Global Financial Markets: More or Less Volatility Going Forward?

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Marilynn Barnett
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1 Global Financial Markets: More or Less Volatility Going Forward? Nigel Gault Research Director US Macroeconomic Service World Economic Outlook Conference October 21-23, 2003

2 Issues For Review How likely is a hard landing of the dollar, and which countries would it hurt most? Could the slow death of the Stability and Growth Pact (SGP) lead to a falling apart of EMU? 10/24/2003 2

3 1980s 2000s Some Things Never Change The Red Sox Break New England Hearts Twin Deficits Threaten To Cause A Hard Landing For The Dollar 10/24/2003 3

4 Same background as in mid-80s Rising U.S. current account deficit Rising U.S. budget deficit Overvalued dollar on the way down An Asian nation cast as the villain Protectionist pressures intensifying All leading to fears of a hard landing 10/24/2003 4

5 What Is a Hard Landing? Dollar falls steeply as foreign investors lose confidence in U.S. assets U.S. long-term interest rates forced up sharply (pulling up long rates worldwide) U.S. short-term interest rates might have to rise because of inflation threat Equity markets might be destabilized Foreign central banks might be unable or unwilling to help by cutting rates sharply The upshot: Global Recession 10/24/2003 5

6 The Global Economy Did Not Have a Hard Landing in the 1980s But The Dollar Did '00 '01 '02 '03 Real FRB Dollar Trade-Weighted Index, Broad, March 1973=100 10/24/2003 6

7 Dollar Against Major Currencies '00 '01 '02 '03 Real FRB Dollar Trade-Weighted Index, Major Currencies, March 1973=100 10/24/2003 7

8 Dollar Against Other Currencies '00 '01 '02 '03 Real FRB Dollar Trade-Weighted Index, Other Important Trading Partners, March 1973=100 10/24/2003 8

9 Reasons for More Concern This Time Around The current account deficit is bigger The budget deficit is rising fast and there is no plan to deal with it Foreign economies were in better shape last time 10/24/2003 9

10 Current Account Deficit: Much Bigger Than In The 80s Percent of GDP '00 '02 10/24/

11 Federal Deficit: Smaller For Now Than In The 80s, but Widening Very Rapidly Percent of GDP '00 '02 '04 10/24/

12 There Was Help From Abroad Last Time Domestic Demand (1985=1.0) Asia (ex-jp) Japan EMU12 US Demand growth elsewhere outstripped growth in the US in the late 1980s Especially in Asia, including Japan And even in Europe 10/24/

13 But We Don t See That This Time Domestic Demand (2002=1.0) Asia ex-jp Japan EMU12 US Asia-ex Japan is growing fast again (and it s a bigger part of the world economy now) But demand in Japan and Europe is likely to grow more slowly than in the US 10/24/

14 Reasons for Less Concern This Time Around The current account deficit has reached levels previously unthinkable without catastrophe yet U.S. still looks a better bet for investment than much of the world Asian central banks are recycling their current account surpluses into dollars 10/24/

15 Conclusions Short term: Asia underpins the dollar Though political pressures in the U.S. have increased the risk of an accident For the medium and long term, risks are higher than in the 1980s Main losers from a full hard landing : everyone Main losers from 1980s-style dollar hard landing: Eurozone and its satellites 10/24/

16 The Eurozone: Why A Stability and Growth Pact? Fiscal Discipline Important For Stability But Some Eurozone Nations Have Bad Track Records And All Face Adverse Demographic Trends Europe s conclusion: For safety, need fiscal rules 10/24/

17 Key SGP Features Budget Deficit Not To Exceed 3% of GDP Violators Must Correct Overshoots Quickly Or Face Sanctions Aim for close to balance or surplus in medium term to allow room for automatic stabilizers 10/24/

18 SGP In Trouble Medium-term budget balance objective was not met by the biggest players (Germany, France) So 3% line could not be held in downturn France now faces censure for failing to take effective corrective action (Ecofin vote due November 4) Possible outcomes of Nov 4 vote: Censure rejected (SGP dead) Censure passed, sanctions follow Censure passed, fudged compromise postpones sanctions 10/24/

19 Can Death of SGP Lead To Falling Apart of EMU? The wrong question? Implemented As Written, SGP Could Destroy Political Support For EMU What are the alternatives for the future? Living death for SGP No rules (risk of fiscal anarchy) A better set of rules (shift focus to long-run sustainability) 10/24/

20 A Final Point OECD projects a 1.6% structural budget deficit for the Eurozone in 2003 And a 4.0% structural deficit for the U.S. So who needs a Stability Pact more? 10/24/

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