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WHITE PAPER ON THE WORLD ECONOMY 1999(SUMMARY)

CONTENTS

Introduction

  1. Part 1. Current State of the World Economy
    1. Section 1: World economy experiences moderate recovery
    2. Section 2: U.S. Economic Expansion Likely to be Longest in Postwar Period
      1. United States: the future course of the economy is still uncertain, although the economy has continued to expand.
      2. Latin America falls into recession following Brazilian currency crisis
    3. Section 3: European Economy Gives Birth to a New Currency
    4. Section 4: Asia Pacific shows widespread signs of recovery
      • China: the economic growth slows down and a deflationary trend emerges
    5. Section 5: International finance/commodity markets
    6. Section 6: Strengthening of international currency and financial systems
  2. Part 2. The U.S. economy: Factors of its long-term expansion and vulnerabilities
    1. Section 1. Characteristics of economic expansion in the 1990s
    2. Section 2. Factors behind stable economic expansion in the 1990s
    3. Section 3. Productivity gains in the U.S.
    4. Section 4. Vulnerabilities of the U.S. economy
  3. Part 3. The World Economy when prices are stable
    1. Section 1. Current state of global price stability
    2. Section 2. Factors behind global disinflation
    3. Section 3. Characteristics of economies with stable prices
  4. Section 4. Monetary policy while prices are stable

Conclusion

Introduction

    As two years have passed since the Asian currency and financial crisis, the world economy is on the path to recovery, albeit at a moderate pace. Though prospects for a continuing increase in equity prices are still uncertain, the U.S. economy weathered the turmoil that took place in the international financial markets in the fall of 1998, and the country's pace of economic expansion has been higher than generally expected. In Europe, the single currency, or euro, was introduced in 11 EU member countries in January 1999, and a large single-currency area comparable to that of the U.S. was created. Western Europe has enjoyed a noticeable economic rebound since the spring of 1999. In East Asia, signs of economic recovery are widespread.

    Looking back at the global economy of the 1990s, we are impressed by the superior performance of the U.S. economy. The U.S. economy began to recover in March 1991, and steady economic expansion has continued for a period of eight years and seven months up to October 1999. In the past, there has been much discussion of the following issues: What are the factors enabling long-term expansion of the U.S. economy? Has productivity growth increased? Are there no areas of concern for the U.S. economy? It would be useful to sort out such discussion as we forecast the future course of the world economy in this final year of the 1990s.

    In the global economy of the 1990s, price stability has been the norm across many countries and regions. Inflation, which ran at double-digit rates in almost all industrialized countries in the 1970s, is now down to just a few percent. In developing countries and nations in transition, which suffered higher inflation than industrialized countries, inflation has, in general, fallen significantly in recent years. The world economy is drastically different from what it was in the 1980s and earlier years, and the challenges of macroeconomic policy have also changed.

    The White Paper on the World Economy 1999 introduces and analyses developments in foreign countries based on the observations mentioned above. In Part 1, the performance of the world economy over the past year is reviewed and important topics are discussed by region. Part 2 looks at factors supporting long-term economic expansion in the U.S. and also covers problems that could hold it back. Part 3 examines characteristics of the economy and monetary policy when prices are stable worldwide.

Part 1. Current State of the World Economy


Summary of Part 1

[Overview of the World Economy]

    Global economic growth slowed in 1998 due to the Asian currency and financial crisis and other factors. The world economy is expected to stage a modest recovery in 1999 because the U.S. economy continues its robust expansion, deceleration of economic growth in Europe is considered temporary and Asian economies are recovering.

[The U.S. and Latin America]

    In April 1999, the U.S. economy entered its ninth year of expansion. Though prospects for a continuing increase in equity prices remain uncertain, the U.S. economy weathered the turmoil that took place in the international financial markets in 1998, and the country's pace of economic expansion has been higher than generally expected.

    Latin American economies have been gripped by recession since the currency crisis in Brazil. But the recession is not as severe as forecast at the beginning of the year.

[Europe]

    Economies in Western Europe slowed moderately since the latter half of 1998 due to weaker external demand caused by an appreciation of currencies, the Asian crisis, etc. Since the spring of 1999, however, clear signs of improvement emerged as the recovery of Asian economies and other factors lifted external demand. In January 1999, the euro was introduced as the single currency for 11 EU member countries, and a large single-currency area comparable to that of the U.S. was created. Russia's economy seems to have hit bottom.

[Asia]

    It is now two years since the Asian currency and financial crisis, and signs of economic recovery have been emerging around East Asia. Factors supporting recovery include the effects of monetary and fiscal stimulus programs and higher external demand due to significant depreciation of regional currencies. In China, where the outlook for employment is uncertain due to the pace at which state-owned enterprises are being reformed, consumption growth has stagnated. The pace of economic expansion has decelerated, and commodity prices have continued to fall.

Section 1: World economy experiences moderate recovery

    The Asian currency and financial crisis of 1997 had a great influence on the world economy as a whole by undermining global demand, decelerating trade growth, pulling down the prices of primary commodities. As a result, real GDP growth for the global economy declined to 2.5% in 1998. Although the U.S. economy enjoyed robust expansion, Western Europe suffered a mild economic slowdown in the latter half of 1998, and Japan's economy was stagnated. Due to the currency and financial crisis, most East Asian countries and Russia posted negative growth rates, and Latin America experienced a significant slowdown in growth.

    According to the IMF outlook toward the world economy covering 1999, the U.S. economy will continue its spirited expansion and Western Europe will experience moderate economic growth due to a slowdown during the first half of the year. As the Japanese economy is expected to post positive growth once again, the overall rate for industrialized countries will likely climb marginally. As for developing countries, although China is expected to see slower growth, growth in Asia as a whole will bounce back. In Latin America, however, the economy is largely in recession. Real GDP growth for the world economy in 1999 is thus expected to reach 3.0%, or slightly higher than in 1998.

    The volume of world trade grew at a robust rate of 9.9% in 1997, before declining sharply to 3.6% in 1998. In 1999, imports can be expected to recover in Asia but to decline in transition countries. As result, the volume of world trade in 1999 is expected to increase 3.7%, similar to the pace in 1998 (Table 1-1-1).

Section 2: U.S. Economic Expansion Likely to be Longest in Postwar Period

1. United States: the future course of the economy is still uncertain, although the economy has continued to expand

    The U.S. economy entered its ninth year of growth in April 1999. It has since continued its dynamic expansion, though the outlook is uncertain. Reviewing last year, the following points warrant mention: 1) the U.S. economy overcame the turmoil that took place in the international financial market in autumn 1998 and continued growth, 2) the economy expanded at a faster pace than was generally expected, 3) fresh inflation concerns emerged, and (4) the future direction of stock prices is unclear.

(1)Turbulence in the international financial markets had minor influence on real economy

    The influence on the U.S. economy of turbulence in international financial markets experienced in autumn of 1998 may be summarized as follows: 1) influence on financial market conditions, such as sluggishness in lower-rated corporate bond issues, persisted for a comparatively long period because investors grew risk-averse, 2) the real economy was little affected due to quick policy response, such as reductions in the Federal Funds Rate; flexibility in financing by the corporate sector (Figure 1-2-4); and a strong income environment. The economy continued to enjoy high growth, and 3) it is likely that the real economy and the stock market imbalances were caused by the extreme monetary relaxation.

(2)Pace of economic expansion was faster than generally expected

    The pace of economic expansion from the latter half of 1998 was faster than generally expected. According to the Congressional Budget Office (CBO) and the Blue Chip consensus, growth for the latter half of 1998 was expected at an annual rate of about 2% or in the 2.0-2.5% range, respectively, compared with the previous period. But the rate actually came in at 3.7% in the third quarter and 5.6% in the fourth quarter (revised estimates in October 1999 are 3.8% and 5.9%, respectively). Growth remains strong in 1999. Behind the impressive performance are persistently low interest rates, continuously rising stock prices, and the absence of any signs of inflation.

