The World Economy in 2004

For business, the squeeze on costs will go on, spurred by low-cost competition from places such as China and India.

2004 will be a year for voters. During the year, countries that account for nearly half the world’s population (the most ever) will hold nationwide elections. In November Americans will judge George Bush less by the wars he has waged than by the state of the national economy. They will weigh America’s return to growth against the loss of more than 2.5 million jobs in the Bush years. The contest will be close.

Among other polls expected in 2004, two stand out as especially important: those in the world’s biggest and newest democracies. India, the biggest, will go to the polls by October; with luck, the country will keep its communal cool so that it can get on with the business of joining China as an emerging economic giant. Iraq, with even more luck, will be on its way to becoming the newest democracy. In 2004 its economy will at last be on the mend, growing by perhaps 20%; a referendum on a new constitution should come before the end of the year, in preparation for elections for a new government.

In Europe, a moment of triumph for democratic transition will come in May, when ten mostly ex-communist countries join the European Union. This will be a stunning symbol of the Union’s success in spreading stability across the continent. But Europeans will hardly pause to celebrate between arguments over reviving the EU’s failed constitution and campaigning for European elections and referendums, in which voters will express misgivings about the pace and direction of change. Britain will again grow fastest among the big European economies, which is why Tony Blair’s job is safe. A healthy competition for reform of bloated welfare systems will start to develop in France and Germany. And the EU newcomers, to the surprise of many, will prove a breath of fresh air. People will start to take note of the Baltic tigers, the Slovak flat tax and suddenly trendy cities like Ljubljana.

For business, the squeeze on costs will go on, spurred by low-cost competition from places such as China and India. But there will be a renewed focus on growth, and how to manage it. Some signs of the changing emphasis: the business lunch will be back; dotcoms will be making money; and even Europe’s 3G (third-generation) mobile telephony will at last show signs of life. New technologies, such as silicon dust and industrial biotechnology, will show that the tech revolution still has the power to excite. Any exuberance will remain rational, though. Corporate leaders will talk a lot about integrity and transparency, and keep a low profile.

What of the clouds that could spoil this low-key recovery? The risks are plenty: another terrorist outrage, a return of the SARS epidemic, currency shocks, security crises in the Middle East or North Korea. But the most glaring threat is the one politicians could inflict on themselves, if they allow the collapse of the global system of trade negotiations that has fostered growth and prosperity for half a century. In an American election year, the temptation of playing with protectionism—dividing the world for the sake of short-term gain at home—is particularly great.

In August, however, the world will come together when all eyes turn to Athens, as the Olympic Games go back to where they began. After all the doubts about whether the Greeks would be ready on time, Athens will sparkle. The games should be a feast.

Barely Back To Trend: Forecasting remains more of an art than a science, especially in today’s unique macroclimate. The current cycle bears no resemblance at all to its predecessors over the past 50 years. The modern-day world economy has never been this US-centric. And the United States has never had to deal with the aftershocks of a post-bubble business cycle like the one still unfolding today. The baseline case, presumes that the world can neatly finesse these extraordinary imbalances.

The forecast for world GDP growth in 2003 remains unchanged at 3.0% a modest improvement from average gains of 2.1% estimated over the 2001-02 interval. And, the estimate for 2004 calls for world GDP growth to accelerate further to 3.9%, fully 30% faster than gains estimated for 2003 and, in fact, the fastest year of global growth in four years.

The mix of global growth is projected to remain decidedly US-centric through 2004. Growth in the US economy is expected to accelerate to 3.9% in 2004, a marked acceleration from sub-par gains of 2.5% over the 2002-03 interval. Powered by a solid capital spending dynamic, the projected rebound in 2004 represents the first year of legitimate cyclical recovery following the mild recession of 2001.

Growth elsewhere in the industrial world is expected to remain sub-par. Europe is a case in point, with a projected 2.6% increase in 2004 qualifying as a disappointing rebound in the aftermath of three years of 1.3% average growth.

Japan is expected to have average gains of just 0.5% over the 2003-04 interval underscoring an unwillingness to get on with the heavy lifting of financial sector reforms. Over all, the industrial world GDP growth is expected to accelerate to just 2.9% in 2004.

In the developing world, GDP growth is expected to hit 5.3% in 2004. Domestic demand continues to lag in the developing world; as such, the growth dynamic in this segment of the world remains export-led. China continues to lead the pack, with its GDP growth expected to reaccelerate to 7.9% in 2004 after average gains of 7.5% in 2002-03. Elsewhere in Asia, the acceleration is expected to be more muted.

