U.S. economy: will Atlas shrug?
Is the value of the U.S. stock market justified by economic “fundamentals”? Is the new economy here to stay? Amid a slowing U.S. economy and falling stock prices, the answers are of more than academic interest.
Struggling to understand the stock market. Stanford University’s Robert Hall made the case that there is no need to invoke fads, animal spirits, or irrational exuberance to explain what appear to be wild swings in the value of the stock market (relative to GDP). To the contrary, he argued, the stock market’s movements are generally consistent with rational behavior by investors.
Delivering the 2001 Richard T. Ely lecture, Hall said that a rational stock market measures the value of the property owned by corporations. But property today is not just physical capital. A far more important part of corporate property is “intangibles”—stocks of business know-how and organizational principles, all of which are becoming increasingly dependent on the use of computers and software.
Valuation of such electronic capital is difficult, Hall observed, because it is a relatively new development, and investors have no easy way of forming beliefs—say, by using a long history of performance of similar companies. This is a problem not just in valuing Yahoo, a new company, but also in valuing established retail businesses like Wal-Mart. Now, he said, even companies at the “mundane end of a mundane business” have a much higher stock of intangibles than of physical capital.
The difficulties of forming beliefs about future earnings, combined with the phenomenal growth in earnings for companies such as Bay, lead to a situation where stock market valuations are high but volatile.
New economy, old risks? A panel on “Charting Our Course in the New Economy,” perhaps unavoidably, had one eye on the recent past and one eye on the possible implications of a hard landing. Robert Gordon of Northwestern University served as the panel’s hard-nosed skeptic, dismissing talk of a new economy as the unhappy product of circular arguments and prodigious hype. The Phillips Curve is alive and well, he said, and the “good things in the 1980s” played a key role in holding down inflation in the 1990s.
The remainder of the panel, however, were true believers. According to Martin Baily of the U.S. Council of Economic Advisers, the economy’s sharply improved performance was linked to developments in information technology, and recent data give indications that accelerated labor productivity is now a fact in the services as well as in the manufacturing sector.
William Nordhaus of Yale University, underscoring the importance of information technology, cited the unprecedented speed with which computer products have evolved and pointed to an eye-opening 50 percent annual increase in the speed of electronic communication. The cost of obtaining knowledge has tumbled and the rate of diffusion has jumped, he said, but there is no evidence yet that the speed with which new knowledge is developed has been affected.
Paul Krugman of the Massachusetts Institute of Technology (MIT), a self-professed “big skeptic” early on, rued having ignored the groundswell of support among business for a “new economy” explanation. He said he had a very hard time buying a supply-side explanation that favorable shocks alone fueled the strong performance of the U.S. economy in the late 1990s. But what, he wondered, should he make of the current pessimism? Is America 2001 really Japan 1990? He doubted it, noting that much of the recent pessimism is emanating from financial rather than business circles.
The United States might not be Japan, but Gordon, alone among the panelists, was downright worried that a vicious cycle may supplant the current virtuous one. The U.S. economy, he said, is in trouble for old economy reasons—among them, rising energy prices (“you ain’t seen anything yet”), the dollar hanging by a thread, and increases in medical insurance premiums.
Gazing into the crystal ball
Recession or a soft landing? That is one question facing the U.S. economy and its policymakers. A number of panels looked at forecasting tools and what esteemed economists have to say about times like these.
Forecasting the economy and the stock market. While academic debate continues on the broader questions about the economy, corporations and policymakers face the immediate task of forecasting the extent of the apparent economic slowdown and judging whether declines in the stock market presage a more calamitous fall. The reliability of forecasts of GDP growth and corporate earnings was the subject of a panel chaired by Clive Granger of the University of California, San Diego. Prakash Loungani of the IMF suggested that, if past experience is any guide, forecasters are good at recognizing that slowdowns are in progress but underestimate their severity. The record of forecasting recessions, in fact, is one of virtually unblemished failure.
Why are recessions not predicted? One reason may be that forecasters prefer to cluster around a common prediction rather than issue an “outlier” forecast. Granger presented evidence that forecasters tend to conform to the mean (“consensus”) forecasts; in particular, an individual’s growth forecasts are strongly influenced by the consensus forecast of the previous month. This “imitation” behavior can sometimes lead the consensus toward convergence at a forecast value far from the target (actual) value.
Dan Bernhardt of the University of Illinois and Edward Kutsoati of Tufts University noted that forecasts of corporate earnings are less subject to clustering. Participants at the session suggested earnings forecasts, and forecasts of financial variables more generally, translate into decisions on whether to buy or sell particular stocks. Hence, the reputation and the compensation of forecasters are more directly related to the outcome of their recommendations. In the case of economic growth forecasts, where the link is more tenuous between forecasts and decisions based on those forecasts, there is less incentive to differentiate their product, and forecasters may instead attempt to free ride off the opinions of others, thus producing the clustering Granger described.
