WHITE PAPER ON THE WORLD ECONOMY 1998
(SUMMARY)
CONTENTS
- Introduction
- Part 1: The current state of the world economy
- Section 1: Effects of Asian currency and financial crisis widen
- Section 2: Concern about the future has begun to appear in the U.S. economy
- Section 3: Economic expansion begins in Europe
- Section 4: Economic downturn worsens in Asia and Oceania
- Section 5: International finance and the capital market
- Part 2: The Asian currency and financial crisis and the world economy
- Section 1: Causes and characteristics of the Asian currency and financial crisis
- Section 2: The state of Asian economies after the currency and financial crisis
- Section 3: Recovery of East Asian economies after the currency and financial crisis
- Section 4: Effects of the Asian currency and financial crisis on the world economy
- Part 3: Trends in the labor market and progress toward reform
- Section 1: Characteristics and problems of the U.S. labor market
- Section 2: Labor market reforms and their results in Europe
- Section3: Rapidly worsening employment situation in Asia
Conclusion
Introduction
The Asian currency and financial crisis which began in July 1997 with the collapse of the Thai baht has not only constricted the economy of the region but also exerted a great influence on the world economy, throwing the currency and financial markets of Russia and Central and South America into disarray. In the U.S., the protracted period of economic expansion that began in March 1991 is still continuing, but in August 1998 the stock market registered a steep decline and since then has been performing erratically amid growing uncertainty over the future.
In this atmosphere of economic instability, there exist a number of risks, and deflationary pressure is generally increasing. Various arguments are being advanced on the policies needed to prevent a worldwide depression. In view of the fact that the direct cause of the Asian currency and financial crisis was sudden and vast movements of capital, the impact of accelerating international capital movements is also being discussed from a variety of angles. A survey of these discussions will be useful when considering the future prospects of the world economy.
Next, moving to questions of employment, the unemployment rate has declined in the U.S., the U.K., and the Netherlands. But it remains in double figures in Germany France, Italy, and other continental European countries. Despite economic recovery, the increase in employment is sluggish. In this way, the employment situation in the U.S. and Europe is has moved further in the direction of a bipolar structure. Various factors could be cited as possible causes, including differences in the flexibility of labor markets and systematic differences. Another interesting theme is the relation between reform of the labor market and the unified currency that will be introduced in Europe in January 1999. Since the currency and financial crisis, the employment situation in Asia has worsened greatly, pointing up the need for future establishment of unemployment insurance and other features of a social safety net.
From this perspective, this year's White Paper on the World Economy introduces and analyses important developments in overseas economies. Part 1 provides an annual review of the economic situation, presenting important topics by region. Part 2 analyses the Asian currency and financial crisis and its effect on the world economy. Part 3 discusses trends in the overseas labor markets and progress toward reform of those markets.
Part 1: The current state of the world economy
[Summary of Part 1]
Overview of the world economy
In 1997, the economic growth rate increased in the industrialized countries and there was economic recovery in transition countries. In Asia, however, the currency and financial crisis since July 1997 has slowed the pace of growth. The effects of the Asian currency and financial crisis were felt throughout the world economy, causing turmoil in the currency and financial markets of Russia, Latin America and so on. In 1998, the rate of growth in real GDP is expected to decline for the world economy as a whole.
U.S. and Latin America
In March 1998, expansion in the United States economy entered its eighth year. Domestic demand continues to be strong, and there are no signs that the economic fundamentals have weakened. However, developments are beginning to appear that give concern for the future, such as the sharp adjustment in the stock market that occurred in late August 1998.
In Latin America, there is a general trend toward economic growth rate decline.
Europe
Throughout 1997, the values of the currencies of continental European countries tended to decline, which increased their export competitiveness. In general, European economies are expanding, as increased exports are reflected in increased domestic demand.
Final preparations are underway for the start of the third stage of the European Monetary Union (EMU) in January 1999. The strength of the euro is being debated from a variety of viewpoints.
In countries making the transition to a market economy, growth is expected to decline slightly, due to factors such as the fact that Russia has returned to minus growth.
Asia
Asia experienced a currency and financial crisis starting in July 1997. In 1998, the growth rate is expected to decline sharply, especially in East Asia.
Section 1: Effects of Asian currency and financial crisis widen
Effects of Asian currency and financial crisis felt throughout the world economy
From 1994 through 1997, the world economy achieved growth of about 4%. As a whole, it was on a course of steady expansion. However, the Asian currency and financial crisis, which began in July 1997 with the collapse of the Thai baht, curtailed growth throughout the region. Moreover, it also led to a decline in exports to East Asia, and to a decline in prices for primary commodities. The effects of the crisis were felt throughout the world economy, causing turmoil in the currency and financial markets of Russia, Latin America and so on.
According to the IMF outlook, the United States and the EU countries will continue to enjoy steady economic expansion in 1998. However, Japan will show minus growth, depressing the growth rate for all industrialized countries to 2.0%. Among the developing countries, many countries in East Asia will show minus growth, and growth will also decline in Latin America. Therefore, the growth rate for all developing countries will decline sharply to 2.3%. With Russia returning to minus growth, the growth rate for all transition countries will be minus 0.2%, and the real GDP growth rate for the world will decline to 2.0%.
In 1997, the volume of world trade increased sharply by 9.7%. But due to the Asian currency and financial crisis, imports by developing countries are stagnating in 1998, with the rate of increase declining sharply to 3.7% (see Table 1-1-1).
Section 2: Concern about the future has begun to appear in the U.S. economy
The U.S. is in an eight-year-long period of economic expansion, which began in March 1993. In August 1998, however, in the wake of the disruption of international financial markets, the stock market registered its second largest decline in history. Since then the stock market has performed erratically, and figures giving cause for concern about the future have begun to appear in the U.S. economy.
Balancing of federal budget and conduct of monetary policy
As the strong performance of the economy produced a major increase in tax revenues, and government expenditures on defense and other areas were reduced, the government budget deficit has been steadily shrinking since 1993. In fiscal 1998, the budget showed a surplus of 70 billion dollars, the first surplus in 29 years. This improvement in government finances led to fewer issues of government bonds. We examined the impact of these developments on long-term interest rates, and found that they tended to result in lower long-term interest rates (see Chart 1-2-1). The lowering of long-term interest rates can be said to have increased the margin of liberty for exercise of monetary policy. In the area of recent monetary policy, the Federal Reserve System (FED) cut interest rates by 0.25% on September 29 and October 15, 1998.
Wealth effect through rising stock market prices and attendant risks
One reason why personal consumption has remained strong in the period of expansion since 1991 is an increased propensity to spend. The background for this is 1) the creation of wealth through factors such as the high stock prices, and 2) an increase in borrowing, encouraged by low interest rates (see Figure 1-2-2).
In the U.S., securities account for a relatively large share of household assets. This tendency has become more pronounced in the 1990s. The increase in personal consumption in the 1990s occurred together with a rise in the stock prices (see Figure 1-2-3). The stock market declined sharply in August 1998 in the wake of turmoil in international financial markets. The possibility remains that future declines in the average may result in a loss of wealth, thus putting a damper on personal consumption. We performed calculations using net financial assets, and found that their contribution to the increase in real personal consumption was 17.6% for the period from 1996 through 1997. This is the effect of direct ownership of securities. If indirect ownership through pension funds and mutual funds is included, it becomes about 1.6 times larger. This result can be compared with the minus 3.3% contribution to personal consumption after Black Monday in 1987. The share of securities in household assets has increased, and the influence of stock prices on consumption has become larger. Next, we calculated the negative wealth effect through declining stock prices. If the stock market average falls from its current level of approximately $8,000 to approximately $7,000 (a decline of approximately 12.5%), real personal consumption will decline by approximately 0.08 to 0.26% points, considering only directly ownership of securities. If indirect ownership is included, the decline is from approximately 0.12 to 0.42% points. Further, if the stock market average falls to $6,000 (a decline of approximately 25%), real personal consumption will decline by approximately 0.15 to 0.52% points considering only directly ownership of securities, and by approximately 0.25 to 0.84% points when indirect ownership is included. The share of personal consumption in GDP is about seven tenths. Therefore, if the market average declines to between $6,000 and $7,000, the annual GDP growth rate will decline by approximately 0.05 to 0.57% points.
