U.S. and Hong Kong (1999)

COMMERCE DEPT.'S SHAPIRO ON RISKS IN GLOBAL ECONOMY

Following is the text of Shapiro's address as prepared for delivery:

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Risks and Responsibilities in a Global Economy

An Address by Robert J. Shapiro
Under Secretary of Commerce for Economic Affairs

To the Society of Government Economists
Washington, D.C.
February 18, 1999

Introduction

To hear some economists talk about the world these days, you'd think we're all headed for trouble. But take a look at the American economy. For the last three years, GDP has grown by 4 percent a year, in an expansion that's broken all previous peacetime records. Unemployment has stayed below the level most of us believed would reignite inflation. In fact, for the last three years, inflation has been falling, to less than 2 percent a year. The Dow Jones average has reached 9000 and stayed there. And the federal budget is now promising substantial surpluses -- indefinitely.

Maybe economists are more sensitive to change than most people. Certainly, they know that economic change carries risk. And there is a great deal of risk, higher risks and new risks, in today's global economy.

Like yours, my job, as the chief economic adviser at the Commerce Department, is all about evaluating economic change and risk. I'm just not allowed to use my evaluations to forecast anything because the job also includes overseeing the nation's major statistical agencies, the Bureau of Economic Analysis and the Census Bureau. So, if I get lucky and hit the mark, I can be accused of cooking the books. And if I miss the mark, I look like I don't know what I'm talking about. So I leave the forecasting to those paid to do it.

I still have to understand the forces driving the American economy. And I have to use that understanding to help inform national policy decisions.

Based on what I understand today about the global economy, I believe that the new risks associated with globalization carry with them new national responsibilities for the United States. We bear a new social and economic burden to lead world economic growth and help pull other countries out of recession. We also bear a greater social and economic burden to help all Americans build their human capital.

To understand these new risks and responsibilities, the best place to start is with the complicated dynamics shaping the current world economy. We should know why the smaller Asian economies suffered the debacles of 1997 and 1998. We need to understand why, in the midst of this, the large and economically integrated countries of North America and Europe have been doing well. And we have to figure out why the large and less integrated economies of Asia, Russia and South America are struggling. Then we need to use that understanding to try to build a more secure and prosperous world.

So, I'm going to do a brief survey of global economic conditions, look at the forces that are driving uneven growth in the world, and offer analysis of what this means for the American economy today and for the future.

Current Global Conditions: Uneven Growth

One of the most striking aspects of global conditions in 1999 is their unevenness. Growth is strong in North America and reasonably strong, if slowing, in Europe. Asia is struggling with serious recession, South America faces possible recession, and Russia is in economic collapse. What does this mean?

For one thing, its means that resources -- especially capital -- are shifting to the strong economies, primarily the United States. Here, with our export industries weakened by the Asian recession, the capital is especially flowing to interest-sensitive sectors with high domestic demand. As a result, the United States has continued to grow strong, even as our manufacturing exports have taken a large and sustained hit. Business investment, especially in information technologies, construction and durable goods, has probably been strengthened by the Asian crisis. And with all that capital flowing in, the stock market has flourished -- again, especially in shares of information technology and durable goods firms.

Resources are also shifting in Asia, especially domestic resources shifting to their exporting sectors. That's because export growth to North America and Europe has cushioned their recessions a bit. Now, domestic demand in Asia needs to expand to build a full-fledged recovery. Meanwhile, the financially stressed service sectors in most Asian countries are being forced to rapidly reorganize. When eventually the global business cycle evens out, Asia will be changed, just as the U.S. economy was changed by our asymmetrical business cycle of the 1980s. It will probably be less dependent on investment spending to build up capacity, with more attention paid to productivity and profits.

Another aspect of the current economic picture is the overall slowdown in global growth. The world economy grew 2 percent in 1998 and, by the IMF forecast, will grow only another 2 percent this year. That's half the rate of the 1980s and mid-1990s, and not enough to raise worldwide per-capita incomes. That tells us that the recession in Asia, and perhaps South America, cannot turn around by itself. Real changes are needed.

A third important aspect driving the bumpy global economy is the sustained, worldwide decline in inflation. This has several sources. In part, it reflects the weakening of global demand arising from Asia's long downturn. But there is more to it than the business cycle. In fact, the downward pressures on prices around the world are mainly structural. Perhaps most important, technological changes have been lowering costs in many industries, sometimes sharply. In addition, there has been a buildup of excess capacity in both Asia and commodity industries worldwide because of too much investment-led growth over the past decade. Also playing a role is intensified global competition, propelled by the continuing liberalization of international trade, especially in North America and Europe. Finally, the deregulation and technological transformation of capital markets has brought more competition among currencies. That in turn has driven down inflation by forcing countries around the world to tighten their monetary and fiscal policies.