(3)Rekindled inflation concerns

    It is likely that the U.S. economy grew over the past few years at a rate beyond its potential. Although there are no signs of inflation, it is likely that the potential inflationary pressure increased due to a further tightening of the labor market (the result of economic overheating), the rebound in crude oil prices, economic recovery in foreign countries, etc. (Figure 1-2-9). Inflationary concerns are considered problematic because we cannot deny their potential to bring about tighter monetary policy or other developments which could lead to a painful hard-landing of the economy.

(4)Prospects remain uncertain

    In addition to inflationary concerns stemming from the overheated economy, the U.S. faces several potential problems, such as overvalued stocks, a continuously declining household savings rate, and an expanding current account deficit (for details, see Section 4. of Part 2).


2. Latin America falls into recession following Brazilian currency crisis

    In Brazil, the economy has been in recession since the middle of 1998. In January 1999, Banco Central do Brasil announced a change in its exchange rate policy, and effectively adopted a floating exchange rate system by expanding fluctuation band. In March, the Brazilian government and IMF representatives met to discuss the new economic stabilization policies, and in the course of the discussion the IMF had approved additional lending to Brazil. The Brazilian economy has slowed less than expected since the country's currency was devalued. Inflation remains subdued.

    In Argentina, the economic growth slowed down due to the financial crisis in Russia in 1998, currency unrest in Brazil, low international prices for primary commodities, etc. Real GDP growth has been negative year on year since the fourth quarter of 1998, and the recession has continued. In the future, there is a strong possibility that the economy will continue in a severe state that leaves it at the mercy of external influences, such as the prices of primary commodities, economic trends in neighboring countries, especially Brazil, and the confidence of international financial markets.

    In Mexico, the economy recovered rapidly in 1997. But growth has slowed since 1998 due to such factors as sluggish private consumption and falling public expenditures, the latter reflecting budgetary restraint. Inflation rate is high but stable (Figure 1-2-15, 16).

Section 3: European Economy Gives Birth to a New Currency

    January 1, 1999 marked the introduction of the euro, a single currency adopted by 11 EU countries. The Economic and Monetary Union (EMU), supporting work for which began in July 1990, entered the final phase. The total economic size of the 11 countries participating in the Monetary Union (Euro-zone) features a population of about 290 million (1997) and nominal GDP of around 6.5 trillion dollars (1998). Thus, a large single-currency area with an economy bigger than Japan's (population: about 130 million, nominal GDP: about 3.7 trillion dollars) and comparable to that of the U.S. (population: about 270 million, nominal GDP: about 8.5 trillion dollars), was created. Effective January 1999, both local currencies and the euro can be used for cashless payment. From January 2002, euro banknotes and coins will begin circulating.

(Economic performance of the Euro-zone)

    The Euro-zone economy continued to expand until the first half of 1998, due to increasing personal consumption and fixed investment. In and after the latter half of 1998, however, external demand fell sharply and economic expansion decelerated due to a substantial appreciation of member countries' currencies, the spread of the Asian currency crisis to Russia, etc. Depreciation of the euro after its introduction in January 1999, the economic recovery of Asian countries, and the end of the currency crises in Latin America and Russia combined to revive external demand, and personal consumption and fixed investment continued to be buoyant. As a result, the economic slowdown was only temporary, and economic growth began to improve around the spring of 1999 (real GDP growth rate was 2.7% in 1998 with an annualized quarter-to-quarter change of 1.7% in the first quarter and 2.0% in the second quarter of 1999 -Figure 1-3-2).

(Problems and efforts to solve them following euro introduction)

    Since its introduction in January 1999, the euro has fallen 16% against the U.S. dollar over six months (Figure 1-3-4). Factors driving the depreciation include the fact that Euro-zone currencies were strong at the end of 1998, differences in economic conditions between the Euro-zone and the U.S., the prolonged Kosovo conflict. Although the euro's value in the short term depends on the gap in economic conditions between the Euro-zone and other regions, its medium- to long-term performance largely depends on efforts to solve structural problems, such as employment and government finances.

    EU efforts to boost employment went into high gear at the Luxembourg Extraordinary European Council in 1997. In June 1999, the ”European Employment Agreement” was adopted at the Cologne European Council with the aim of enhancing the exchange of opinions among employment-related parties and fostering trust in order to strengthen economic growth and employment in Europe. In March 1999, ”Agenda 2000” was adopted, and a broad agreement was reached concerning reform of the EU financial structure, including a review of the framework for subsidies, one issue being cohesion funds to help stabilize the economic foundation of the EU as a whole.

    We can expect creation of the European Single Market in 1992 and the dual display of prices in euro and local currencies to facilitate price comparisons in the zone. Price differentials will shrink in due course, though they are prevalent at this point in time. One of the more important factors causing price differentials within the EU may be the absence of institutional harmonization in the fields of taxation and regulation. Introduction of the euro is expected to help close price gaps, since price comparison in EU countries will be easier due to the display of prices in a common currency. As a result, downward pressure on prices will be exerted by trading partners and consumers.

    The issues of direct taxes, including corporate taxes, and social security levies have rarely been discussed by EU members, the reason being that such matters were deemed to be sovereign. In December 1997, before the introduction of the euro, the Council for Economy and Finance agreed on certain aspects of direct taxes for the first time, deciding to establish a study group to discuss corporate taxation and other matters. The fear was that there could be ”harmful tax competition” if member countries engage in competitive reductions of tax rates. At the Cologne European Council in June 1999, an agreement was reached on certain aspects of taxation, with the chairman's statement referring to the necessity of a study on energy taxation, as well as taxation such as business taxation and capital income taxation at source. The study is now being conducted.

(Economic performance of major EU countries)

    Germany experienced a temporary economic slowdown in the first half of 1999 but thereafter recovered moderately, thanks mainly to increased production in the latter half of the year. The Schroeder administration, which was formed in October 1998, prioritizes employment and tax reform. In June 1999, the Schroeder government established a program called ”Renewing Germany,” the core of which involves curbing government expenditures. That program and a fiscal reconstruction effort focusing on reduction of social security outlays are important issues at the moment.

    In France, real GDP growth climbed to 3.2% in 1998, the highest level in the 1990s, due to strengthening domestic demand. Also in 1999, the economy has continued to expand moderately. Improvement in consumer confidence due to stable prices, higher wages and an increase in employment have led to higher personal consumption. The French government prioritizes job security, and decided to adopt a 35-hour work week effective January 2000 in order to create and maintain employment through the reduction of working hours (Figure 1-3-12).

    In the United Kingdom, economic growth decelerated temporarily in the latter half of 1998 but began to recover in the second quarter of 1999 due to a recovery in export and increased personal consumption and capital investment, mainly in the service sector. The British government decided not to participate in the third phase of European Monetary Union, which started in January 1999. The primary reason was the objection indicated by the general public. In February 1999, however, Prime Minister Tony Blair announced his ”National Changeover Plan” and indicated an intention to participate in the European Monetary Union possibly after the general election to be held by 2002. For the UK to participate in the European Monetary Union in the future, it is essential for the government to satisfy political conditions with an agreement from the general public. It must also live up to economic conditions, currently in the form of ”Five Economic Tests,” which include an assessment of the degree of convergence with Euro-zone economy.

(Economic performance of Central and Eastern Europe)

    In Central and Eastern Europe, the economic framework is shifting from a planned economy to a market economy. But differences in economic performance among the various countries are increasingly evident, depending on the kind of transition process they have taken and other considerations (Figure 1-3-20).

    In Poland, growth in real GDP decelerated from 6.8% in 1997 to 4.8% in 1998, due to weak demand from EU member countries and the financial crisis in Russia.

    In Hungary, real GDP growth in 1998 increased to 5.1%, from 4.6% in the previous year, thanks to robust foreign direct investment and a rebound in domestic demand from a period of weakness which began in 1995 due to austerity measures.

    In the Czech Republic, economic activity slowed due to a fall in domestic demand resulting from austerity measures, weakness in industrial production caused by a delay in corporate restructuring, etc. In 1998, real GDP shrank 2.3%, compared with 0.3% growth in 1997.

    The introduction of the euro strengthened integration among EU members. A smooth relationship with the EU has grown more important to Central and Eastern Europe. Poland, Hungary and the Czech Republic are now associate members of the EU. Formal negotiations aimed at awarding them full membership have been underway since March 1998.