Declining savings rate and worsening of household balance sheet
Although the savings rate of U.S. households has always been relatively low, recently it has shown a further decline. On the other hand, debt has increased encouraged by low interest rates. The ratio of personal debt to disposable income is now at a higher level than during the previous period of economic expansion (see Figure 1-2-6). For this reason, observers have pointed to the possibility of an adjustment in the household balance sheet, depending on developments in income, interest rates, and stock prices. Since 1996, however, outstanding consumer credit has been declining with respect to the previous year, even though incomes and consumption have been increasing. Possible reasons for this are 1) the amount of debt itself has reached such a high level that further borrowing is difficult, 2) security assets have increased because of high stock prices, resulting in the creation of wealth and an increase in consumption without relying on borrowing, 3) borrowing has been inhibited since 1994 by higher interest rates, and 4) banks have become stricter in screening loan applications, which has inhibited borrowing. Therefore, although it cannot be said at the present time that the ratio of debt to income is showing a major increase, the fact remains that outstanding consumer credit is at its highest level ever, which may imply a distinct worsening in the household balance sheet. Further developments in this area require close attention.
Plant and equipment investment in information technology
Within total investment in plant and equipment, the share of investment in information technology is increasing. This category is a very important indicator of trends in equipment investment. Investment in information technology is said to be resistant to variations in the economy (it has become an independent investment category). In fact, when we examined variation coefficients in investment in information technology, we found that the amount of variation was smaller than for other kinds of investment. Reasons for the small amount of variation in information technology investment include the fact that the pace of innovation in computer and software technology is fast, and that there is a great deal of demand from U.S. business for information technology. When we calculated the vintage of information technology and computer stock, we found that the vintage of computer-related stock in particular was only one year, showing that American business have a strong interest in information technology investments, particularly computer related investments (see Figure 1-2-12). Innovation in information technology can be expected to continue. Therefore, although the pace of investment in information technology may slow due to developments in the stock market, corporate earnings, and interest rates, it will continue to be a leading category in plant and equipment investment.
Latin America: economic slowdown due to external factors
The pace of growth in Mexican real GDP slowed from an increase against the previous year of 6.6% in the first quarter of 1998 to an increase of 4.3% in the second quarter. The decline in crude oil prices has begun to exert an influence on the economy around the end of 1997. Due to decreased revenues (in 1997 the share of oil-related revenues was about 36%), the government has carried out three reductions in expenditures in 1998, totaling 36.3 billion pesos (about 1% of projected annual GDP for 1998). In the area of finance, a plunge in stock prices was triggered by apprehension about Asian economies, including Japan, and by turmoil in the Russian economy. Mexican stock prices at the end of August were 29.5% lower than at the end of the previous month. The value of the peso is declining against the dollar (see Figure 1-2-14).
In Brazil, market disorder was quelled by the announcement of higher interest rates and measures to secure government fiscal consolidation, which came in the wake of the Thai currency crisis in July 1997 and the worldwide plunge in stock prices triggered by the Hong Kong crash of October 1997. In 1998, however, stringent fiscal policy and other factors have resulted in a slowdown in the domestic economy. In the area of finance, the devaluation of the ruble and apprehension about the devaluation of the Venezuelan currency resulted in a plunge in stock prices, which at the end of August were down 39.6% against the end of the previous month, falling to a level lower than after the 1997 Asian currency and financial crisis.
The pace of growth in Argentine real GDP slowed from an increase against the previous year of 7.4% in the first quarter of 1998 to an increase of 6.9% in the second quarter. The growth rate is expected to decline even further, because of declining exports due to the economic slowdown in Brazil, Argentina's main trading partner, and declining demand worldwide. Other countries in Central and South America have also experienced large declines in stock prices, which at the end of August were down 39.1% against the end of the previous month.
Section 3: Economic expansion begins in Europe
Western Europe: final preparations for currency unification
Unification of the EU is about to enter a new stage. The Economic and Monetary Union, which got underway in July 1990, has completed stage 1, in which market unification was achieved, and stage 2, in which preparations were made for the unified currency. In January 1999, it will enter the final stage 3, in which the unified currency (the euro) is actually introduced. The single monetary policy will be adopted and most financial transactions will euro denominated, including transactions in the private sector.
To participate in stage 3 of the EMU, EU Member States were required to meet the Maastricht convergence criteria by 1997. In May 1998, the European Council decided that 11 Member States met these criteria (see Table 1-3-1). The newly born currency area (which is often called Euroland) will have a population of about 290 million and a nominal GDP of about 6.9 trillion dollars. Its population will be greater than that of the U.S. (270 million), and its GDP will be comparable to that of the U.S. (7.3 trillion dollars).
As the participating states were decided, the framework for introduction and management of the euro was nearly completed. In the area of single monetary policy, the European Central Bank (ECB) was established in June 1998, and various aspects of the management system left unspecified by the Maastricht treaty were decided, including targets for monetary policy, the foreign reserve structure, and the introduction of a minimum reserve system.
Current state of Euroland economy
An overview of the Western European economy shows that, in the 11 participating states of the monetary union (Euroland), exchange rates tended to decline throughout 1997. This stimulated exports and led to economic expansion as increased exports were reflected in domestic economies. From 1997 through 1998, an uninterrupted policy of low interest rates has been adopted in Euroland, which stimulated private consumption and investment in machinery. Real growth in GDP against the previous year was 2.5% in 1997, 2.8% on an annual basis in the first quarter of 1998, and 0.4% on an annual basis in the second quarter (see Figure 1-3-2(1)).
On the other hand, due to the currency collapse which occurred in Asia in the latter half of 1997, exports from Euroland to Asia declined, which worked to depress GDP slightly (see Figure 1-3-2(2)).
In terms of employment, economic expansion in Euroland reduced the unemployment rate. This caused wages to rise slightly in some countries, but inflation has been stable (see Figure 1-3-2(3)).
Foreign reserves of central banks and short-term strength of the euro
From January 1999, when national central banks convert the Euroland currencies into the euro, foreign reserves which national central banks in Euroland hold in the Euroland currencies (for example, the lira and francs held by the German Bundesbank) will be treated in the same way as national currencies. This leads to the diminishment of foreign reserves of the national central banks in Euroland. Therefore, if national banks wish to compensate for the diminishment of their foreign reserves by buying other currencies (U.S dollars for example), the euro will be sold over the short term, which will depreciate its relative value.
In the industrialized countries, the amount of foreign reserves is closely related to the amount of imports (see Figure 1-3-4(1)). This is because foreign reserves signify the ability to meet external obligations, and it is considered proper to hold reserves corresponding to the amount of imports. Taking this point of view into account, the foreign reserves of Euroland were at an appropriate level in comparison to the average of other industrialized countries at the end of 1997. However, after the euro is introduced, they will be at an excessive level (see Figure 1-3-4(2)). If the amount of imports requiring foreign reserves declines, providing an incentive to reduce the amount of non-euro foreign reserves, the euro will be bought over the short term, which will appreciate its relative value.
