Prof. Joseph E. Stiglitz Columbia University March 3, 2005

1. THE GLOBAL ECONOMY: THE PUZZLES OF 2004, THE PROSPECTS OF 2005 Paris, France Prof. Joseph E. Stiglitz Columbia University March 3, 2005

2. The Two Puzzles • 2004 was, on the face of it, one of the most best years for growth in the global economy; yet there was not a feeling of global prosperity (at least comparable to the 1990’s) • In spite of huge US borrowing, and prospects of even increased borrowing in future, long term interest rates remain very low • Why?

3. The Short Answer • Strongest boom in Asia, not in Europe and the U.S. • America’s growth numbers good, but employment numbers disappointing - Huge levels of disguised unemployment and underemployment - Growth not sustainable: • Some from temporary tax provisions, shifting investment from 2005 to 2004 • Huge debt overhang in household sector • Huge fiscal deficit - Cutbacks in long term investments • Huge trade deficit

4. The Short Answer • Europe continues to languish • Debates about the root causes • Lack of aggregate demand • Poor institutional framework— Stability Pact and independent central bank focusing only on inflation • Labor market rigidities • Probably both are relevant, but Europe did not suddenly become more rigid • Without better macro-framework, there can be little robust growth

5. High Level of Global Uncertainty • Volatile Exchange rates: - Not a zero sum game - All lose with uncertainty • Volatile Oil prices: - Worst of possible worlds - High oil prices - but not sure that they will be sustained—so little investment - U.S. foreign policy may be responsible for spreading instability

6. Global Growth Outlook for 2005 • Growth prospects for 2005 is lower than it was in 2004, for all economic groups and regions, including China! 1. OECD Economic Outlook 76, http://www.oecd.org/dataoecd/21/13/33975094.pdf 2. IMF World Economic Outlook http://www.imf.org/external/pubs/ft/weo/2004/02/pdf/chapter1.pdf 3. EIU Country Report: USA http://db.eiu.com/report_dl.asp?mode=pdf&eiu_issue_id=1517951751 4. The EIU Forecast for Euro Area is actually for EU25

7. Whither the dollar? Another Puzzle: • Why was the huge U.S. fiscal and trade deficit of the early 80s accompanied by a strong exchange rate, but today’s fiscal and trade deficit by a weak exchange rate? - As a percentage of GDP, trade deficit is larger -- increased from -1.46% in 1983 to - 5.39% in 2004 (WDI and EIU) - As a percentage of GDP, fiscal deficit is lower, from -5.47% in 1983 to -3.7% in 2003 (BEA) Basic Economics: • Trade deficit = capital inflows • Capital inflows = domestic investment – domestic savings

8. Effects of Fiscal Deficit Large fiscal deficit contributes to low domestic savings: • Net National savings (as % of GNI) rate has fallen from 5.8% in 2000 to about 1% in 2004 (BEA) • National savings rate today is even lower than it was during the bad years of early 80s – it was 4.7% in 1983 • Capital inflows (and therefore trade deficit) would be larger, except that domestic investment is weak • Gross domestic investment fell from 18.5 % of GNI in 2000 to under 13% in 2004

9. Prognosis Continuing large fiscal deficits: • If the U.S. economy had a strong recovery, investment would increase and trade deficit would get worse • But prospects for investment in 2005 are weak – end of tax break for investment spending (due to end in 2005), and rising interest rates will reduce capital expenditure • Administration is asking to make tax cuts permanent • And partial privatization of social security • Both would add trillions to deficit - Making the 2001, 2002, and 2003 tax cuts permanent will increase fiscal deficits by $2.0 trillion through 2014 ; Social security privatization may add another $1.5 trillion to the deficit in first 10 years, $5 trillion in the next 10 years

10. Key Question • What exchange rate will accommodate these capital flows/trade imbalances? Real factors: • U.S. imports are likely to remain robust • Growth somewhat moderated • But little change in import share of GDP • Uncertainty about oil prices • U.S. exports will be limited by slow global economic growth • Growth to be lower in 2005 than in 2004 • European Stability Pact’s focus on inflation and other problems will limit European growth

11. Key Question Financial Factors: Would revaluation of Yuan matter? • Not much for U.S. trade deficit (for arguments already made) • Trade deficit would appear somewhere else • Europe might be helped • Low price elasticity of demand for Chinese goods? • Some of price adjustment would occur in China and in margins • So, even effect on other countries would be limited

