When the last World Economic Outlook was published in September 2002, the global recovery was expected to continue at a moderate pace, but the risks to the outlook were seen primarily on the downside. In the event, activity in the second and third quarters of 2002—except in western Europe—proved stronger than expected; correspondingly, global GDP growth for the year as a whole is now estimated at 3 percent, 0.2 percentage point higher than earlier projected (Figure 1.1 and Table 1.1). But since then the pace of the recovery has slowed, particularly in industrial countries, amid rising uncertainties in the run-up to war in Iraq and the continued adverse effects of the fallout from the bursting of the equity market bubble. Industrial production has stagnated in the major advanced countries, accompanied by a slowdown in global trade growth; labor market conditions remain soft; and forward-looking indicators—with a few exceptions—have generally weakened (Figure 1.2). And while global fixed investment has begun to turn up, it does not yet appear strong enough to sustain the recovery if consumption growth—a key support to demand so far in the upturn together with the turn in the inventory cycle—slows.

When the last World Economic Outlook was published in September 2002, the global recovery was expected to continue at a moderate pace, but the risks to the outlook were seen primarily on the downside. In the event, activity in the second and third quarters of 2002—except in western Europe—proved stronger than expected; correspondingly, global GDP growth for the year as a whole is now estimated at 3 percent, 0.2 percentage point higher than earlier projected (Figure 1.1 and Table 1.1). But since then the pace of the recovery has slowed, particularly in industrial countries, amid rising uncertainties in the run-up to war in Iraq and the continued adverse effects of the fallout from the bursting of the equity market bubble. Industrial production has stagnated in the major advanced countries, accompanied by a slowdown in global trade growth; labor market conditions remain soft; and forward-looking indicators—with a few exceptions—have generally weakened (Figure 1.2). And while global fixed investment has begun to turn up, it does not yet appear strong enough to sustain the recovery if consumption growth—a key support to demand so far in the upturn together with the turn in the inventory cycle—slows.

Figure 1.1.
Figure 1.1.

Global Indicators1

(Annual percent change unless otherwise noted)

The recovery is expected to remain moderate in 2003, with global growth returning to trend in 2004.

1Shaded areas indicate IMF staff projections. Aggregates are computed on the basis of purchasing-power-parity weights unless otherwise noted.2Average growth rates for individual countries, aggregated using purchasing-power-parity weights; the aggregates shift over time in favor of faster growing countries, giving the line an upward trend.3GDP-weighted average of the 10-year (or nearest maturity) government bond yields less inflation rates for the United States, Japan, Germany, France, Italy, the United Kingdom, and Canada. Excluding Italy prior to 1972.4Simple average of spot prices of U.K. Brent, Dubai, and West Texas Intermediate crude oil.
Table 1.1.

Overview of the World Economic Outlook Projections

(Annual percent change unless otherwise noted)

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Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during February 7–March 7, 2003.

Using updated purchasing-power-parity (PPP) weights, summarized in the Statistical Appendix, Table A.

Includes Indonesia, Malaysia, the Philippines, and Thailand.

Includes Malta.

Simple average of spot prices of U.K. Brent, Dubai, and West Texas Intermediate crude oil. The average price of oil in U.S. dollars a barrel was $25.00 in 2002; the assumed price is $31.00 in 2003, and $25.00 in 2004.

Figure 1.2.
Figure 1.2.

Current and Forward-Looking Indicators

(Percent change from previous quarter at annual rate unless otherwise noted)

The recovery in global industrial production and trade has slowed and most forward-looking indicators have turned down.

Sources: Business confidence for the United States, the National Association of Purchasing Managers; for the euro area, the European Commission; and for Japan, Bank of Japan. Consumer confidence for the United States, the Conference Board; for the euro area, the European Commission; and for Japan, Cabinet Office (Economic Planning Agency). All others, Haver Analytics.1 Australia, Canada, Denmark, euro area, Japan, New Zealand, Norway, Sweden, Switzerland, the United Kingdom, and the United States.2Argentina, Brazil, Chile, China, Colombia, Czech Republic, Hong Kong SAR, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Pakistan, Peru, the Philippines, Poland, Russia, Singapore, South Africa, Taiwan Province of China, Thailand, Turkey, and Venezuela.32002:Q1–Q4 data for China, India, and Russia are interpolated.

After strengthening in the last quarter of 2002, mature financial markets fell back in early 2003, with equity markets declining to 40–60 percent below their early 2000 peaks (Figure 1.3).1 This appears largely to have reflected rising risks and uncertainties, with respect to both the geopolitical situation and the sluggish pace of the recovery, offset in part by some improvement in risk appetite, At the same time, bond markets remained subdued, continuing to price in expectations of sluggish growth, while—perhaps aided by some easing of concerns about corporate governance—corporate spreads declined, particularly for high-yield paper. In foreign exchange markets, the depreciation of the U.S. dollar resumed in December, reflecting both geopolitical concerns and the continued heavy reliance of the United States on foreign capital inflows. By mid-March, the U.S. dollar had depreciated by 14 percent in trade-weighted terms from its early 2002 peak, accompanied by a 13 percent appreciation of the euro and a 4 percent appreciation of the yen. Since the middle of March, however, as expectations that the war would start shortly—and be over quickly—rose markedly, these trends have reversed, with global equity markets picking up, bond yields rising, and the U.S. dollar appreciating against most major currencies. At the time of writing, markets remain volatile, with the potential for substantial movements in either direction depending on how the geopolitical situation develops.

