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Monetary policy: Global growth challenges

V. Anantha-Nageswaran.

Japan, that boldly charted its path to prosperity in the aftermath of the Second World War, struggles to accept reality that its economy is still in precarious health. `Denial' is hard to resist and, hence, hard to overcome. India's policy-makers suffer from a similar malaise. Until we get over this mental hurdle, appropriate policy measures would not appear until circumstances thrust them on us.

INDIAN newspapers have had a field day reporting on the stalled US Presidential election process. Some talked of dispatching suitcases and others of sending Bihar's (why only of Bihar?) politicians to resolve the stalemate. It is strange that the constitution of what is arguably the world's most advanced democracy does not provide for a simple repoll in such controversial circumstances. However, the logical response, under the circumstances, is for both candidates to concede victo ry to the other rather than slug it out. With such a close result, all that the winning candidate gets is a free four-year accommodation and little else. There is no mandate to carry out any agenda. Political bargaining and lobbying would dominate and policy shifts would be difficult if not impossible to achieve.

Adding to Wall Street woes

Amidst this totally unexpected political uncertainty, Wall Street has clearly lost its marbles as it treats each forecast of slowing revenue and bottomline growth as the arrival of the doomsday. Just as investors lost their head on the way up, they are l eaving it behind on the way down. What this means for the seemingly impenetrable confidence of the American consumer is anybody's guess. Opinion is divided. Some argue that even if the wealth effect of the stock market travails this year were modest in r elation to the gains realised in the last six years, the sentiment effect would be considerable. Others opine that as long as there are jobs to be had and there is steady income growth, consumers would not lose heart. There is some precedence here. The m eltdown we had in 1998 in the wake of the Asian crisis, the default by Russia and the collapse of a hedge fund in the US, did little to shake American households as rock-bottom interest rates threw them a lifeline. Mortgage refinancing soared, putting su rplus money in consumer pockets and, thus, offset the wealth losses from the stock market. The economy hardly paused for breath as the expansion continued.

Living on borrowed times literally

If consumers do not pull back, then the question is how long could the American balance of payments hold out? It is true that Americans are borrowing in their own currency but, surely, the stock market correction and slower profit growth ahead should all ow the scales to drop from the glazed eyes of domestic and foreign investor alike? If foreigners stop piling on to American assets, something has to give. Either policy-makers shed their obsession with wiping away the national public debt or else, the US private sector should start to save. Private sector includes not just the households but corporations too. The corporate sector has leveraged itself quite substantially throughout the last decade.

Distinguished academician Wynne Godley (Professor Emeritus of applied economics at Cambridge University and a fellow of King's College), in a simple paper (Policy Notes 2000/6, Drowning in Debt, Jerome Levy Economics Institute) shows that if the US gover nment budget surplus projections for the next 10 years were to occur, it would involve continued deterioration of the private sector balance-sheet which is not only unprecedented in the US but anywhere in the world. Of course, this could be mitigated by a sudden export boom from the US to the rest of the world. How realistic is this, given that the US is a large closed economy in which export growth has never played such a dominant role? Moreover, global economic growth prospects remain too uncertain to allow a strong US export recovery in the face of a strong dollar.

How long before it stops?

The argument that the US household networth had risen far in excess of the rise in household debt does not convince him. If the US private sector sells equities to realise capital gains, it has to be to foreigners as, otherwise, there is no net accretion to capital gains. No economy, even something as formidable as the US, can afford to tie its fortunes to the continued wide-eyed admiration of foreigners. There are indications that their appetite just might have begun to wane.

In the second quarter of this year, foreign purchases of US long-term securities slowed compared to the first quarter (see table). It is interesting to note that Europeans have been the most enthusiastic buyers of US securities (debt and equity both thro ugh portfolio investment and swaps) and, therefore, it is not much of a surprise that, given such a massive portfolio shift, the euro weakened against the dollar.

Projected fiscal surpluses could be in jeopardy

Therefore, to avoid a serious collapse of the dollar when foreign investor interest cools, the US private sector net deficit has to reverse and/or the projected public sector surpluses in the coming years have to be given up in favour of deficits. Viewed in this light, the proposed fiscal policy stance of either Mr George Bush Jr or Mr Al Gore could be termed appropriate. However, it would have been better if they were an outcome of sound analysis and presented as a buffer to be used in the event of a r eturn to prudence in the private sector. That was not the case. Further, Mr Bush's proposals for the social security rely entirely on the private sector for today's young workers even as it actually takes away the funds available for relatively near-term retirees.

The shortfall would then devolve on the government anyway. So, even if the candidates had a fiscal policy plan that might have been coincidentally appropriate for the scenario described above, it was not presented to the public appropriately and not all the implications were taken into account. Indians can take comfort from the quality of political debate that punctuated the US presidential election campaign.

