Yesterday morning I testified to a Joint Economic Committee of Congress hearing. The session discussed the latest GDP numbers, the impact of the fiscal stimulus earlier this year, and whether we need further fiscal expansion of any kind.
I argued that a global recovery is underway and in the rest of the world will likely be stronger than the current official or private consensus forecast, but it remains fragile in the United States because of problems in our financial sector. While our situation today is quite different in key regards from that of Japan in the 1990s, the Japanese experience strongly suggests that fiscal stimulus is not an effective substitute for confronting financial sector problems (e.g., lack of capital, distorted incentives, skewed power structure) head on.
We are well into the adjustment process needed to bring us back to living within our means. Although such a process always involves an initial fall in real incomes, as the real exchange depreciates, growth can resume. The idea that we necessarily are in a "new normal" scenario with lower productivity growth seems far fetched, but continuing failure to deal effectively with the "too big to fail" banking syndrome delays and distorts our adjustment process – it also makes us horribly vulnerable to further collapses.
The fiscal stimulus enacted in early 2009 had a major positive impact, particularly as it was coordinated with other industrial countries – this prevented the global recession from being even deeper (disclosure: I testified to the need for a major fiscal stimulus in October 2008). But a further broad stimulus at this time is not warranted and high profile measures, such as the first-time home buyers tax credit, should be phased out. We should extend unemployment insurance and focus our future efforts on improving the skills of people with less education, e.g., through strengthening community colleges.
Like all industrialized countries, we also need to look ahead to "fiscal consolidation" in order to stabilize our debt-GDP levels (and pay for the rising cost of Medicare). The large contingent government liabilities implied by the existence – and potential collapse – of big banks are a major risk to medium-term outcomes.
My written testimony (with some small updates indicated) is below. This is now our revised baseline scenario view.
Main Points
1. The world economy is experiencing a modest recovery after near financial collapse this spring. The strength of the recovery varies sharply around the world:
a. In Asia, real GDP growth is returning quickly to pre-crisis levels, and while there may be some permanent GDP loss, the real economy appears to be clearly back on track. For next year consensus forecasts have China growing at 9.1% and India growing at 8.0%; the latest data from China suggest that these forecasts may soon be revised upwards.
b. Latin America is also recovering strongly. Brazil should grow by 4.5% in 2010, roughly matching its pre-crisis trend. We can expect other countries in Latin America to recover quickly also.
c. The global laggards are Europe and the United States. The latest consensus forecasts are for Europe to grow by 1.1% and Japan by 1.0% in 2010, while the United Sates is expected to grow by 2.4% (and the latest revisions to forecasts continue to be in an upward direction). Unemployment in the US is expected to stay high, around 10%, into 2011. (Update: the latest quarterly GDP data do not make us want to revise this view)
2. The current IMF global growth forecast of around 3 percent is probably on the low side, with considerably more upside possible in emerging markets (accounting nearly half of world GDP). The consensus forecasts for the US are also probably somewhat on the low side.
3. As the world recovers, asset markets are also turning buoyant. Recently, residential real estate in elite neighborhoods of Hong Kong has sold at $8,000 US per square foot. A 2,500 square foot apartment now costs $20 million. Real estate markets are also showing signs of bubbly behavior in Singapore, China, Brazil, and India.
4. There is increasing discussion of a "carry trade" from cheap funding in the United States towards higher return risky assets in emerging markets. This financial dynamic is likely to underpin continued US dollar weakness.
5. One wild card is the Chinese exchange rate, which remains effectively pegged to the US dollar. As the dollar depreciates, China is becoming more competitive on the trade side and it is also attracting further capital inflows. Despite the fact that the Chinese current account surplus is now down to around 6 percent, China seems likely to accumulate around $3 trillion in foreign exchange reserves by mid-2010.
6. Commodity markets have also done well. Crude oil prices are now twice their March lows (despite continued spare capacity, according to all estimates), copper is up 129%, and nickel is up 103%. There is no doubt that the return to global growth, at least outside North America and Europe, is already proving to have a profound impact on commodity markets.
7. Core inflation, as measured by the Federal Reserve, is unlikely to reach (or be near to) 2% in the near future. However, headline inflation may rise due to the increase in commodity prices and fall in the value of the dollar; this reduces consumers' purchasing power.
8. This nascent recovery is partly a bounce back from the near total financial collapse which we experienced in the Winter/Spring of 2008-09. The key components of this success are three policies.
- First, global coordinated monetary stimulus, in which the Federal Reserve has shown leadership by keeping interest rates near all time lows. Of central banks in industrialized countries, only Australia has begun to tighten. (Update: and Norway, obviously affected by rising oil prices)
- Second, global coordinated fiscal policy, including a budget deficit in the US that is projected to be 10% of GDP or above both this year and next year. In this context, the Recovery Act played an important role both in supported spending in the US economy and in encouraging other countries to loosen fiscal policy (as was affirmed at the G20 summit in London, on April 2nd, 2009).
- Third, after some U-turns, by early 2009 there was largely unconditional support for major financial institutions, particularly as demonstrated by the implementation and interpretation of the bank "stress tests" earlier this year.
9. However, the same policies that have helped the economy avoid a major depression also create serious risks – in the sense of generating even larger financial crises in the future.
10. A great deal has been made of the potential comparison with Japan in the early 1990s, with some people arguing that Japan's experience suggests we should pursue further fiscal stimulus at this time. This reasoning is flawed.
11. We should keep in mind that repeated fiscal stimulus and a decade of easy monetary policy did not lead Japan back to its previous growth rates. Japanese outcomes should caution against unlimited increases in our public debt.
12. Perhaps the best analysis regarding the impact of fiscal policy on recessions was done by the IMF. In their retrospective study of financial crises across countries, they found that nations with "aggressive fiscal stimulus" policies tended to get out of recessions 2 quarters earlier than those without aggressive policies. This is a striking conclusion – should we (or anyone) really increase our deficit further and build up more debt (domestic and foreign) in order to avoid 2 extra quarters of contraction?
13. A further large fiscal stimulus, with a view to generally boosting the economy, is therefore not currently appropriate. However, it makes sense to further extend support for unemployment insurance and for healthcare coverage for those who were laid off – people are unemployed not because they don't want to work, but because there are far more job applicants than vacancies.