Figure 1.3.
Figure 1.3.

Developments in Mature Financial Markets

While risk appetite has picked up, equity markets remain weak, and the U.S. dollar has again begun to depreciate.

Sources: Bloomberg Financial Markets, LP; State Street Bank; Bank for International Settlements; and IMF staff estimates.1 Calculated as the difference between the 10-year government bond rate and 3-month interest rate.2IMF/State Street risk appetite indicators.

In emerging markets, financing conditions have improved, reflecting improved sentiment toward Brazil and—until recently—Turkey following the elections in those countries; the impact of actual and expected financial support from the international community, including the International Monetary Fund (IMF); and some improvement in risk appetite. During 2002, net capital flows picked up in all major regions except the Western Hemisphere—where foreign direct investment fell very sharply—although they still remain moderate by historical standards (Table 1.2). Emerging market spreads have declined markedly since October (Figure 1.4), although within this substantial tiering has emerged. In some key markets—including Russia, eastern Europe, and Mexico—spreads have declined sharply, in some cases to near historic lows. In contrast, where risks are still perceived to be significant, notably in some countries in South America and Turkey, spreads remain relatively high. A similar tiering is evident in primary markets, where—despite a marked pickup in issuance since November—only a few sub-investment-grade borrowers in Latin America have been able to access the market, and consequently most of them have been unable to prefinance their 2003 borrowing needs to any significant degree. Emerging equity markets have generally moved in tandem with mature equity markets; in currency markets, outside eastern Europe and South Africa, exchange rates have generally remained constant or fallen in trade-weighted terms (the latter primarily in some countries in Latin America and Asia—including China and Hong Kong SAR, whose currencies are closely linked to the U.S. dollar).

Table 1.2.

Advanced Economies: Real GDP, Consumer Prices, and Unemployment

(Annual percent change and percent of labor force)

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Based on Eurostat’s harmonized index of consumer prices.

Consumer prices are based on the retail price index excluding mortgage interest.

Consumer prices excluding interest rate components.

Figure 1.4.
Figure 1.4.

Emerging Market Financial Conditions

Emerging market financing conditions have improved in recent months, although spreads for some countries remain high, and primary market issuance is still modest.

Sources: Bloomberg Financial Markets, LP; J.P. Morgan Chase; and IMF staff estimates.1Average of 30-day rolling cross-correlation of 20 emerging market debt spreads.

Geopolitical uncertainties have also had a significant impact on commodities markets. After exhibiting considerable volatility throughout much of 2002, oil prices rose sharply in late 2002 and early 2003, owing both to increased expectations of war in Iraq and to supply disruptions associated with the political crisis in Venezuela (see Appendix 1.1, “Commodity Markets”). Despite OPEC’s decision in early January to raise its output target by 1.5 million barrels a day, prices continued to climb, peaking in mid-March at $34 a barrel. Since that time, mirroring the developments in financial markets noted above, oil prices have fallen back sharply on expectations that the war would shortly begin and be over quickly, but the market remains exceptionally volatile. Nonfuel commodity prices also rose significantly during 2002, particularly for food, beverages, and agricultural raw materials, although they are still low by historical standards. While this partly reflected the global recovery, it was mostly due to adverse weather conditions in parts of North America, Australia, Brazil, and Africa; correspondingly, if conditions improve, nonfuel commodity prices are likely to increase only moderately further during 2003.2

Four features of the current conjuncture appear particularly germane to an assessment of the global outlook:

  • Geopolitical and other uncertainties, and how they are resolved. In the run-up to the war in Iraq, geopolitical uncertainties increased sharply, reflected among other things in the rising trend (until very recently) in oil and gold prices. This is already having a substantial effect: notably, the upward revision in oil prices since the last World Economic Outlook and all the attendant uncertainties associated with it, accounts for a substantial proportion of the downward revision to global growth in 2003. Clearly, much now depends on the speed with which the conflict is resolved, the extent to which it is contained within Iraq, and the damage to infrastructural and other facilities, all of which are impossible to predict at this stage (see Appendix 1.2, “How Will the War in Iraq Affect the Global Economy?”). In contrast to the situation before the 1991 conflict in the Middle East, markets—especially since mid-March—appear to be pricing in a quick and relatively costless resolution of the situation. Correspondingly, the upside risks from a benign outcome, while real, may be smaller than the downside risks if matters turn out worse than expected.

  • The continued “headwinds” from the bursting of the equity market bubble, and the extent to which these persist. In most countries, the direct impact of the past fall in equity markets on demand growth is likely to have peaked in late 2002 or the first half of 2003; thereafter, provided equity prices do not fall further, the drag on GDP growth—while still significant—should start to diminish. This is also broadly consistent with the historical experience, which suggests that GDP growth begins to fully recover two to three years after the bursting of an equity price bubble (see Chapter II). However, considerable uncertainties remain, not least with respect to the impact on the balance sheets of banks and insurance companies, in Japan and some countries in Europe. In corporate sectors, excess capacity, losses on defined benefit pension plans, and still-high corporate debt levels weigh on the investment outlook—to different degrees—in all three major currency areas (Chapter II).

