Sunday, Feb. 01, 2004

How Long Can This Grow On?

By PETER GUMBEL

Ah, the sweet smell of economic recovery. Stock markets around the globe are surging, corporate spending looks set to rise and optimists are even talking about a return to the golden years of repeated noninflationary growth in the mid-'90s. But how strong is this upturn really — is it sustainable? And what will happen to the recovery's losers?

That may depend on where you stand. When Time's Board of Economists met during the World Economic Forum in Davos late last month, the perspectives varied according to geography. "The U.S. economy is on steroids," worried Pascal Blanqué, chief economist at the French bank Crédit Agricole. Blanqué fears an America bulking up on dangerous deficits, a lax monetary policy and the falling dollar. "The European economy is on tranquilizers," retorted Laura D'Andrea Tyson, dean of the London Business School and former chair of the Council of Economic Advisers in the Clinton White House. She argues that Europe is both too complacent about its weak growth and strong common currency, and too slow to boost its international competitiveness in response to buoyant American and Chinese competitors.

The face-off between Blanqué and Tyson highlights a sharp divergence in risk perceptions at this year's Board session. There was some common ground: all five economists — respected analysts from around the world — seemed upbeat about the resumption of growth worldwide and relieved that investment is picking up. But while America focuses on how to translate strong productivity gains into more jobs, and obsesses about the emergence of China as a low-cost economic colossus, European Union nations have turned inward. They are preoccupied by the addition of 10 new E.U. members this year, the tussle over a new European Constitution and the collapse of the Growth and Stability Pact that imposed rigid discipline — overly rigid, critics say — on governments to curb deficits. While Europeans seem worried about the impact of the falling dollar on exports, they've yet to take actions to stem it. "Be patient with Europe," pleaded Blanqué. After all, he said, economic-reform efforts in France, Germany and elsewhere are on track, but they will take time to yield tangible results.

Too much time, said Tyson and Moisés Naím, a former Venezuelan Trade and Industry Minister who is editor of the Washington-based journal Foreign Policy. "Europe has a tsunami coming its way this year," warned Naím. He predicts that as the weak dollar harms European exporters and puts European companies at an ever greater disadvantage against their Asian and American rivals, the countries will be paralyzed by a clash between businesses urging far greater flexibility, and those who will seek to erect protectionist barriers. "This is the clash we're going to see emerging powerfully in Europe in the next 24 months," Naím said.

For all such sparring, the sentiment this year is far better than it was 12 months ago, when the Board worried that a "culture of caution" had taken root among consumers and business alike. Back then the world was preparing for war in Iraq, business was still clearing up the mess left by the high-tech euphoria at the turn of the century, and governments and regulators were fussing about how to prevent further corporate scandals like Enron and WorldCom. Today, while business scandals continue to crop up, most notoriously at Italy's Parmalat, the pessimism has faded. Oil prices didn't spike as feared, world trade is up, mergers and acquisitions are back in fashion — and American consumers, boosted by President Bush's tax cut, are helping to lift the whole world out of the doldrums. Even Japan, mired in recession for much of the past decade, is growing at a healthy pace again. "There's a remarkable degree of consensus" among economic forecasters for U.S. growth somewhere between 3.5% and 4% this year, Tyson said. If they're right, that could be the fastest growth in four years.

"I have some doubts" about those growth predictions, said Blanqué. "Recovery is a bet on investment, and investment is running out of steam." He believes the U.S. economy still suffers from overcapacity — not to mention consumer indebtedness. Tyson agreed that the American consumer's ability to keep on spending would prove decisive.

There are other risks. The U.S. tax cuts and defense spending that have had that steroidal effect on the American economy have also caused the federal budget to go from a modest surplus to a deficit — one the Congressional Budget Office last week estimated would total $477 billion this year. That's the biggest ever in dollar terms and, at about 5% of gross domestic product, the largest in more than a decade. The U.S. current- account deficit, which measures the combined balances on trade in goods and services, income and currency transfers, is also at a record high — about $550 billion for 2003. Last month the International Monetary Fund warned that these deficits pose "significant risks" for the U.S. and the world economy, because they are so large they could force interest rates to rise worldwide and potentially destabilize foreign-exchange markets. And while productivity is again rising in the U.S., that's not translating into new jobs. Instead, said Tyson, productivity gains are feeding directly into corporate profits, which are at a record high relative to national income.

The big question, Tyson said, is this: At what point does a growing structural federal budget deficit undermine international confidence in the U.S. economy? For the moment, Asian central banks are helping to fund the deficit by buying dollars. That's keeping their trade with America on track and U.S. interest rates down, and effectively financing the worldwide expansion. But, Tyson asked: "How long can they keep doing this?" The U.S. Federal Reserve gave a partial answer last week when it abandoned a five-month-old commitment to keeping rates low "for a considerable period" — a statement widely interpreted to mean that rates are headed upward later this year. Higher rates may keep dollars flowing into the U.S. to fund the deficit, but it might put the brakes on the domestic economy.

It's a sign of the times, too, that international attention has shifted. The troubled economies of Latin America — until recently, America's obsession — seem to have dropped off the agenda. "Latin America is no longer the backyard. It has become Atlantis, the lost continent," quipped Naím, who sees Latin manufacturers as some of the big losers because they can no longer compete with lower-cost producers. Stepping into Latin America's place as the primary focus of U.S. attention is China, whose economy continues to grow apace and attract huge amounts of foreign direct investment — an eye-popping $53.5 billion last year. For months now, American economists and politicians have been fretting publicly over whether China is overheating, whether it could be the next Asian meltdown-in-waiting, and how long its currency can remain so blatantly undervalued against the dollar.