A high level of foreign reserves contributes to international confidence by demonstrating the ability of EU states to meet their foreign obligations. On the other hand, if the level is too high, that amount of capital is not being used for productive purposes in the domestic economy. After 1999, the amount of foreign reserves held by national banks will vary depending on the judgement of the banks as to the appropriate target level. This issue requires attention because over the short term it will have a large impact on foreign exchange rates.
Russia: Devaluation of the ruble
In Russia, minus growth continued from the start of the transition to a market economy up to 1997. In 1997, real GDP showed 0.8% growth against the previous year. In 1998, however, growth was depressed by falling prices for crude oil, Russia's main source of foreign earnings, and by the effects of the Asian currency and financial crisis. Growth in real GDP was negative 0.9% in the second quarter and minus 7.5% in the third quarter against the previous year. Mining and manufacturing industrial production increased by 1.9% in 1997 and 1.3% in the second quarter of 1998, but plunged into negative growth showing minus 11.8% in the third quarter (see Figure 1-3-15).
Russian financial crises
In May 1998, Russia was hit by downward pressure on bond and foreign exchange markets and a decline in stock prices, touching off a series of financial crises (see Figure 1-3-16). The background for these crises is a large infusion of foreign capital (mainly short-term) in 1997. For the following reasons, this capital fled from Russia and touched off the financial crises. The first reason is the government budget deficit. The second is the decline in international prices of crude oil, Russia's main source of foreign earnings. This led to a large decline in export value and a large reduction in the current account surplus. In addition to these worsening fundamentals, other contributing factors included the economic situation in Asia and political and social instability at home.
Devaluation of the ruble
In August, there was apprehension that Russia did not have the resources to meet its short-term government bond obligations, and doubt that the government would be able to implement its financial stabilization program, which consisted mainly of reductions in government expenditures and strengthening of tax collection. The triple decline in stocks, bonds, and the ruble worsened. On August 17, the government and central bank announced a de facto devaluation of the ruble and a 90-day moratorium on repayment of some foreign debt in the private sector. The joint announcement also included a debt restructuring plan under which mid-term government bonds due to mature by the end of 1999 were converted into new national bonds.
In the wake of the devaluation of the ruble, inflation reached 9.6% in August against the previous year, and in September showed a sudden increase to 52.2%. The ruble continued to lose ground, and in early September the government abandoned its target trading band and allowed the currency to float.
The government is now faced by conflicting demands from the national assembly, which wants changes in economic policies, including strengthened control of exchange rates and the printing of more currency, and international society, which wants Russia to continue its reforms and transition to a market economy. The decisions made by the government will be watched closely.
Section 4: Economic downturn worsens in Asia and Oceania
East Asian economies suffer sharp downturn
The currency crisis which began in Thailand in July 1997 spread quickly to other ASEAN countries and South Korea. Thailand, Indonesia, and South Korea applied for aid from the IMF. The subsequent implementation of austerity policies brought a measure of stability to currencies and improvements in current account balances. But high interest rates and turmoil in the financial system took their toll on the economy, with consumption and investment dropping to new lows in 1998. The economic downturn in East Asia has also begun to spread to China and Taiwan, which up to now have been performing relatively well.
A year has passed since the onset of the currency crisis, but production is still declining and the employment situation is worsening. In view of the seriousness of the economic downturn, governments have turned to relaxed fiscal and monetary policies, but there is little hope for early recovery. Indonesia, Thailand, and many other countries are expected to register minus growth in 1998 (see Figure 1-4-2).
In many of the countries and territories in the region, inflation has been declining in recent years. But in 1998, currency depreciation and surging food prices have touched off a new round of inflation, primarily in the ASEAN countries.
Large decline in imports improves current account balances
Due to reduced exports of semiconductors and other products, the rate of increase in dollar-base exports from East Asia declined sharply in 1996. In 1997, the sudden plunge in currency values from the middle of the year helped exports to recover, but not to the hoped-for extent. In 1998, exports are down from the previous year in most countries. On the other hand, the economic slowdown has resulted in a large decline in imports, which has improved the balance of trade in most countries in the region.
Except for China, Taiwan, and Singapore, the countries of East Asia have had continuing deficits in their current account balances. But mainly because of the large decline in imports, the size of the deficits has been reduced. Korea and Thailand have shown a surplus since the fourth quarter of 1997, and Malaysia has shown a surplus since the first quarter of 1998 (see Figure 1-4-4).
Section 5: International finance and the capital market
Factors behind the strong dollar
The value of the dollar, which had been relatively stable throughout the 1990s, began to rise in 1995. It has generally continued to rise in 1998, although in the recent period since August it has tended to decline. According to the J.P Morgan nominal effective rate, the value of the dollar rose by 17.2% in the three years from September 1995 to September 1998. Although it is difficult to identify factors that affect demand in the currency market, the theory which explains long-term trends in the currency market in terms of purchasing power shows that price indices generally rose faster in the U.S. than in Japan and Germany. In terms of the actual economy, against the yen, the nominal wage gap (the excess of Japan over the U.S.) has been declining since the last half of the 1970s. Also, the advantage of Japan over the U.S. in per capita productivity has been increasing. In general, these factors have worked to decrease the purchasing power of the dollar. Next, assessing recent developments using the portfolio balance approach, which places more emphasis on short-term market movements, we see that the movement of the dollar against the yen was affected by a gap in real interest rates. Since 1997, this has made large contributions to the increased value of the dollar. Since 1997, the foreign assets factor has been gradually increasing its contribution toward a lower dollar (see Figure 1-5-3).
Continuing decline in international commodities market
Since 1996, the international commodities market has been in a period of adjustment. This has continued in 1998, impelled by the Asian currency and financial crisis, which depressed demand. In 1998, the Commodity Research Bureau futures index started the year at a monthly average of around 220 points. Although it briefly passed the 230 point mark, it later declined and as of September had fallen to just above 200 points.
Crude oil prices have been in a downward trend since 1996. They began to fall rapidly in November 1997, when OPEC increased its production quotas, plunging from 19 dollars to 13 dollars. For this reason, oil-producing countries worked out agreements to limit production at the OPEC general meetings in March and June 1998. The agreements included both members and non-members of OPEC. Since then, the market has been watching to gauge the effects of the agreements on price movements (see Figure 1-5-16).
Part 2: The Asian currency and financial crisis and the world economy
[Summary of Part 2]
Causes of the currency and financial crisis
The causative factors behind the currency and financial crisis that began in July 1997 with the collapse of the Thai baht include the overvaluation of currencies through exchange policies that effectively fixed national currencies against the dollar, large current account deficits and a rapid increase of short-term capital inflow, and weak financial systems.
Prospects for recovery of East Asian economies
Exports from Asian economies have not increased as much as was hoped for. Domestic demand has fallen dramatically, and production is still declining. However, bright signs such as lower interest rates have begun to appear in some countries.
For Asian economies to recover, it will be necessary to regain investor confidence by improving current account balances and implementing structural reforms. Because the mid- and long-term prospects for growth in East Asia have not changed significantly, it should be possible for the region to return to high growth after an adjustment period of several years.
Effects on the world economy
The depreciation of East Asian currencies contributes to improve the balance of trade in these countries, and to worsen it in other countries. Weakening of domestic demand in East Asia has resulted in falling prices for trade goods, particularly primary commodities. Countries with a high degree of dependence on export of these goods have been adversely effected.