  • The marked differences in the macroeconomic stimulus in the pipeline in the key currency areas. In the United States, Canada, and United Kingdom, monetary and fiscal policies have been eased significantly more in response to the global slowdown than in the euro area and Japan (Figure 1.5), partly reflecting the smaller room for policy maneuver in the latter two. This pattern—reinforced by recent exchange rate movements—is expected to continue in 2003, and will tend to increase global dependence on U.S. growth.

  • Movements in major currencies. As noted above, the U.S. dollar has depreciated markedly over the past year, a generally welcome development in light of the continued large imbalances in the global economy, discussed in more detail below. However, geopolitical uncertainties appear also to have played a significant role; correspondingly, currency markets are likely to remain volatile in the immediate future, with significant movements possible in both directions depending on how events unfold. Such movements have important effects on activity and inflation particularly when—as in Japan—the authorities have relatively little room for offsetting policy maneuver.3

Figure 1.5.
Figure 1.5.

Fiscal and Monetary Easing in the Major Advanced Countries


Monetary and fiscal policies have been eased significantly more in the United States and the United Kingdom than in the euro area and Japan.

Source: IMF staff estimates.1The improvement in Japan’s structural fiscal balance during 2000–02 reflects the one-off costs of bank support in the base year amounting to 1.2 percent of GDP in 2000 compared with 0 percent in 2002. Excluding such support (and including social security), the structural balance actually deteriorated by about 1 percent of GDP.

IMF staff baseline projections are based on the assumption that the uncertainties surrounding the conflict in Iraq are broadly resolved in the near term, with little spillover outside the region, and that the global economic impact is correspondingly limited. On this basis, the global recovery is expected to continue during 2003, albeit at a relatively subdued pace, with GDP growth in the major currency areas remaining below potential until the end of the year (Figure 1.6). For the year as a whole, global growth is projected at 3.2 percent, 0.2 percentage point higher than in 2002, underpinned by a reduction in geopolitical uncertainties, a gradual ebbing of the headwinds to growth described above, the policy stimulus still in the pipeline, and a turn in the inventory cycle. Monetary policy would be expected to remain accommodative, with some further easing possible in the euro area, and with interest rate increases in the United States and elsewhere deferred until at least late 2003; in Japan, the zero interest rate policy would continue.

Figure 1.6.
Figure 1.6.

Global Outlook

(Percent change from four quarters earlier)

GDP growth will be weaker than earlier expected in most regions, and in the United States and euro area will not approach potential until late 2003.

Sources: Haver Analytics; and IMF staff estimates.1Australia, Canada, Denmark, euro area, Japan, New Zealand, Norway, Sweden, Switzerland, the United Kingdom, and the United States.2Hong Kong SAR, Korea, Singapore, and Taiwan Province of China.3Indonesia, Malaysia, the Philippines, and Thailand.4Czech Republic, Hungary, Israel, Pakistan, Poland, Russia, South Africa, and Turkey.5Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.

Looking across individual countries and regions:

  • In industrial countries, the United States is expected to continue to lead the recovery, although GDP growth is projected to be somewhat lower than in 2002, with current weakness partly offset by a recovery in confidence and investment and additional fiscal stimulus (Table 1.3). In the euro area, with domestic demand still quite weak, fiscal policy tightening, and the euro appreciating, growth projections have been reduced sharply. The situation in Germany, where GDP growth is expected to be well under 1 percent for the third year running and strains in the financial sector are becoming increasingly apparent, is of particular concern. GDP growth is also expected to remain weak in Japan, where deflation persists and domestic demand growth is expected to fade further.

  • In emerging markets, GDP growth prospects for 2003 have fallen moderately, in part reflecting the weaker outlook in industrial countries. Growth in emerging Asia exceeded expectations in 2002, particularly in China, and is expected to remain solid in 2003. However, the recent slowing in the global information technology (IT) sector will, if sustained, have an adverse impact on the newly industrialized economies and the ASEAN-4 (Indonesia, Malaysia, the Philippines, and Thailand), and the recent outbreak of Severe Acute Respiratory Syndrome (SARS) poses a risk to activity in several countries. Domestic demand has generally strengthened, but in most countries is not sufficiently robust to support a self-sustaining recovery, and the region continues to run a very large balance of payments surplus with the rest of the world (Table 1.3). In Latin America, after the deep recession in 2001–02, activity has begun to turn up. However, significant vulnerabilities remain in a number of countries, including Argentina, Brazil, and Uruguay, and the political crisis has had a serious impact on activity in Venezuela. In the Middle East, many countries have benefited from higher oil prices, but the regional security situation continues to have serious implications for activity, including in those countries with close economic relations with Iraq, and in Israel and the West Bank and Gaza. GDP growth in Turkey has exceeded expectations, but the new government faces significant challenges, especially in light of recent policy slippages and the impact of war in Iraq. GDP growth has also remained solid in the transition countries, although in Russia delays in implementing reforms have weakened investment prospects. In central and eastern Europe, GDP growth continues to be underpinned by strong foreign direct investment inflows as EU accession nears, offsetting the impact of weaker euro area demand.

  • Among the poorest countries, GDP growth in Africa remained relatively resilient to the global downturn, reflecting improved macroeconomic policies and stability, progress in resolving regional conflicts, rising commodity prices, and debt relief under the Heavily Indebted Poor Countries (HIPC) initiative. While GDP growth is expected to rise in 2003, aided by the continued global recovery, the outlook is clouded by adverse shocks. Poor weather—with the effects exacerbated by governance problems and the HIV/AIDS pandemic—has led to a serious famine in southern Africa, the Horn of Africa, and the western Sahel, now affecting 38 million people. The continuing turmoil in Zimbabwe and the political crisis in Côte d’Ivoire also have serious implications for these countries and their neighbors.

