World Economic Outlook
Room for (Fiscal) Improvement

The paper provides an account of the current situation, outlook and policy options for the global economy. Medium-term prospects are mediocre and fraught with considerable downside risk, as indicated in Section 1. Section 2 outlines fiscal and monetary policy options for the main industrial countries to improve global economic performance. Worries about the US fiscal position are shown to be exaggerated in Section 3. In Section 4 it is argued that while the US economy is well on course to become a net external debtor, it has not yet reached that position. In the longer run too, prosperity or depression will be determined to a large extent by policy choices.

Mediocre medium-term prospects and considerable downside risks for the world economy Among the few bright spots in the current world economic situation are the achievement of a lower rate of inflation and the absence of any serious immediate threats of a renewed inflationary surge. Another positive development is the realignment of nominal and real exchange rates which has taken place since 1985, mainly through the depreciation of the US dollar and the appreciation of the Deutschmark and Yen. This is a necessary, but by no means sufficient condition for the restoration of global macroeconomic equilibrium.

Barring significant changes in the fiscal-monetary policy mix in the leading industrial countries, there is unlikely to be a significant improvement in the medium-term outlook for global economic growth. The current tendency toward low and gently declining growth rates of GDP and world trade is therefore likely to continue. There also is considerable "downside risk" in the shape of a world recession which could be triggered by a number of unfavourable contingencies. These include:

(1) An uncoordinated attempt to redress the intra-OECD macroeconomic imbalances by a unilateral fiscal contraction in the United States without offsetting changes in monetary policy in the United States and in monetary and fiscal policy in the rest of the OECD to support the level of global economic activity.

(2) An abrupt "free fall" of the US dollar, triggered by a loss of confidence in the international financial markets. This could provoke a defensive tightening of US monetary policy, resulting in an increase in nominal and real interest rates (especially at the short end) and a recession in the United States, with spillovers to the rest of the world and an immediate worsening of the position of the major debtor countries.

(3) An exacerbation of the debt crisis, which weakens the banking and financial systems of the industrial countries and results in an increase in the cost and a reduction in the availability of credit for domestic and international lending. The reduced demand by badly affected debtor countries for the goods and services of the industrial countries would intensify the contractionary pressures in the world economy.

(4) A financial crisis triggered by a major stock market collapse in one or more of the world's financial centres. Price/earnings ratios of 100 or more have become routine recently on the Tokyo stock market and the sustainability of this situation is open to question. The interdependence of the major financial centres is now such that a serious collapse in any one of them is likely to spill over into the others. The very high levels of consumer and other private credit outstanding in many of the industrial countries (notably in the United States) make their financial systems much more vulnerable to shocks. The rapid pace of deregulation and innovation in domestic and international financial markets may have outstripped the capacity of the established mechanisms for prudential control. The resulting uncertainties and vulnerability matter little when the world economy is prospering and major shocks are absent. They carry the potential, however, for cumulative "debt deflation" and financial crisis should the world economy stagnate and unanticipated shocks rock the system.

(5) A worsening of global protectionist tendencies and, in the worst-case scenario, a serious trade war. A global recession triggered by any set of unfavourable contingencies is likely to carry in its wake a tendency towards more intense protectionism. This would in turn deepen the recession and delay the recovery.

(6) A major increase in the price of oil, triggered by a conflagration in the Gulf for example.

Policy options to improve global economic performance. None of these adverse events may come to pass; most of them can be avoided by reasonable international cooperation spurred by no more than enlightened self-interest. Some form of global contingency planning does seem highly desirable. Anticipating adverse shocks, avoiding contributing to them and being ready to respond flexibly and in a coordinated manner to those that are beyond their control should figure prominently on the agendas of the monetary and fiscal authorities of the major industrial countries.