With respect to the flow of capital, the crisis has shaken investor confidence in the prospects of the so-called emerging markets, putting a brake on the inflow of capital to these markets. In particular, investors have become more cautious of countries with government budget deficits or other macroeconomic imbalances, and countries which are highly dependent on the export of primary commodities.
Regulation of international capital flow
Some argue that the flow of short-term capital should be regulated. But it should be remembered that the free international flows of capital have brought great benefits to the world economy by facilitating the optimum allocation of resources around the world. However, countries with weak financial systems should, after reforming these systems, or while reforming these systems, proceed with the liberalization of capital in a well sequenced and prudent manner. The main focus of regulation should be short-term capital flows.
Risks in the unstable world economy and policy measures against them
There are a number of risks in today unstable world economy. General deflationary pressure is increasing. In order to prevent the risks from materializing, and to bring about a stable world economy, major countries such as the U.S., EU member countries and Japan are required to cope with the risks by sufficient stimulation measures and by financial assistance to emerging countries in difficulty.
Section 1: Causes and characteristics of the Asian currency and financial crisis
Accelerating international capital flows and the currency and financial crisis
The currency and financial crisis precipitated by the collapse of the Thai baht in July 1997 spread throughout East Asia, especially in South Korea, Indonesia, the Philippines, Malaysia and Thailand (called "the 5 Asian countries" below). The crisis produced steep depreciation of currencies and turmoil in financial markets. As the crisis widened and deepened, and as the flows of international capital accelerated, investor confidence was shaken not only in the East Asian countries but also in the economies of a number of developing countries. Subsequently, currency and financial markets were thrown into disarray in Central and South America, Eastern Europe, and the CIS countries, including those countries which are highly dependent on the export of primary goods.
Causes of the Asian currency and financial crisis
The crisis was triggered by the outflows of capital from these countries. But this was not the only cause. In the background were a number of problems faced in recent years by East Asian economies, including; 1) the maintenance of de facto fixed exchange rates against the dollar; 2) large current account deficits and a rapid increase of short-term foreign capital inflows (see Figure 2-1-3) and 3) weak financial systems. The crisis has struck a heavy blow against the economies of the region, but these were the basic causes which resulted in the current situation. However, these three causes are not uniformly applicable to all countries in the region. There are differences in degree, which have resulted in large differences in the impact of the crisis (see Table 2-1-4).
Section 2: The state of Asian economies after the currency and financial crisis
Deepening of the currency and financial crisis and the current economic situation
In the 5 Asian countries, the current account balance has significantly improved. External demand has made a major contribution to growth, but this has been more than cancelled by the weakening of domestic demand. The economic outlook is generally harsh, with GDP and industrial production indices showing negative growth against the previous year in all of the countries.
It is hoped that exports will be the driving force in the recovery of the 5 Asian countries. An examination of trends in exports in real terms shows that there has in fact been a significant increase in exports from the 5 Asian countries most strongly affected by the currency and financial crisis. However, a comparison with the crisis that occurred in Mexico in 1994 shows that growth in real exports is substantially lower (see Figure 2-2-5).
Stagnation of domestic demand in East Asia
Despite the fact that external demand is making a major contribution to growth due to substantial falls in imports in the 5 Asian countries, their current GDP growth rates are negative. Further, the growth in production that normally accompanies an increase in real exports has not appeared. In these countries, the governments have implemented austerity economic policies. In the household sector, inflation by rising prices for imported goods as the result of currency depreciation and the worsening employment situation have restrained consumption. In the corporate sector, the swelling debt burden has become a constraint on management.
This is because the extent of the decline in domestic demand has been very large. Prospects for recovery are further clouded by the fact that turmoil in the financial system has made it difficult to obtain import credit and supply funding to industry. This means that the industrial sector has found it difficult to obtain the funding it needs to maintain and increase production, and that it has become difficult to import capital and intermediate goods. In particular, financial institutions are saddled by a significant amount of non-performing loans, which has hindered expansion of domestic demand (see Figure 2-2-8).
Section 3: Recovery of East Asian economies after the currency and financial crisis
---Comparison with the Mexican crisis---
Comparison with the Mexican crisis
It is difficult to believe that the 5 Asian countries which have felt the effects of the Asian currency and financial crisis most strongly, will, like Mexico, achieve an export-led recovery in a fairly short period. Reasons for this are as follows: 1) Although it is hoped that exports will lead the recovery in the 5 Asian countries, the increase in real exports is not as large as Mexico's; 2) Both Mexico and the 5 Asian countries responded to their crises by adopting austerity budgetary policies. This was effective in Mexico because the major cause of the Mexican crisis was the government budget deficit. In the case of the 5 Asian countries, however, there remains some doubt whether it was the most appropriate course of action; 3) Financial institutions in the 5 Asian countries are still in a difficult financial position. This is having a major adverse effect on the real economy, so that solving the problem will be costly and will require a great deal of time (see Table 2-3-1).
Recovery scenario
In 1998 the currencies of each of the countries except Indonesia (South Korea, Malaysia, Thailand, and the Philippines) have recovered. Since January 1998, interest rates have also fallen in South Korea and Thailand. Further, in South Korea and Thailand, reform of the financial system has begun. These developments show that there are some bright signs in the economy other than increased exports. According to the recovery scenario, each of the countries will register a large surplus in its current account balance. Foreign reserves will increase, which will bolster investor confidence. This will stimulate the inflow of foreign capital and have a good effect on the real economy in addition to easing the downward pressure on national currencies. As a result, it will become possible to lower interest rates. In fact, South Korea and Thailand have carried out large reductions in their interest rates, and it is hoped that rates will continue to drop in all of the countries. Falling interest rates and recovering capital inflows are expected to enhance consumption and investment. Together with rising external demand, these will lead the East Asian economies to recovery.
Prospects for mid- and long-term growth in East Asia
The current crisis has brought no major changes to the factors which historically have contributed to a high growth rate in East Asia: a solid macroeconomic environment, including a high savings rate and relatively sound budgetary policy, a high level of education and human resources, and economic interdependence within the region through trade and direct investment. Therefore, after a number of years of adjustment, it should be possible for the countries now affected by the crisis to return to high growth.
Section 4: Effects of the Asian currency and financial crisis on the world economy
Globalization of the world economy is being furthered by factors such as progress in information and communications technology and the deepening of economic interdependence through trade and direct investment. Against this background, the Asia currency and financial crisis is exerting an influence on the entire world economy through trade, financial transactions, and so on(see Figure 2-4-1).
1 Trade effects
Examination of export trends in the U.S., Japan, and three European countries (the U.K.,France,and Germany) show that growth of exports in U.S. dollar terms from these three regions to East Asia has declined. For the world economy as a whole, the decline in exports to East Asia is a negative factor that signifies lower total world demand.
The decline of demand in East Asia is an important factor behind the recent decline in the price of primary commodities. In the 1990s, high growth in East Asia has resulted in increasing consumption and imports of primary commodities. But the current crisis and economic downturn have brought great reductions in the demand for primary commodities, with the effect of depressing prices for all primary commodities (see Table 2-4-6)
2 Effects through capital flows
Trends in bank lending
We examined trends in borrowing from banks of industrialized countries for the period from the end of July 1997 to the end of December 1997. Although the total amount of borrowing by developing countries (including transition countries) remains high, loans with a maturity of one year or less have decreased sharply. During this period, outstanding debts of Asian countries to North American and Japanese banks were reduced, while outstanding debts to European banks increased.