Table 1.3.

Emerging Market Economies: Net Capital Flows1

(Billions of U.S. dollars)

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Net capital flows comprise net direct investment, net portfolio investment, and other long- and short-term net investment flows, including official and private borrowing. Emerging markets include developing countries, countries in transition, Korea, Singapore, Taiwan Province of China, and Israel.

Exludes Hong Kong SAR.

Because of data limitations, “other private capital flows, net” may include some official flows.

A minus sign indicates an increase.

The sum of the current account balance, net private capital flows, net official flows, and the change in reserves equals, with the opposite sign, the sum of the capital and financial account and errors and omissions. For regional current account balances, see Table 27 of the Statistical Appendix.

Includes Korea, Singapore, and Taiwan Province of China in this table.

Includes Israel and Malta.

Global inflation remains very low, with consumer prices expected to increase by less than 2 percent in 2003 in advanced countries, and by just under 6 percent in developing countries. Given the expectation that output gaps in the United States and the euro area will widen further in the short term, and the continued moderate deflation in Japan, a number of observers have expressed concern that outright deflation could become a more widespread problem. While declines in price levels for short periods in individual countries cannot be ruled out—indeed, inflation in Germany was close to zero in the second half of 2002, and the risk of a short period of falling prices is significant—the risks of a sustained deflationary spiral currently appear small (see Box 1.1, “Could Deflation Become a Global Problem?”). Inflationary expectations remain well anchored, and excess capacity and output gaps in most countries seem unlikely to increase to levels that would dramatically change those expectations. However, since deflation has large potential costs, these concerns reinforce arguments for erring on the side of monetary accommodation at the present juncture, and underscore the importance of central banks’ making it clear that they will a ct aggressively and preemptively to forestall deflation if the need arises.

While the baseline scenario predicts a continued but only moderately paced recovery, with war in Iraq now under way with consequences that are not knowable at this stage, the outlook is subject to great uncertainty. Correspondingly, forward-looking indicators—such as asset prices and confidence indicators—are likely to remain highly volatile and will be difficult to interpret until these uncertainties are reduced. On the upside, a relatively rapid resolution of the uncertainties surrounding the situation in Iraq could provide a larger boost to global activity from the second half of 2003 than currently assumed, both through a stronger pickup in confidence and through lower oil prices (as the recent fall in oil prices, which at the time of writing are significantly lower than currently assumed for 2003 in this World Economic Outlook, attests). And with corporations in both the United States and Europe having relatively high cash balances—as discussed in the March 2003 Global Financial Stability Report—it is possible that investment could respond relatively quickly, though overall corporate balance sheets are still not strong. In addition, continued strong productivity growth in the United States remains an important supportive factor (see Box 1.2, “Is the New Economy Dead?”).

But on balance, the risks—similar to those identified in the last World Economic Outlook—remain distinctly on the downside, the more so, the longer the war continues. Beyond the specific risks in major industrial countries, including Japan and to a lesser extent Germany, they include the following.

  • A more prolonged and destructive conflict in Iraq could have a severe impact on global activity, through elevated oil prices, falling consumer and business confidence, lower equity prices, and higher risk premia (Appendix 1.2). While quantitative estimates are subject to enormous uncertainty, such a development would clearly slow—and could choke off altogether—the already fragile recovery in industrial countries. There would also be a serious impact on emerging market countries—particularly highly indebted oil importers, as spreads widen—and the poorest countries, which would be doubly hit by higher oil import prices and lower nonfuel commodity export prices. Moreover, even if the war ends quickly, significant uncertainties—both within the Middle Eastern region and outside—could persist for some time. To address this, it will be important that the international community moves quickly to rebuild confidence and to heal the rifts that emerged in the run-up to the war—and in particular, to ensure that these do not spill over into the economic sphere. To this end, supportive macroeconomic policies and early progress toward cooperatively addressing the major challenges that will continue to face the global community in the aftermath of the war—along the lines discussed below—appear particularly important.

  • The recovery continues to depend heavily on the outlook for the United States. Given the weakness in both Japan and the euro area, this is probably inevitable—and even necessary—in the short run. However, the short-term benefit is bought at the cost of increased medium-term vulnerabilities, notably growing global imbalances (the large U.S. current account deficit and significant surpluses in Japan, emerging Asia, and, to a lesser extent, the euro area) (Table 1.4). These imbalances may adjust benignly; indeed, this possibility has risen somewhat with the depreciation of the U.S. dollar over the past year, although the dollar still appears significantly overvalued. However, the imbalances remain a source of serious concern, especially since—in contrast to the late 1990s—the fiscal position in the United States is now in substantial deficit. First, historical experience suggests that a reduction in the U.S. current account deficit would likely be associated with lower U.S. growth; with few signs at present that this would be offset by stronger growth in the euro area and Japan, this could have significant global consequences. Second, a disorderly adjustment—involving a further sharp depreciation of the U.S. dollar and sharp currency appreciation elsewhere—remains a risk, especially if that appreciation were relatively narrowly focused on a few countries.4

  • The possibility of further declines in mature financial markets cannot be ruled out. While forward looking price earning ratios are now close to their historical averages, and earnings expectations have fallen back from earlier optimistic levels, there remains the possibility that—after a long period of overvaluation—markets could overshoot on the downside, having a direct effect on demand and adding to existing pressures on financial institutions and corporates. Higher-than-expected losses on defined benefit pension plans or the emergence of additional corporate scandals could add to such risks. In the United Kingdom, Australia, some of the smaller European countries, and to a lesser extent the United States, housing prices have been surprisingly strong in an environment where equity markets are falling (Chapter II). Correspondingly, the possibility of a slowdown—or even an abrupt adjustment—is also a source of concern. Looking forward, as growth prospects improve, the possibility of a sharp fall in long term bond prices—which, with interest rates very low, are presently very high—is also a source of risk (as discussed in detail in the Global Financial Stability Report).

