Today's date:
Fall 2003


A Two-Cylinder Global Recovery?

Sebastian Edwards is a professor at University of California Los Angeles' Anderson Graduate School of Management. Between 1993 and 1996 he was the chief economist for Latin America at the World Bank.

Los Angeles -- Recently the National Bureau of Economic Research, the think tank that dates US business cycles, officially declared that the US recession had ended. This is the good news. The bad news is that the US economic recovery continues to be weak: At 6.4 percent, unemployment is at its highest in more than a decade, consumers' confidence is low, and net corporate investment in machine and equipment continues to be negative. During the first half of the year annualized GDP growth in the United States was an unimpressive 1.9 percent.

Economic conditions in the rest of the world don't look much better. The euro zone continues to struggle with sluggish growth and stubbornly high unemployment, and Japan is repeating its past performance of stagnation and banking crises. In Latin America the market-oriented reforms launched with great enthusiasm during the 1990s are under attack, and the economy is barely growing. And much of Africa is paralyzed by disease and political crises. Only emerging Asia -- including China and India -- has posted vigorous growth during the first half of the year.

It is fair to say that the world economy is going through a weak, two-cylinder recovery. The key question going forward is if this fragile global recovery will sputter, with the world falling once again into recession, or if the upturn will gather momentum, with additional "cylinders" adding their efforts to the engine of global growth.

New developments from around the world provide some basis for being cautiously optimistic. Recent data suggest that corporate investment retrenchment in the US has come to an end, and that productivity growth continues to be very high. The recent Bush administration tax cut -- which will add almost $200 billion to consumers' disposable income -- will stimulate expenditure, and exports have benefited from a weaker dollar. Moreover, Chairman Alan Greenspan has stated that the Federal Reserve System is ready to reduce interest rates further and to pump liquidity into the economy if needed. In Europe, Chancellor Gerhard Schroeder is finally making progress in his efforts to reform and modernize the German economy, and in spite of heavy resistance by the unions France is also moving toward modernization.

Contrary to what some had feared, the SARS epidemic has not had a major effect on economic performance in emerging Asia, and there are some signs that the large Latin American countries -- Argentina, Brazil and Mexico -- are turning the corner and that growth is picking up.

There are, however, some clouds in the horizon. The most important one is the resurgence of the "twin deficits" in the US. According to forecasts the US will run extremely large fiscal and trade deficits in 2003 and 2004. Indeed, recent figures suggest that these may reach almost $1 trillion in each year! These huge imbalances are being financed through massive sales of Treasury securities to foreign governments, especially Asian. It has been reported that China and Hong Kong alone will finance more than one-third of the US twin deficits.

If, for whatever reason, foreign governments decide to scale down their purchases of US government securities, there will be major global dislocations. First, interest rates on US government bonds will rise sharply. This will result in an increase in the cost of capital to firms and governments from around the globe. Indeed, some analysts have argued that this process has already begun, as interest rates on 10-year US Treasury bonds have increased by more than 1 full percentage point in a short period of time. Second, a sudden slowdown in foreign governments' willingness to finance the US twin deficits would result in a further and very rapid depreciation of the dollar.

But the twin deficits are not the only problem looming in the horizon. The housing market bubble in several advanced countries -- mostly in the United Kingdom and in the US -- is also a clear and present danger to the global recovery. If, as many have predicted, housing prices -- which have risen at double-digit rates in the last few years in these countries -- collapse, consumers' confidence would be severely hit and expenditure will be seriously affected. With lower expenditures come lower sales and an increase in unemployment.

In this time of global economic fragility the major central banks from around the globe should be particularly vigilant and ready to intervene to calm the markets. Moreover, fiscal authorities should be prudent and take a longer run view that emphasizes solvency and prudence. So far central bankers have done their part. Let's hope that politicians stand up to the challenge and are able to curb their fiscal appetites.