(Russia's economic performance)

    In Russia, real GDP slumped 4.6% in 1998 because of the country's financial crisis (Figure 1-3-22). However, import substitution progressed with the increased price competitiveness of the domestic industry. Rises in such commodity prices as fuel and growth in export and production of energy-related products were remarkable. As a result, industrial production has been growing since March 1999. Real GDP in the fourth quarter of 1998 decreased by 7.8% from the same quarter in the previous year and by 2.8% from the first quarter of 1999. Growth turned positive again in the second quarter, however, reaching 1.4% year on year. The economy thus appears to have hit bottom.

Section 4: Asia Pacific shows widespread signs of recovery

(East Asia bounces back)

    As two years have passed since the Asian currency and financial crisis, signs of recovery have been emerging in many East Asian economies. Real GDP growth for East Asian countries and regions turned positive at the beginning of 1999, and as a result, economic growth forecasts for 1999 as a whole have been revised upward for many countries (Figure 1-4-3).

    Factors supporting the recovery can be summarized as follows. First, there has been a properly functioning automatically self-adjusting mechanism: 1) expansion of the current account surplus resulting from a sharp fall in imports caused by drastic declines in domestic demand --> stability of exchange rates ----> a fall in interest rates, 2) significant depreciation of currencies ----> an increase in external demand. The second reason is that policies were changed from austerity measures to economic stimulus measures in both the fiscal and monetary arenas. More substantial public investments, tax cuts, a reduction in public utility charges, and measures against unemployment, among others, supported economic activity. Third is that the prospects of overcoming the financial crisis became brighter through such means as injecting capital into financial institutions. Once breakdown of the financial system had been avoided, investor and consumer sentiment stopped deteriorating. The fourth factor is recovery of agricultural production due to favorable weather, which contributed to economic recovery in Indonesia and the Philippines.

    The fifth factor is related to external elements. An increase in international liquidity due to monetary relaxation in Western countries contributed to a renewed flow of funds into Asian countries. International financial support programs, strengthened by international institutions such as the IMF, and by the ”New Miyazawa Initiative” of the Japanese government, helped to provide many countries with the breathing space they needed to engineer serious fiscal stimulus initiatives. The programs also helped ensure availability of funds required for reconstructing the financial sectors in many countries. Exports of electronics and other products began climbing, and production expanded, mainly in export-oriented industries, in 1999, contributing to economic recovery.

(The road to full-fledged economic recovery)

    Since the currency and financial crisis, East Asian economies have been supported by public demand and external demand. Personal consumption, which began to show signs of a rebound, is not expected to increase substantially because employment conditions are still severe. Excess production capacity remains and financial institutions maintain a cautious lending attitude. Real interest rates are rising in some countries. Therefore, it seems that it will take some time before capital investment starts to increase (Figure 1-4-7).

    For the tentative recovery we began seeing in 1999 to grow into a full-fledged recovery, domestic private demand needs to recover. To this end, it is important to push steadily ahead with structural reform, which is underway in many sectors, including the financial sector.


China: the economic growth slows down and a deflationary trend emerges

    The Chinese economy has experienced an unprecedented deflationary trend in the 20 years since the policy of ”reform and liberation” was announced in 1978. Retail prices have fallen for 24 straight months since October 1997 (Figure 1-4-9). Real GDP growth was 7.8% in 1998 and 8.3% year on year in the first quarter of 1999. But this strong growth was supported by public investment, and there are no signs that the weakness in consumption, which accounts for 60% of GDP, and the decline in prices are likely to cease. Real GDP growth was 7.1% in the second quarter of 1999 and 7.0% in the third quarter.

    In China's case, the basic factors causing the deflationary trend include weak personal consumption due to a slowdown in income growth and an increase in the savings rate, reflecting anxiety about the future. Excess facilities and inventories are among other factors causing the deflationary trend. Structural problems exist as well, such as higher unemployment as a result of reforming state-owned enterprises, and huge amounts of non-performing loans. The economic slowdown and falling prices are thus problems beyond simple cyclical economic downturn.

(Income growth moderates and propensity to consume falls)

    Per-capita real income growth in urban areas fell to the 3-4% range in 1996 and 1997, reflecting a growing pool of unemployed (or latent unemployed) because of the reform of state-owned enterprises (Figure 1-4-11). Also, income growth in rural areas has remained around 5% on average since the mid-1990s, due to falling agricultural income and moderation of income growth for township and village enterprises (enterprises run by towns, villages, farmers, etc.). The unstable employment environment resulting from increased layoffs and the reform of the social security system, such as abolition of welfare/housing schemes and self-payment of medical expenses, have left households anxious about the future. Consumers tend to postpone purchasing goods because they believe prices, particularly those for consumer durables, will soon fall further. The savings rate in urban areas increased from 17.4% in 1995 to 18.9% in 1997 and 20.1% in 1998. The savings rate in rural areas, which remained between 10-19% from 1990 to 1996, increased to 22.6% in 1997.

(Oversupply surfaces)

    In China, many sectors expanded production capacity in the period from 1992 to 1994, when the economy overheated. A large number of facilities for producing consumer durables and other goods started operation in 1995. As a result, production capacity came to exceed demand by a huge margin and oversupply hit many product markets. This has led to a major decline in capacity utilization. According to the Third Industrial Census conducted in 1995, capacity utilization in the various consumer goods sectors is remarkably low. Some industries of producer goods are only using less than 60% of the capacity they have, which proves that there is an overall excess of production capacity (Table 1-4-16).

Section 5: International finance/commodity markets

(Foreign exchange trends)

    Under the strong dollar policy of the Clinton administration, the U.S. currency has been on a rising trend since 1995. The nominal effective exchange rate index (1990 = 100) rose to a high of 116 points in August 1998, before dropping to 104 points in mid-October as financial markets contracted worldwide following the wake of the devaluation of the Russian ruble. Though the index regained its strong tone thereafter thanks to a return to stability of the financial environment, the index turned weak in July 1999, since the dollar fell significantly against the yen (Figure 1-5-1). Looking at the nominal effective exchange rate index for the euro (1990 = 100), the currency (ECU: before 1999) was firm from August 1997 but turned weak in and after October 1998. It has remained more or less on a declining trend. East Asian currencies strengthened against the U.S. dollar in and after October 1998, as did the yen during the period. They have gone more or less unchanged in 1999, however (Figure 1-5-6).

(Long-term interest rate trends in Western countries)

    Long-term interest rates in the U.S. had been falling for quite some time. Funds flowed into highly creditworthy U.S. government bonds when the worldwide financial crisis broke out in September/October 1998 after Russia stopped servicing its debt. Other factors helped push U.S. rates down as well. With the FRB loosening its monetary policy by lowering interest rates three times, the bout of credit contraction came to an end. In 1999, long-term interest rates began to climb in response to a fear of mounting inflationary pressure as the economy overheated and the labor market tightened. Long-term interest rates eventually climbed above 6%. After the euro was introduced in Europe, because of fears of economic slowdown hanging over such key members of the Monetary Union as Germany and Italy, the ECB interest rates were expected to be reduced. But German long-term interest rates rose due to repeated statements against a cut in rates made by senior officers of the European Central Bank (ECB). In and after April 1999, when conditions in Yugoslavia became unstable, long-term rates rose. The euro remained weak even after the end of the Yugoslavia conflict and interest rates increased on the back of expectations for economic recovery.

(Stock price trends)

    In autumn of 1998, stock prices in the U.S. experienced a sharp drop due to a worldwide financial contraction. Thanks to timely monetary relaxation by the FRB, however, a slowdown in the economy due to the reverse wealth effect and other factors, was avoided, and stock prices regained their bullish tone. In early 1999, U.S. stock prices remained firm, repeatedly setting new record highs. In and after May 1999, however, further gains were limited by rising long-term interest rates, which reflected an economy that was too strong for its own good. The Dow Jones Industrial Average has remained in the 10,000-11,000 point range. Equity prices in Europe have remained firm. In particular, France's CAC-40 index surged thanks to a robust economy supported mainly by domestic demand. Stock prices in East Asian countries rebounded, as currencies began to appreciate around October 1998. In Asian NIEs, stock prices maintained their upward trend in 1999 as funds from overseas flowed in on expectations of economic recovery. In April 1999, stock prices returned to their pre-crisis levels in South Korea. In Singapore, the stock market posted a new record in July 1999, as manufacturing staged a notable recovery. In ASEAN countries, stock prices rallied in and after April 1999. In July 1999, however, stocks in both Asian NIEs and ASEAN countries declined slightly due to tighter monetary policy in the U.S.