  • Vulnerabilities in a number of emerging market countries—notably some countries in Latin America and Turkey—remain high. While financing conditions have recently improved, it is possible that the recent improvement in risk appetite may not prove enduring. A further reduction in spreads—which is necessary to ensure debt sustainability in a number of countries—may depend primarily on strengthened economic fundamentals, rather than on an improvement in the external environment. And while contagion remains low for now (Figure 1.4), it remains possible that—as in the past—heightened difficulties in one country may have a significant impact on other countries in a similar situation.

Table 1.4.

Selected Economies: Current Account Positions

(Percent of GDP)

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Calculated as the sum of the balances of individual euro area countries.

Corrected for reporting discrepancies in intra-area transactions.

Could Deflation Become a Global Problem?

There has been a notable increase recently in concerns about global deflation—defined as a sustained decline in an aggregate price index, such as the consumer price index (CPI). This follows the recognition that deflation in Japan continues to be a major problem; the onset of deflation in China and several other Asian emerging markets; and fears that the bursting of the equity price bubble has led to significant excess capacity, which will continue to weigh on prices, especially given weak global recovery and geopolitical uncertainties. Such an environment also gives rise to concerns that deflationary impulses could be transmitted across countries through trade, corporate, and financial linkages. This is the second time in the past five years—the first being in the aftermath of the Asian crisis—that the risks of generalized deflation have come to the fore (Roach, 2002). However, unlike the first time, the global economic situation is now particularly uncertain, with widespread vulnerabilities.

A key background to the concerns about deflation is the marked reduction in inflation rates in recent years. Among industrial countries, CPI inflation has declined to an average of below 2 percent, a level not seen since the 1950s (see the figure). Among emerging market economies, inflation rates are now the lowest since the late 1960s. Low inflation brings substantial benefits in terms of efficiency in resource allocation and a reduction in uncertainty. However, very low inflation—less than 2 percent or so—in the presence of negative demand shocks can increase the risks of moving into deflation (see the April 2002 World Economic Outlook).


Industrial Countries: Average Inflation Rate

(Consumer price index; percent)

Deflation can arise from both supply-driven and demand-driven shocks. In the former case, declining prices could be driven by productivity growth and technological innovations, and may be accompanied by an increase in output growth. In contrast, demand side shocks—such as the bursting of an asset price bubble—are generally accompanied by a slowdown, or a decline, in activity. Deflation is seldom benign, however. Even in a positive supply shock, unless it affects all sectors equally—an unlikely case—a generalized decline in prices can be problematic if wages are rigid downward. This is because sectors not experiencing productivity improvements, with rigid wages and falling prices, may nonetheless face higher real labor costs and a loss in competitiveness. And regardless of the source of the shock, deflation, especially when unanticipated, leads to a redistribution of income from debtors to creditors—that is, from groups with a high propensity to spend to those with a low propensity, depressing demand. Moreover, given the zero-interest-rate floor, the effectiveness of monetary policy is curtailed—of particular concern when output is weakening—and credit intermediation can be severely distorted as collateral loses value.

The biggest concern is that a temporary period of declining prices could develop into a more sustained and self-reinforcing deflationary spiral, as expectations of falling prices become entrenched, consumption and investment are postponed, and risk appetite drops off. Historically, this has entailed rising real debt burdens, widespread bankruptcies, pressures on banks, and collapsing demand, fueling a self reinforcing downward spiral in activity, employment, profits and prices (Krugman, 2002).

At the current conjuncture, sustained deflation has been experienced only in Japan, where it has been accompanied by a persistent weakness in activity; Hong Kong SAR, China, Singapore, and Taiwan Province of China have also experienced periods of falling prices. Nonetheless, among the group of industrial and large emerging market economies, episodes of CPI declines have increased from about 1 percent of countries in the first half of the 1990s to over 13 percent in the past three years, with a particularly pronounced increase in emerging markets (see the table). Given that the CPI is subject to upward bias of between ½ and 1 percent (by ignoring substitution possibilities and new or improved products), measured inflation of 1 percent or less may in practice be close to price stability, or even deflation. If so, mild deflation may already be affecting a substantially higher proportion of industrial and emerging market economies.

Incidence of Deflation and Low Inflation1


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Number of country months with year-on-year inflation less than 1 percent or negative, as a percent of total. Data based on 35 of the largest industrial and emerging market economies.

