears, the moderation of fiscal stimulus in the latter part of next year could adversely affect household spending, or new unfavorable shocks-- geopolitical or otherwise--may yet appear. Still, the incoming data have continued for the most part to surprise on the upside, and the odds accordingly have increased that 2003 will be remembered as the year when this recovery turned the corner. Private-sector forecasters generally expect real growth to be approximately 4 percent in 2004, and they foresee modest improvements in the unemployment rate this year and continued reductions in unemployment in 2005. I think these predictions are broadly reasonable, and indeed I would not be surprised if the pace of real growth next year exceeded 4 percent.

With this generally upbeat scenario in mind, some observers in the markets and the media have questioned the appropriateness of the current stance of monetary policy. Certainly, the policy stance we have today is historically unusual. More than two years after the recession trough, and following several quarters of strong growth, the historically normal pattern would be for the Fed to be well into the process of tightening policy by now. Instead, the FOMC has held its policy instrument rate, the federal funds rate, at the very low level of 1 percent. I would like to take some time now to explain why I believe this policy remains appropriate, despite its historically unusual character.

The positive case for maintaining an accommodative monetary policy at this stage of the recovery has three elements, some of which will be familiar to many of you, at least in broad outline.

First, core inflation rates in the United States are as low today as they have been in forty years, and they have been trending downward. For example, the twelve-month inflation rate as measured by the consumer price index, current-methods basis and excluding food and energy prices, was 2.7 percent at the recession trough in November 2001. This measure of core inflation fell to 2.0 percent as of November 2002 and to only 1.1 percent as of November 2003. Other measures of core inflation, such as the one based on the chain price index for personal consumption expenditures, have displayed a similar pattern. Inflation is not simply low; for my taste, it is very nearly at the bottom of the acceptable range for (measured) inflation. In contrast, in previous episodes of recovery, inflation was above the range consistent with price stability, so that a tightening of monetary policy at an earlier stage of the expansion represented the prudent response to inflation risks. Because inflation is so low today, monetary policy can afford to be more patient to ensure that the recovery is self-sustaining.

The second unusual aspect of the current situation relevant for monetary policy is the truly

304 remarkable increase in labor productivity that firms and workers have achieved in recent years. Those productivity increases affect the inflation outlook in two related ways: first, by raising potential output and thus (for given growth in aggregate demand) the size of the output gap; and, second, by reducing the costs of production, which puts downward pressure on prices. I will first address the effect of productivity on costs, returning later to the link of productivity and the output gap.

Labor costs account for the lion's share, about two-thirds, of the cost of producing goods and services. The labor cost of producing a unit of output depends, first, on the dollar cost per hour (including wages and benefits) of employing a worker and, second, on the quantity of output that each worker produces per hour. When the cost per hour of employing a worker rises more quickly than the worker's hourly productivity--the historically normal situation--then the dollar labor cost of producing each unit of output, the so-called unit labor cost, tends to rise. Recently, however, labor productivity has grown even more quickly than the costs of employing workers, with the result that unit labor costs have declined in each of the past three years. Indeed, in the second and third quarters of 2003, unit labor costs in the nonfarm business sector are currently estimated to have declined by a remarkable 3.2 and 5.8 percent, respectively, at annual rates.

Again, because labor costs are such a large part of overall costs, and because capital costs have also been moderate, the business sector has enjoyed a net decline in total production costs. A decline in production costs must result in lower prices for final consumers, an increased price-cost markup for producers, or both. In practice, both have occurred in recent years: Firms have passed on part of the reduction in costs on to final consumers in the form of lower (or more slowly rising) prices, and price-cost markups (as best we can measure them) have risen well above their historical averages. The high level of markups is an important and perhaps insufficiently recognized feature of the current economic situation. To the extent that firms can maintain these markups, profits will continue to be high, supporting investment and equity values. To the extent that product-market competition erodes these markups, as is likely to occur over time, downward pressure will be exerted on the inflation rate, even if, as is likely, the recent declines in unit labor cost do not persist.2

The third unusual factor is the persistent softness of the labor market. As I already noted, fully two years after the official recession trough, we are only just beginning to see significant gains in employment. Of course, the unemployment rate, at about 6 percent of the labor force, is not exceptionally high by historical standards, and one can debate the degree to which structural change and other factors may have affected the level of employment that can be sustained without overheating the economy. Assessing the amount of slack in the labor market is very difficult and ultimately a matter of judgment. Reasonable people can certainly disagree.

However, my sense is that, when one looks at the full range of information available, the labor market looks (if anything) weaker than a 6 percent unemployment rate suggests. For example, it appears that workers who have lost their jobs in the past couple of years have been more likely to withdraw from the labor force (rather than report themselves as unemployed) than were job losers in previous recessions. Indeed, the labor force participation rate fell sharply between 2000 and 2003, from a little over 67 percent to about 66-1/4 percent. Similarly, the ratio of employment to the working-age population, a statistic that reflects both those who become unemployed and those who leave the labor force, has fallen significantly, by 2.8 percentage points between its peak in April 2000 and its trough

305 this past September. The tendency of recent job losers to leave the labor force likely masks some of the effects of job cuts on the unemployment rate, so that the current measured level of unemployment may understate the extent of job loss or the difficulty of finding new work. Of course, a labor market that is slack and improving only slowly is likely to produce continued slow growth in nominal wages, contributing to continued moderate growth in costs.

