Global Economic Prospects: Bright for 2004
but with Questions Thereafter
Michael Mussa
Institute for International Economics
April 1, 2004
iie.com
Excerpt:
The very low level of policy interest rates is an imbalance (relative to normal conditions) that reflects exceptionally easy monetary policies to combat economic weakness. This policy imbalance poses an important challenge for the future conduct of monetary policy. Situations of low policy interest rates and low inflation tend to be associated with unusual inertia in the processes of general price inflation, which makes traditional indicators of rising inflationary pressures less reliable as measures of the need to begin to tighten monetary conditions. Also, these situations tend to be associated with high valuations of equities, real estate, and long-term bonds, which can become fertile ground for large, unsustainable increases in asset prices. In this situation, if monetary policy is tightened too much too soon (perhaps because of worries about unsustainable increases in asset prices), the result can be an unnecessary asset market crunch and economic slowdown, and monetary policy may have relatively little room to ease in order to counteract this outcome.
On the other hand, if monetary policy remains too easy for too long (perhaps because subdued general price inflation gives no clear signal of the need for monetary tightening), then large asset price anomalies may develop before corrective action is taken.
ME: I think we are already have "large asset price anomalies".
The monetary authority would then confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing.
ME: Yep, we might be stuck.
A further concern related to the general monetary policy imbalance in the industrial countries is its effect on emerging market economies. Interest rate spreads for emerging market borrowers have contracted substantially and flows of new credit have increased. The boom in emerging market credit has not yet reached the frenzy of the first half of 1997, but it is headed in that direction. Another major series of emerging market financial crises (such as 1997-99) does not seem likely in the near term in view of the very low level of industrial country interest rates and the favorable global economic environment for emerging market countries. By 2005 or 2006, however, either upward movements in industrial country interest rates or deterioration of market perceptions of the economic and financial stability of some emerging market countries could trigger another round of crises.
Another important policy imbalance of global significance is the medium- and long-term fiscal imbalance of most industrial countries. Ratios of government debt to GDP are high in several countries, most notably Japan and Italy. Fiscal deficits are large in Japan and the United States and above the desired ceiling of 3 percent of GDP in Germany and France. Most important, industrial countries generally face enormous fiscal challenges from financing social benefits for aging populations that will materialize during the next two to three decades. These problems imply that, even in the near term, expansionary fiscal policy cannot prudently be used as a significant means for stimulating more rapid growth of aggregate demand in the industrial countries. To the extent that such stimulus may be needed, monetary policy is the prudent tool. But, as just noted, monetary policy does not at present have much remaining capacity to play this role and may not regain this capacity any time soon.
ME: Mussa nails one of my main concerns: If we get in trouble, we have no fiscal flexibility (because of the massive Bush deficits) and we have no monetary flexibility. |