Looking ahead, a number of factors could exacerbate deflationary pressures. The pace of global recovery is likely to remain sluggish, reflecting geopolitical concerns as well as the continued effects of equity price declines. The latter, particularly through their impact on corporate balance sheets and financial institutions, may restrain activity more than currently anticipated. House prices, which have increased substantially in many countries, thus helping to mitigate effects of equity price declines on consumption, could experience a correction, exacerbating the weakness in household demand. There has also been a notable decline in private sector credit in many countries, reflecting subdued demand but also in several cases banking sector difficulties. Corporate profits remain under pressure, and although labor markets have held up better than during previous downturns, growth in labor incomes has begun to slow. The World Economic Outlook projections suggest that the output gaps—already substantial in many countries—are likely to widen in the near term to levels that are likely to considerably exacerbate the downward pressures on prices. While risk appetite appears to have stabilized, financial markets remain volatile amidst increased risks and uncertainties.

These considerations suggest that in the period ahead there may well be an increase in the number of countries facing deflation, or a worsening in countries already beset by it. Moreover, the vulnerability to deflation could be higher where the room for policy maneuver, both on the monetary and fiscal fronts, is constrained. That said, the risk of a generalized global deflation, or even of a deflationary spiral in the major economies, appears small: financial markets and institutions have remained broadly resilient so far; corporate and household debt burdens appear manageable; and there remains scope for policy adjustment in most countries.1 The likelihood of imported deflation also appears remote, given the small trade shares of countries experiencing deflation. In the case of China, high productivity combined with a defacto pegged exchange rate has led to sharp price declines in some sectors. But even here, its overall trade shares are too small to lead to a generalized deflation among trading partners.

Nevertheless, a potential increase in the spread of deflation is a cause for concern. Policymakers have the instruments to head it off, and can do so provided they act quickly and preemptively (Rogoff, 2002). Where deflation vulnerabilities are high, the operations of the automatic fiscal stabilizers should be allowed full play, and—if the risks became sufficiently large—well-directed discretionary fiscal measures could play a role in stabilizing demand. With regard to monetary policy, it is important that the inflation targets be high enough to minimize risks of deflation (given the upward CPI bias and the costs of deflation); and an undershooting of inflation targets should be as much a concern as overshooting inflation targets was in the past—that is, targets should be pursued symmetrically (Bernanke, 2002). Moreover, as Japan’s experience illustrates, deflation can be difficult to anticipate—both household and business surveys and financial markets in the mid-1990s expected a continuation of moderate inflation, right up to when deflation began (Ahearne and others, 2002). Correspondingly, policymakers need to be alert to the heightened risks, and in some circumstances a more accommodative monetary policy stance may be justified than would be strictly warranted by conjunctural conditions.

Note: The main author of this box is Manmohan Kumar.1For a detailed assessment, see Kumar and others (2003).

Is the New Economy Dead?

“Rest in peace, New Economy. It was fun while it lasted” (Dudley, 2002). While the stock market crash and economic downturn in the United States have dashed many of the hopes of New Economy enthusiasts, the increase in labor productivity growth that became evident in the second half of the 1990s has proven to be resilient. The precise magnitude of the increase depends on the dates chosen for the calculation and the methodology for adjusting the data for the business cycle, but there is now almost universal agreement that there has been a rise in trend labor productivity growth in the United States from about 1½ percent in the period from the mid-1970s to the mid-1990s to about 2¼ percent since 1995 (see the figure). This increase is somewhat smaller than the estimates of a 1 percent increase that were prevalent a couple of years ago. This box reviews the recent literature on the links between information technology (IT) and labor productivity growth, updating the chapter on the IT revolution in the October 2001 World Economic Outlook.


United States: Labor Productivity Growth1


Sources: U.S. Bureau of Labor Statistics; and IMF staff estimates.1Change in output per hour in the nonfarm private business sector from four quarters earlier. Trend based on Hodrick-Prescott filter using a smoothing parameter of 6400.

Most analysts agree that the increase in labor productivity growth is largely due to IT, but there is a debate about the exact sizes of the different channels. Labor productivity growth can be decomposed into the contributions of total factor productivity (TFP) and capital deepening, that is, the increase in capital per worker. There is no doubt that technological advances have raised TFP growth in the production of IT equipment. In recent years, computer prices have continued to fall rapidly, reflecting the doubling of the capacity of semiconductor chips roughly every 18–24 months—a phenomenon known as “Moore’s Law.” While the steep decline in the price of computer power has clearly stimulated real investment in computers, there is some controversy about the precise magnitude of the contribution of IT-capital deepening to labor productivity growth. Oliner and Sichel (2002) calculate that IT-capital deepening, along with TFP growth in IT production, more than fully accounts for the increase in labor productivity growth.

However, Gordon (2003) suggests that these calculations overstate the contribution of IT capital deepening, because IT investment appears to have been necessary but not sufficient to yield labor productivity benefits. Specifically, firm-level evidence from the retail sector, which accounts for much of the acceleration in labor productivity at the aggregate level, shows that all of the increase in labor productivity growth in the United States in the 1990s was achieved by new establishments and none by establishments that already existed in 1990, no matter how many computers they bought (Sieling, Friedman, and Dumas, 2001, and Foster, Haltiwanger, and Krizan, 2002). In other words, the benefits of higher investment in IT were only felt when accompanied by a substantial redesign of the store itself.