(Commodity prices: the lowest level in 20 years)

    The CRB (Commodity Research Bureau) futures price index (1967 = 100), which reflects the prices of 17 primary commodity futures, turned weak in the first half of 1996. Although the index managed a temporary rebound thereafter, it continued downward and fell below 183 points at the end of February 1999, the first time it had been that low in some 24 years (Figure 1-5-20). Though it did move up from there, the momentum was weak and the index was at 204 points (monthly average) as of October 1999, due to the fact that more time was needed to liquidate excess inventory.

(Crude oil prices: shifting to an upward trend in 1999)

    Crude oil prices (Brent, spot prices) grew weak at the end of 1996 and continued to decline thereafter because of poor global demand. They fell beneath the historic low of $10/bbl at the end of 1998. But as it became apparent that the OPEC countries would agree on additional production reductions at the general meeting held in March 1999, crude oil prices rallied and were at about $22/bbl in early November 1999, their highest level in two and a half years, as oil producing countries adhered to the agreement (Table 1-5-23).

Section 6: Strengthening of international currency and financial systems

    The currency and financial crisis which started in Asian countries in the latter half of 1997 spread to Russia and Latin America, which revealed the vulnerability of international currency and financial systems. In this section, approaches to strengthening international currency and financial systems to prevent or solve future crises are discussed.

(International currency and financial crises, herd behavior and the contagion effect)

    With the rapid progress of technology in both hardware such as those used for information and telecommunications and software such as those used for derivatives transactions, international currency and financial systems have undergone significant changes. In particular, 1) the effects of international currency and financial problems spread within and between national markets more rapidly than before, 2) the number of transactions by investors exploiting time differences increased, and 3) the ratio of short-term debt in foreign currencies to net international reserves increased. Under these conditions, the global financial market is essentially characterized by currency and financial crises stemming from herd behavior and the contagion effect.

    Herd behavior occurs when the number of investments based on an assessment of ”whether many other investors will regard the investment as good or not” outweigh the number of those based on the criterion of ”whether the investment is good or not.” If the ratio of short-term foreign debt to net international reserves in a certain country is high, the capital market of the country is not only vulnerable to sudden herd behavior by investors, but also tends to induce such herd behavior.

    Contagion effect takes place 1) when currencies or stock prices react to a common shock in a similar way in countries which have similar economic structures or conditions, and 2) when investors who suffered losses in one country try to make up for them by selling assets in another country.

(Lessons learned from currency and financial crises in emerging economies)

    Recent currency and financial crises taught us several things concerning 1) how to proceed with liberalization of capital transactions, 2) what exchange rate regimes should be, and 3) whether capital control would be allowed in times of crisis.

    Concerning the process of liberalizing capital transactions, there is international agreement that liberalization should proceed in a careful and well-sequenced manner after confirming that the conditions are appropriately met.

    With exchange rate regimes, it should be noted that different countries need different systems which reflect, depending on the time period in question, differences in the sizes of economies, composition of trading partners and degree to which trade and capital markets have been liberalized.

    When it comes to controlling capital transactions, emerging economies should take a pragmatic approach by examining -- through comparing the costs and benefits of capital control -- under what conditions capital control is justified as a means of crisis management.

(Establishing a system to prevent international currency and financial crises)

    Based on the ”Report of G7 Finance Ministers to the Cologne Economic Summit” (June 1999), we focus on 1) strengthening and reforming international financial institutions and international policy coordination, 2) enhancing transparency in international financial markets, 3) strengthening financial regulations in industrialized countries, and 4) principles for private-sector involvement in crisis resolution.

    In strengthening and reforming international financial institutions and international policy coordination, it is important to 1) enhance accountability of the IMF for its actions, and 2) continue to conduct systematic evaluations both internally and externally of the effectiveness of IMF actions.

    To enhance transparency, international financial institutions, monetary authorities of each country and private sectors should further promote information disclosure.

    Concerning the improvement of financial regulations in industrialized countries, it is important to 1) require creditors and investors to improve their risk evaluation and risk control, 2) let supervisors and regulators monitor the activities of highly leveraged institutions so that excessive leverage does not lead to excessive concentration of risk, and 3) require offshore banking centers to comply with international standards.

    The key issues surrounding private-sector involvement in crisis resolution are as follows: 1) debtors should be responsible for meeting their debts in full and on time, and 2) creditors should accept the consequences of the risks they take (to prevent moral hazard).

(International currency and financial systems as public goods and markets)

    In the financial markets, a kind of regulation mechanism is naturally created by the work of participants. No government can implement effective policy if it disregards market movements. FRB Chairman Alan Greenspan emphasizes the importance of regulation created by private market participants, calling it private market regulation.

    IMF Managing Director Michel Camdessus says, ”promotion of the global public good, not merely the correction of disequilibrium in the assisted country, is the clear purpose of the IMF's financial assistance”

    Therefore, it is necessary to fully utilize the functions of regulations which are created autonomously and endogenously in international financial markets. At the same time, greater efforts should be made to answer a question concerning how governments and international currency and financial systems should make up for the limitations inherent in such regulations.

Part 2. The U.S. economy: Factors of its long-term expansion and vulnerabilities

Summary of Part 2

[Characteristics of economic expansion in the 1990s]

    The U.S. economy began to recover in March 1991, and steady economic expansion has continued for a period of eight years and seven months up to October 1999. The economic expansion of the 1990s has been characterized by the ”stable” continuity of good performance ”over an extended period.” The current expansion phase is also characterized by extremely low inflation and unemployment rates. The misery index, which is defined as the sum of inflation and unemployment rates, hit a record low in April 1998 for the first time in 33 years.

[Factors of economic expansion in the 1990s]

    Factors supporting long-term, steady economic expansion in the U.S. include (1) appropriate economic management represented by preemptive monetary policy, (2) greater structural flexibility of the economy, including the labor market. The concurrent realization of low inflation, low unemployment and high economic growth since 1997 have been facilitated by (3) temporary factors, such as the appreciation of the dollar and a fall in prices of primary commodities.

[Productivity gains in the U.S.]

    As the rate of economic growth accelerated over the past few years, productivity growth clearly increased as well, even after allowing for cyclical factors. By industry, productivity gains in manufacturing, especially in high-tech industries such as electrical and electronic equipment, are higher. Factors supporting gains in productivity include the improved quality of capital stock due to increased investment in information and telecommunications equipment. Such high growth in productivity may not remain the norm, however, because it is unlikely that the current investment boom will continue over the long term.

[Vulnerabilities of the U.S. economy]

    The following four issues cloud the outlook for the U.S. economy: (1) overvalued stocks, (2) extremely low household savings rate, (3) expanding current account deficit, and (4) mounting inflation concerns. The task at hand is to usher in a soft-landing of the economy without triggering a sharp fall in stock prices or the value of the dollar.

Section 1. Characteristics of economic expansion in the 1990s


1. Long-term stable expansion

    The economic expansion of the 1990s has been characterized by the ”stable” continuity of good performance ”over an extended period of time.” Growth has stayed in the 2-4% range, which is not so high compared with past periods. But since 1991, stable expansion has continued for about nine years without any major fluctuation (Table 2-1-2).

(Personal consumption)

    During this expansionary phase, stable growth in personal consumption, which accounts for about 70% of GDP, was a major factor behind the economy's strength. Contributing to stability in consumption was the fact that fluctuations in the consumption of durable goods, especially automobiles, were smaller than they had been in the past.

(Business investment)

    Growth in private business investment also remained firm, reflecting changes which resulted in more investment in areas little affected by economic fluctuations, such as IT investment, and less spending on buildings, industrial machinery and other investments vulnerable to changes in the economic environment.

(Housing investment)

    Housing investment has remained steady thanks to stable interest rates, firm household income growth, introduction of policies which create demand, increased demand for more expensive or larger houses among baby boomers, who began buying real estate in the 1980s, and other factors.


