THE G-7, the rich man's club of developed nations, stands divided over the policies needed to stall the deceleration in growth of the world economy. While there is not much disagreement over whether the United States and the rest of the world is likely to experience a significant economic slowdown, opinions differ on whether the observed slack in the system is a temporary correction and whether interest rate cuts are the best way to redress the problem.
The source of the near-consensus on the direction in which the world economy is headed is clear. The U.S. economy, which is seen as having served as the locomotive of global growth through the 1990s, has been experiencing a sharp deceleration since the second half of 2000, after almost a decade of buoyancy. Profit warnings from New Economy firms and lay-off announcements from most-favoured corporates like Cisco Systems are now signalling a sharp fall in corporate investments in information technologyhardware that had sustained the earlier U.S. boom. Claims for unemployment insurance climbed during the last week of April to their highest level in five years, suggesting that the U.S. economy is weakening enough to affect adversely jobs and workers. The Labour Department reported at the beginning of May that the number of workers filing new claims for joblessness benefits rose to a seasonally adjusted 421,000 for the work week ending April 28, an increase of 9,000 from the previous week. This is compounded by fears that the U.S. stock market downturn would adversely affect consumer confidence and consumer purchases that account for a dominant share of domestic demand.
The U.S. Federal Reserve itself sees "the possible effects of earlier reductions in equity wealth on consumption" as an element that "threatens to keep the pace of economic activity unacceptably weak". Putting these together, the prognosis is one of a near-term downturn in the U.S., which is expected to affect growth prospects elsewhere as well, threatening a worldwide slowdown.
Views such as these have pervaded national and global watch-dog organisations like the Federal Reserve and the International Monetary Fund (IMF). In late April the Fed announced an unscheduled interest rate cut. The fourth such cut since the beginning of the year, it brought the Federal Funds rate and the discount rate down by 2 percentage points. Clearly, sensing that "the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future," the Federal Reserve, led by a pro-active Alan Greenspan, had decided to trigger a revival. In its view, an interest rate cut effected by reducing investment costs for the corporate sector and encouraging durable purchases and housing investments by consumers, would stall and reverse the downslide.
PESSIMISM pervades the IMF's World Economic Outlook as well, released in April in time for the spring meetings of the IMF and the World Bank. To quote the Outlook: "Since the publication of the October 2000 World Economic Outlook, the prospects for global growth have weakened significantly, led by a marked slowdown in the United States, a stalling recovery in Japan, and moderating growth in Europe and in a number of emerging market countries. Some slowdown from the rapid rates of global growth of late 1999 and early 2000 was both desirable and expected, especially in those countries most advanced in the cycle, but the downturn is proving to be steeper than earlier thought." In the event, the IMF projections for global growth in 2001 have been marked down from 4.2 to 3.2 per cent, with region- or country-wise reductions varying "depending in part on the closeness of linkages with the U.S."
While this perception dominated discussion at the spring meetings, the pessimists were in for a surprise. For, in the midst of the proceedings, U.S. growth figures for the first quarter of 2001, released on April 27, indicated a relatively strong annualised growth rate of 2 per cent, as compared to 1 per cent in the previous quarter, pointing to sustained consumer confidence. While some people were quick to attribute this performance to the Fed's consistent effort to trigger a revival with interest rates cuts, others argued that it suggested that the slow growth during the second half of 2000 was a mere correction, and that those predicting a sharp downturn were mere alarmists.
As it stands, the pessimists seem to have the edge in the debate, given the profit warnings and layoff announcements coming in quick succession from the cream of corporate America. As the effects of reduced profits and rising unemployment, the latter currently put at 4.3 per cent, begin to sap business and consumer confidence, growth would definitely slow, argue the Fed's backers, making the agency's latest interest rate cut a warranted measure.
It is here that the debate spills over into the realm of policy. The Federal Reserve and the IMF are obviously in agreement that monetary policy in the form of interest rate reduction remain the preferred response to cyclical downturns, backed if necessary by tax cuts. The World Economic Outlook declares that "given the shift in the balance of inflationary risks, a moderate cut in interest rates is now appropriate with a larger one being in order if the exchange rate were to appreciate sharply or indications of the impact of the global slowdown were to mount."