The corollary of the argument that IT-capital deepening contributed less to the observed increase in labor productivity growth is that an acceleration in TFP outside of IT production may have contributed somewhat. Indeed, Jorgenson, Ho, and Stiroh (2002) find a shift from negative to positive TFP growth in the IT using sector. For example, in the retail sector, organizational changes in large retailers that occurred in parallel with IT investment were possibly responsible for at least part of the increase in labor productivity growth. This is consistent with the fact that, in Europe, IT-using industries (such as retail, wholesale, and securities) did not see an acceleration in productivity similar to their counterparts in the United States (van Ark, Inklaar, and McGuckin, 2002), reflecting greater difficulties in making organizational changes because of structural impediments (like land-use regulations, shop-closing laws, and restrictive labor rules).1 Related evidence supporting an increase in TFP growth in IT-usage is provided by the positive correlation between the acceleration in TFP and measures of IT intensity, such as the ratio of IT expenditure to GDP (Haacker and Morsink, 2002).

Looking ahead, the impact of the IT revolution on underlying labor productivity growth will depend largely on three things: the pace of technological innovation in the IT sector, the responsiveness of investment to further declines in the prices of IT goods, and the ability of firms to reorganize production to take advantage of IT. First, there is a consensus that technological innovation in IT production will continue at a rapid pace, though perhaps not at the extraordinary pace that prevailed in the late 1990s (Jorgenson, 2001). As IT production constitutes a growing share of total output, technological innovation in this sector will likely continue to support labor productivity growth.

Second, there is an ongoing debate about the extent to which the ever-cheaper supply of IT goods will create end-user demand. Optimists, like DeLong (2002), argue that, just as price declines brought forth new uses in the past, they will continue to do so in the future, as IT is potentially useful for an extremely wide variety of production processes. As a result, the share of IT investment in nominal GDP in the United States, which rose from about 1 percent in 1960 to about 5½ percent in 2000, will rise further. However, skeptics argue that IT spending in the late 1990s reflected a unique set of factors and that nominal IT investment as a share of GDP is likely to fall over the coming decade. Specifically, Gordon (2003) points to the dampening effects on IT investment of excess capacity in telecommunications equipment, limited potential for e-commerce, slowing software innovation relative to hardware innovation, and obstacles to the adoption of broadband by households.

Third, it is likely that TFP growth outside of the IT sector will rise, reflecting the reorganization of production to take advantage of IT along the lines already seen in the retail sector. David (1990) observes that it took nearly half a century before the American economy had acquired enough experience with electric motors to begin to use them to their full potential. Similarly, Crafts (1985) shows that, in the original industrial revolution, the main contribution of steam power and textile machinery to British economic growth occurred in the middle half of the nineteenth century, well after the period of most rapid productivity growth within the steam-power and textile-spinning sectors in the early nineteenth century. It is likely that it will take time for people to figure out how best to reconfigure economic activity to take advantage of IT.

In sum, IT has led to an increase in labor productivity growth in the United States, which has held up through the economic downturn. TFP growth in IT production, as well as IT-related capital deepening, have already boosted labor productivity growth; the mixed macroeconomic evidence regarding an acceleration in generalized TFP associated with IT is not surprising, given that this effect typically emerges only gradually. Looking ahead, rapid technological innovation in the IT-producing sector will likely continue for the foreseeable future. As the price of computer power continues to fall, new uses for IT will likely continue to be found, thus stimulating investment. This will continue to provide support for productivity growth looking forward, albeit to a lesser extent than during the second half of the 1990s. Beyond this—as discussed above—much will continue to depend on the pace at which productivity improvements spread to other sectors of the economy, a process that may have only just begun.

Note: The main author of this box is James Morsink.1There is growing evidence on the role of structural impediments in dampening labor productivity growth. See, for example, Gust and Marquez (2002), Scarpetta and Tressel (2002), Vijselaar (2002), and Nicoletti and Scarpetta (2003).

These risks are of more concern given the fragility of the global recovery, and the likelihood that the resiliency of the global economy to shocks may now be weakening. On the macroeconomic side, the substantial monetary policy easing over the past two years has used up a considerable proportion—though not all—of the available room for maneuver, and the scope for additional fiscal policy easing has also become more limited. And while global financial markets have been surprisingly resilient, the shocks of the past two years have taken their toll. This is of particular concern in Japan, but also in some countries in Europe where financial cushions in the banking system have been sharply reduced. In addition, the financial condition of insurers has significantly weakened. One consequence of that has been to reduce insurers’ role in the credit derivatives market, diminishing banks’ ability to lay off credit risk, and possibly their willingness to extend credit. Both of these factors could limit the ability of the financial system to absorb new shocks and to support the recovery in the period ahead.

Against this background, policymakers in both industrial and emerging market countries continue to face an environment of great uncertainty and risk. With inflationary pressures in general quite moderate, monetary policies in major industrial countries should remain accommodative, providing some insurance against geopolitical uncertainties and other downside risks. However, it is clear that policymakers will need to be flexible and adapt quickly to changing circumstances. If the uncertainties surrounding the war in Iraq are resolved in the near term, no further stimulus may be necessary. But if the conflict were to be prolonged and widespread, further policy stimulus might be needed, particularly if—as may well be the case—the adverse effects of such a shock on demand were to dominate. (The situation would be more complicated if higher oil prices were to lead to substantial second-round pressures on prices, and some central banks might then face a difficult dilemma.)

Looking across the major regions, the following appear to be the main policy priorities.