Excluding China, growth in Asia except Japan is expected to hit only 4.6% in 2004, only a slight pick-up from average gains of 4.1% in 2002-03. Growth in Latin America is expected to pick up to a 4.1% rate in 2004, a dramatic acceleration from average gains of just 0.4% over the preceding three years, 2001-03. A post-crisis snapback in Argentina is expected to account for the bulk of the rebound; gains elsewhere in the region are expected to remain little changed from the pace of 2003-03. Growth in emerging Europe is expected to pick up to 4.3% in 2003 following two years of 3.5% growth in 2002-03; gains in Russia (4.6%) and Turkey (5.0%) are anticipated to lead the way.

Minor structural reform in Iran in 2004 will burnish Iranian President Khatami’s reputation as a cautious economic modernizer. The challenge he faces is to carry on pumping money into food subsidies and job-creation schemes while preventing inflation, around 16% by the end of 2003, from reaching crises levels. Unemployment will peak at about 18% of the workforce, but the central bank will fight a losing battle to tighten monetary policy.

The government’s failure to wean the economy off its dependence on oil revenues will leave Iran vulnerable to price fluctuations. When the oil price is high, as it has been for the past four years, Iran powers ahead. Unless Iraq’s oil exports soar, or the world recovery proves illusory, the economy will grow by at least 5% in 2004. The car industry will exemplify the dynamism of the internal market. Iran will produce 1 million cars, 250,000 more than in 2003. Almost all will be sold domestically.

To most people exchange rates simply determine how much cash they have to spend when on holiday abroad. But the dollar’s exchange rate against the euro is surely the world’s single most important price, with potentially much bigger economic consequences than the prices of oil and computer chips, for example. The strength of the dollar affects trade balances, capital flows, growth rates, profits, share prices, inflation rates, interest rates and even the relative size of economies. The euro area’s GDP was only 60% the size of America’s in 2001. If current exchange rates are sustained, it swells to around 80%. If the economies of Britain, Sweden and Denmark are added to the euro area, the European Union now has a slightly larger economy than that of the United States.

At first sight it seems odd that the dollar is falling. The American economy and profits are sprinting ahead, while the euro area’s economies are barely able to maintain a walking pace and Japan is just getting off its knees. In the year to the third quarter, America’s GDP grew by 3.5% and euro area’s by a dismal 0.3%. Although Japan’s real GDP grew by 2.3%, its nominal GDP was flat.

Surely, stronger American growth should be pushing the dollar higher, not lower? That is what happened during the late 1990s. But the problem this time is that, if domestic demand grows much more strongly in America than in its main trading partners, America’s already large current-account deficit swells further because it imports more. America then needs to borrow even more from the rest of the world to finance that deficit. And the real cause of America’s growing taste for imports, of course, is not unfairly cheap production in China—usually named as the culprit—but its low saving, the result of rampant household borrowing and a huge federal budget deficit. So long as these persist, it will take an even bigger fall in the dollar to correct America’s external deficit.

A few years ago, foreign investors were eager to purchase dollar assets. But now investors seem to be losing their appetite. Foreigners were net sellers of American shares in the third quarter, leaving America dependent on other governments’ purchases of American Treasury bonds. Net capital inflows into America fell to only $4 billion in September, their lowest for five years. If the demand for dollars falls short of supply, then either the dollar must fall or American bond yields must rise to make dollars more attractive to investors.

Is a weaker dollar cause for concern? For America, it should be a boon, helping to boost exports, profits and jobs. The usual worry that a falling currency will lift inflation is also lessened, because America still has ample spare capacity and its inflation rate (1.3% on its core measure, excluding energy and food) is, if anything, too low—the Fed would welcome a modest rise. If a continuing gradual fall in the dollar trims the current-account deficit, this could, paradoxically, also lessen the chance of a sudden collapse of confidence in the dollar.

Unfortunately, that is a big "if", given the ECB’s proven reluctance to reduce interest rates. And yet a stronger euro not only should make it easier for the ECB to cut rates while holding inflation down, it also should make such reductions imperative because the rise in the euro itself is equivalent to a tightening of monetary conditions.

Although manufacturers may be hurt in the short term by the euro’s rise, the euro area’s economy as a whole should benefit. A stronger exchange rate improves any economy’s terms of trade, and so boosts consumers’ spending power: they can buy more foreign goods in exchange for the same amount of domestic production. Lower interest rates will also, at last, boost Europe’s feeble domestic demand, which has long been a big drag on euro-area economies. Finally, a stronger euro should force politicians and firms in Europe to pursue the kind of painful but necessary structural reforms which they have long talked about, but resisted making.

Many of the same arguments apply to Japan, where a weaker dollar is also feared. Japan’s options are more restricted. It cannot cut interest rates below zero. But if foreign-exchange intervention is allowed to feed into the money supply (in effect, by printing yen to buy dollars), then this, too, would be a useful form of monetary easing.