The worldwide inflation of the 1970s affected the development and course of virtually every economy. The current global disinflation has similar broad and serious implications. It constrains every country's political capacity to manage its business cycle, just as its opposite did in the 1970s. The most troubling example of that is Japan -- the powerhouse of the 1980s, now stagnating. The new pricing dynamic also disciplines the power of business and labor to affect prices. We see this in the United States and Europe, as well as Asia. That discipline has shifted the focus of business investment from building capacity to building productivity. As a result, for example, 45 percent of all fixed U.S. business investment over the last five years has gone to information technologies. Disinflation also forces labor to shift its strategy, from seeking higher pay to bolstering job security.

Finally, the current global predicament is affected by an intensified competition among currencies. This dynamic has led Europe to create the largest single currency area since the demise of the gold standard. It has also forced countries as varied as Indonesia, Russia and Brazil to squeeze their domestic inflation from triple digits to two or even one. Of course, when pressures build to ease monetary policy, the new competition among currencies may also trigger economic havoc.

Asia: A Case Study in the Dynamics of Uneven Growth.

To better understand these dynamics, let's look a little closer at Asia. There, the connections between uneven global growth and the worldwide disinflation are probably most obvious. In Asia, we have seen how much a sudden shift in capital flows can traumatize a small, trade-oriented economy operating in a competitive global market. The extent of the trauma across most of the continent is well known -- surging unemployment, rising bankruptcies and the deepest recessions in 50 years.

Geography has also played a part in Asia's current traumas. The continent's largest customer has been Japan, which has spent the 1990s stumbling in and out of recession. Meanwhile, China has emerged as a huge, regional competitor for international investment and export markets.

Some common structural forces have also been hammering Asian economies, whose political arrangements, balance of payments, reliance on foreign investment and economic cultures all show so much variation. One such force is pegged exchange rates, whose pegs become out of date, as they eventually must. Obviously, pegged exchange rates can help attract foreign investors. But they also make a country vulnerable, since the dollar and yen to which they were pegged are themselves subject to sharp swings. Even before the currency crisis, Asian countries tied to the dollar had a wild ride, especially those also competing with Japanese manufactures.

Of course, pegged currencies can't by themselves explain the crisis. South Korea's currency floated down for several years before it hit a serious crisis. While most Asian currencies now float, two important ones -- Hong Kong and China -- are still pegged to the dollar -- and therefore to each other. And Malaysia has reestablished its dollar peg.

Another common factor behind the crisis is the weak domestic banking and financial systems of most Asian countries. In a global economy, where currencies compete and foreign investment is channeled through domestic institutions, any country that lacks a fully developed banking system is at risk because of the sometimes-volatile movements of international capital. But here, too, there is the exception. Hong Kong, with fairly sound banks and very open capital markets, finds itself in a recession as bad as many others in the region.

Nevertheless, without the integrating force of a sound private banking system, short-term foreign capital flowing into a country tends to be distributed haphazardly. Then, when a sudden devaluation looms and capital flows out, businesses that would never have been financed under sound banking arrangements fail quickly. In a country like Indonesia, where the domestic banks have been conduits for politics and cronyism -- or even Japan, where the flaws of the banking system are more subtle -- the biggest problem is not the vulnerability to a financial crisis. Rather, it's the distorted distribution of the country's real resources that precedes a crisis. And it's also the enormous costs in lost output and unemployment that come when global competition forces a country to abruptly reallocate its reduced resources on sounder economic grounds.

The vulnerability of these economies is also aggravated by the current production process for many sophisticated goods. Part of the East Asia success story in the early 1990s was the tremendous expansion in exports of advanced products produced by a number of businesses linked by the production of the product. When times are good and the currency is stable, this chain-related production system can create a virtuous circle of broad investment and economic expansion. When things turn sour, the chain breaks, and everyone suffers.

Asia's current business downturn will not last forever. In fact, the United States is an important key to their recovery. Most Asian countries trade heavily with us, and our strong expansion continues to be the main source of new demand for their products. Further, the financial conditions in these countries have been improved by our lower interest rates, as well as by the stronger yen and weaker dollar we've been seeing since last October.

More important to Asia's long-term recovery, however, are reforms, especially in the financial and banking sectors. The recent history of most East Asian economies demonstrates their capacity to adjust quickly to outside forces. With the exception of perhaps Malaysia, the crisis has strengthened East Asian support for market-based, trade-oriented economic policies. Already, U.S. direct investment in Asia is increasing again. We may also be seeing a real recovery in Korea, where interest rates have declined, fiscal stimulus has taken some hold, and structural reforms are proceeding.

Large Integrated Regions Are Prospering

As Asia struggles, most of the world's large and highly integrated economies have seemed to shrug off the crisis. The United States is, of course, the leading example. But Mexico and Canada are also doing pretty well, in large part because of NAFTA and the greater integration it has brought to the North American regional economy.

Another star performer of 1999 has to be the euro, and its unification of monetary policies across countries that have not always been good friends. The euro got a big push in the 1980s, when European governments became concerned that a two-currency world of the dollar and the yen could hurt them. These governments further paved the way for the euro in the 1990s by tightening their fiscal and monetary policies. Today, it is Japan that worries about a two-currency world, of the dollar and euro.