The elements of a policy package that would significantly improve global macroeconomic performance in the near and medium term are the following:

There should be a "supply-side friendly" fiscal expansion in the fiscally strong industrial countries, such as Japan, Germany, and the United Kingdom. The behaviour of their debt/GDP ratios, their primary government deficits and, in the case of Japan and Germany, their current account deficits suggest that these countries have ample fiscal elbow room. In addition there is considerable real slack in all three economies, which can be expanded in the case of Germany and the United Kingdom if the right supply-side friendly fiscal measures and other reforms of the key markets are undertaken (especially the labour market and, in the United Kingdom, the housing market). These measures include cuts in employers' social security contributions, private investment subsidies (possibly temporary to get maximal short- term effects on demand), other cuts in direct taxation, increased investment in the social infrastructure and, especially in Japan, measures to stimulate investment in private housing. The recently announced fiscal stimulus in Japan is a step in the right direction but seems very small (about $35 billion) in relation to both the macroeconomic and the structural needs of both Japan and the world economy. The German decision to bring forward some already scheduled tax cuts (0.9% of GDP in 1988) also seems inadequate. France, however, appears to have little room currently for a significant fiscal stimulus and Italy needs to retrench in view of the magnitude of its primary deficit. It is important in the case of Italy that the government does not abandon its seigniorage tax, as this would either cause a further debt explosion or necessitate a very savage cut in the primary deficit. Tight monetary policy in Italy today seems very counterproductive.

To prevent the Japanese-European fiscal expansion from being "crowded out" by further exchange rate appreciation, monetary policy in Japan and Europe should aim to stabilize the exchange rate or at least prevent a very sharp appreciation of their currencies.

Unilateral fiscal contraction in the United States, would only succeed in improving the US fiscal and trade deficits by exporting a recession to the rest of the world through a further depreciation of the US real exchange rate, unless this contraction is accompanied by a correspondingly expansionary US monetary policy and a European-Japanese fiscal-monetary package to expand demand at a given exchange. A coordinated global package of fiscal and monetary policies is therefore essential.

Unnecessary alarm about the US Fiscal position. The "unsustainability" of the current US fiscal position has been much exaggerated. If the United States has a general government primary deficit at all, it is small and no fiscal heroics to eliminate it seem required. In order to achieve full employment and surpluses in the current account and trade balance, spending cuts and/or tax increases are called for in the United States. It is important to announce these measures as soon as possible and to schedule the fiscal retrenchment over a number of years. Credible announcements today of future fiscal tightening have expansionary effects today: the anticipation of future spending cuts or tax increases lowers today's long real interest rates and may even boost the market price and shadow price of existing capital stock, encouraging new investment. When the fiscal contraction is actually phased in, it will have its normal depressing effect on aggregate demand. At that stage the Fed should be ready to provide the necessary once-off monetary stimulus to avoid a recession.

The net international investment position of the United States has worsened steadily since 1982. There had been small current account deficits previously but the recent current account deficits are unprecedented both in dollar terms and as a percentage of GNP. Since 1983, the current account deficit has been 1.4, 2.8, 2.9 and 3.3% of GNP. The previous postwar peaks in 1977 and 1978 were a mere 0.7% of GNP.
These current account deficits have eroded the net international investment position of the United States, but it is doubtful whether the United States is yet a net external debtor country, as is often reported. The official data on the US net international investment position support the view that the country became a net external creditor in 1985. The picture of the United States as a net external debtor is contradicted by the robustly positive stream of net investment income (or net foreign factor income) of $29 billion in 1982, $25 billion in 1983, $19 billion in 1984, $25 billion in 1985 and $23 billion in 1986. A country that is a net external debtor cannot have a persistently positive net stream of foreign investment income.

The question therefore is whether to believe the negative stock data or the positive flow data. It is likely that both series are subject to severe measurement errors. The external assets and liabilities of the United States, for example, tend to be valued at "historic cost". On balance, it seems likely that the picture presented by the positive net stream of foreign investment income is correct and that the United States has not yet become a net external debtor. The persistence of current account deficits would mean, however, that it is only a matter of time until the true net external investment position of the United States becomes negative and the positive flow of net investment income turns negative. Regardless of the net external investment position of the United States, it hardly seems right from the point of view of a globally efficient allocation of scarce investible funds for the most capital-rich country to appropriate such a large share of the world's savings.

Long-run prospects. In the longer term, potential output growth is to a large extent the result of policy choices. Even if the underlying or trend growth rate of factor productivity is unaffected by stabilization policy, which is by no means certain, potential output growth is a function of the growth of the private and public sector capital stocks, which can be boosted by appropriate supply-side policies and by demand management aimed at securing a high degree of capacity utilization.