The Japanese and Europeans may ask why they should be forced to adjust to imbalances in the world economy caused by profligate American consumers and an even more profligate American government. They should be grateful for America’s profligacy: those borrowing-and-spending habits, though plainly unsustainable, have recently been the major engine of global growth. It is past time for others to do their part. The ECB, in particular, must boldly seize the opportunity presented by the euro’s rise. If euro-area GDP growth now slows, the ECB will be to blame, not the rise in the dollar.

America’s expansion has been hesitant, and growth else­where in the rich world tepid at best, because the recession that went before was so remarkably tame. Given the violence of the late-1990s’ boom, the subsequent combination of mild slowdown and timid expansion should be regarded as a good result. After the bursting of the stock market bubble, businesses cut investment right back, not just in America but in many other industrial countries as well. The slowdown in the United States was nonetheless mild because of what didn’t happen next: consumers didn’t panic. Financially overstretched, they could have cut their spending abruptly, to control their debts and gird themselves for harder times. Mostly, they kept borrowing and spending, and the fearsome recession that might otherwise have happened never came.

That was fine while it lasted. But the debts of America’s imperturbable consumers continue to hang over the world economy. This fact, and its various manifestations—Ameri­ca’s burgeoning current-account deficit, instability in currency markets and the country’s awesome appetite for foreign capital, to name just three—will sooner or later make themselves felt. With luck, when the inevitable squeeze on spending comes, it will happen gradually; when American business sentiment is firm; with clearer signs of sustained recovery in Japan; and alongside a healthier showing by con­tinental Europe. Then all will be well.

It could happen that way. Stock markets have been pre­dicting lately that it will. If they are right, 2004 will be a year of higher global growth and relatively painless adjustment. But if a sudden consumption slump in America turns out to align with bad economic news on one or two other fronts, the result would be grim. It would not be the first time stock­ markets got their forecasts wrong.

Can the odds of success be improved? Consumer con­fidence, still the crucial factor in all this, is a law unto itself. Governments cannot hope to drive it directly. But they can affect the context in helpful ways. In America the most use­ful step would be a plan to reduce government borrowing over the medium term – or even some sign, absent thus far, that the Bush administration cares a hoot about its colossal long-term budget deficit. Rapid cuts in spending or increases in taxes are certainly not called for, with the economy still poised between stagnation and growth. But believable plans to do both those things beyond the short term would help to settle currency markets, stabilize interest rates and make a traumatic interruption of the capital flowing to America less likely.

Europe and Japan, meanwhile, must still do more to spur demand, mainly by keeping their monetary policies loose, and more to improve their productivity, mainly through reg­ulatory reform. On the latter, Japan seems to be making some progress; and the signs are that France and Germany are also, at last, taking up the challenge. All quite encouraging. At this rate, the rest of the world could soon see clearer signs of the productivity break­through that America has been enjoying since 1995.

One could argue that the fiasco of the World Trade Organization’s talks in Cancun in September 2003 was no great cause for concern. (Many developing-country governments, of course, and most of the North’s development and anti-globalization activists, found it a cause for celebration.) Trade negotiators are past masters at brinkmanship and phony crises: none of this bogus drama amounts to very much, one might conclude. Well, the Doha round is not dead yet, that much is true; and it would be surprising if attempts to revive it failed altogether over the coming months. Yet the setback in Cancun was an ominous event nonetheless.

At the very least, a splendid opportunity to advance the welfare of rich and poor countries alike—and to improve the global economic climate when it badly needed improv­ing—was squandered. The deal that should have been done required the United States, the European Union and Japan to roll back their agricultural protection. This is something which all the governments concerned have promised to do at various times; and which, by the way, would make their own citizens better off even if it were done unilaterally, without "concessions" from their trading partners.

In return, the developing countries were not required to do much (far less than would be in their best interests, in fact). Europe insisted that they open negotiations on some of the so-called Singapore issues, which touch on matters such as competition policy and customs procedures. That idea went down badly. In the end, the industrial countries, and enough of the developing countries, preferred to do noth­ing—some even calling it victory—rather than strike a deal that would have made the world, with poor farmers in the third world to the fore, much better off.

This loss, though bad enough, is insignificant compared with the harm that will follow if the WTO now falls apart. And it might. American negotiators, who watched as their developing-country counterparts walked away punching the air, are inclined to say, "So screw’em." As for develop­ing countries, their anger at rich-country hypocrisy (call for free trade, then exempt your own farmers) is both genuine and justified. The breach is real.

America is already exploring what it sees as a more productive avenue: bilateral free-trade agree­ments with "can do" devel­oping countries, selected case by case. That path does not lead to genuinely liberal trade. Adding to the problem, a presidential election is coming, and anti-trade interests are drawing up their demands. Asia, meanwhile, has regional, as opposed to multi­lateral, trade options of its own to consider. And don’t expect much of the European Union, increasingly preoccupied with enlargement. Its determination to revive the WTO process is in doubt in any case, since an end to its mad but tenacious common agricultural policy might be the price.