The medium-term outlook for the world economy - transcript

The economic recovery in the OECD [Organization for Economic Cooperation and Development] is now completing its second year, with inflation still well down, and appears likely to continue in 1985. The international financial system seems to have weathered the worst of the debt crisis. Yet there are still blemishes on the economic scene. Serious concerns have been expressed that the recovery is not solidly based and that we have only papered over our most serious economic problems, particularly including the international debt situation. Have we, in fact, found the key to noninflationary growth and lasting prosperity? Is the debt crisis well on its way to a solution? Or have we, on the contrary, built the recovery on weak foundations that areg, even now, crumbling beneath our feet? Let me try to put this question into a medium-term perspective.

The Prologue

As the decade of the 1980s began, the world economy was in a morass of stagflation. OECD countries, reeling from the impact of the second oil shock and suffering from undisciplined financial policies, were experiencing high rates of inflation, sluggish growth, and weak productivity performance. Profitability and incentives to undertake productive investments were weak. Interest rates were on their way to unprecedented levels. A good number of important developing countries were burdening themselves with unsustainable accumulations of debt.

In the 1980s the economic strategy of the OECD countries changed direction. While there were many differences in policies and timing, OECD countries generally adopted a broad strategy to reestablish financial stability and to lay the foundation for durable growth. Inflation was to be lowered, primarily through more disciplined monetary policies, and profitability restored, with an eye to a sustainable, investment-led recovery. In some countries, including the United States, there was to be more use of market forces to allocate resources efficiently.

The transition to noninflationary growth has been a bumpy one. Anti-inflationary monetary policies clashed with an inflation deeply entrenched in expectations and institutional arrangements. Interest rates shot up further, and recession hit, driving unemployment rates to the highest levels of the postwar era. Developing countries in heavy debt were caught in a squeeze between high interest rates and debt-servicing burdens on one hand, and shrinking markets for their exports on the other. Extraordinary financial arrangements had to be made for the hardest hit of these debtor countries while, at the same time, sharp and painful adjustments in their external accounts had to be accomplished.

But the strategy began to pay off in 1983. In the United States, inflation had come down from over 13% to less than 4%, and interest rates had fallen. A vigorous recovery began, pulling along the rest of the industrialized countries in its wake and offering great assistance to its wake and offering great assistance to the trade position of debtor countries. U.S. growth in 1984, compared with 1983, will be almost 7%. OECD growth, excluding the United States, was only 1.8% in 1983 but should register close to 3.5% this year. Inflation in the OECD area, which had averaged around 13% in 1980, has now fallen to about 5%, and intercountry differences have narrowed. Some of this decline reflects weakness in oil prices and non-oil commodity prices, but there is also considerable encouraging evidence of more wage moderation than one would have expected, even given high levels of unemployment. Corporate profitability has recovered sharply, easing liquidity and cash-flow strains. And in a number of important countries--especially in the United States but also in Japan, the United Kingdom, and Germany--fixed investment has been (or is now) recovering well, even though real interest rates have remained high. With inflation showing no signs of accelerating (and, indeed, still diminishing in some countries) and with the U.S. expansion easing off to more sustainable rates, most forecasters are predicting continued widespread growth in 1985.

Finally, with the help of the OECD recovery, active international financial cooperation, and strenuous adjustment efforts on the part of some key debtor countries, the financial situation of most debtor countries is improving--and improving dramatically in some cases. Thus, the OECD strategy for growth and the international strategy for dealing with the debt crisis appear to be succeeding. Why, then, is there so much concern?

The answer is that three principal problem areas cloud the medium-term outlook: the imbalance in OECD growth; continued strains and risks for debtor LDCs [less developed countries]; and protectionist pressures which threaten the world trading system and the sustainability of the global recovery. These problems, all sharing a structural character, must be dealt with if we are to cap off our anti-inflation successes with a period of sustained growth.

Imbalances in the OECD Recovery

In the first 2 years of the recovery, the United States, accounting for about 40% of OECD GNP [gross national product], has accounted for about 70% of OECD growth in demand. For the year 1984 alone, real total domestic demand in the United States will probably be up by about 8.5%; of this amount, about 1-3/4 percentage points have gone into a widening external deficit on goods and services, which served to spread the recovery abroad. The growth in real domestic demand in Europe, on the other hand, will probably be less than 2% this year. Both Europe and Japan have depended heavily for their growth on the rapid expansion of export markets in North America and their improved competitive position due to the strong dollar.

