The global economy did well in 2004. Despite sharply higher energy prices and significant imbalances in international trade, economic growth in most countries and regions exceeded the early predictions of private and official economists. Moreover, forecasts for 2004 growth have been progressively revised upward for many countries, though not all. For the United States, for example, the IMF was predicting a growth rate for real GDP of about 3.6% in April 2003. By September 2004, the Fund staff had revised up their estimates to 4.3%. For Japan, pessimism about Japanese economic prospects abounded in the spring of last year. Growth of only 1% was predicted by most economists specializing on the Japanese economy. The latest IMF forecast estimated a growth rate of 2.6%. Similarly forecasts for China have been progressively revised up from excellent (about 7.5%) to extraordinary (9.0%).
Evolving IMF forecasts for 2004
The only major region for which this pattern has not materialized is the euro area. But even in Europe growth is estimated to be above 2% for 2004 (though not for Germany). Because Europes population is constant, this translates into a similar percentage increase in per capital income, a highly respectable increase by historical standards, although admittedly below that of the United States and a few other advanced industrial countries.
The outlook for 2005 is reasonably good, too. As the new year unfolds, however, there will be some tendency for growth to taper off, especially in the main locomotive countries of the United States and China. In both countries, central banks are in the process of gradually removing the lavish degree of monetary accommodation that helped to fuel rapid growth. Instead, rising interest rates in the US and more restrictive credit rules in China will have a moderately constraining effect.
In the US higher interest rates will be felt most directly in the overheated housing market. According to the latest US government tabulation, average prices of existing homes soared by 13% in the twelve months through October 2004, after an astonishing 18.5% per annum increase in the third quarter itself. The positive wealth effects of this gigantic increase in housing values will continue to boost consumer and business spending well into next year. But increases in interest rates will start to cool off the housing market, prevent a dangerous bubble from occurring, and set the stage for more subdued price increases in 2005 and beyond. Higher interest rates, however, are unlikely to discourage businesses from increasing their capital investments, particularly on equipment and software. This category of spending advanced at rates in excess of 15% per annum in real terms during much of this year. And new orders for non-defense capital goods, excluding commercial aviation, have been increasing at about a 12% rate when compared to year ago levels. That suggests that business corporations are optimistic, profitable, and well-financed, and have every intention of expanding productive capacity.
In China investment spending has been the main spearhead of the phenomenal growth that the country has been experiencing. The ratio of investment to GDP is about 45% and had been rising. Much of this is construction related. But a considerable portion is in manufacturing industry. Chinas industrial structure is obviously designed to mimic other East Asian success stories. It is export-oriented. Meeting expanding domestic consumption demands has a lower priority. The export drive is also disproportionately targeted toward the United States. Exports to the US are about five and a half times imports from the US: $16 billion a month in exports compared to $2.8 billion a month in imports. This leaves a bilateral trade imbalance approaching $200 billion per year or about a third of the entire US deficit. For its part, China runs a deficit with all the rest of the countries of the world, notably with oil and other commodity producers.
Both the US and China are experiencing a rise in inflationary pressures, which of course forms the basis for the more restrictive monetary policies that are being assembled. In the US so far these have been modest, when measured by the standard price indexes. But the outlook is for rising inflation in 2005, as the combination of reduced productivity improvement, higher oil and other commodity prices, a lower dollar, a somewhat tighter labor market, and scattered shortages of capacity work their way through the system. For China, however, inflationary dangers are mounting quickly. In 2004 inflation surged from under 3% to over 5%, and there is a high likelihood of further acceleration next year.
Risks to our Forecast
What are the risks to our baseline forecast for 2005?
- That the dollar is not allowed to adjust and the US Congress forces protectionist measures on the Bush administration. Asian exporting countries have been intervening in massive amounts with little or no criticism, either from the Bush administration, from the IMF, or most puzzling from the Europeans, who have been just as damaged by this market manipulation as has the US. The US Congress may not be so tolerant and is capable of trade-threatening legislation that would rile the financial markets.
- That the dollars decline gets out of hand, with the result that US stock and bond markets take fright and housing markets abruptly weaken. The impact on US consumption could be substantial. Growth would sharply slow, imports would fall off, but protectionist pressures would mount as the US unemployment rate turned higher.
Only a reasonably moderate but persistent decline in the value of the dollar against the Asian currencies can avert either of these two downside risk scenarios.
- That the war in Iraq does not subside, even after the planned election, and that hostilities spread to other parts of the region, threatening oil supplies and triggering another sharp increase in oil prices. Higher energy costs are still working their way through the system. If there is no breathing space to absorb this relatively smoothly, the inflationary consequences could multiply.
- That China steps on the brakes too hard, and the economy slows to a much greater extent than now expected. The main casualties would be commodity producing countries among the emerging economies. They would face both economic and financial challenges. However, other industrial countries would get an anti-inflationary respite.
- That stock markets surge on new optimism about economic policies and growth prospects. Suppose the Bush administration were successful in legislating a partial privatization of Social Security. Suppose the European countries were successful in reaching agreement with labor unions and other interest groups for a comprehensive reform of costly welfare programs. Suppose that the Japanese real estate market began to show signs of reviving strongly. Each of these, and other eventualities, are capable of triggering a burst of demand for equities, and a rally that began in one market could easily spill over onto other markets. The ensuing rise in wealth would stimulate stronger consumer and business demand and faster growth. But it would also tend to lead to shifts out of bonds and a corresponding increase in bond yields. That would hurt housing. And central banks would likely move more quickly to shift from monetary accommodation to outright tightening.
In short, 2005 is likely to be a year of moderate and moderating growth. But it would not take much either to produce a considerably better or a considerably worse outcome. That sense of instability is an inherent dilemma when global growth is still dependent so much on just one or two locomotives, with the consequence that existing imbalances are bound to worsen. Doing away with those imbalances quickly is impossible, but failing to do anything about them is equally dangerous. The equilibrium in the global economy is therefore shakier than it may appear from the numbers themselves.