Oil prices and the economic outlook. Gyrations in oil prices over the past two years have complicated the task of assessing the economic outlook. At a session organized by the International Association of Energy Economists, Loungani and Mine Yucel of the U.S. Federal Reserve Bank of Dallas noted the impact of oil on the macroeconomy—unemployment, in particular—has dampened in recent years. In other words, “oil shocks” do not appear to cause the economic disruptions they once did. Participants at the session, including the IMF’s Allan Brunner, speculated on whether this was due to structural changes in the energy markets and in the economy’s dependence on oil, changes in the way the U.S. Federal Reserve responds to oil shocks, or differences in the characteristics of oil shocks. Loungani suggested that recent oil shocks did not have the same impact on the macro-economy as earlier ones, because they were not associated with the potential threat of major disruptions to oil supplies.
Is it all in Mundell? Would U.S. policymakers responding to a slowing economy and falling stock prices benefit from rereading their Robert Mundell? Participants at a luncheon honoring the 1999 Nobel Prize winner seemed to think so. MIT’s Rudiger Dornbusch said that Mundell solved the “policy mix problem” by showing that fiscal policy should shore up the supply side of the economy and boost growth, while monetary policy took on containing inflation. This solution was very much against the conventional wisdom when Mundell proposed it. The IMF’s Economic Counsellor, Michael Mussa, referring to Mundell as an “intellectual agent provocateur,” noted that U.S. policymakers at the moment are grappling with the policy mix problem Mundell tackled many decades ago.
Exchange rate regimes: anything goes?
Over the past three decades, countries have experimented with a wide variety of exchange rate regimes. What have we learned about the choice of exchange rate regimes from this rich experience?
Avoid the middle? Delivering the Distinguished Lecture on Economics in Government, IMF First Deputy Managing Director Stanley Fischer noted that countries have started to avoid soft pegs (regimes intermediate between fixed and floating) in favor of either hard pegs or floating regimes. The middle has hollowed out, he said, not because of prodding from the IMF or the U.S. Treasury, as some have suggested, but because soft pegs have proved unsustainable. Each of the major international capital market-related crises since 1994 has in some way involved a fixed or pegged exchange rate regime.
Which corner should countries go to? The decision, Fischer emphasized, has to be made on a case-by-case basis. Hard pegs, he noted, make more sense for countries with a long history of monetary instability or those closely integrated with another economy or a group of other economies. Hard pegs can also be used to disinflate from high levels of inflation, but it is critical to have a strategy in place to exit from the peg during the process of disinflation.
For countries moving toward greater exchange rate flexibility, the inflation targeting framework has much to commend it, according to Fischer. In that framework, exchange rate movements are taken into account to the extent that they are expected to affect future inflation. An alternative framework for greater exchange rate flexibility is the use of wide and adjustable bands within which the exchange rate is allowed to float. An example of this is the “BBC” (band, basket, and crawl) arrangement recommended by John Williamson of the Institute for International Economics. Fischer argued, however, that “it is not at all clear” why such a system is preferable to an inflation targeting framework.
Mundell on exchange rate regimes. The topic of exchange rate regimes was also center stage at the luncheon to honor Robert Mundell. Andrew Rose of the University of California, Berkeley, puzzled over why Mundell had been in favor of the euro, since the euro area did not satisfy many of Mundell’s own criteria for establishing an optimum currency area. Rose reckoned that the euro area had Mundell’s support for two reasons. The first was that the establishment of a common currency area can provide tremendous savings in transactions costs and an expansion of trade that make it worthwhile to bear the risks of entering into what may be an unsustainable currency area. And, second, the criteria for an optimum currency area are “endogenous.” For instance, he said, the establishment of a currency area can further labor mobility—one of the criteria for a successful currency area.
Rudiger Dornbusch asked if Mundell’s support of the gold standard as an exchange rate regime was serious or was intended simply to be provocative. Mundell replied that it was only through the contrivance of gold that the world had achieved monetary unity without political unity. Mundell recommended a move toward a single world currency area in the future; he said the optimum number of currencies for the world, like the optimum number of gods, “should be an odd number, preferably less than three.”
The crisis-wracked 1990s continue to fuel interest in the nature of financial crises and to spur the search for effective “early warning systems” and appropriate policy responses.
Early warning systems. The development of systems that could alert policymakers of impending problems is now a cottage industry. For those wishing to enter the industry, the IMF’s Hali Edison provided a user’s guide to the literature. An assessment of leading early warning systems led her to conclude that while not foolproof, they offered a useful diagnostic tool for predicting crises. The U. S. Federal Reserve Board’s Steven Kamin presented an early warning system geared to identifying the roles of domestic and external factors in emerging market crises. Kamin found that while crises are largely a function of domestic factors, adverse external shocks do play a significant secondary role.