This situation served to ignite the recovery, but it cannot continue to sustain it indefinitely. U.S. economic growth is now clearly slowing to a more sustainable pace. We are expecting growth of about 4% next year; some private forecasters put it somewhat lower. Prospects for the dollar are more problematical, but most forecasters expect some decline in its exchange value in 1985. Thus, other OECD countries will need to generate more of their own steam for their recovery in order to replace the more moderate forward thrust coming from demand generated in the United States. (We expect the U.S. current account balance to deteriorate much less from now on into 1985 than it has up until now during the recovery.) The sluggishness in internally generated European demand is, therefore, a reason to worry about the robustness of the OECD recovery. Moreover, it is also a cause of great concern that the recovery in Europe has not succeeded in making any dent in the high European

unemployment level.

To some extent, Europe's lagging recovery may reflect the fact that certain key countries lagged behind in their application of anti-inflation policies. But, a common perception from outside Europe (and shared by many Europeans) is that the problems of sluggish domestic demand and high European unemployment are now largely structural in nature, involving market rigidities that hinder significant private sector growth and job creation. These include, for example, disincentive effects of high marginal rates of taxation on labor and capital incomes, excessive job security arrangements that discourage labor mobility and make it risky to take on additional workers, and subsidies to declining industries that are paid by taxing away the profits of more competitive firms. High real wage rates may also have encouraged a labor-saving bias in investment. Structural rigidities become even more important when rapidly changing relative prices (e.g., for energy) and demand patterns (e.g., for steel) require major changes in resource allocation in response to market forces. I ask for your assessment of this diagnosis and of prospects for dealing with it.

I am aware that many European observers would add to this set of difficulties high real interest rates, which some of them would blame largely on high rates in the United States and, in turn, on high U.S. budget deficits.

We would argue that other factors (such as strong investment demand stimulated by tax incentives) are, at the least, more important explanations of U.S. interest rate levels and the strong dollar than is the U.S. budget deficit. Moreover, high European interest rates are probably still reflecting--as, indeed, they still are in the United States--market skepticism as to the permanency of the lowering of inflation. In sum, we believe that European factors are primarily responsible for European problems.

Nevertheless, I emphasize that we recognize that reducing our budget deficit is important not only for the sustainability of our own economic growth but for global economic health. The United States should not, certainly in the long run, be depending so heavily on importing foreign savings to finance domestic investment. Our level of net (private plus public) saving must be increased. The Administration will be making strenuous and inevitably painful efforts to accomplish this.

International Debt Prospects

Continued progress in the resolution of international debt problems is clearly vital to the sustainability of the global economic recovery. Early in the debt crisis it was widely thought that there was danger of imminent widespread default and financial collapse, so that radical measures were necessary; these voices have subsided. But now our successes in short-term financial arrangements and balance-of-payment adjustment have convinced a good many observers that, despite persisting problems in some key debtor countries, the problem is largely solved. Other commentators feel, however, that we have merely postponed the problem and that more radical solutions will eventually need to be found.

In my view, the truth is somewhere in between. I believe that our present case-by-case management of the problem has been sound, that real progress has been made, but that long-term resolution of the problem is still some ways off.

Two principal questions remain about our present success.

First, is our present success in reducing these payments deficits based on a draconian depression of activity and incomes that is not sustainable either socially or politically?

Second, is the present outlook viable only under the most favorable assumptions and vulnerable to new shocks, such as OECD recession or higher interest rates?

Let me lay a foundation for our understanding of these questions. The origins of the international debt crisis are usually described as a combination of events-overzealous lending by the banks and imprudent borrowing by debtor countries, both based on overoptimistic assumptions about the future, together with the combination of high interest rates and recession that accompanied the disinflationary process in the industrialized economics. The short-run solution is usually described in terms of rescheduling, filling financing gaps, and rapid current account adjustment. To understand the requirements for a lasting solution, however, I would like to discuss the problem from a somewhat different perspective--the requirements for the international capital-transfer process to work effectively, how it broke down for some countries, and how it can be restored.

I will take it as given that our ultimate goal is long-term growth and higher living standards for the peoples of the developing countries. We in the Western developed countries have an important economic and political stake in the achievement of this goal. An international flow of investment is one major contribution--not the only one, but an important one--that we can make to this process.