It is a complex situation and history does not provide any encouragement to the notion that the current situation would change gradually so as not to plunge the economy into a recession. Prof Godley puts it somewhat ominously: ``While I believe continued prosperity in the United States to be at grave risk without a major change in fiscal and exchange rate policy at some stage, I would be a fool to try to put a date on the turning point. I simply do not know when it will come.''

Can Europe and Japan pick up the baton?

In a situation like this, it would come as a tremendous relief to the rest of the world if Europe and Japan were ready to shoulder the growth burden should the US expansion go into reverse gear. Unfortunately, even three years after the Asian crisis, rec overy from which was greatly aided by the monetary policy easing undertaken by the US, the European Central Bank (ECB) and the Bank of Japan (BoJ) do not appear to view growth as an outcome to be desired. Even if somewhat harsh, financial markets judge t hat both these central banks view growth as something to be bottled up sooner rather than later.

The ECB raised its repo rate even as late as October when global stock markets had already appeared shaky and business confidence in most European economies had taken a turn for the worse. Still, Europe is somewhat better off than Japan. The ECB might ho ld back from further rate actions and the weak euro could aid the recovery of business confidence. Domestic demand recovery might continue on the back of falling unemployment rates and low interest rates.

Japan is a greater worry. The BoJ, since abandoning its zero rate policy, has been putting a brave face on the negative signals emanating from the Japanese economy. In a new development, BoJ board members began quantifying their assessment for economic g rowth and price developments. This is to be done twice a year in April and October. The majority of members expected the consumer price index to drop between one-tenth and four-tenth of one per cent this year. Separately, the government-affiliated Econom ic Planning Agency revised down its GDP growth estimate at current prices for the financial year ending March 2001, from 0.8 per cent to 0.4 per cent. In contrast, real GDP was ``revised up'' to 1.5 per cent from 1.0 per cent before suggesting that defla tion is more entrenched than before. This is not the only problem.

The Nikkei and other broader stock indices refuse to come out of their stupor and stay at depressed levels since the air was let out of the market in the middle of last year. Surely, this must hurt bank balance-sheets further and set back their restructu ring since most of them hold corporate equities. Many now expect the Tankan survey of business conditions to be released in December to reverse some of the recent gains in optimism.

BoJ in ``denial'' mode...

The BoJ is putting on a brave front amidst such renewed gloom. It attributes its own deflation forecast to positive structural supply side restructuring in the economy. That is a bold assertion since there has been no news of major corporate or governmen t reforms for the last several quarters. Even in the US, where such changes could reasonably be considered more advanced than in Japan, many feel that the consumer price index could be overstating inflation as the main component of the CPI (40 per cent) -- owners' equivalent rent -- is statistically imputed by the Bureau of Labour. That naturally leads to distortions.

Prof Randall Wray writes provocatively (Why does the Fed want slower growth, Policy Notes 2000/7, Jerome Levy Institute) that CPI and other measures of inflation are constructed indexes that are not designed to capture ``market pressures'' to which a cen tral bank ought to react. Hence, changes in the CPI that are below four-five per cent should probably be ignored -- maybe not even reported -- because the noise-to-signal ratio is too high to allow for a satisfactory interpretation. The lower the measured inflation rate, the greater the uncertainty regarding its meaning. A zero inflation target should be dismissed out of hand merely for those reasons.''

If this is the recommendation for the US, it must be truer in the case of Japan that deflation is deeper than what official statistics reveal. The problem with Japan's policy-makers is not want of competence but want of will (shades of India). The countr y that boldly charted its path to prosperity in the aftermath of the Second World War, struggles to accept reality that its economy is still in precarious health. `Denial' is hard to resist and, hence, hard to overcome. The BoJ has to first acknowledge t hat its removal of the zero interest rate policy was premature and then go on to conduct an easier monetary policy with a view to eliminating deflation. This would call for the expansion of monetary base and a weaker yen. One hopes the US would not objec t to such an approach on the part of Japan. That is where the hope for a sustained economic recovery in Japan lies.

...as is the case in India

India's policy-makers suffer from a similar malaise. They not only publicly (but worse, privately too) deny the existence of a problem but also misidentify its symptoms. For instance, the Finance Minister, Mr Yashwant Sinha, first denied that there was a ny economic slowdown and then chose to blame external factors for it. He did not admit that his Budget robbed much of the dynamism that threatened to break out over the Indian corporate horizon and that the subsequent lack of substantive action on privat isation doused foreign investor interest in India. Until we get over this mental hurdle, appropriate policy measures would not appear until circumstances thrust them on us and unfortunately, not until after they have* lost much of their efficacy.

If the global economy were to avoid a debilitating stagnation, developing economies have to hope that monetary policy-makers in the three major economic blocs recognise the challenges ahead soon enough.

(The author is the regional head of Investment Consulting in Credit Suisse, Asia-Pacific. He writes here in his personal capacity. Feedback may be sent to nageswar@singnet.com.sg)