Why has the labor market remained relatively weak, despite increasingly rapid growth in output? I addressed the causes of the "jobless recovery" in an earlier talk (Bernanke, 2003). Although many factors have affected the rate of job creation, I concluded in my earlier analysis that the rapid rate of productivity growth, already discussed in relation to unit labor costs, has also been an important reason for the slow pace of recovery in the labor market. All else equal, strong productivity gains allow firms to meet a given level of demand with fewer employees. Thus, for given growth in aggregate spending, a higher rate of productivity growth implies a slower rate of growth in employment.3

To summarize, then, the current economic situation has three unusual aspects, which together (in my view) rationalize the current stance of monetary policy. First, inflation is historically low, perhaps at the bottom of the acceptable range, and has recently continued its decline. Second, rapid productivity growth has led to actual declines in nominal production costs, which reduce current and future inflationary pressures. Finally, the labor market remains soft, reflecting the fact that growth in aggregate demand has been so far insufficient to absorb the increases in aggregate supply afforded by higher productivity. A soft labor market will keep a lid on the growth in the cost of employing workers. An accommodative monetary policy is needed, in my view, to support the ongoing recovery, particularly in the labor market. At the same time, the risks of policy accommodation seem low, as inflation is low and inflation pressures seem quite subdued.

These arguments notwithstanding, I realize that some remain unconvinced that the FOMC is pursuing the right course. Citing factors such as the rise in commodity prices and the decline of the dollar, a number of observers have warned that the Federal Reserve's policies risk re-igniting inflation. I would like to address these concerns briefly. Naturally, I will try to show why these arguments are not of immediate concern, given the three points I made earlier in support of the current accommodative policy. Before I do that, though, I would like to emphasize to those uncomfortable with the Fed's policy stance that, speaking for myself at least, their views are being heard and taken seriously. Achieving price stability in the United States was an historic accomplishment, and preserving that legacy is crucially important. I say that not only because I think that price stability promotes long-run growth and efficiency, which I do, but also because I believe that low inflation and well-anchored inflation expectations are critical to maintaining economic stability in the short run. Price stability is of utmost importance to the nation's economic health, and I believe that the FOMC will do whatever is necessary to be sure that inflation remains well contained.

With that preface, I will address briefly a few concerns of those who worry that inflation is poised to rise, beginning with the recent behavior of commodity prices.

A number of commodity price indexes have indeed risen sharply over the past couple of years, including a large jump in the past several months. This acceleration has been broadly mirrored in the behavior of the core producer price indexes (PPIs) for crude and intermediate materials, probably the best and most comprehensive measures of prices at

306 early stages of processing. Specifically, over the past two years, the twelve-month change in the core PPI for crude materials has risen rather dramatically, from -9.4 percent to 17.1 percent, and the twelve-month change in the core PPI for intermediate materials has risen from -1.3 percent to 1.8 percent. Do these developments imply a significant increase in inflation risk at the level of the final consumer?

The answer is almost certainly not. Two points should be made. First, the recent movements in commodity prices are hardly surprising; they are in fact quite normal for this stage of the business cycle. The acceleration in the core PPI for crude materials that we have seen is about what should have been expected, given the increases that have occurred recently in both domestic and worldwide economic activity.4 The increase in the demand for commodities from China alone has been substantial; for example, that country's share of world copper consumption is estimated to have risen from less than 5 percent in 1990 to 20 percent in 2003. The much more moderate acceleration in intermediate goods prices can likewise be traced to the increase in economic activity, with some additional effect coming from the decline in the dollar and the indirect impact of increases in energy prices.

Second, the direct effects of commodity price inflation on consumer inflation are empirically minuscule, both because raw materials costs are a small portion of total cost and because part of any increase in the cost of materials tends to be absorbed in the margins of final goods producers and distributors. Accelerations in commodity prices comparable to or larger than the most recent one occurred following the 1981-82 and 1990-91 recessions, as well as in 1986-87 and 1999, with no noticeable impact on inflation at the consumer level.5 A reasonable rule of thumb is that a permanent 10 percent increase in raw materials prices will lead to perhaps a 0.7 percent increase in the price of intermediate goods and to less than a 0.1 percent increase in consumer prices. Thus the recent acceleration in commodity prices, even if it were to persist (and futures prices suggest that it will not), would likely add only a tenth or two to the core inflation rate. In short, rising commodity prices are a better signal of strengthening economic activity than of inflation at the consumer level.

Two specific commodity prices that often command attention are the prices of gold and crude petroleum. The price of gold has increased roughly 60 percent since its low in April 2001, from about $255 per ounce to about $410 per ounce. A portion of that increase simply reflects dollar depreciation, which I will discuss momentarily. Gold also represents a safe haven investment, however, and I agree that there have been periods in the past when the fear that drove investors into gold was the fear of inflation. But gold prices also respond to geopolitical tensions; these tensions have certainly heightened since 2001 and, in my view, can account for the bulk of the recent increase in the real price of gold.

Oil prices are relatively high, in the range of $33/barrel, but they have been elevated for most of the past four years, despite a broadly disinflationary environment. According to futures markets, oil prices are expected to decline gradually over the next two years, despite accelerating economic activity, as new supplies are brought on line. Of course, there is considerable uncertainty about what the price of oil will do, given the possibility of supply disruptions. But if it follows the course projected by the futures market, the price of oil should have a modest disinflationary effect on overall consumer prices in the next couple of years.