BUT, in an increasingly integrated global environment interest rate reductions have major implications for capital flows and exchange rates. Higher interest rates in the U.S. have in the past helped the U.S. suck capital out of the rest of the world economy both to finance its record trade and current account deficits and keep the stock markets buoyant. Buoyant stock markets were, given the high share of direct and indirect investments in stocks in the portfolio of U.S. household savings, also crucial determinants of consumer confidence.
With the stock indices falling and interest rates being cut to stall the downturn, a flight from dollar-denominated assets is a real possibility, unless other nations, especially those in the European Union, are also willing to reduce interest rates. Unfortunately for the U.S., the European Central Bank (ECB) has refused to oblige thus far. In the view of its chief, Wim Duisenberg, it is inflation, not growth, that should be the concern of a good central bank Governor. Cutting interest rates could work against the realisation of the more fundamental goal of inflation control.
This reticence to follow the leader has set off an attack against the ECB, led by Paul O'Neill, the U.S. Treasury Secretary, who has argued that given the fact of interdependence in today's world, Europe cannot live under the illusion that it can continue to grow when the U.S. economy is slowing. He has been joined by some Bretton Woods functionaries in Washington and a number of Finance Ministers. The outgoing Chief Economist of the IMF, Michael Mussa, obviously fronting for Managing Director Horst Kohler, declared: "It is time for the ECB to become part of the solution, not part of the problem, of slowing global growth." And Canadian Finance Minister Paul Martin called on the ECB to cut rates when he argued: "Given the downside risks to the global economy, an easing in rates would prove quite helpful in the near term. Moreover... waiting too long to ease could prove costly."
This has created problems for European advocates of a cut in interest rates, who resent U.S. interference in their policy affairs. French Finance Minister Laurent Fabius had in his address to the spring meetings argued that the effort to keep budgetary deficits in control should not be adversely affected by a growth slowdown. Declaring that "vigilance will remain the order of the day in Europe" and that there is a "distinct feeling over the last weeks that the balance of risks has altered", he said that "our monetary stance will have to take account of these elements." But his response to the U.S. remarks was clear. "If I were being polemical, which I am not, I would say with a large smile on my face it is not for an official from a country where growth is only 1 per cent to tell an official from a country whose growth is 3 per cent what to do," he told reporters.
GIVEN these divisions and the fear that a public airing of differences within the G-7 could adversely affect economic sentiment, the G-7 meeting chose not to comment on the appropriateness of an interest rate reduction. As a result, Duisenberg seems to have emerged unscathed from the attack. He claimed after the meeting that the G-7 had accepted his explanation of why the bank had not cut interest rates. "Perhaps we were not clear enough in our explanation," he said. "Now it is more widely understood that with inflation above the central goal, a move in interest rates in that context would not enhance the credibility of the ECB." Underlying this stubbornness must be the belief that European growth is not hitched to growth in the U.S., just as U.S. growth over the last decade was not affected by the recession in Japan and slow or moderate growth in Europe.
This leaves the efficacy of the Federal Reserve's policy of cutting interest rates unclear. To start with, while reduced interest rates may encourage individual consumer spending on durables and housing, this effect may be neutralised by the adverse impact of rising unemployment on such spending. The problem is that interest rate cuts may not be as effective in spurring investment, which is currently being curtailed by limited demand relative to capacities created in the recent past. So long as investment does not recover, especially investment in information technology, the problem of rising employment would persist.
Secondly, to the extent that lower interest rates in the U.S. affect the flow of capital into the U.S., financial markets may slump further, affecting consumer and business confidence adversely, and the dollar could depreciate, threatening inflation. Greenspan may, in the wake of his interest rate cuts, be left with higher inflation and slower growth, even if his view that U.S. growth does matter for an export-dependent European Union is vindicated. That may be the price to pay for following Keynesian-style counter-cyclical policies in a globalised world dominated by financial flows.
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