How crises spread. Contagion has many avenues, and a panel chaired by Beatrice Weder of the University of Basel examined four. Sergio Schmukler of the World Bank, presenting a paper coauthored with Graciela Kaminsky and Richard Lyons, looked at the increasing importance of mutual funds in emerging markets. Mutual fund investment, he said, is volatile across time and crises, with country fragility at the heart of withdrawals after crises (notably in Korea and Colombia).
To gauge the impact of trade links in the spread of crises, Kristin Forbes of MIT focused on three potential channels. She found a significant negative impact in terms of competitiveness and income effects, and a positive, but less significant, impact on bargaining effects. Caroline van Rijckeghem of the IMF, summarizing a study coauthored with Weder, asked whether a crisis is spread when banks respond to one problem by reducing exposure elsewhere. There was strong evidence of such a link after the Mexican and the Thai crises, she said, but little evidence of this after the Russian crisis.
And what of the moral hazard criticism that the prospect of an IMF bailout encourages unwise investment? Isabel Goedde of Mannheim University, presenting a study coauthored with Giovanni Dell-Ariccia and Jeromin Zettelmeyer of the IMF, examined investor behavior after Russia was not bailed out in August 1998. They found investors behaved more cautiously—significantly increasing spreads to most emerging markets, particularly those with weaker fundamentals. This finding suggests, Goedde said, that moral hazard was present prior to the Russia crisis, or that more selective crisis lending could increase the depth or likelihood of future crises in some countries, or that a mixture of both was true.
Policy responses. Financial crises and the fear of contagion have generated a variety of policy responses across countries. John Fernald of the U.S. Federal Reserve Bank of Chicago (in a paper coauthored with Loungani) asked if China’s policy response during the Asian crisis of 1997-98 offered a blueprint for other countries to counter the contagion effects of future crises. Many expected China to succumb to the Asian crisis, Fernald explained, because of the potential adverse effect on its exports of the real depreciations of neighboring currencies and because its financial system shared many of the same weaknesses as the Asian crisis countries. But neither fear was realized. Competition between China and the Asian crisis economies turned out to be much less adversarial than anticipated. And China’s financial sector was insulated from the pressures of adjustment, despite balance-sheet weaknesses, because of the government’s support.
Globalization and its discontents?
Dominick Salvatore of Fordham University assembled a distinguished panel to weigh the implications of a process that is bringing about extraordinary changes and stirring extraordinary anxieties. Salvatore offered a look at what made the U.S. economy so competitive in recent years, citing openness to trade and investment, efficient capital markets, and a high level of excellence in management and in science and technology.
Michael Mussa weighed the benefits and risks of capital account openness. The same logic that argues for trade liberalization argues for open capital accounts, he said, although he acknowledged capital markets are more susceptible to distortions and sudden shifts in investor sentiment. The relevant question now, he said, is not whether to liberalize capital accounts, but how to do so prudently. Most countries want open capital accounts. Those that have lost access to capital markets seek to regain it. Those that do not have access are moving toward it. Its risks can be mitigated, he said, through responsible government management of debt (notably short-term and foreign-currency-denominated debt) and an effective regulatory environment.
Globalization can be done right, Joseph Stiglitz of Stanford University suggested, citing the example of East Asia. That region closed the knowledge gap, partook of investment, and emphasized trade, while opting not to eliminate trade barriers or pursue capital market liberalization. The “Washington Consensus” got it wrong, he said, charging that its adherents pushed capital account liberalization for Wall Street’s benefit, encouraged full trade liberalization without appropriate safeguards, and supported policies that undermined social cohesion and benefited political elites.
Jagdish Bhagwati of Columbia University argued that globalization was a positive force that too often lacked a human face. As globalization proceeds, he said, institutions both domestic and international will need to be rethought. But countries and civil society will also need to rethink the means they use to redress wrongs. He worried that the future of the World Trade Organization could be imperiled by trade sanctions and social clauses.
If globalization can speed up growth in the leading economies and provide enormous opportunity for catch-up in the poor countries, why, asked Paul Romer of Stanford University, is there such hostility to it? In part, he said, it is because higher growth is often equated with greater damage to the earth. That is wrong, he argued, but economists must do a better job of explaining the benefits of growth and demystifying how markets work. He also urged economists to be mindful of the potential for collateral damage when they debate policy choices. He feared that broader goals could be undermined if the public misconstrues fractiousness over details as condemnation of globalization as a whole.
AEA panel addresses reform issues facing Bretton Woods institutions
More than a year after publication of the “Meltzer Report” (the findings of the U.S. Congress-authorized Financial Institutions Advisory Commission), Allan Meltzer of Carnegie Mellon University asked coauthors of the report, prominent critics, and IMF First Deputy Managing Director Stanley Fischer to discuss reforming the Bretton Woods institutions. Much of the debate centered on the IMF.