2. Interest, inflation and unemployment rates were all low

    One reason for the stable economic growth may be that interest, inflation and unemployment rates were all low. Real interest rates declined toward the end of the 1980s and stayed down. Inflation rates fell significantly at the beginning of the 1990s and remained under control. Unemployment rates have continued to fall and have settled at its lowest level in 30 years (Figure 2-1-10).


3. High stock prices: causes and effects

    One characteristic of the current expansionary phase is that (annual) increases in stock prices have been the highest in history. With the relationship between stock prices and the real economy stronger than ever, the influence stock prices have on the economy is greater than it was in the 1980s and before.

(Characteristics of rising stock prices in the 1990s)

    It is useful to consider two characteristics of the rally in equity prices. The first is that stock prices have remained high despite a feeling that they have been overvalued, with the second being that volatility has declined. The rally in stock prices has been fueled by an increase in the expected rate of return and low interest rates. One driving factor on the demand side is that demand for stocks, which are comparatively attractive when interest rates and inflation are low, has increased among baby boomers saving for retirement. A factor on the supply side is that corporations have been very active in redemption of shares by purchase.

(Relationship between stock prices and the real economy)

    Higher prices have stimulated personal consumption through the wealth effect. And this has led to strong economic growth in recent years. The reason the wealth effect is greater than before is that the relationship between households, financial assets and stock prices has strengthened, as stock prices have risen sharply and individual investors have increasingly chosen stocks for their retirement savings. Consequently, the proportion of households' total financial assets represented by stocks has almost doubled.

Section 2. Factors behind stable economic expansion in the 1990s

    Factors supporting long-term stable economic expansion include 1) appropriate management of the economy and 2) an increasing flexibility of the economic structure. The simultaneous realization of low inflation, low unemployment and high growth since 1997 have largely been made possible by 3) temporary factors.

(The effects of policies)

    The U.S. economy has continued to extend its record for the longest economic expansion under normal circumstances. Stable expansion has been largely made possible by the implementation of appropriate policies. In other words, a preemptive and timely monetary policy prevented the economy from overheating and helped to stabilize prices (Figure 2-2-2, 2-2-3). The administration of monetary policy in the U.S. in the 1990s has focused on smooth communication with markets, preemptive policy measures in consideration of the economy's future course and various lags inherent in policy formation and implementation and the ability of the Federal Reserve to operate free of political pressure. As a result, the necessity of sharply raising interest rates to cope with higher inflation has been avoided, unlike in the past, and long-term economic expansion was made possible. Confidence in FRB Chairman Alan Greenspan has grown excessive, however, and stock prices have risen to the point where it is increasingly felt that they are overvalued. Efforts to curtail expenditures on defense and in other areas and increased tax revenue due to the booming economy have led to a reduction in the fiscal deficit. The resulting shorter supply of government bonds has pulled long-term interest rates down, thereby stimulating investment and consumption. Furthermore, deregulation in the telecommunications, energy and transportation sectors since the 1970s contributed to stable economic growth by facilitating a decline in prices, greater job creation and the development of efficient markets. Low interest rates and other economic conditions, which have been achieved by the series of successful policies mentioned above, have created a suitable environment for long-term stable expansion of consumption and investment.

(The increasing flexibility of the economic structure)

    Contributing to the stable economic expansion has been an increase in the inherent flexibility of the U.S. economy thanks to deregulation and the opening of markets since the 1970s. In other words, an improvement in the flexibility of the economic structure has accelerated adjustment speed, strengthening resilience in the face of changes to the economic environment and helping stable economic expansion to be achieved. For example, high start-up/shutdown rates and a large net increase in the number of corporations operating in the U.S. are appropriate for efficient allocation of labor and capital under the rapidly changing current economic circumstances.

    Higher mobility of labor thanks to the success of the temporary help business and improved portability of pensions has caused NAIRU (Non-Accelerating Inflation Rate of Unemployment) to decline. As a result, the simultaneous achievement of low inflation and low unemployment has been made possible (Figure 2-2-16). Our estimation based on data up to 1996 shows that NAIRU was around 6% at the very beginning of the 1990s and may have declined to less than 5% in 1991-1993.

(Temporary factors deserve much credit for the simultaneous realization of low inflation and unemployment)

    During the current expansionary phase, growth has risen to almost 4% since 1997, and low unemployment in the low 4% range and low inflation of about 2% have been simultaneously achieved.

    The simultaneous realization of high growth rate, low inflation and low unemployment since 1997, however, was largely due to temporary factors. These include 1) a fall in prices and a reduction in other costs due to appreciation of the dollar and the drop in import prices for raw materials (accounting for an estimated 0.8 percentage point of the total 0.9 percentage point drop in consumer prices in the period from 1991/1996 to 1997/1998), 2) a fall in prices due to intensified competition with the increased flow of imports (accounting for 0.1 percentage point), and 3) a reduction in medical insurance and other expenses, which curbed employment costs (accounting for 0.2 percentage point).

    Temporary factors thus fully explain the reduction in the consumer price inflation for the period from 1991/1996 to 1997/1998. Therefore, there is a strong possibility that the current environment, with its low rate of inflation, is quite vulnerable to an increase in upward price pressure, depending on exchange rate movements and commodity prices, including those for crude oil. Crude oil prices have already started rising in 1999.

Section 3. Productivity gains in the U.S.

(Labor productivity trends)

    The rate of economic growth has increased over the last few years, and along with it the rate of growth in labor productivity has been accelerating since 1996. Though the gains may be affected by revisions to inflation statistics or short-term economic cycles, we can say that the rate of labor productivity growth increased, even excluding the effects of these factors. Concerning the influence of revisions to inflation statistics, the GDP deflator was revised down by 0.21 percentage point since 1996, which accelerated the rate of growth in labor productivity by the same amount. As for short-term economic cycles, labor productivity growth generally picks up due to labor input being relatively slow in catching up at a time of increasing demand. Short-term economic fluctuations are thought to have added 0.30 percentage point to the rate of labor productivity growth in each year since 1996. Factoring these influences out of the 1.94% annual labor productivity growth rate seen in the non-farming private business sector since 1996 leaves us with a real growth rate of about 1.43% (1.94 - 0.21 - 0.30) (Table 2-3-5). Since the real rate of growth is higher than in the past (1.12%), we may safely say that real labor productivity growth has increased since 1996.

(Productivity trends by industry)

    Not all industries have experienced improvement in labor productivity to the degree mentioned above. Looking at industries which saw an improved productivity growth rate, durable goods manufacturers enjoyed high growth rates in the 1990s (Table 2-3-6 (1)). The growth rate for high-tech industries, including electrical and electronic equipment, was particularly high, and it accelerated in the latter half of the 1990s. The high labor productivity growth seen in these industries during the 1990s contributed to the acceleration of productivity gains for the economy as a whole.

    Non-manufacturers as a group did not experience gains in labor productivity because the service industry posted a negative rate. It is possible, however, that the actual rate of growth in the service industry is not as low as it seems, since the industry's production figures may be underestimated due to measurement difficulties and other factors.

(Factors supporting productivity gains)

    What factors contributed to the acceleration of labor productivity growth, mainly among durable goods manufacturers, in the latter half of the 1990s? Though the limited availability of data prevents us from drawing a concrete conclusion, the improved quality of capital stock owing to the investment boom of the 1990s was an important factor. In addition, the information and telecommunications revolution had a positive effect, and management innovation may also have improved efficiency (Figure 2-3-11 (1)). The phenomena of productivity not improving on the macro level despite the progress of information technology has been referred to as the productivity paradox. On the micro level, however, we observe a correlation between the progress of information technology and labor productivity. A positive correlation is found between the rate of labor productivity growth and the IT stock ratio (IT-related capital stock/the aggregate amount of capital stock) in all industries except service during the 1980s and 1990s. However, since the relationship between IT stock ratio and labor productivity growth is not clearly established in the service industry, which accounts for 1/5 of the overall economy, greater IT investment ratio does not necessarily boost productivity on the macro level (Figure 2-3-15).