Fang Xinghai was bemused by such talk. The deputy chief executive of the Shanghai Stock Exchange, who joined the Board for the first time this year, said there is no reason to think that China's economy will soon boil over simply because it is growing at around 8-9% per year. Japan, he pointed out, averaged a growth rate of about 10% for 25 years during its big developmental leap starting in the 1950s. (Of course, when the growth finally stopped a decade ago, the problems revealed were so deep and wide that the country is still trying to emerge from the slump.) China's inflation is relatively low, and a huge surplus of workers in China keeps the labor market humming — and cheap. The starting salary of an average Chinese college graduate today is one-third lower than it was three years ago, Fang said, and 30% or more of graduates can't find jobs despite the 9.1% growth rate. "Wage pressure is nowhere to be seen," he said. Sure, there are a few signs of overheating. The number of cars sold in China doubled last year, from 1 million to almost 2 million, for example, and the real-estate market in some coastal regions is frothy. (Fang knows this firsthand: he regrets not buying an apartment in Shanghai when he moved there a year ago from Beijing; prices have jumped 60% in the meantime.) But China's central bank is trying to calm things down. Among other actions, it has changed the rules on some mortgages to require house buyers to make bigger down payments and borrow less. "We should not be concerned about overheating," Fang said.

Should the Chinese currency appreciate against the dollar? The yuan is currently pegged to the U.S. dollar and China is under growing pressure from the U.S. to adjust the rate or let it float. The argument is that the current exchange rate artificially cheapens China's exports, to the detriment of U.S. jobs and its trade deficit. The trade gap with China alone is now well over $100 billion. Naím called the current exchange rate of $1 to 8.3 yuan "the world's most dangerous number." The question, he said, is whether it will change in an orderly and slow manner, "or suddenly, surprisingly and unleashing a wave of instability."

Fang won't be drawn into the argument. The exchange rate "has served China very well, and we don't want to change voluntarily," he said, although none of the Board ruled out that the country could eventually yield to U.S. pressure. But "it's wrong to focus so much energy on the exchange rate," Fang argued, noting that even a 5% movement won't do much to plug the U.S. trade deficit. It would be smarter to change China's uncompetitive service sector — allowing foreign banks to set up shop, for example. "China can open up a lot more to the outside world — that's a much more constructive way to solve the problem," he said.

The other fearsome exchange rate, of course, is between the euro and the dollar. The euro has taken the brunt of the dollar's depreciation: the greenback has dropped more than 30% against the euro over the past two years. That makes U.S. goods more competitive overseas, but also threatens to choke off an export-led recovery in Europe. Naím foresees steroidal American competitors grabbing European market share, "and a wave of European companies investing in the U.S., where they'll find companies 30% cheaper." Blanqué calculates that each 5% appreciation of the euro against all currencies translates into a loss of European gdp growth of 0.5%.

Yet Blanqué, like Fang, warned against excessive focus on currency. Governments, particularly in France and Germany, need to continue reforming their economies in order to boost productivity, reduce the relatively high cost of labor and find better investment uses for a huge pool of savings that is currently sitting in bank accounts that yield very low returns. "The strength of the euro highlights European structural problems, it doesn't cause them," the French economist said.

Naím and Tyson quickly took issue with him. "It's amazing how little worried the Europeans are about the euro," Tyson said, pointing to two areas: the European Central Bank's tight monetary policy and the E.U.'s battered Growth and Stability Pact, which long required governments to limit debt and budget deficits. Exchange rates matter, she contends. The last 10 years was "a lost decade" for Germany because — among other reasons — it reunified with the former Communist East Germany at an exchange rate that was too high. "How many times do you go through this?" she asked, incredulously. The sliding dollar isn't bad news for all Europeans. "We're the only ones not complaining," said Slawomir Sikora, president of Poland's Bank Handlowy w Warszawie — now part of Citigroup. The reason: Poland's external debt is in dollars, while most of its exports are in euros, which means it benefits both ways. "We dream about this situation," Sikora said. Poland is the biggest of the 10 nations set to join the E.U. later this year, and Sikora is hopeful that accession will boost its growth. Its lower labor costs mean it will have a competitive edge, and Poland continues to enjoy some foreign direct investment. A recent McKinsey report suggests that Poland is well placed to create as many as 500,000 jobs over the next five years by becoming a new center for outsourced services for European companies. Already Lufthansa and GE have moved some back-office operations to Poland.

Still, the transition to E.U. membership could be tough, as Poland has an 18% unemployment rate and total debt creeping up toward 60% of gross domestic product. Sikora says most Polish economists believe Poland should join the euro as soon as possible, perhaps by 2007. But he says that uncertainties about the Growth and Stability Pact may push that back by a couple of years.

Should Europe have a stability pact at all? France and Germany have pulled back from their commitments to budgetary rigor as they struggle to jump-start their economies. Blanqué said a new pact is vital, and warned: "Don't throw the baby out with the bathwater." The old pact needed to be retooled because it had no incentives for governments to reduce deficits in good times, but sanctioned them for big deficits in a downturn. Once again, Tyson is skeptical. "You didn't even talk about the growth rate," she said. "Even the Japanese are going to grow faster than Germany this year." Blanqué nodded. Europe is underperforming its own potential — but then, it may not be alone in this predicament. The rosier scenarios for other parts of the world may yet prove too optimistic.