Meltzer, who chaired the AEA panel, complimented the IMF on recent steps to reduce the number of lending facilities, improve precautionary lending arrangements, and increase transparency. But he reiterated his concern that in its response to crises in the 1990s, the IMF had moved well beyond its original mandate and had become a lender of first resort, and in effect was now bailing out everyone. The IMF, he said, must allow profligate countries to fail, and lenders must bear their losses. He regretted that the IMF had not accepted the full logic of the Meltzer Report and cited its recent efforts in Turkey and Argentina as evidence that the IMF had not taken the report’s criticisms to heart.
Charles Calomiris of Columbia University suggested that the discussions of reforming the IMF really consist of two debates: a narrow one preoccupied with means and objectives and a broader and more important one to determine whether the IMF and the World Bank should serve as tools of U.S. and Group of Seven foreign policy. He argued that the constraints the Meltzer Report recommended—namely, respect for sovereignty, distinct tasks for these organizations, credible boundaries on goals, effective external evaluation, transparent accounting, and fair burden-sharing across countries—would thwart the use of these organizations as ad hoc foreign policy tools and have met fierce resistance from the U.S. Treasury and the Group of Seven. Failure to restrict lending to economic goals, he cautioned, damages the credibility of these institutions and subverts U.S. congressional oversight. Specific problems in need of reform, Calomiris said, are, among other things, the institution’s poor track record on conditionality; the “weeks and months” it takes to negotiate programs with countries facing liquidity crises; the huge bailout costs that are, he said, funded by citizens and represent a transfer to cronies; and operations that in his view still resist accountability and transparency, notably an obfuscatory accounting system. Joseph Stiglitz, a former Chief Economist of the World Bank who is now at Stanford University, argued that the IMF and the World Bank are indeed political institutions and suggested the Meltzer Report did not go far enough in addressing governance issues at these organizations. He also questioned what he termed the antidemocratic nature of apportioning voting rights according to GDP.
Fischer pointed to areas in which he was in agreement with the Meltzer Report—notably the basic goals of the IMF and the need for precautionary lending—but emphasized that there were also serious areas of disagreement. In particular, he argued that the relationship between politics and decision-making in the international financial institutions was more complicated than Calomiris allowed. Fischer noted that the Bretton Woods institutions took shape in response to the horrors of the Great Depression and World War II. These institutions, he said, “are based on the interactions of economics and politics. It is patently obvious that if the international economic system is incapable of delivering reasonable performance to the countries in it, then the political and economic system that we support and that is conducive to human freedom will not survive.” He added that “we would live in a different world if we did not have an international economic system that provides the benefits of stability to countries that participate in it on the basis of rules set up by mutual consent.”
Fischer stressed the accountability the IMF already has to its member countries through its Executive Board. Some decisions the IMF makes inevitably have a political element, and that is one of the key reasons an accountability of management and staff to member governments is so critical. That accountability, he said, is achieved via the Executive Board, representing all 183 member governments—and the IMF very rarely goes ahead without near unanimous support in the Board.
The IMF draws proportionate resources from its membership, and its voting rights reflect the financial stake of these countries in the institution. “That seems to me,” he said, “a highly appropriate way for a financial institution to behave.”
On conditionality, Fischer suggested, it would be more accurate to say that most of the time countries meet almost all of the conditions attached to IMF loans. The reviews built into IMF loans deal with a fact of life: circumstances change, and sometimes conditions have to be waived in the face of these changes. And as to the byzantine nature of the IMF’s former accounting system, Fischer said he could not agree more. The Meltzer Report made an apt and useful criticism of the transparency of IMF financing. But that system has now been overhauled to the point when “even I can understand the accounts,” he said. And crisis negotiations do not take weeks or months; in Korea and elsewhere, they were concluded in a matter of days.
Finally, Fischer challenged an assumption in both the Calomiris and the Meltzer presentations that the IMF bails out everyone. It’s just not true, he said; many investors in emerging markets took very large losses. It is also naive to think that there is an ideal solution in which all citizens are shielded from harm and the responsible parties assume the full cost of their mistakes. If a country defaults or a banking system collapses, Fischer explained, there are huge losses for everyone until these matters are righted. IMF lending cannot—and is not intended to—prevent all losses, but it can reduce the costs of adjustment in these countries. IMF lending in a crisis is meant to provide a safety net for citizens. In Korea, for example, funds were transferred to depositors, not bank owners.
Fischer also forcefully challenged the notion that allowing countries to fail would necessarily bring about sought-after reforms. Crises do not inevitably lead to reforms, he observed, and allowing a country to fail and face the consequences is not necessarily the best way to promote better economic policies. He said he was wary, in fact, of critics who find it “much too easy to bear the pain of others.”