Let me turn now to the recent depreciation of the dollar and its implications for inflation. The dollar has fallen dramatically against some major currencies, notably the euro, against

307 which the dollar has declined roughly 30 percent from its recent peak in the first quarter of 2002. However, looking at movements of the dollar against a single currency can be misleading about overall trends; broader measures of dollar strength show somewhat less of a decline. For example, an index of the dollar's real value against the currencies of important U.S. trading partners, weighted by trade shares, has fallen only about 12 percent from its peak in the first quarter of 2002. Notably, this broader index of dollar value remains about 7 percent above its average value in the 1990s and 17 percent above the low it reached in the second quarter of 1995.

Moreover, the direct effects of dollar depreciation on inflation, like those of commodity price increases, appear to be relatively small. In part, the small effect reflects the modest weight of imports in the consumer's basket of goods and services. Perhaps more importantly, however, the evidence suggests that foreign producers tend to absorb most of the effect of changes in the value of the dollar rather than "passing through" these effects to the prices they charge U.S. consumers. A reasonable estimate of the portion of changes in the value of the dollar passed through to U.S. consumers is about 30 percent. The extent of passthrough also appears to have declined over time, suggesting that foreign producers also lack "pricing power" in the current low-inflation environment in the United States. Overall, on rough estimates, a 10 percent decline in the broad value of the dollar would be expected to add between one and three tenths to the level of core consumer prices (not the inflation rate), spread out over a period of time.

I haven't said anything yet about the rate of growth of the money supply, another indicator that is sometimes cited by those concerned about inflation, largely because there is not too much to say. Growth in standard monetary measures such as the base and M2 has been moderate (and declining) in recent years, certainly well within expected ranges given the growth of nominal GDP and normal variation in velocity. For example, for 2003 as a whole, growth in both the monetary base and M2 should be about equal to growth in nominal GDP. Even should money growth rates accelerate, however, I would caution against making strong inferences about the likely behavior of inflation, except in the very long run. Money growth has not proven to be especially useful for predicting inflation in the short run, in part because various institutional factors unrelated to monetary policy often affect the growth rate of money. A striking example of the way special factors can affect money growth rates is the fact that M2 growth has actually been sharply negative, at about -5 percent at an annual rate, for the past three months for which data are available. Factors such as the falloff in mortgage refinancing activity and outflows from retail money market funds into equities and other investments are the proximate explanations for the decline in M2. Certainly, this short-term decline in broad money is not to be taken as evidence of tight monetary policy!6

To summarize, 2003 seems to have marked the turning point for the U. S. economy, and we have reason to be optimistic that 2004 will see even more growth and continued progress in reducing unemployment. The remarkable strength and resiliency of the American economy- -an economy that has shown the capacity to grow and become more productive in the face of serious adverse shocks--deserve most of the credit for these developments. Highly stimulative monetary and fiscal policies have also played a role, of course.

The Federal Reserve enters 2004 with monetary policy that is unusually accommodative in historical terms, relative to the stage of the business cycle. That accommodation is justified, I believe, by the current very low level of inflation, and by the productivity gains and the

308 weakness in the labor market, both of which suggest that inflation is likely to remain subdued. In my view, weighing the relative costs of the upside and downside risks also favors accommodation; in particular, it is important that we ensure, as best we can, that the current expansion will become self-sustaining and that the inflation rate does not fall further.

On the other side, as I have already noted, the achievement of price stability must not and will not be jeopardized. We at the Federal Reserve will closely monitor developments in prices and wages, as well as conditions in the labor market and the broader economy, for any sign of incipient inflation. We will also look at the information that can be drawn from surveys and financial markets about inflation expectations. For now, I believe that the Federal Reserve has the luxury of being patient. However, I am also confident that, when the time comes, the Fed will act to ensure that inflation remains firmly under control.

REFERENCES

Bernanke, Ben (2003). "The Jobless Recovery," At the Global Investment and Economic Outlook Conference, Carnegie Mellon University, Pittsburgh, Pennsylvania, November 6.

Kohn, Donald (2003). "Productivity and Monetary Policy," At the Federal Reserve Bank of Philadelphia Monetary Seminar, Philadelphia, Pennsylvania, September 24..

Footnotes

1. Thanks are due to Sandy Struckmeyer and members of the Board staff for useful comments and assistance, but they are likewise not responsible for the views expressed here.

2. As employment begins to pick up and the recovery matures, productivity growth is likely to decelerate, perhaps markedly. Nevertheless, slow growth in wages and the return to normal of price-cost markups should help keep inflation low.

3. Of course, all else is not necessarily equal. In general, one would expect strong productivity growth to expand aggregate demand, for example, by stimulating capital formation. However, the stimulative effect of productivity growth on demand appears to have been weaker than normal in recent years (Kohn, 2003). Also, the conclusion that productivity growth has contributed to weak job growth in the short run is in no way inconsistent with the view that productivity growth raises wages and living standards in the long run, when full employment has been restored.

4. A part of the increase in the core crude PPI also reflects indirect effects of energy prices (direct effects of energy prices are excluded from core inflation measures by construction). The depreciation of the dollar, discussed below, may also have played some role

5. Commodity prices are also well below previous peaks--indeed, about 15 percent or more below the peaks reached in 1977, 1980, 1989, and 1995, when weighted by U.S. import shares.

6. The difficulties with using the monetary base as an inflation indicator are even greater

309 than those with using M2. The base is nearly all (97 percent) currency, about half to two- thirds of which circulates outside the United States. Hence, to a significant degree, base growth is determined by the foreign demand for dollars, rather than by economic conditions in the United States.