Ultimately, the euro represents something of the essence of globalization. It is the clear recognition by some of the world's most highly regulated, advanced economies that they must intensify their own market forces by reforms that can help create the conditions -- the capital pool, labor supply and efficiencies of scale -- to respond effectively to global market forces.

Of course, Euroland will face serious challenges. If the single currency produces an even, continental business cycle, as intended, the European economy could lose one of the advantages of foreign trade. I refer to the ability of firms in one country to counter a recession by selling more to neighbors that are still growing. Or conversely, the ability of firms in a country that's growing to counter rising inflation by importing more from neighbors in recession. Or the euro may face a different set of problems, if some of its countries slide into recession while others continue to expand. Then, the Maastricht Treaty's restrictions on national fiscal and monetary policy could produce political conflicts that could threaten their common policies. But these are problems that come with the territory -- and ones that the United States learned to solve as we moved to a continental-sized economy.

One of the goals of Euroland is to achieve sufficient economic size and power to protect its members from strong negative winds from globalization. But size alone is not enough to protect countries from economic crisis elsewhere. Just look at Russia and Brazil. They found themselves caught in the aftershock of the Asian devaluations when international investors moved to reduce their risk exposures elsewhere. Despite their size, Russia and Brazil found themselves in much the same box as Thailand and Korea.

This lesson is clearer still in Japan and China. In Japan, highly efficient export industries have long coexisted with generally protected domestic service enterprises. China has some of the same characteristics. This lack of economic integration was exacerbated by their weak banking systems, which made their economies more vulnerable to recessions when their smaller trading partners hit their crisis.

Lessons for the United States

What does all this tell us about our own economic prospects? Can the United States help lead the world to recovery -- as I believe we are doing -- or will the rest of the world pull us down?

The risks to us are two-fold. One is the falling demand for American exports. The other is the possibility that as exports fall, global investors could eventually withhold the credit we need to finance large and growing current account deficits.

A key issue, then, is the strength of the dollar. An important adjustment to the dollar has already taken place in the last six months. Now it's back to roughly its pre-crisis 1997 average value. World markets will judge whether this is sufficient to restore our export competitiveness.

Another key issue is our return on capital. Once again, we should be reasonably confident. Returns on capital in the United States continue to be strong. If we can sustain our recent productivity gains, and if wage inflation stays moderate, investments in America will remain profitable. And foreign investment will continue to flow in.

Our basic responsibility is to bring the world along with us on the road to prosperity. The best ways of achieving this are strong national savings and strong productivity growth. These should maintain the high return on capital that attracts foreign capital and that finances strong import growth.

As a matter of basic American economic leadership, it is our responsibility to maintain and save the budget surplus, rather than squander it on tax cuts that will only increase consumption, imports and dependence on foreign investment. This will enable us to provide more of our own resources for investment here and abroad.

It is also a national responsibility to increase investment in the factors that will make us more productive. First and foremost, that means innovation, the predominant factor in growth. And the best ways to promote innovation is to invest more in research and development, expand open trade, and reduce unnecessary economic regulation. Second, both government and business have to prepare American workers to take advantage of innovation, by investing in education and supporting lifelong training.

American leadership entails a further responsibility. As governments and nations compete more for global investment, we cannot allow that competition to dumb down our own standards. Rather, we must help the rest of the world approach our standards on matters ranging from child labor, and intellectual property, to antitrust and environmental protection.

We also must promote the integrity of the statistical data that economies around the world collect. There are many examples of governments trying to politicize how their statistics are collected. Bad data and faulty statistics have been an Achilles heel for most of the countries in crisis today -- not only because they produce bad investment decisions, but also because funds quickly flow out of a country when investors doubt the integrity of the economic data. The United States -- led by the Bureau of Economic Analysis and the Census Bureau -- has long produced the world's best economic information. It's part of my job to ensure it stays that way.

In this area, the IMF has also played a useful role by forcing more countries to be transparent and accurate in reporting data. The United States can act as a useful adviser in this regard.

Conclusion

The world is no longer merely a collection of discrete economies. We are all in this global economy together. The best news is that, as a result of the Asian crisis, virtually everyone affected understands that they have to change their policies and reform their institutions. That adjustment process is wrenching, but there appears to be surprisingly little denial or backsliding. South Korea and Thailand are pressing even faster to open their investment, capital, and production markets. Even Malaysia seems prepared to loosen the capital controls it put in place in more desperate days.

And throughout the crisis, the basic forces of globalization -- of production, capital and technology -- have proceeded. Even with the current slowdown, the volume of world trade continues to grow twice as fast as world output. As it does, the prices of many traded goods, commodities and even wages across countries are growing more equal. And as that continues, the competitive pressures forcing governments to change policies and businesses to reorganize on more efficient lines, will intensify.

In the long run, as many economists warn, it may not be possible for America to grow much faster than the rest of the world. But if we meet our responsibilities to save and to invest in our productivity, we may be able to approach the long-term world growth rate of 3 to 4 percent. That will be our reward for meeting our responsibilities in the age of globalization. And economists, the world's designated worrywarts, should be able to relax a little.

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