Simply stated, three elements are necessary for the international flow of investment to work effectively for the mutual benefit of capital exporting and importing countries.

First, the capital flow must be invested in such a way as to bring about, through higher output and income growth, the means whereby interest payments--or adequate return to foreign equity--can be met, leaving a net income gain for the capital-importing country.

Second, sufficient resources in the recipient country must be efficiently deployed to the external sector so as to generate the foreign exchange to meet debt service payments.

Third, this internal adjustment must be accompanied by a complementary adjustment in the trade patterns and economies of trading partners, again to permit the means for debt-service payments to be earned.

Two additional prescriptions should be added: equity investment should be encouraged to avoid sole reliance on debt finance with its less flexible debt-servicing needs; second, external capital must be used to supplement, not replace, domestic savings as a source of capital formation.

In fact, during the 1970s, the capital-transfer process worked very well in a considerable number of countries. In several capital-importing countries of the Far East, in particular, equity investment was welcomed, capital was wisely invested, economies were made open and responsive to international market forces, and resources were deployed efficiently to the external sector. The capital transfer process worked well. Even though the unfavorable external environment of the early 1980s, these countries continued their growth and today continue to enjoy access to financial markets.

In other countries the requirements of effective capital transfer were not so well observed, and the process worked less well. Protection of domestic industry and overvalued exchange rates drew resources away from the external sector. Inefficient state-owned enterprises and artificially controlled domestic prices hindered the efficient deployment of resources. Artifically controlled interest rates discouraged saving and encouraged capital flight. International direct investment was discouraged at the cost of access to technology, training, and marketing know-how. With less flexible and efficient economies, these countries were particularly hard hit by the adverse international developments of the early 1980s. They borrowed even more heavily rather than take the necessary adjustment measures. These became the debt-crisis countries.

There has been great progress in achieving adjustment of the unsustainable external payments positions of the major debtors. These gains have been made as the result of improving external markets, lower interest rates, and painful internal adjustment measures by debtor nations. The IMF [International Monetary Fund] shows the aggregate current account deficit of the "non-oil developing countries" (which strangely includes Mexico) falling from $108.5 billion in 1981 to $45 billion in 1984. The two largest debtor countries, Mexico and Brazil, according to recent estimates published by Morgan Guaranty, account for much of this improvement. Mexico has gone from a $12.5 billion deficit in 1981 to an estimated $3.9 billion surplus in 1984, while Brazil has trimmed its deficit from $11.7 billion to $2.3 billion. Morgan Guaranty's selection of 16 major debtor countries experienced a positive swing of $56.2 billion in their balance of goods and noninterest services only partly offset by an increase of $13.4 billion in interest payments. As a result, in 1984 these countries in the aggregate are estimated to be covering 79% of their external interest payments with a surplus on merchandise trade and noninterest services.

Banks, for their part, have been building up their capital and slowing growth of loans to LDCs so that loan-to-capital ratios have been reduced. The recently agreed medium-term restructuring of Mexican debt, with more favorable interest terms, is an appropriate reward to Mexican adjustment efforts and will ease planning problems that stemmed from the uncertainties that had accompanied the year-to-year approach. A similar multiyear agreement with Venezuela has also been reached in principle, and Brazil is expected to begin talks on a multiyear arrangement soon. All these agreements are designed so as to strengthen the role of the IMF in continued close monitoring of economic policies and performance.

There are, of course, countries with severe debt problems where adjustment actions have been far less impressive and where much more needs to be done. In several countries, efforts to adjust have been seriously hampered or frustrated by the inevitable political and social strains as the required measures threaten economic interests. In a few countries, adjustment has also been hampered by adverse export price movements, such as Chile's problems with copper prices or the effect on oil-exporting countries of recent weakness in the oil market. These countries need to do more to promote export diversification.

Moreover, even the success of countries like Mexico and Brazil would be illusory if the improvement in their external accounts resulted solely from cutting imports through quantitative restrictions and compression of demand. Such a means of adjustment would be neither efficient nor sustainable, socially or politically. It would not correct the fundamental failure of the capital transfer process. In fact, at first, most of the gains did come from import cutbacks accompanied by falling economic activity. Nearly all of the major Latin American debtor countries suffered declines in real GDP [gross domestic product] over 1982-83.