310

Remarks by Chairman Alan Greenspan At the 21st Annual Monetary Conference, Cosponsored by the Cato Institute and The Economist, Washington, D.C. November 20, 2003 Current Account

Among the major forces that will help shape the euro's future as a world currency will be the international evolution of the euro area's key financial counterparty, the United States. I will leave the important interplay between the euro and the dollar--and particularly forecasts of the dollar-euro exchange rate--to more venturesome analysts. My experience is that exchange markets have become so efficient that virtually all relevant information is embedded almost instantaneously in exchange rates to the point that anticipating movements in major currencies is rarely possible.1

I plan this morning to head in what I hope will be a more fruitful direction by addressing the evolving international payments imbalance of the United States and its effect on Europe and the rest of the world. I intend to focus on the eventual resolution of that current account imbalance in the context of accompanying balance-sheet changes.

I conclude that spreading globalization has fostered a degree of international flexibility that has raised the probability of a benign resolution to the U.S. current account imbalance. Such a resolution has been the general experience of developed countries over the past two decades. Moreover, history suggests that greater flexibility allows economies to adjust more smoothly to changing economic circumstances and with less risk of destabilizing outcomes.

Indeed, the example of the fifty states of the United States suggests that, with full flexibility in the movement of labor and capital, adjustments to cross-border imbalances can occur even without an exchange rate adjustment. In closing, I raise the necessity of containing the forces of protectionism to ensure the flexibility needed for a benign outcome of our international imbalances.

* * *

The current account deficit of the United States, essentially net imports of goods and services, has continued to widen over the past couple of years. The external deficit receded modestly during our mild recession of 2001 only to rebound to a record 5 percent of gross domestic product earlier this year. Our persistent current account deficit is a growing concern because it adds to the stock of outstanding external debt that could become increasingly more difficult to finance.

These developments raise the question of whether the record imbalance will benignly defuse, as it largely did after its previous peak of about 3-1/2 percent of GDP in 1986, or whether the resolution will be more troublesome.

311 * * *

Current account balances are determined mainly by countries' relative incomes, by product and asset prices including exchange rates, and by comparative advantage. To pay for the internationally traded goods and services that underlie that balance, there is a wholly separate market in financial instruments the magnitudes of which are determined by the same set of asset prices that affects trade in goods and services. In the end, it is the balancing of trade and financing that sets international product and asset prices and global current account balances.

The buildup or reduction in financial claims among trading countries--that is, capital flows--are hence exact mirrors of the current account balances. And just as net trade and current accounts for the world as a whole necessarily sum to zero, so do net capital flows. Because for any country the change in net claims against all foreigners cumulates to its current account balance (abstracting from valuation adjustments), that balance must also equal the country's domestic saving less its domestic investment.

* * *

In as much as the balance of goods and services is brought into equality with the associated capital flows through adjustments in prices, interest rates, and exchange rates, how do we tell whether trade determines capital flows or whether capital flows determine trade? Answering this question is difficult because the balancing process is simultaneous rather than sequential, so that there is no simple unidirectional causality between trade and capital flows. For example, increased demand for dollar assets may lower interest rates and equity premiums in the United States and thus engender increased demand for imports. But the need for import financing may raise domestic interest rates and thereby attract the required additional capital inflows to the United States.

Nonetheless, as the U.S. current account deficit rose from 1995 to early 2002, so too did the dollar's effective exchange rate. Evidently, upward pressure on the dollar was spurred by rising expected rates of return that resulted in private capital investments from abroad that chronically exceeded the current account deficit. The pickup in U.S. productivity growth in the mid-1990s-- the likely proximate cause of foreigners' perception of increased rates of return on capital in the United States--boosted investment spending, stock prices, wealth, and assessments of future income. Those favorable developments led, in turn, to greater consumer spending and lower saving rates.

The resulting widening gap between domestic investment and domestic saving from 1995 to 2000 was held partly in check by higher government saving as rising stock prices drove up taxable income. When, in 2002, that effect reversed and the federal budget slipped back into deficit, and as the U.S. economy emerged from its downturn, the gap in the current account balance widened further. After contracting in the aftermath of the U.S. stock market decline of 2000, private capital from abroad was apparently again drawn to the United States in substantial quantities by renewed perceptions of relatively high rates of return. In addition, during the past year or so the financing of our external deficit was assisted by large accumulations of dollars by foreign central banks.

* * *

Even before the productivity surge of the late 1990s, the United States had become particularly

312 prone to current account deficits and rising external net debt because of the historical tendency on the part of U.S. residents to import, relative to income, at a significantly higher rate than our trading partners, at least for U.S. goods and services.2 If all economies were to grow at the same rate, such differential propensities would produce an ever-widening trade deficit for the United States and a corresponding surplus for our trading partners, failing offsetting adjustments in relative prices.

In the 1960s or 1970s, because our trading partners were growing far faster than we were, a trade gap did not surface. When, in the 1980s, the difference in growth rates narrowed while the dollar rose, our trade and the associated current account deficits widened dramatically. By the late 1980s, we had become a net debtor nation, ending seven decades as a net creditor. While most recent data reaffirm our above-average propensity to import, there is evidence to suggest that its magnitude has diminished.