Trends in direct investment since the crisis
In February 1998, UNCTAD conducted a survey of 500 corporations in Japan, the U.S., and Europe, and found that companies in all three regions have not lost their confidence in growth in East Asia. Despite the current crisis, many companies reported that they had not altered their direct investment plans. In particular, 57% of manufacturers reported that they had not altered their short- and mid-term direct investment plans, and 34% reported that they planned to invest more in the region (see Figure 2-4-12).
Effects on currency and financial markets in emerging economies
Until the current crisis, the growth potential of East Asian economies had been highly evaluated. Now, however, it has become clear that growth is down significantly and will require at least two or three years to recover. This fact led to a loss of investor confidence in all emerging economies, and threw the currency and financial markets of Central and South America and Russia into disarray. However, there are some emerging economies which have not been strongly affected. Countries that suffered a pronounced loss of confidence are characterized by macroeconomic problems such as budget and current account deficits, and by a strong dependence on the export of primary commodities (see Table 2-4-13).
Regulations on the flows of international capital
The main trend in the international financial market since the 1970s has been increased liberalization. However, in the wake of the Asian currency and financial crisis and the instability which it produced in the world economy, the argument that the flows of international capital should be regulated is rapidly picking up strength. In the future this point will be discussed from a variety of angles, including the structure of the international financial system centered on the IMF. Firstly, it should be remembered that, as the IMF points out, the liberalization of finance should be carried out in a well sequenced and prudent manner. Secondly, it is important to distinguish between long-term and short-term capital flows. If regulations are introduced on the flow of international capital, they should be centered on short-term capital flows and policy measures against them. Long-term capital flows should in principle be deregulated.
3 Risks in the unstable world economy
There are a number of risks in today's unstable world economy, and in general deflationary pressure is increasing. The risks are as follows.
(1) Decline of the U.S. stock market
(2) Chain reaction decline of stocks and currencies in developing economies, and worldwide credit crunch
(3) Management failures in financial institutions in advanced countries and destabilization of their financial systems
(4) Prolonged economic slump in Japan and heightened concern about financial system
(5) Devaluation of Chinese yuan
(6) Expansion of U.S. current account deficit and protectionist pressure
The impact of these potential risks may be of limited magnitude when each is taken individually. Yet, in the case that these risks are materialized in a synergetic chain reaction, this is likely to have a huge impact on the world economy. The worst scenario could include the possibility of global depression. As discussed earlier, massive amounts of capital are flowing rapidly around the world. Due to such capital flows, changes in the economic situation in one region could affect other regions by changes in capital flows and finance as well as by changes in the real sector, including trade flows. We have not yet fully understood the mechanism of capital and financial flows, including the psychological aspect of investor decisions. We cannot exclude the possibilities that a currency and financial crisis in one region will have unexpected contagious effects on other regions.
In order to prevent the risks described above from materializing, and to bring about stable development of the world economy, it is necessary to have a clear understanding of the risky situation in which the world economy is placed. Each country must make the greatest possible effort to prevent these risks from materializing. Due to the scale of their economies and their influence on other regions, the roles of the U.S., the EU member states, and Japan are especially important. The first requirement, coming before all others, is for these countries to maintain or recover favorable economic conditions. To counter the worldwide increase in deflationary pressure, these countries must respond appropriately by implementing sufficient expansionary policies and by offering financial assistance to emerging countries under difficulty. The U.S., the EU member states, Japan, and other industrialized countries need to pay close attention to trends in the world economy, including the risks described above, and to cooperate as necessary to implement appropriate policies.
Part 3: Trends in the labor market and progress toward reform
[Summary of Part 3]
Characteristics and problems of the U.S. labor market
One reason why the U.S. employment situation is good is the flexibility of its labor market. Other factors are low inflation, which has enabled long-term economic expansion, and the absorption of personnel released through restructuring at large corporations by small and medium sized companies and newly founded companies. The growth of help supply services (manpower dispatching industries) and higher levels of education have made it possible to provide a good match between labor resources and the demand for labor.
Labor market reforms and their results in Europe
A bipolar situation is developing with on the one side countries such as the U.K. and the Netherlands, where the structural unemployment rate is declining, and on the other side countries such as Germany and France, where little decline is evident. A comparison of OECD member countries shows that the youth unemployment rate tends to be higher in countries with high minimum wages and high discharge costs, and that unemployment rates tend to be higher in countries where unemployment benefits are high. It also shows that the promotion of part-time employment is associated with low unemployment rate, high rates of labor market participation, and low wage growth rates.
The benefits of structural labor market reforms based on liberalism are evident in the U.K., and in the Netherlands reforms carried out under employer-employee agreements are bearing fruit. Germany and France have also implemented employment programs in the 1980s. However, their structural unemployment rates remain high, because of Social Europe policies, which aim at promotion of high wages, generosity to low income earners and the unemployed and extreme protection for the employed.
Recently, a new labor policy called the Third Path is beginning to emerge, offering an alternative that is neither liberalism nor a Social Europe approach.
Rapidly worsening employment situation in Asia
Since the Asian currency and financial crisis, the employment situation in the region has markedly worsened. Up to now there has not been sufficient systematic protection for workers. In view of the fact that rural areas will not be able to absorb excess labor, the establishment of social security systems is required.
Section 1: Characteristics and problems of the U.S. labor market
Unemployment in the U.S. is at its lowest point in 28 years. This means that the U.S. labor market is strong, but structural problems such as stagnation in real wages are evident. This section examines the strengths of the current U.S. labor market.
Is the NAIRU declining?
The U.S. economy in the 1990s has continued to expand by achieving both low inflation and low unemployment. One of the reasons for this may be a decline in the Non-Accelerating Inflation Rate of Unemployment (NAIRU) and the Non-Accelerating Wage Rate of Unemployment (NAWRU). We carried out calculations to verify this hypothesis, and found that it is possible that the NAIRU and NAWRU are declining over the in long term. The actual unemployment rate is lower than both the NAIRU and NAWRU. Therefore, latent inflationary pressure exists (see Table 3-1-4). Further, it became clear that 1) increases in employment costs other than wages and salaries have been restrained, and 2) falls in prices canceling out rises in employment costs have existed. From this it can be concluded that the combination of low inflation and low unemployment at the present time is due largely to temporary factors such as falling import prices and restraint of the rate of increase in employment costs.
Number of workers employed, seen by industry
Even after the U.S. economy bottomed out in 1991, intensifying international competition prompted large corporations to continue with major restructuring programs. Therefore, no major improvements in the employment situation were seen in the manufacturing sector, and employment in the financial sector did not recover until 1993 (see Figure 3-1-10). However, there was strong demand for labor from help supply services (manpower dispatching), software houses, and other companies in the high-tech field as well as from newly founded companies and small and mid-size companies in the service sector. Many workers started their own venture enterprises. As a result, the number of employed workers increased and the overall unemployment rate declined. Restructured companies tended to become more profitable, which improved their employment situation. This kind of economic structure, characterized by vigorous renewal, is well adapted to the recent context of rapid globalization and technological innovation. By responding flexibly to change, it is able to allocate capital, labor, and management resources efficiently and create large numbers of new jobs.
Creation of new jobs by small and mid-size companies and newly-founded companies
In the 1980s and 1990s, large U.S. corporations strove to increase their profitability by reducing the size of their work forces and becoming more efficient. On the other hand, new companies and small and mid-sized companies grew and absorbed the labor resources thus released. Approximately 90% of the 8.7 million (net) new job jobs created between 1989 and 1995 were created by small and mid-sized companies. Newly founded companies made an especially large contribution. Approximately half of net new jobs created in the U.S. are created by new establishments.