(Sustainability of productivity gains)

    We cannot conclude that productivity gains will continue from here on because there are many uncertainties. IT investment is expected to remain high because the speed of technological innovation in the computer and related industries is so rapid, and because IT investment is not affected by economic fluctuations. As a result, productivity growth may continue as the IT stock ratio grows. But there are three reasons labor productivity improvement may not continue at its recent rapid pace. These are: 1) it is unclear whether IT investment will continue to increase and whether the quality of capital stock will improve, when the economy slows down, 2) some industries cannot use IT investment as a substitute for the labor force and the capital stock that they require, and 3) as labor productivity gains in the service industry cannot be measured properly, it is difficult to forecast this industry's productivity figures. Therefore, it is necessary to collect and analyze more detailed data concerning the relationship between IT investment and labor productivity and to properly grasp the concept of value added in the service and other sectors. By doing so, a sufficient amount of information must be obtained before we can accurately assess the prospects for future productivity.

Section 4. Vulnerabilities of the U.S. economy

    Although the U.S. economy has performed impressively in recent years, there are four major factors clouding the outlook: 1) overvalued stocks, 2) a declining household savings rate, 3) the expanding current account deficit, and 4) growing concern about inflation.

(Overvalued stocks)

    Overvaluation of U.S. stocks has been repeatedly pointed out in the last couple of years. Stock prices in the second quarter of 1999 were higher than the level justified by corporate earnings and long-term interest rates by 20-55%, based on various estimations (Figure 2-4-1). So why do stock prices remain high in the face of overvaluation? One reason may be that there is a delay in the adjustment of stock prices because of confidence in the Federal Reserve. If stock prices were to fall sharply, the effect on the real economy and overseas markets would be serious. The relationship between consumption and stock prices has been fortified by the wealth effect and other factors (Figure 2-4-10). Consequently, plummeting stock prices would reduce the pool of financial assets in the possession of households and slow consumption. The corporate sector would see the cost of capital rise. Furthermore, since the correlation between stock prices in the U.S. and those in other countries strengthened in the latter half of the 1990s, it is feared that a sharp drop in the U.S. stock prices would influence financial markets overseas.

(Declining household savings rate)

    The household savings rate has continued to fall in the 1990s. The significant decline may be due to the wealth effect in the household sector as a result of rising stock prices, lower unemployment, higher income and the improvement in consumer confidence generated by these factors. In particular, since there is a strong relationship between the ratio of financial assets to disposable income and the savings rate (Figure 2-4-13), the wealth effect resulting from higher stock prices is substantial. Therefore, the savings rate will not remain so low unless stock prices continue to rise.

(Current account deficit)

    The current account deficit is extremely large because of strong consumption and investment, hitting an all-time high of about 80.7 billion dollars (3.5% of nominal GDP) in the second quarter of 1999 (Figure 2-4-20). In the 1980s, the budget deficit expanded as well. In the 1990s, there has been a considerable degree of excess investment in the private sector, with the sectoral investment/savings balances differing greatly from those in the 1980s. The trade deficit has expanded because import growth has been larger than export growth due to strong domestic demand. If the current account deficit continues to expand, 1) pressure to depreciate the dollar will increase and the inflow of funds from overseas may shrink, and 2) protectionist sentiment will probably become more prevalent.

(Growing inflation concerns)

    Inflation concerns have reemerged because of tightness in the labor market due to the overheating economy, a rebound in crude oil prices, the weaker dollar, higher external demand due to the recovery of overseas economies, and other factors. Inflation is likely to not only directly affect consumer spending and corporate investment but also push long-term interest rates higher, undermine stock prices and cause exchange rate volatility, which, in turn, lead to greater fluctuation in levels of consumption and investment. Depending on the trend of inflation from now on, it is possible that a rather restrictive monetary policy will be required and economic expansion will come to a halt. Should prices trend higher, the room for monetary relaxation would be limited at times when stock prices fall, and the economy may come down hard. It is thus essential to keep a close eye on inflation going forward.

Part 3. The World Economy when prices are stable

Summary of Part 3

[Current state of global price stability]

    Price stability has been one of the characteristics of the recent world economy. Inflation, which ran at double-digit rates in almost all industrialized countries in the 1970s, is now down to only several percent. In developing and transition countries, which have suffered higher inflation than industrialized countries, inflation rates have, in general, fallen significantly in recent years.

[Factors behind global disinflation]

    The price stability in industrialized countries can be attributed to the following factors relating to economic policy: (1) monetary policy has targeted price stability as the most important objective, (2) confidence in policymaking bodies that aim for price stability has improved because of fiscal consolidation. On the supply side, the following factors are important: (1) lower prices for primary commodities, including crude oil, (2) globalization, (3) progress in economic structural reform, such as regulatory reform, (4) technological innovation, and (5) changes in the labor market.

[Characteristics of economies with stable prices]

    With prices stable, economies are typically characterized by low nominal interest rates and low growth in nominal wage levels. The effective redistribution of wealth from creditors to debtors due to inflation is limited.

[Monetary policy when prices are stable]

    Macroeconomic policies have succeeded in achieving price stability in the 1990s. But new and difficult problems have emerged for policymakers: the possibility of deflation in times of recession and large swings in asset prices. Under current conditions, with inflation at a mere few percent and a possibility of deflation in times of recession, policymakers must be just as cautious of excessive decreases in rates of inflation as they would be of excessive increases. In particular, policy makers should be careful to prevent the economy from becoming caught in a deflationary spiral. Also, monetary policy cannot be successfully administered without taking into account the effects asset price movements have on economic and financial stability.

Section 1. Current state of global price stability

    Price stability has been one of the main characteristics defining the world economy of late. In almost all industrialized countries, inflation rates have gone from double-digit levels in the 1970s to a remarkably low level of a few percent today. In developing countries and countries in transition as well, which had to cope with higher inflation faced by industrialized countries, rates of inflation have fallen significantly in recent years.

(Industrialized countries: the progress of disinflation)

    Industrialized countries, which experienced soaring prices in the 1970s, included price stability among their most important policy objectives in the 1980s. The policies -- monetary policy in particular -- were successful overall, and falling prices for primary commodities such as crude oil helped to stem inflation. The average rate of change in consumer prices in industrialized countries declined to as low as 2.6% in 1986. And the disinflationary trend continued thereafter, except in the period from 1989 to 1990. The average consumer price inflation rate for 1998 was a mere 1.4%, the lowest level in some 30 years (Figure 3-1-1).

(Latin America: 1990s bring end to inflation)

    In the 1980s, Latin American countries suffered from low economic growth, huge budget deficits and hyperinflation driven by massive accumulations of debt. Prices skyrocketed in 1989 and 1990 but some semblance of order returned later in the decade thanks to smaller budget deficits and other factors. In Brazil, for instance, the consumer price index declined dramatically from about 5,000% (year-on-year change, June 1994), immediately prior to introduction of the Real Plan (currency pegged to the dollar, fiscal austerity, etc.) in July of the same year, to 16% in 1996 (the inflation rate was 3.2% in 1998).

(Countries in transition: price liberalization)

    When Russia relaxed price controls in 1992, prices there soared in a short period of time. During the early stages of reform in Russia, authorities had little success containing inflation because fiscal austerity and monetary restraint were not seriously implemented. But things changed once budgets were forced to follow IMF guidelines, with the consumer price inflation declining since 1995. After depreciation of the ruble in 1998, however, the consumer price inflation has risen sharply with the year-on-year growth rate of the consumer price inflation, exceeding 100% in the first half of 1999.

    In both Poland (1990) and the Czech Republic (1991), prices rose sharply following the introduction of full-scale reform measures. But the rate of change in consumer prices has been on a declining trend since 1995 thanks to fiscal austerity and other efforts.

Section 2. Factors behind global disinflation

1. Monetary policy

    To attain the objective of price stability, it is most important for policymakers to establish credibility. One approach is to reduce expected inflation and limit the discretion of monetary authorities by establishing some explicit nominal anchor (a kind of anchor to secure price stability) for monetary policy.