* * *

There is no simple measure by which to judge the sustainability of either a string of current account deficits or their consequence, a significant buildup in external claims that need to be serviced. Financing comes from receipts from exports, earnings on assets, and, if available, funds borrowed from foreigners. In the end, it will likely be the reluctance of foreign country residents to accumulate additional debt and equity claims against U.S. residents that will serve as the restraint on the size of tolerable U.S. imbalances in the global arena.

Unlike the financing of payments from export and income receipts, reliance on borrowed funds may not be sustainable. By the end of September 2003, net external claims on U.S. residents had risen to an estimated 25 percent of a year's GDP, still far less than claims on many of our trading partners but rising at the equivalent of 5 percentage points of GDP annually. However, without some notion of our capacity for raising cross-border debt, the sustainability of the current account deficit is difficult to estimate. That capacity is evidently, in part, a function of globalization since the apparent increase in our debt-raising capacity appears to be related to the reduced cost and increasing reach of international financial intermediation.

The significant reduction in global trade barriers over the past half century has contributed to a marked rise in the ratio of world trade to GDP and, accordingly, a rise in the ratio of imports to domestic demand. But also evident is that the funding of trade has required, or at least has been associated with, an even faster rise in external finance. Between 1980 and 2002, for example, the nominal dollar value of world imports rose 5-1/2 percent annually, while gross external liabilities, largely financial claims, also expressed in dollars, apparently rose considerably faster.3

This observation does not reflect solely the sharp rise in the external liabilities of the United States that has occurred since 1995. For other OECD economies, imports rose about 2 percent annually from 1995 to 2002; external liabilities increased 8 percent. Less-comprehensive data suggest that the ratio of global debt and equity claims to trade has been rising since at least the beginning of the post-World War II period.4

From an accounting perspective, part of the increase in finance relative to trade in recent years reflects the continued marked rise in tradable foreign currencies held by private firms as well as a very significant buildup of international currency reserves of monetary authorities. Rising global wealth has apparently led to increased demand for diversification of portfolios by

313 including greater shares of foreign currencies.

More generally, technological advance and the spread of global financial deregulation has fostered a broadening array of specialized financial products and institutions. The associated increased layers of intermediation in our financial system make it easier to diversify and manage risk, thereby facilitating an ever-rising ratio of domestic liabilities (and assets) to GDP, and gross external liabilities to trade.5 These trends seem unlikely to reverse, or even to slow materially, short of an improbable end to the expansion of financial intermediation that is being driven by cost-reducing technology.

Uptrends in the ratios of external liabilities or assets to trade, and therefore to GDP, can be shown to have been associated with a widening dispersion in countries' ratios of trade and current account balances to GDP.6 A measure of that dispersion, the sum of the absolute values of the current account balances estimated from each country's gross domestic saving less gross domestic investment (the current account's algebraic equivalent), has been rising as a ratio to GDP at an average annual rate of about 2 percent since 1970 for the OECD countries, which constitute four-fifths of world GDP.

With the seeming willingness of foreigners to hold progressively greater amounts of cross- border claims against U.S. residents, at what point do net claims (that is, gross claims less gross liabilities) against us become unsustainable and deficits decline? Presumably, a U.S. current account deficit of 5 percent or more of GDP would not have been readily fundable a half- century ago or perhaps even a couple of decades ago.7 The ability to move that much of world saving to the United States in response to relative rates of return would have been hindered by a far lower degree of international financial intermediation. Endeavoring to transfer the equivalent of 5 percent of U.S. GDP from foreign financial institutions and persons to the United States would presumably have induced changes in the prices of assets that would have proved inhibiting.

* * *

There is, for the moment, little evidence of stress in funding U.S. current account deficits. To be sure, the real exchange rate for the dollar has, on balance, declined more than 10 percent broadly and roughly 20 percent against the major foreign currencies since early 2002. Yet inflation, the typical symptom of a weak currency, appears quiescent. Indeed, inflation premiums embedded in long-term interest rates apparently have fluctuated in a relatively narrow range since early 2002. More generally, the vast savings transfer has occurred without measurable disruption to the balance of international finance. In fact, in recent months credit risk spreads have fallen and equity prices have risen throughout much of the global economy.

* * *

To date, the widening to record levels of the U.S. ratio of current account deficit to GDP has

314 been seemingly uneventful. But I have little doubt that, should it continue, at some point in the future adjustments will be set in motion that will eventually slow and presumably reverse the rate of accumulation of net claims on U.S. residents. How much further can international financial intermediation stretch the capacity of world finance to move national savings across borders?

People seem to prefer to invest in familiar local businesses even where currency and country risks do not exist. For the United States, studies have shown that individual investors and even professional money managers have a slight preference for investments in their own communities and states. Trust, so crucial an aspect of investing, is most likely to be fostered by the familiarity of local communities.

As a consequence, home bias will likely continue to constrain the movement of world savings into its optimum use as capital investment, thus limiting the internationalization of financial intermediation and hence the growth of external assets and liabilities.8

Nonetheless, during the past decade, home bias has apparently declined significantly. For most of the earlier postwar era, the correlation between domestic saving rates and domestic investment rates across the world's major trading partners, a conventional measure of home bias, was exceptionally high.9 For OECD countries, the GDP-weighted correlation coefficient was 0.97 in 1970. However, it fell from 0.96 in 1992 to less than 0.8 in 2002. For OECD countries excluding the United States, the recent decline is even more pronounced. These declines, not surprisingly, mirror the rise in the differences between saving and investment or, equivalently, of the dispersion of current account balances over the same years.