The rate of founding of new companies is high, at over 10%. The survival rate of new companies after five years is about half, but many of the survivors grow quickly into large enterprises. For companies traded on NASDAQ, the average time from company foundation until the initial public offer is five to seven years (compared to 30 years in Japan). Successful companies subsequently show spectacular growth and make further contributions to new employment. The approximately 3,000 companies listed on the over-the-counter market administered by the NASD created about 730,000 new jobs (a 13% increase) between 1996 and 1997. During this period, the number of employed workers in the U.S. rose by only about 3% (see Table 3-1-15). Review of the approximately 1,300 companies for which data is available shows that, as of 1997, their employment share was 3.3%, and their total stock value was 9.9%. This indicates that labor and capital resources are being distributed appropriately in accordance with market principles to areas of growth. Factors behind the growth of venture enterprises are the fact that a well-functioning system for acquisition of risk money is in place, featuring open publication of investment data, and the fact that these enterprises have moved quickly to incorporate information technology in their business.
Expanding help supply service supports labor market mobilization
Labor mobility among occupations in the U.S. has increased in the 1990s, while unemployment has declined (see Figure 3-1-18). This indicates that the mismatch between labor supply and demand has diminished. In addition to institutional factors (the portable pension system for example), one factor behind this development is the growth of help supply services. The growth began in the 1980s with the outsourcing of office work that was carried out as part of corporate restructuring. With growing specialization, it continued as the agencies branched out into specialist and service categories. This provided a good match to the needs of clients, who wanted to reduce their employment costs and obtain quick access to personnel with specialized technical expertise. This trend has accelerated in the 1990s (see Figure 3-1-19). The most important reason why businesses use help supply services is employment flexibility. Recently, as demand for specialists has risen, many businesses say that they turn first to help supply services when they need the service of highly trained specialists. For their part, the help supply services are strengthening their training programs and working to increase the quality of their labor forces. This growth in the temporary employment industry has enabled the speedy, flexible, and efficient redistribution of labor resources.
Section 2: Labor market reforms and their results in Europe
1 Long-term trends in the European labor markets
A bipolar situation is developing in the European labor markets. On the one side are countries like the U.K. and the Netherlands, where the unemployment rate has declined up to 1997 with economic recovery and expansion. On the other side are the many EU member countries, including Germany and France, where the unemployment rate has risen during the economic recovery since 1996. In the U.K. and the Netherlands, during economic expansions since 1993, the unemployment rate has begun to fall immediately whenever the vacancy ratio has risen. In Germany and France, however, although the vacancy ratio continued to rise for more than a year in the economic expansion up to the end of 1997, the unemployment rate rose (see Figure 3-2-2). This indicates that there are structural problems in Germany and France that prevent workers taking jobs, even though the vacancy ratio increases. This is one of the factors behind the bipolar trends in unemployment rates.
2 Policies for the labor markets in OECD countries and their effects
Minimum wage system and youth unemployment
A look at the relationship between minimum wages and unemployment among young workers shows that there is high youth unemployment in countries such as France and Belgium, where the minimum wage is high relative to the median wage. Conversely, youth unemployment rate is low in countries such as Japan and South Korea, where the minimum wage is low relative to the median wage (see Figure 3-2-7). This probably indicates that young and untrained workers with little working experience are easily affected by a minimum wage system that increases the employment costs of businesses.
For this reason, many countries have established separate minimum wages for young workers and apprentices, and introduced training programs designed to increase youth employment. The emphasis in these programs is on imparting basic, practical skills that will be useful in the workplace. As minimum wage policies, some countries (Canada, New Zealand, the U.S.) have introduced employment subsides, while others (Belgium, France, the Netherlands) offer income tax offsets to minimum wage workers. These measures serve to stimulate the incentive to work among unskilled workers, and help alleviate the dilemma of being unable to escape from poverty even while working.
Unemployment benefits and unemployment rates
When unemployment benefits are too high, they tend to decrease employment by lessening the incentive to return to work. The ratio of unemployed workers receiving benefits is low in the U.S. (35%) and U.K. (20%). and high in Germany (84%) and France (90%). The German and French systems may be said to be generous to the unemployed. In fact, examination of the relation between the unemployment rate and the ratio of unemployed workers receiving benefits shows that the unemployment rate is higher when the ratio of unemployed workers receiving benefits is higher (see Figure 3-2-8).
Dismissal costs and unemployment rates
To protect workers, employment laws generally require employers to notify workers in advance of dismissal and provide dismissed workers with severance pay. Examination of the relation between employment and these severance pay requirements shows that unemployment rates tend to be higher in countries where maximum legally mandated severance pay requirements are higher (see Figure 3-2-10). When dismissal costs are high, companies are reluctant to fire. Over the short term, this decreases the number of unemployed. Over the medium and long terms, however, high dismissal costs reduce the demand for labor and lead to increased unemployment. In addition, higher dismissal costs lengthen the average employment cycle and decrease new employment.
Influence of increase in part-time labor
As measures to decrease unemployment, flexible working hours and especially the promotion of part-time work are being widely discussed. When the ratio of part-time workers is high, the participation rate in the labor market is also high. Part-time work opens the door to employment even to workers who are unable to hold full-time jobs because of child-care or other household circumstances. Part-time work is convenient for workers, and naturally serves to increase the participation rate in the labor market (see Figure 3-2-12).
When the incidence of part-time workers is higher, the unemployment rate tends to be lower. The participation of workers who work short hours facilitates the adjustment of supply and demand in the labor market as a whole, and consequently works to depress the unemployment rate (see Figure 3-2-13). Factors behind this phenomenon are the fact that part-time workers are useful in adjusting for temporary increases or decreases in labor demand, so that employers have an incentive to hire them, the fact that the government often facilitates part-time work to reduce unemployment, and the fact that many of the workers hired under training contracts are part-time workers.
Moreover, when the incidence of part-time workers is high the rate of increase in wages is low. Although the rights of part-time workers vary in different countries, a large number of part-time workers generally serves to ease the friction between supply and demand for labor, and thus to lower the rate of increase in wages.
3 European labor market policies in the 1980s turning point toward bipolarization
In the 1970s and later, European countries adopting the so-called "Social Europe" approach that demands high wage increases, payment of excessive allowances to low income earners and the unemployed, and protection from dismissal, experienced severe increases in unemployment during periods of recession. Even after recovery, businesses in these countries were reluctant to hire new workers, and unemployed workers had less incentive to return to work. As a result, the employment situation worsened with each business cycle. Especially in the U.K. and the Netherlands, excessively high benefits and overprotection of workers resulted in economic and social maladies such as high inflation and high unemployment, features of the "British disease" and "Dutch disease" found particularly in industrialized countries.
In the 1980s however, both countries reformed their labor markets. The reforms were effective in 1) correcting the overly high rate of increase in wages, 2) raising participation rates in the labor market and lowering the unemployment rate, and 3) bringing about increased flexibility in working hours and a larger number of part-time workers. In the 1990s, the structural unemployment rates in these countries have fallen. The case of the Netherlands is especially noteworthy. Unlike the U.K., which adopted a labor market reform based on the liberalism, the Netherlands successfully carried out a basic reform of its labor market based on a 1982 agreement among authorities, employers and employees. This became known as the "Dutch model".