12. Key Question Financial Factors: Would revaluation of Yuan be in the best interest of China? • Large balance sheet effects • Just as a devaluation is bad for country with large dollar denominated debts, appreciation is bad for country with large dollar denominated assets • Magnitude of capital loss is huge • Would dampen inflationary pressures • But how serious a problem is inflation today? • Might dampen global political pressures on China • But if trade imbalance, loss of jobs in manufacturing remain large, only temporary palliative • If there is significant price elasticity, there may be better ways to do this • On the real side, prospect of a stronger dollar remains slim! Both real and financial considerations contribute to a cloudy outlook for the global economy and for dollar

13. The Basic Problems • Deteriorating confidence in the U.S. economy and the U.S. leadership, mainly due to worsening fiscal deficit - Short run problem is the tip of iceberg - U.S. uses ten year budget projections, but Changes in U.S. fiscal position as a result of Medicare bill alone in the next twenty years are in the range of $2.5-3.0 trillion - There simply isn’t room in discretionary budget to make the arithmetic work • And some of the cutbacks will be in areas which will harm U.S. long term economic growth • Investments in science and technology • Already suffering from war on terrorism, as supply of foreign engineers/scientists/students drying up • And suffering from anti-science stance of administration, or at least widespread perception of that within the scientific community

14. End of Dollar as the Reserve Currency • Reserve currencies need to be good store of value • Which is why inflation has always been viewed so negatively by central bankers • But the credibility of a currency as a reserve currency depends also on exchange rates • For foreign holders of dollars, weakening of the exchange rate is as bad as an increase in inflation • Even true for domestic wealth holders, because of opportunity costs • Negative dynamics—as confidence erodes, people move out of currency, weakens currency • Problem is partly inherent—reserve currency country gets increasingly in debt as others hold its currency; ease of selling debt entices borrowing; but eventually, debt gets so large that credibility is questioned

15. End of Dollar as the Reserve Currency? • Now there are alternatives to dollar • And many in Asia are waking up to the new realities • They are the world’s net savers • Why should they be lending money to the richest country of the world at low interest rates? • Basic principles of portfolio diversification would call for diversification of reserve assets • And increased perceived risk associated with U.S. dollar would lead to further diversification out of the dollar • For small countries, this is easy • But for large countries, more difficult • Political ramifications • Balance sheet effects as they move out • Argues for a policy of gradualism • And for the anticipation of further weakening of dollar • With so much of U.S. debt held as reserves, politics, not just economics, become important in determining exchange rates and even possibly long term Treasury interest rates

16. Alternative Scenarios Best case (for strong U.S. dollar): • U.S. reins in its fiscal deficit • Europe successfully pursues more expansionary policy • Asian countries decide to continue to gamble on holding dollar as reserve currency, no progress on Asian cooperative front More pessimistic case: • U.S. deficit not brought under control, and actually increases with partial privatization of social security and permanent tax cut • Proposed budget gimmickry in social security unlikely to fool anyone

17. Alternative Scenarios More Pessimistic Case: • Financial markets wake up to long run prospects of U.S. fiscal position and its long run real consequence • Political gridlock in the U.S. • Impossible to raise taxes, impossible to cut back significantly on commitments • Especially problematic given huge gap between US’s health technology and its health performance • Social tensions rise as even those in the middle see their incomes erode (real median family income in U.S. down by $1,500) • Markets and governments wake up to changing global economic scene • Strength in science and engineering in China and India • Scientists are mobile; U.S.’s dominance partly due to migration after World War II

18. Alternative Scenarios More Pessimistic Case: • Political and economic pressures build up for movement out of dollar as reserve currency • Political accountability for foreseen loses in value of reserves • Popular sentiment about lending to U.S. at low interest rates, demands for Asian cooperation, sensibilities about how to do it quietly • WTO limits retaliation by U.S., though there will be plenty of talk • Eventually U.S. and global real long term interests rise (matter of supply and demand), risk premiums rise, with adverse effects on weaker emerging economies, possibly new crises, and on U.S. economy, with heavy debt overhang

19. Concluding Remarks • Economics and politics are intimately intertwined • Economic forecasting is difficult • Political forecasting is even more difficult • The most sure bet is continued high levels of uncertainty • And even that is uncertain