The decline in home bias probably reflects an increased international tendency for financial systems to be more transparent, open, and supportive of strong investor protection.10 Moreover, vast improvements in information and communication technologies have broadened investors' scope to the point that foreign investment appears less exotic and risky. Accordingly, the trend of declining home bias and expanding international financial intermediation will likely continue as globalization proceeds.

* * *

It is unclear whether debt-servicing restraints or the rising weight of U.S. assets in global portfolios will impose the greater restraint on current account dispersion over the longer term. Either way, when that point arrives, what do we know about whether the process of reining in our current account deficit will be benign to the economies of the United States and the world?

315 a reserve currency.12 This ability has presumably enlarged the capability of the United States relative to most of our trading partners to incur foreign debt.

* * *

Besides experiences with the current account deficits of other countries, there are few useful guideposts of how high our country's net foreign liabilities can mount. The foreign accumulation of U.S. assets would likely slow if dollar assets, irrespective of their competitive return, came to occupy too large a share of the world's portfolio of store of value assets. In these circumstances, investors would seek greater diversification in non-dollar assets. At the end of 2002, U.S. dollars accounted for about 65 percent of central bank foreign exchange reserves, with the euro second at 15 percent. Approximately half of private cross-border holdings were denominated in dollars, with one-third in euros.

More important than the way that the adjustment of the U.S. current account deficit will be initiated is the effect of the adjustment on both our economy and the economies of our trading partners. The history of such adjustments has been mixed. According to the aforementioned Federal Reserve study of current account corrections in developed countries, although the large majority of episodes were characterized by some significant slowing of economic growth, most economies managed the adjustment without crisis. The institutional strengths of many of these developed economies--rule of law, transparency, and investor and property protection--likely helped to minimize disruptions associated with current account adjustments. The United Kingdom, however, had significant adjustment difficulties in its early postwar years, as did, more recently, Mexico, Thailand, Korea, Russia, Brazil, and Argentina, to name just a few.

Can market forces incrementally defuse a worrisome buildup in a nation's current account deficit and net external debt before a crisis more abruptly does so? The answer seems to lie with the degree of flexibility in both domestic and international markets. In domestic economies that approach full flexibility, imbalances are likely to be adjusted well before they become potentially destabilizing. In a similarly flexible world economy, as debt projections rise, product and equity prices, interest rates, and exchange rates could change, presumably to reestablish global balance.

The experience over the past two centuries of trade and finance among the individual states that make up the United States comes close to that paradigm of flexibility even though exchange rates among the states have been fixed. Although we have scant data on cross-border transactions among the separate states, anecdotal evidence suggests that over the decades significant apparent imbalances have been resolved without precipitating interstate balance-of- payments crises. The dispersion of unemployment rates among the states, one measure of imbalances, spikes during periods of economic stress but rapidly returns to modest levels, reflecting a high degree of adjustment flexibility. That flexibility is even more apparent in regional money markets, where interest rates that presumably reflect differential imbalances in states' current accounts and hence cross-border borrowing requirements have, in recent years, exhibited very little interstate dispersion. This observation suggests either negligible cross- state-border imbalances, an unlikely occurrence given the pattern of state unemployment dispersion, or more likely very rapid financial adjustments.

* * *

We may not be able to usefully determine at what point foreign accumulation of net claims on

316 the United States will slow or even reverse, but it is evident that the greater the degree of international flexibility, the less the risk of a crisis.13 The experience of the United States over the past three years is illustrative. The apparent ability of our economy to withstand a number of severe shocks since mid-2000, with only a small decline in real GDP, attests to the marked increase in our economy's flexibility over the past quarter century.14

* * *

In evaluating the nature of the adjustment process, we need to ask whether there is something special in the dollar being the world's primary reserve currency. With so few historical examples of dominant world reserve currencies, we are understandably inclined to look to the experiences of the dollar's immediate predecessor. At the height of sterling's role as the world's currency more than a century ago, Great Britain had net external assets amounting to some 150 percent of its annual GDP, most of which were lost in World Wars I and II. Early post-World War II Britain was hobbled with periodic sterling crises as much of the remnants of Empire endeavored to disengage themselves from heavy reliance on holding sterling assets as central bank reserves and private stores of value. The experience of Britain's then extensively regulated economy, harboring many wartime controls well beyond the end of hostilities, provides testimony to the costs of structural rigidity in times of crisis.

* * *

I say this with one major caveat. Some clouds of emerging protectionism have become increasingly visible on today's horizon. Over the years, protected interests have often endeavored to stop in its tracks the process of unsettling economic change. Pitted against the powerful forces of market competition, virtually all such efforts have failed. The costs of any new such protectionist initiatives, in the context of wide current account imbalances, could significantly erode the flexibility of the global economy. Consequently, it is imperative that creeping protectionism be thwarted and reversed.

Footnotes

1. The exceptions to this conclusion are those few cases of successful speculation in which governments have tried and failed to support a particular exchange rate. Nonetheless, despite extensive efforts on the part of analysts, to my knowledge, no model projecting directional movements in exchange rates is significantly superior to tossing a coin. I am aware that of the thousands who try, some are quite successful. So are winners of coin-tossing contests. The seeming ability of a number of banking organizations to make consistent profits from foreign exchange trading likely derives not from their insight into future rate changes but from making markets and consistently being able to buy at the bid and sell at the offering price, pocketing the spread.