1) Employment policies of the U.K. Conservative administration
At the time when Prime Minister Thatcher entered office, the U.K. labor market was characterized by rigid conventional systems regulating the relation between employer and employees such as the closed-shop system, under which companies were obliged to hire new employees from among the members of labor unions. Despite a worsening economy, unions often demanded wage increases that exceed gains in productivity and labor disputes were frequent. For this reason, the Conservative Party moved to ban new closed-shop agreements in a stepwise process up to 1990. In 1982, it limited the range of legal strikes, and in 1984 mandated procedures to be carried out in advance of strikes. These measures served to weaken labor unions (see Figure 3-2-19).
On the other hand, it also implemented measures to encourage the unemployed to return to work. It conducted several reevaluations in the 1980s of the unemployment insurance system, and it reformed the vocational training system with the aim of enhancing the quality of labor. By 1989, it also lifted restrictions on working hours for women and abolished discriminatory regulations on the employment and promotion of women workers. It abolished restrictions on working hours of young workers, rescinded the ban on holiday work, and extended the length of the period required to qualify for appeals on unjust dismissal.
2) The Dutch model
The main reason why the Netherlands was afflicted by the Dutch disease was the steep rate of increase in wages during the 1970s, which exceeded productivity gains. In view of this fact, employers and labor came to an agreement in 1982 on work sharing and the active introduction of part-time employment (the Wassenaar agreement), which not only restrained the rate of increase in wages but also adopted shorter working hours and the introduction of early retirement programs. Since then, labor unions and employers have cooperated in negotiations on wage moderation, using the legal minimum wage, set relatively low, as a guideline.
In addition, under the slogan "A chance for everyone", unemployment and disability benefits were cut and disability insurance was re-examined, aiming at providing everyone with the opportunity to find a job.
As the key measure to create employment, the Wassenaar agreement aimed at the creation of part-time jobs. Since the reforms began in 1982, about two thirds of all new jobs have been part-time. The ratio of part-time workers as a percentage of total employed is higher in the Netherlands than in any other OECD member country. In 1996 it was 35%. As evidenced by the fact that many of these workers (70%) were women, prevailing part-time employment has made the female participation rate higher (see Figure 3-2-24).
4 The currency unification and the European labor market
The beginning of gradual reforms of labor markets in the 1990s is probably not unrelated to the introduction of the euro in 1999. On the other hand, EU member countries where labor costs are relatively low see the introduction of the single currency as an opportunity to attract investment in their economies. However, low wage levels alone are not sufficient. Countries that continue to maintain excessive social benefits and restrictions on worker dismissals may find that businesses shift production to other countries that have made more progress in reforming their labor markets, for example by reforming their tax and social benefit systems, and by mitigating restrictions on worker dismissal. Some of the low-wage countries hope that the introduction of the euro will in itself produce more investment in their economies. In fact, however, decisions by businesses to locate in a country are dependent on a number of factors other than wage costs, making it important for these countries to proceed with further reforms of their labor markets. Labor market flexibility is also important from the viewpoint of the theory of optimal currency area.
5 New labor market policies
Labor market policies of the U.K. and the Netherlands have lowered the structural unemployment rate, but they have also produced some new problems. Abolishment of the minimum wage system in the U.K. has increased the number of low-paid workers. The income gap between low-paid and high-paid workers is increasing faster than in any other industrialized country except the U.S. (see Figure 3-2-28). Wages that are too low sap the incentive to work, increase the youth unemployment rate, and weaken the effectiveness of vocational training.
On the other hand, signs of a movement away from Social Europe policies have begun to appear in the 1990s. The main causative factors are a sense of crisis about the increase in government outlays due to aging populations, and worries about intensified competition within Euroland. However, concerns have been expressed that French employment policies are moving in the opposite direction from this trend.
A review of labor market policies in the 1990s in the U.K. and the Netherlands and in other continental European countries shows that there has been a common effort to define a new alternative (often called the Third Path), which is neither a Social Europe approach nor an extreme form of liberal policies. In many EU countries, the Third Path is perceived as an approach that avoids the drawbacks of the liberal policies and Social Europe approaches (inequitable distribution of income and high unemployment) and incorporates their advantages (low unemployment and equitable distribution of income).
The labor market policies adopted by EU countries can be broadly classified by purpose as policies which aim to 1) increase employment incentives on the labor demand side, 2) increase the number of businesses which provide demand for labor, 3) increase the incentives to work on the labor supply side, and 4) increase the framework for the supply of labor. All of these policies are effective in reducing unemployment. However, to achieve reductions in unemployment over the medium and long terms, it is important to achieve a sustainable, not a temporary, increase in opportunities for employment.
Section3: Rapidly worsening employment situation in Asia
The 1997 currency and financial crisis brought sweeping changes to the employment situation in East Asia. Until recently, East Asia had enjoyed high growth and low unemployment. Since the crisis, however, it has fallen into low (or minus) growth, with rising unemployment rates. Unemployment policies, which up to then had received almost no attention, have suddenly become very important.
Increasing unemployment and falling wages
In late 1997 and early 1998, unemployment rose sharply in South Korea and Hong Kong. It is also showing a gradual increase in Taiwan and Singapore (see Figure 3-3-11). The South Korean unemployment rate rose from 3.1% in December 1997 to 8.1% in August 1998, and the Hong Kong unemployment rate rose from 2.2% in July through September 1997 to 5.0% in June through August 1998. Historically, the unemployment insurance, pension and other social insurance systems of East Asia have not been sufficient. In the future, this will be an important theme from the standpoint of ensuring social and economic stability.
Conclusion
The Asian currency and financial crisis and the world economy
Developments in the world economy over the past year can be summarized in terms of the deepening of the Asian currency and financial crisis and its effects on the rest of the world. In the countries afflicted by the crisis, the downturn in production exceeded most forecasts, and has still not bottomed out. The employment situation is markedly worsening. Declining demand in Asia and depreciation of currencies are exerting deflationary pressure in other regions. In particular, prices of primary goods have declined sharply. In addition to these real sector effects, the currency and financial crisis undermined investor confidence in emerging economies. Capital flight from some countries has occurred, accompanied by turmoil in currency and financial markets. This has been evident particularly in countries with current account and budget deficits, and in countries with a high degree of dependence on the export of primary goods. In this context, capital has begun a "flight to quality", flowing back into government bonds of industrialized countries. In this way, global deflationary pressure is increasing not only in the real sector but also in the financial sector.
The U.S. economy-concern about inflation replaced by concern about recession
The U.S. economy is in a prolonged period of expansion that has lasted since 1991. Moreover, even though the demand for labor has been strong and the unemployment rate low, prices have been stable. To explain this extremely strong performance, some argue that that the U.S. has entered the stage of a New Economy, in which progress in information technology is producing unprecedented gains in productivity, and in which inflation and business cycles are things of the past. Although this theory has its proponents and detractors, examination of conditions in the past few years shows that the economy's strong performance has been supported by temporary factors such as the strong dollar, falling prices of primary commodities, and restraint in medical costs. In any case, there were signs that the labor market and other markets were becoming overheated. Up to the summer of 1998, monetary policy tended to take a restrictive stance. In mid-August, however, monetary policy shifted to a neutral stance, in view of the fact that the Asian currency and financial crisis was adversely affecting exports and corporate profits. Later in August, the Russian currency and financial crisis touched off a plunge in the stock market and some currency and financial markets of emerging countries in Latin America and elsewhere were put into disarray. This resulted in large losses by hedge funds and widespread apprehension about the future of the economy. In this context, the Federal Reserve System (FED) cut interest rates by 0.25% on September 29 and October 15, 1998. Some market observers have started to anticipate additional cuts. Concerns about overheating of the U.S. economy have been replaced by concerns about recession.