However, there is now increasing evidence of adjustment of a more fundamental kind. Some of the savings in imports reflect import substitution, as a result of changes in relative prices. With the revival of OECD demand, more of the gains have recently come on the export side. The IMF's adjustment programs--which are sometimes falsely characterized as enforcing austerity alone--are, in fact, largely focused on freeing up internal markets and achieving realistic relative prices and exchange rates, so an efficient capital-transfer process can resume. Positive growth is now reviving in most of the troubled debtor countries. Although real per capita incomes still remain below pre-crisis levels, the successfully adjusting countries can expect to achieve healthy growth in the coming years--so long as they continue their long-term adjustment policies.

It will take political courage and determination for necessary steps to be taken. But the choice is not between adjustment and no adjustment. It is between orderly adjustment now--cushioned whenever possible by external support--and the extreme, disorderly, and much more painful adjustments that will otherwise inevitably be forced by precipitous economic decline.

The second question on the debt issue involves the vulnerability of the optimistic adjustment scenario to adverse external developments. There can be no question that maintenance of OECD growth is vital for successful further adjustment to take place. So far, the United States has provided the principal source of growing markets for LDCs. For example, over two-thirds of the increase in non-OPEC LDC exports from the prerecovery period to 1984 went to the United States and almost 85% of the increase in Latin American exports.

As to the future, the scenario does not have to be unreasonably optimistic to generate enough export growth to allow quite satisfactory adjustment and growth in LDCs. For example, a Morgan Guaranty "base case" assumes slowing OECD growth to 3.3% next year, only 1.5% in 1986 (a small recession), and 2.5% thereafter. This is sufficient to allow Brazil, for example, to grow at a 5% rate while still continuing to reduce their current account deficit.

Slowing growth would also make itself felt in lower interest rates--as, indeed, is now occurring in the United States--which would be at least partly offsetting. Indeed, as the U.S. economy has been slowing to a more moderate rate of growth, interest rates have also subsided substantially. Our rough calculations indicate that the decline in interest rates just since their peaks of this last summer will save LDCs more than $10 billion in annual interest charges. In fact, for some countries with especially high debt-to-export ratios, the short-run interest rate relief associated with the slowdown will more than compensate for the trade effects of a growth slowdown limited in duration and extent. What we must not permit--and what we need not permit--are more apocalyptic scenarios involving higher interest rates and deep receission, which would gravely damage prospects for LDC adjustment even with good adjustment policies on their part.

The Threat of Protectionism

As you will recall, the third element I cited in a successful capital-transfer process must be adjustment on the part of the trading partners of those debtor countries seeking to earn enough abroad to service their external debt. This means, of course, that in addition to the gains in our own standards of living and efficiency, we have another reason--the health of the international financial system--to ward off protectionism. Developing countries have benefited greatly from expanding markets in the recovering OECD economies, particularly in the United States where markets have expanded rapidly and remained relatively open. Still, LDC exports have been impeded in a good number of cases by various sorts of restrictive trade policies adopted by OECD countries.

Unfortunately, several factors have worked against a freer trading system: the recession, uneven recovery, still high unemployment, and major movements in exchange rates have all contributed to protectionist pressures. Restrictive policies have increased in certain key manufacturing sectors--textiles, clothing, steel, and autos--as well as persisting strongly in agriculture and services. Subsidies have been used to ward off the effect of market forces on industrial structure. Such policies directly reduce living standards, worsen the threat of renewed inflation, and stifle growth. They are also a barrier in the path of a satisfactory resolution of the international debt problem. While recognizing the sometimes painful costs of adjusting to changing trade patterns, the medium- and long-term costs of not adjusting are far greater. We must work together to substitute "positive adjustment policies" for protectionism.

Conclusion

The world economy has come through a painful process of disinflation and is now reaping the benefits of renewed growth. Our accomplishments are real. They are based on sound policies which we must continue. But they must now be supplemented with increasing efforts in the structural area. The U.S. budget deficit must be reduced. All economies, but especially in Europe and the debtor LDCs, need to achieve better adaptation to change through realistic, market-oriented policies. All sources of short-run instability have not, and will probably never, be removed. But if we can be as successful in improving the flexibility of our economies as we have been in reducing inflation, there is no reason why we cannot enjoy sustained growth in the medium term.

COPYRIGHT 1985 U.S. Government Printing Office
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