2. This anomaly was first identified more than three decades ago; see H.S. Houthakker and Stephen P. Magee, "Income and Price Elasticities in World Trade," The Review of Economics

317 and Statistics vol. 51 (May 1969), 111-25.

3. Gross liabilities include both debt and equity claims. Data on the levels of gross liability have to be interpreted carefully because they reflect the degree of consolidation of the economic entities they cover. Were each of our fifty states considered as a separate economy, for example, interstate claims would add to both U.S. and world totals without affecting U.S. or world GDP. Accordingly, it is the change in the gross liabilities ratios that is the more economically meaningful concept.

4. For the United States, for example, the ratio of external liabilities to imports of goods and services rose from nearly 1-1/2 in 1948 to close to 2 in 1980. The comparable ratios for the United Kingdom can be estimated to have been in the neighborhood of 2-1/2 or lower in 1948 and about 3-3/4 in 1980.

5. For the United States, for example, even excluding mortgage pools, the ratio of domestic liabilities to GDP rose at an annual rate of 2 percent between 1965 to 2002. For the United Kingdom, the ratio of debt liabilities to GDP increased 4 percent at an annual rate during the more recent 1987-2002 period.

6. If the rate of growth of external assets (and liabilities) exceeds, on average, the growth rate of world GDP, under a broad range of circumstances the dispersion of the change in net external claims of trading countries must increase as a percent of world GDP. But the change in net claims on a country, excluding currency valuation changes and capital gains and losses, is essentially the current account balance. Of necessity, of course, the consolidated world current account balance remains at zero.

7. It is true that estimates of the ratios of the current account to GDP for many countries in the nineteenth century are estimated to have been as large as, or larger, than we have experienced in recent years. However, the substantial net flows of capital financing for those earlier deficits were likely motivated in large part by specific major development projects (for example, railroads) bearing high expected rates of return. By contrast, diversification appears to be a more salient motivation for today's large net capital flows. Moreover, gross capital flows are believed to be considerably greater relative to GDP in recent years than in the nineteenth century. (See Alan M. Taylor, "A Century of Current Account Dynamics," Journal of International Money and Finance, 2002, 725-48, and Maurice Obstfeld and Alan Taylor, "Globalization and Capital Markets," NBER Working Paper 8846, March 2002.)

8. Without home bias, the dispersion of world current account balances would likely be substantially greater.

9. See Martin Feldstein and Charles Horioka, "Domestic Saving and International Capital Flows," The Economic Journal, June 1980, 314-29.

10. Research indicates that home bias in investment toward a foreign country is likely to be

318 diminished to the extent that the country's financial system offers transparency, accessibility, and investor safeguards. See Alan Ahearne, William Griever, and Frank Warnock, "Information Costs and Home Bias" Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 691, December 2000.

11. Caroline Freund, "Current Account Adjustment in Industrialized Countries," Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 692, December 2000.

12. Less than 10 percent of aggregate U.S. foreign liabilities are currently denominated in nondollar currencies. To have your currency chosen as a store of value is both a blessing and a curse. Presumably, the buildup of dollar holdings by foreigners has provided Americans with lower interest rates as a consequence. But, as Great Britain learned, the liquidation of sterling balances after World War II exerted severe pressure on its domestic economy. Return to text

13. Although increased flexibility apparently promotes resolution of current account imbalances without significant disruption, it may also allow larger deficits to emerge before markets are required to address them.

14. See Alan Greenspan, remarks before a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30, 2002.

319 Semi-Daily Journal The Semi-Daily Journal of Economist Brad DeLong: Fair and Balanced Almost Every Day November 29, 2003

"Starve the Beast"?

Having looked forward only three years ago to a future of budget surpluses (at least until the baby boom generation retired in earnest), we now look forward to huge deficits as far as the eye can see. Let's take the reasonable budget projections for George W. Bush's policies that generate deficits of more than $500 billion a year as far as the eye can see (until the baby boom generation retires, and the deficits grow bigger). These projections assume that there will be a Medicare drug benefit (which there is), that the expiring provisions of the tax code will be extended (which the Bush administration wants to do), that the Alternative Minimum Tax will be reformed along the lines assumed by the Congressional Budget Office (which the Bush administration says it wants to do), and that discretionary spending will grow at the rate of nominal GDP.

Where did this sudden swing back to deficits come from? Republican ideologues who say that this is all part of a clever plan (rather than being yet another mammoth demonstration of the incompetence at governing of the current crew in the White House) say that the purpose of this is to "starve the beast": to cut taxes as a share of GDP to create a budgetary crisis that some future

320 (Democratic?) administration will have to solve. This future administration will, putting the national interest first, recognize that persistent enormous budget deficits do first-order harm to the American economy. It will--as the Clinton administration did--make getting the deficit under control its first and highest priority. And it will have no choice but to do so by severely cutting back Social Security, Medicare, Medicaid, and the other programs of the social insurance state.

Not surprisingly, Republican ideologues are wrong--and innumerate, to boot. A simple look at the numbers in the CBO's reasonable projections will tell you that this is not what is going on at all. Bush administration policies have cut taxes as a share of GDP, yes. But Bush administration policies have also raised spending as a share of GDP.