    In and after the mid-1970s, when many countries adopted floating exchange rates, a number of industrialized nations chose policies under which monetary aggregates were used as the nominal anchor. In the 1980s, however, the relationship between monetary aggregates and inflation weakened due to technological innovation in the financial markets and other factors. The result was a decrease in the effectiveness of policy targeting monetary aggregates. It was soon recognized that a variety of indicators should be used in setting monetary policy, including interest rates, prices, economic growth rates and employment, as well as monetary aggregates. At present, monetary policies based on consideration of such indicators are adopted in the U.S., Japan and other countries.

    In the 1990s, an increasing number of countries explicitly set inflation targets and developed monetary policies to meet that goal. In these countries, inflation rates dropped after the introduction of inflation targeting (Figure 3-2-2(2)). In countries which did not choose to follow inflation targeting, however, inflation rates generally trended lower. Thus, further observation is needed before we can accurately assess the effectiveness of inflation targeting.

2. Lower prices for primary commodities

    Prices of primary commodities, which were a factor behind the rise in prices in the 1970s, fell significantly in the first half of the 1980s. Thereafter, prices of primary commodities have remained more or less unchanged. Consequently, prices of primary commodities relative to those of manufactured products in industrialized countries have declined remarkably since the 1980s(Figure 3-2-4).

    Crude oil is representative of primary commodities. Supply side factors which drove the price of oil lower include 1) higher production in non-OPEC member countries, and 2) an increase in proven reserves of crude oil due to the advance of exploration technology. Factors on the demand side include 1) a downward trend in the consumption of primary energy compared to real GDP since the mid-1980s, and 2) a continuing decline in the percentage oil represents of primary energy as a whole due to solid growth in the use of alternative energies (Figure 3-2-7).


3. Structural factors on the supply side

(Globalization)

    With the progress of globalization, trade and foreign direct investment among countries has significantly expanded. Recent growth rates are particularly remarkable. Greater trade contributes to price stability by improving resource allocation because comparative advantage leads countries to specialize in production of certain types of commodities. Increasing foreign direct investment contributes to price stability by promoting technology transfers to developing countries and improving productivity in those countries.

(Progress on regulatory reform)

    Regulatory reform facilitates reductions in prices by enabling the market mechanism to work effectively and promoting competition. For instance, according to an OECD report on regulatory reform (1997), regulatory reform resulted in a 33% reduction in prices in the U.S. aviation industry (Table 3-2-12).

(Technological innovation)

    Technological innovation contributes to the reduction of prices by supporting the creation of new products, improving the quality of existing products and lowering production costs. For example, in the case of the U.S., the deflator for private fixed investment in computers and peripheral equipment for 1998 was down 73% from its 1992 level.

(Changes in the labor market)

    One factor contributing to disinflation was a decline in the rate of wage growth in industrialized countries, which reflected changes in the labor market. In the United Kingdom, for example, improvement in previously rigid labor-management relations and abolition of the minimum-wage system kept a lid on employment costs.


4. Demand side factors

    Due to the Asian currency and financial crisis, which was triggered by the devaluation of the Thai baht in July 1997, six East Asian countries (Indonesia, South Korea, Singapore, Thailand, Malaysia and the Philippines) collectively registered a negative GDP gap of approximately 10% in 1998. The large GDP gap is seen as an important factor in pulling down prices in industrialized countries.

Section 3. Characteristics of economies with stable prices

(Low nominal interest rates)

    In economies where prices are stable, nominal interest rates tend to be low because of a low expected inflation rate. The relationship between inflation and nominal interest rates in seven major industrialized countries indicates that nominal interest rates have tended to fall while inflation has trended downward in the 1980s and 1990s. But real interest rates have not moved downward over the long term. On the contrary, there was a period in which a negative correlation was observed between real interest rates and inflation (Figure 3-3-2). For example, during the high-inflation era of the 1970s, real interest rates turned negative.

(Downward rigidity of nominal wages and its effect on real wages and unemployment)

    Growth in nominal wages tends to be lower in economies with stable prices. Nominal wage growth in seven major industrialized countries slowed significantly from the 1970s through the 1980s and 1990s, reflecting a lower inflation rate. But the rate of growth in real wages has shown no such long-term downward trend (Figure 3-3-4). Due to the downward rigidity of nominal wages, there is a possibility that nominal wages (and real wages) will not decline to the level required to balance supply and demand in an economy with stable prices. As a result, there is a possibility that the natural rate of unemployment will rise.

(Public finance)

    Since almost all countries have some type of progressive tax rate system for personal income and other taxes, natural increases in tax revenue are least likely in economies with stable prices, not in times when inflation is high. As nominal interest rates are typically low for economies with stable prices, interest payments for government debt are considered to be less than when rates of inflation are high.

(Wealth Redistribution)

    In economies with stable prices, the possibility is slim that arbitrary redistribution of wealth from creditors to debtors due to inflation will take place. When prices decline, income transfers from debtors to creditors.

Section 4. Monetary policy while prices are stable

    Macroeconomic policies have succeeded in achieving price stability in the 1990s. But new and difficult problems have emerged for policymakers: the possibility of deflation in times of recession and large swings in asset prices. What policy responses are appropriate when inflation rates turn negative, rather than just being low or at zero, in a recession or when asset prices exhibit volatility when the prices for goods and services are stable? These are the new and important policy issues to be addressed when prices are stable.

(Concerns over deflation and monetary policy)

    In the 1980s and early 1990s, a general objective of monetary or economic policies in industrialized countries was to reduce inflation to lower levels. Under current conditions, with inflation running at a few percent and a possibility of deflation in times of recession, policymakers must be just as cautious of excessive decreases in rates of inflation as they would be of excessive increases. In a sense, problems could be even more serious in the former case. This is because monetary policy could be asymmetric under price stability. That is, monetary policy may find it more difficult to stimulate economies by monetary relaxation than to suppress overheated economies by monetary tightening.

    Generally speaking, to combat deflation, which is caused by demand side factors, expansionary monetary and fiscal policies should be adopted to prevent the economy from becoming caught in a deflationary spiral. For expansionary monetary and fiscal policies to be more effective, it is important to address structural problems, such as those of financial system and rigidities of labor markets.

(Fluctuations in asset prices and monetary policy)

    Policymakers, especially monetary authorities, must pay attention to not only the price stability of goods and services but also developments in asset prices (Table 3-4-1). It was often observed that significant volatility in asset prices caused or increased macroeconomic instability in the financial crises that hit some countries in the 1990s. Monetary policy should not have stabilization of asset prices as its objective. But monetary policy cannot be successfully administered without taking into account the effect asset price movements have on economic and financial stability.

    When asset prices exhibit large fluctuations, central banks should make effort to clarify the causes. To this end, a central bank should examine not only developments in asset prices, but also whether or not imbalances that can be abruptly reversed have occurred in other parts of the economy. In other words, monetary authorities should determine whether large imbalances have developed in the investment-savings balance in the private sector and in the current account. They must also pay attention to whether growth in money supply and outstanding credit is too high or too low compared with growth in nominal output.

(Costs and benefits of zero inflation and low inflation)

    As inflation rates for industrialized countries have dropped to a few percent, a question of which is preferable, zero inflation or low inflation, arises. Reasons low inflation is preferable include 1) downward rigidity of nominal wages, 2) a high sacrifice ratio (the number of percentage points of output lost while reducing inflation by one percentage point) when prices are stable, and 3) zero interest rate floors. On the other hand, reasons zero inflation is preferable include 1) a disturbance in resource allocation, 2) distortions in income distribution, and 3) unintended changes in tax liabilities due to non-indexation of the tax code, all of which are caused by inflation. In addition, we need to take into account the fact that official price indices tend to overstate real inflation rates. Based on these observations, a general conclusion that would be applicable to all countries cannot be drawn. Each country would have to answer the question of which is preferable, zero inflation or low inflation, taking into account its initial conditions, including its inflation rates, and its economic system.

(Concluding remarks)

    In this new environment characterized by stable prices, neither policymakers nor economic agents should follow behavioral patterns suitable in an extended era of high inflation. Rather, new behavioral patterns should be adopted that are more appropriate for new era. For the economy as a whole, inflation only redistributes wealth arbitrarily, and economic problems should basically be resolved through economic growth. The redistribution of wealth and income should be conducted through economic polices that are clearly defined.