  • Macroeconomic policies in industrial countries should continue to be accommodative. In the United States, following the 50 basis point cut in interest rates in November 2002, the present stance of monetary policy appears appropriate for the time being, although further cuts should be considered if the recent weakness in economic indicators is sustained. While the U.S. administration’s tax proposals have some merit from an efficiency perspective, there is a risk they may prove pro-cyclical, and if enacted in full they will significantly worsen the medium-term fiscal position. In the euro area, interest rates have also been reduced, most recently in March; with inflation projected to decline, additional cuts should be considered, and would be needed if the outlook remains weak or the euro appreciates significantly further. Given the difficult medium-term fiscal situation, some structural fiscal tightening in the larger euro area countries appears appropriate, notwithstanding the short-term impact on demand (Table 1.5). However, automatic stabilizers should be allowed to operate fully around a sustained consolidation path toward the Stability and Growth Pact (SGP) norm of close to balance, even if this were to result in deficits in 2003 above the 3 percent of GDP limit. In Japan, despite recent measures, monetary policy needs to be much more aggressive to combat deflation. A start toward medium-term fiscal consolidation is now needed to begin to rein in Japan’s high and rising public debt, unless more ambitious corporate and financial sector restructuring—which could exert a near-term drag on the economy—is undertaken.

  • In emerging markets, the situation continues to vary substantially across countries. In those countries experiencing external financing difficulties, macroeconomic policies must continue to be aimed at rebuilding external confidence; elsewhere—particularly in many countries in Asia—there is more room for policy maneuver in response to adverse shocks. As noted above, a number of emerging market countries could be seriously affected by a prolonged war in Iraq, and in some cases additional assistance from the international financial community may be necessary.

  • A greater sense of urgency is needed in implementing policies to reduce global dependence on the United States and foster an orderly reduction in global imbalances over the medium term. As has long been argued in the World Economic Outlook, a broad-based and multilateral effort is required, including aggressive steps to address the serious corporate and financial sector problems in Japan; accelerating labor and product market reforms in Europe; reestablishing a sound medium-term fiscal position in the United States; and shifting from external to domestic sources of growth in emerging Asia, including through additional financial and corporate reforms (in China, greater exchange rate flexibility is also desirable). The broader such efforts, the less the burden of an eventual adjustment on individual countries or regions, and the greater the prospect of an orderly resolution. In the event, notwithstanding some welcome but still rather partial moves in Japan, progress over the last six months has been limited (although, if implemented, the recent proposals announced by the German authorities appear an important step in the right direction); moreover, in the United States, if the administration’s budget proposals are adopted, significant budget deficits will remain well into the next decade. Beyond the multilateral aspects, this lack of progress significantly increases medium-term vulnerabilities and reduces medium-term growth prospects in individual economies themselves. For example, as discussed in Chapter IV, if the euro area reduced product and labor market rigidities to U.S. levels, GDP could be boosted by 10 percentage points over the medium term.

  • Fiscal consolidation remains a central medium-term priority around the globe. In the industrialized world, public debt is already very high in Japan and some parts of the euro area, and almost all countries face mounting fiscal pressures from aging populations. While the scope for short-term tightening is inevitably constrained by the current cyclical situation, additional action to ensure medium-term sustainability is required in many cases, including by reforming pension, health, and benefit systems and in some cases reining in substantial shadow economic activity. In emerging markets, the size and structure of public debt are significant sources of macroeconomic vulnerability in Latin America, and public debt accumulation—including off-balance sheet liabilities—is also an increasing concern in some countries in emerging Asia, including India and China. The key priorities include civil service reform, broadening tax bases and improving tax administration, addressing governance problems, and reducing contingent liabilities (including by strengthening banking and pension systems).

  • Among the poorest countries, the central priority is still to put in place the policies needed to reduce poverty, and to make progress toward meeting the other Millennium Development Goals. This will require, among other things, an enduring increase in GDP growth, which—particularly in sub-Saharan Africa—remains well below the levels necessary to achieve these goals. While action is needed in many areas, one overarching priority is to strengthen institutions, a central theme of this issue of the World Economic Outlook. As discussed in Chapter III, the quality of domestic institutions plays a key role in explaining differences in income levels, growth rates, and growth volatility across countries. Improvements in this area could have a profound effect on economic performance: for example, other things being equal, the estimates in Chapter III suggest that real GDP per capita in sub-Saharan Africa could be 80 percent higher if its institutions were on a par with those in developing Asia.

Table 1.5.

Major Advanced Economies: General Government Fiscal Balances and Debt1

(Percent of GDP)

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Note: The methodology and specific assumptions for each country are discussed in Box A1 in the Statistical Appendix.

Debt data refer to end of year; for the United Kingdom they refer to end of March. Debt data are not always comparable across countries. For example, the Canadian data include the unfunded component of government employee pension liabilities, which amounted to nearly 18 percent of GDP in 2001.

Percent of potential GDP.

Data before 1990 refer to west Germany. For net debt, the first column refers to 1988–94. Beginning in 1995, the debt and debt-service obligations of the Treuhandanstalt (and of various other agencies) were taken over by general government. This debt is equivalent to 8 percent of GDP, and the associated debt service to ½ to 1 percent of GDP.

Excludes one-off receipts from the sale of mobile telephone licenses (the equivalent of 2.5 percent of GDP in 2000 for Germany, 0.1 percent of GDP in 2001 and 2002 for France, 1.2 percent of GDP in 2000 for Italy, and 2.4 percent of GDP in 2000 for the United Kingdom). Also excludes one-off receipts from sizable asset transactions.