Europe on the eve of the currency unification
European economies are generally expanding. Participation by eleven EU countries has been determined in the third stage of the Economic and Monetary Union (EMU), slated to be introduced in January 1999, and final preparations are now underway. If the European Central Bank (ECB), which will be responsible for monetary policy after the transition to the third stage of EMU, formulates the clear goal of price stability and implements policies to that end, and makes the euro a stable and reliable currency, this will benefit international society as a whole. Some are apprehensive that the ECB will pursue an overly restrictive policy in an effort to establish its reputation as an inflation fighter. In the context of global concerns over deflation, an appropriate degree of monetary relaxation is to be desired. Success of the currency unification will also depend crucially on progress in reforms to increase the flexibility of labor markets. This is because after unification it will become impossible to use national monetary policies and exchange rate variations to cushion the shock of non-symmetrical economic upswings and downturns in the participating countries, and because fiscal transfers in the participating countries will be limited. Unless there is labor mobility and a margin for expansion and contraction in wages, it will be extremely difficult to make economic adjustments among the participants. In any case, the currency unification is a grand venture that transcends the realm of economics, moving toward the dream of a unified Europe. Its progress will be watched closely.
Importance of labor market reforms
The background for the Asian currency and financial crisis discussed in Part 2 and the subsequent turbulence in the world economy is the rapid growth in capital flows across national borders. Conversely, an element of production that rarely crosses national borders is labor. Labor was discussed in Part 3. Generally speaking, expansion in the free flow of capital heightens the importance of reforms in the labor market, particularly in the industrialized countries. Capital is not attracted solely by inexpensive labor. Even when wages are low, they can be offset by high non-wage employment costs. It may be that capital will not flow into countries where there are frequent strikes and excessive restrictions on worker discharges. A typical example will be provided by the EU after currency unification in January 1999. As the movement of international capital accelerates, it will be necessary to proceed even faster with labor market reforms that encourage the inflow of capital and create additional employment.
A comparison of the recent performance of labor markets in North America and Europe shows that employment has increased and unemployment has declined in the U.S., which has historically been flexible in terms of labor market, and also in the U.K. and the Netherlands. Conversely, employment growth has been slow despite economic recovery in continental European countries such as Germany, France, and Italy. In these countries, double-digit unemployment rate is continuing. This bipolarization is probably due to differences in labor market policies. The U.K. is benefiting from the labor market reforms carried out under Prime Minister Thatcher based on liberalism. In the Netherlands, the flexibility of the labor market has been greatly enhanced by the promotion of part-time labor, as set forth in an agreement between employees and employers. On the other hand, the employment policies of Germany, France, Italy, and other continental European countries have generally been short-sighted and characterized by reluctance to implement painful structural reforms. On the other hand, it has been pointed out that the functioning of market mechanisms in the U.S. and U.K. has resulted in high degree of inequality in the distribution of income. In some European countries, this has prompted the search for a Third Path, which would achieve both low unemployment rate and equity in the distribution of income. With the recent victory of the Social Democratic Party in the September elections in Germany, 13 out of the 15 EU member states are now governed by social democratic parties (or by parties with a social democratic cast). In this context, it will be interesting to observe what kind of balance is struck in Europe between low unemployment and high equity in the distribution of income, or more generally speaking between free market principles and social democratic ideals.
The U.S. labor market
Turning to the U.S., approximately 14 million jobs have been created in the economic expansion since 1991. The unemployment rate in April and May of 1998 was 4.3%, a 28-year low. This strong performance indicates that basic market mechanisms for the smooth allocation of resources in the labor market are functioning well. During this prolonged period of economic expansion, particularly large contributions have been made by factors such as 1) monetary policy, including the early implementation of tightening measures, together with favorable economic conditions, which have enabled a prolonged period of economic expansion and growth in the demand for labor without inflation, 2) the absorption of workers laid off through corporate restructuring in the manufacturing sector and elsewhere by small and medium size companies and by newly founded venture enterprises, and 3) the growth of the help supply service (manpower dispatching) industry, which has facilitated the supply of labor to match demand. On the other hand, there has been little progress in solving problems such as the stagnation in real wages and expansion of the income gap.
Mounting global deflationary pressure
Despite recession in Japan and East Asia, economies in North America and Europe were generally expanding up to mid-1998. Viewed as a whole, deflationary pressure was not great. Rather, there was concern in the U.S. and U.K. about overheating of the economy, and rather tight monetary policies were maintained. However, the Asian currency and financial crisis began to exert a grave influence on the entire world economy, both in terms of trade and finance. In mid-August Russia experienced a financial crisis. This set the stage for the sharp decline at the end of August in the U.S. stock market. Subsequently, there was increasing turmoil in the currency and financial markets of emerging countries in Latin America and elsewhere, which led to extensive losses by financial institutions in the industrialized countries. Against this background, the U.S., Canada, the U.K. and other countries lowered their interest rates in September and October. As of late 1998, worries about deflation have spread from Asia to the world economy as a whole.
Importance of the international capital movement
Historically, changes in economic conditions have been thought to be propagated across national borders most strongly through the avenue of trade. For example, a recession in a country with a large-scale economy was felt in other countries as a decrease in its import demand. However, the Asian currency and financial crisis and the subsequent turmoil in the currency and financial markets of developing countries shows that international finance has become an equally important, or perhaps more important, avenue of propagation. International financial transactions are growing at a faster pace than trade in goods and service, and their importance is increasing. Developments in trade and real sectors are easy to grasp because a relatively large amount of data is available. But data on the movement of capital is lacking, hindering an understanding of the actual situation. Consequently, when an economic shock occurs, it is relatively easy to predict its real sector effects. But it is difficult to gauge the financial effects. In addition, changes in the flow of goods generally occur gradually, but large swings in the flow of capital can occur instantaneously. This makes it possible for changes in the flow of capital to exert a very large influence in completely unforeseen parts of the world, instantaneously. As integration of world capital markets rapidly progresses, the deepening interdependence of the world economy appears to have entered a new stage.
Lessons of the Asian currency and financial crisis
The Asian currency and financial crisis has thrown a sudden spotlight on the importance of international capital movements. The shock has been all the greater because the crisis occurred in a region that had been regarded as a growth center of the world economy. The crisis proved to be deeper than expected, and it exerted an extremely grave influence on the entire world economy. It has raised the following questions with respect to the control of international capital movements, the role of international financial institutions, the desired international currency system, and the economic policies of countries around the world.
- First, it may be questioned whether the remedies applied by the IMF were appropriate. Why were they unable to prevent a deepening of the crisis? Perhaps the policies for macroeconomic stabilization were too restrictive. Conversely, would economies have stabilized and recovered without austerity programs? Was it appropriate to demand structural adjustments in the very midst of the crisis?
- What is the proper approach to the liberalization of capital movement? In general there is a consensus that countries with weak financial systems should proceed with capital market liberalization in a well sequenced and prudent manner. But in countries with well developed financial systems, for example Chile, how should restrictions on the flow of capital be regarded?
- In a world economy where vast amounts of capital flow instantaneously across national borders, it has become more difficult than ever for developing countries to maintain fixed exchange rate system. It appears that this is becoming an untenable option. For developing countries, a desirable exchange rate system would be flexible enough to prevent undervaluation and overvaluation, but not subject to extreme variations. How could such a system be realized?
- Half a century has passed since the construction of the global financial system centered around the IMF and the World Bank. Has not the time for reexamination of this system come?
Discussion of these and other questions has already begun within the G7, the IMF, the World Bank, and between governments. This paper has also presented a perspective on some discussion points. In the future, countries around the world will cooperate in searching for answers to these questions and defining the character of capitalism in the 21st century.