Conclusion

(Recovery from the Asian currency and financial crisis)

    The Asian currency and financial crisis, which was triggered by the collapse of the Thai baht in July 1997, seriously affected the entire world economy in terms of both real and financial factors. In mid-August of 1998, the financial crisis took hold in Russia. This crisis was a major factor behind a sharp sell-off in U.S. stocks at the end of that month. The turmoil was soon carried over to the currency and financial markets in emerging countries, particularly those in Latin America. Against this background, a leading U.S. hedge fund found itself in a precarious financial position after suffering huge losses. In the latter half of 1998, concerns over the future course of the world economy prevailed for a short period of time. But thanks to monetary relaxation and other steps taken by industrialized countries, with the U.S. alone cutting interest rates three times from the end of September 1998, the worst-case scenario of worldwide depression was avoided.

    In 1999, Asian economies weakened by the crisis hit bottom and began to recover, while the U.S. economy expanded more rapidly than expected. For emerging economies, such as Russia and Brazil, the economic contraction caused by the currency and financial crises was not as serious as feared. In Japan, the economy has recorded positive growth for the first two quarters of 1999. The world economy is recovering in 1999, albeit at a modest pace.

    The world economy since mid-1997 has thus been characterized by the deepening of the Asian currency and financial crisis, the spread of the crisis' effects to economies around the world and finally recovery from those effects. Fortunately, the Asian economy is recovering at a more rapid pace than expected. But such regional recovery will not in any way diminish the importance of lessons learned from the crisis. Now is the right time for us to redouble efforts aimed at preventing future crises because global currency and financial systems have avoided a critical situation for the time being. It is essential for countries that were hit by the crisis to put greater effort into reform of their economic structures, including reform of the financial system, which invited the crises. At the same time, it is important for countries around the world to make a concerted effort to stabilize the international currency and financial systems.

(Global price stability)

    In this last White Paper for the 1990s, we focus on major characteristics of the world economy over the past decade, rather than on recent developments in the world economy, such as those discussed above. The first characteristic to look at is global price stability. In almost all industrialized countries, inflation rates have fallen from double-digit levels in the 1970s to a remarkably low level of a few percent today. In developing countries and countries in transition, which had to cope with higher rates of inflation than did industrialized countries, inflation has fallen significantly in recent years.

    In this new environment defined by stable prices, policymakers and economic agents should not follow the behavioral patterns appropriate for past era of long-term high inflation, but rather should adopt fresh behavioral patterns more fitting to the new era. Policymakers should not let their guard down just because prices of goods and services have stabilized. Due attention must be paid to asset price trends. In recent years, large swings in asset prices have greatly contributed to instability of the macro economy. When inflation was high, it was always desirable policy to try and bring it down. But under current circumstances, with inflation at a mere few percent, policymakers must be just as cautious of excessive decreases in rates of inflation as they would be of excessive increases. In particular, policymakers should be careful to prevent the economy from becoming caught in a deflationary spiral.

    Companies must develop approaches to business different from those effective in times when sales and profits were continuously growing in an era of high inflation. To generate sufficient earnings with lower sales, productivity improvement and the development of new products will be more important than ever before. Unlike in an era of high inflation, it is impossible to expect inflation to reduce real debt burdens when the environment is defined by price stability. Both corporations and consumers must therefore be careful not to accumulate excessive debt.

(Long-term stable expansion of the U.S. economy)

    The U.S. economy has exhibited remarkable strength in the 1990s. Though recession struck in 1990 and 1991, it was only moderate. The subsequent expansion of the U.S. economy will be the longest in the postwar era if it continues into February 2000. Considering the state of the European economy, which is beset with the structural problem of high unemployment, and a Japanese economy grappling with recession following the collapse of the ”bubble economy,” the robust nature of the U.S. economy during the 1990s has been impressive to say the least. With the economy experiencing steady growth for an extended period and unemployment low, the rate of inflation, which would typically have risen under such conditions, actually declined. And the federal budget, which was characterized by huge deficits at the beginning of the decade, turned to surplus in fiscal 1998.

    The strength of the U.S. economy may be explained by the fact that the country's economic structure had enough inherent adaptability (flexible labor market, efficient capital markets, etc.) to successfully cope with the rapid progress of information technology and globalization. Also, we can safely say that macroeconomic policies have been properly administered in the U.S.

    Long-term stable expansion on the macroeconomic level does not, however, necessarily guarantee stability for individual economic agents, such as workers and corporations. Because the labor market is flexible and labor mobility high among job categories, industries or regions, workers are forced to change jobs more frequently. With start-up/shutdown rates high, the management environment is very harsh for entrepreneurs. In general, U.S. citizens tend to respond positively to changes. Anyway, it is because individual economic agents have taken a positive attitude toward changes that the U.S. economy as a whole has been able to enjoy steady growth.

    Despite the rapid pace of the information technology revolution, it has been said that labor productivity did not improve in the U.S. (the productivity paradox). Since 1996, however, productivity has improved, primarily in industries manufacturing durable goods. Part of this productivity improvement may be explained by a downward revision of inflation statistics and cyclical factors reflecting the economic expansion. The balance of the gains in productivity can be viewed as improvement in real terms. The improved productivity over the last few years is largely the result of buoyant investment. To judge if the improvement in productivity continues, we must carefully monitor productivity trends and try to understand how productivity would be affected by a slowdown in the economy and in investment.

    The IT revolution has had an undeniable influence on productivity levels, with industries exhibiting high ratios of IT capital stock to total capital stock tending to enjoy higher productivity growth. As such, we can safely say that there is a positive correlation between IT investment and productivity. But not all industries have shared in the gains, since the wholesale industry, which has rapidly increased the rate of IT stock to total capital stock, has seen only a slight acceleration in productivity. Similarly, manufacturers of non-durable goods have invested enough to see their ratios rise but productivity has remained more or less unchanged. And the service industry actually experienced a decline in productivity, despite a higher IT stock/total capital stock ratio. Though no organization, including the U.S. government, seems to have figured out what is behind these phenomena, one factor is thought to be the difficulty in measuring productivity for service industry. It looks as if it will take more time for the benefits of information technology innovations to spread to many sectors of the economy. Looking at it another way, if benefits do spread to many sectors of the economy, it would be reasonable to expect continued improvement in productivity.

(Causes for concern in the U.S. economy)

    Although the U.S. economy has grown at a pace of around 4% per year since 1997, this rate is thought to exceed the economy's potential growth rate (about 2.4% according to an estimate by the Council of Economic Advisers) by a wide margin. Factors such as the recent strength in the dollar and the decline in prices of primary commodities explain why inflation has been subdued despite the high growth. If the environment changes and commodity prices rise, however, inflationary pressure could mount. Indeed, the prices of crude oil and some other commodities have already started to rebound.

    Domestic demand has been the primary factor supporting the strong expansion of the U.S. economy, with the wealth effect growing out of the stock market rally contributing a great deal to the buoyant consumer spending in recent years. As of the second quarter of 1999, it is estimated that stock prices exceeded by some 40% the level warranted by fundamental factors alone (interest rates, corporate earnings). This being the case, there would seem to be far more than a slim chance of stock prices declining sharply. And if a sell-off did occur, domestic demand, particularly personal consumption, would be dramatically affected. Furthermore, it is feared that a sharp fall in stock prices would not only affect the real economy but also seriously influence the currency and financial markets of the U.S. as well as those in the rest of the world. Needless to say, the U.S. government would respond to such a situation with expansionary macroeconomic policy, including easier monetary policy, and at present there seems to be enough room for such action. But if stock prices fell sharply at a time when the inflation rate starts to accelerate and restrictive policies become necessary, an effective policy response would be extremely difficult. This is another reason we have to keep a close eye on inflation.

    The strength in domestic demand has led to large current account deficits in terms of both the absolute amount and as a percentage of GDP (3.5% in second quarter of 1999). It will be very difficulty to maintain these huge deficits over the long term and there is a risk of it triggering depreciation of the dollar. A weak dollar, in turn, would push the rate of inflation higher.

    The most important task, not only for the U.S. but also for the world, is for the U.S. economy to experience a gradual slowdown from the current high levels of growth to sustainable growth, without triggering a sharp fall in stock prices or the dollar.

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