Consider what the Congressional Budget Office tells us about the difference between fiscal 2001--the last budget year started under the Clinton administration--and fiscal 2004, the year we are currently in. Of the 5.3% of GDP swing since 2001 in the cyclically-adjusted budget balance from surplus into deficit, 2.3% comes from higher spending and 3.0% from lower revenues. For the last fiscal year to start in Bush's prospective second term--fiscal 2009--the CBO's projections are for revenues to fall from their 19.6% of GDP 2001 value to 17.8%, and for expenditures to rise from their 18.4% of GDP 2001 value to 21.6%. Relative to fiscal 2001, the tax share of GDP falls by 1.8% of GDP. The spending share of GDP rises by 3.2% of GDP. Of the 5.0% of GDP swing in the budget balance the CBO believes that the Bush administration's current policies* will produce between fiscal 2001 and fiscal 2009, 64% will be due to a higher spending share of GDP,** and only 36% will be due to a lower tax share of GDP.

When I teach macroeconomics to the graduate students, one of the things I teach is Alberto Alesina and Guido Tabellini (1990), which builds models in which political parties produce budget deficits as part of a high-stakes and extremely dangerous game of "chicken" they play with each other. In his models, a right-of-center government that seeks a smaller government cuts taxes in order to leave a successor liberal government with a choice between drastically pruning back the size of the government or an Argentina-style budgetary and economic disaster. A left- of-center government, by contrast, that seeks a larger government share raises spending in order to leave a successor conservative government with a choice between drastically pruning back the size of the government or an Argentina-style budgetary and economic disaster. (Alberto's models do not work too well when applied to the Clinton administration.)

But what do you make of a government that calls itself right-of-center, and that both cuts taxes and raises spending as shares of GDP--and that raises spending by significantly more?*** In one's mind's eye, one sees Alberto Alesina dressed in a soccer referee's uniform running out onto the field and telling the Bush administration team, "No! No! You don't understand! You're trying to keep the ball out of that goal!!" "Starve the beast?" In a pig's eye.

*Defining "current policies" to include extension of expiring tax provisions, the Medicare drug benefit, AMT reform, and discretionary spending growth at the rate of growth of nominal GDP. **Democrats should not cheer. 8 of those 64 percentage points are higher debt service--not higher programmatic spending. Only 56 of those percentage points are higher programmatic spending. And a lot of that programmatic spending--pork for Republican interest groups with weak claims--has a very low social value. ***And it's not that the budget is being driven by defense spending. Defense spending rises by only 0.4% of GDP from 2001 to 2009 on Bush administration policies.

321

Reference: Alberto Alesina and Guido Tabellini (1990), "A Positive Theory of Fiscal Deficits and Government Debt," Review of Economic Studies 57 (July), pp. 403-14. Posted by DeLong at November 29, 2003 04:33 PM http://www.j-bradford-delong.net/movable_type/2003_archives/002821.html

322 ANNEX.- nº 69

BACKGROUND PAPERS

23. What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules, Lars E. O. Svensson (2003), Journal of Economic Literature Vol. 41 Nº 2, Junio, pp. 426-477 (52 pp.).

24. OCDE press conference in Davos, by Jean Phillipe Cotis (8 pp.) http://www.oecd.org/dataoecd/8/48/25125880.pdf 25. Sustained Budget Deficits: Longer-Run U.S. Economic Performance and the Risk of Financial and Fiscal Disarray Robert E. Rubin, Peter R. Orszag, and Allen Sinai, Paper presented at the AEA-NAEFA Joint Session, Allied Social Science Associations Annual Meetings, The Andrew Brimmer Policy Forum, “National Economic and Financial Policies for Growth and Stability,” January 4, 2004, San Diego, CA. (20 pp.) http://www.brook.edu/dybdocroot/views/papers/orszag/20040105.pdf

26. ¿Firmaría Laffer la próxima rebaja del IRPF?, por Carlos Cuesta, Expansión, 10-II-2004 (2 pp.) 27. Understanding the Effects of Government Spending on Consumption”, by Jordi Galí, J.David López-Salido & Javier Vallés en Second Conference: International Research Forum on Monetary Policy, Federal Reserve Board of Governors, Washington D.C., 14-15 Noviembre 20030 (39 pp.) http://www.ecb.int/events/conf/intforum/material/Galietal.pdf 28. Economic reform in Europe, by J.C. Trichet, Enterprise Conference London, (26-I-2004) (5 pp.) http://www.hm- treasury.gov.uk/media//78FFD/Advancing_Enterprise_Trichet.pdf

323 29. When Leaner Isn’t Meaner: Measuring Benefits and Spillovers of Greater Competition in Europe, by Tamim Bayoumi, Douglas Laxton &Paolo Pesenti , in Second Conference: International Research Forum on Monetary Policy, Federal Reserve Board of Governors, Washington D.C., 14-15 Noviembre 2003 (56 pp.)

http://www.ecb.int/events/conf/intHTU forum/material/Bayoumietal.pdf UTH 30. Hard and soft economic policy coordination under EMU: problems, paradoxes and prospects, by Iain Begg, Center for European Studies Working Paper Series nº 103 (13 pp.)

http://www.ces.fas.harvard.edu/woHTU rking_papers/BeggHardEMU.pdf UTH

31. The Stability and Growth Pact in need of reform, by Paul De Grauwe, CEPS 2003 (9 pp.)

http://www.econ.kuleuven.ac.be/ew/HTU academic/intecon/Degrauwe/PDG- papers/2003%2001%20Stability%20and%20Growth%20Pact%20CEPS%2020

03.pdf UTH

32. ¿Cómo reconstituir el Pacto de estabilidad?, por Carlos Mulas-Granados en Expansión, 10-II-2004 (1 p).

324