United States
2002 Article IV Consultation-Staff Report; Staff Supplement; and Public Information Notice on the Executive Board Discussion

This 2002 Article IV Consultation highlights that the United States economy slipped into recession in early 2001, as industrial production dropped sharply, investment and exports declined, and employment and weekly hours fell. The downturn was triggered in part by the collapse of the Information Technology boom and stock prices in March 2000, but was further exacerbated by the September 11th terrorist attacks. As a result, following real GDP growth in excess of 4 percent during the previous four years, the economy slowed sharply in 2001.

Abstract

This 2002 Article IV Consultation highlights that the United States economy slipped into recession in early 2001, as industrial production dropped sharply, investment and exports declined, and employment and weekly hours fell. The downturn was triggered in part by the collapse of the Information Technology boom and stock prices in March 2000, but was further exacerbated by the September 11th terrorist attacks. As a result, following real GDP growth in excess of 4 percent during the previous four years, the economy slowed sharply in 2001.

I. Introduction

1. The 2002 consultation took place as the U.S. economy started to recover from an unusually mild recession. Following a decade marked by the longest U.S. expansion on record, low inflation, and a remarkable turnaround in the federal fiscal position of roughly 7 percentage points of GDP, the U.S. economy slipped into recession in early 2001. However, the economy has proven exceptionally resilient, even in the face of the September 11th terrorist attacks. Timely fiscal and monetary stimulus in 2001, strong consumer spending, and continued productivity gains contributed to a turnaround in late 2001 and early 2002.

2. The discussions, therefore, centered on prospects and policies for a renewed and durable expansion. Despite the rebound in activity, uncertainties still remain regarding both the underlying strength of final domestic demand and the extent to which the rapid productivity growth achieved during the latter half of the 1990s will be sustained. At the same time, progress toward a number of the key policy objectives that the new Administration had adopted following the 2000 elections—including preserving the Social Security surplus and trade liberalization—has been disrupted. Against this background, the key issues for the consultation included:

  • Re-establishing a clear medium-term fiscal framework. The fiscal outlook has been significantly eroded by the economic slowdown, tax cuts, and additional defense and security outlays. Ambitious efforts toward re-establishing fiscal surpluses will be necessary to prepare for the fiscal pressures arising from the retirement of the baby-boom generation that will begin at the end of the decade.

  • The pace and timing of the withdrawal of monetary stimulus. Monetary policy remains highly accommodative, and interest rates will need to be moved to more neutral levels, provided that evidence of recovery continues to accumulate.

  • Concerns about corporate governance. The U.S. financial system has been resilient in the face of the economic downturn, but recent corporate failures have increased investor uncertainty and highlighted the need to strengthen governance and accounting practices.

  • Multilateral implications. The persistently large U.S. current account deficit continues to raise concern regarding the risk of disorderly exchange rate adjustment, while protectionist pressures risk imposing significant costs, both domestically and abroad, and disrupting multilateral trade negotiations.

II. Recent Economic Developments

3. The U.S. economy slowed in the second half of 2000 and slipped into recession in early 2001 (Table 1). The downturn was marked by a sharp drop in industrial production, declining investment and exports, and falling employment and weekly hours. Real GDP growth slowed to 2¾ percent during 2000 (Q4/Q4), from 4½ percent during the previous year, and growth in the second quarter of 2001 was only ¼ percent (annualized rate). The economy’s weakness was exacerbated by the September 11th terrorist attacks, which triggered a plunge in consumer and business confidence, as well as further job losses (Box 1). As a result of the underlying recessionary pressures and the temporary disruptions to activity caused by the attacks, real GDP fell by 1¼ percent in the third quarter of 2001.

The Macroeconomic Effects of September 11th

The events of September 11th dealt another blow to the already weak U.S. economy.1 In the wake of the attacks, equity prices and consumer and business confidence dropped sharply, and economic activity was disrupted, including the shutdown of the air transport system, and segments of New York’s financial infrastructure.

However, swift and forceful policy actions—an aggressive easing in monetary policy and an emergency spending package—helped to mitigate the short-run negative impact of the attacks. Indeed, by year-end, equity prices and confidence had returned to their pre-attack levels, and the impact on the economy over the medium term is generally expected to be modest.

Estimates of the impact of the attacks include:

  • The destruction of private and government capital is estimated to have been around $15 billion in the third quarter.2 In addition, insurance losses are estimated at $30–$58 billion, the largest insurance event in history.

  • The fiscal costs include $40 billion in emergency spending that was appropriated in the immediate aftermath of the attacks, and $15 billion in direct grants and loan guarantees for the airline industry. The FY 2003 budget proposed significant increases in defense and homeland security in response to the attacks.

  • Over the medium term, increased security costs in the private sector are expected to have a small effect on the productive capacity of the economy, lowering the level of potential output by about ½ percent by 2007.3

1 For a detailed analysis, see “Economic Consequences of Terrorism,” OECD Economic Outlook, 71, 2002. See also the December 2001 World Economic Outlook.2 Based on national income accounts.3 Council of Economic Advisers, Economic Report of the President, 2002.
Table 1.

United States: Selected Economic Indicators

(Percent changes from previous period, unless otherwise indicated)

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Sources: IMF staff estimates.

Contribution to growth.

4. The recession appears to have been remarkably short and shallow (Box 2). Bolstered by significant monetary and fiscal stimulus in early 2001, and the additional measures taken in the immediate aftermath of the attacks, the economy began to recover at the end of 2001. Output rebounded by 1¾ percent (annual rate) in the fourth quarter, and then surged by 6¼ percent in the first quarter of 2002. More recent monthly data, while generally positive, indicate that the pace of the expansion slowed in the second quarter and point to continued uncertainties regarding the strength of the recovery (Table 1 and Figure 1).

Figure 1.
Figure 1.

United States: Real GDP

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

Comparing the U.S. Recession to Past Downturns

The recession in the United States that began in March 2001 was a typical in a number of respects.

  • The downturn was shorter and much milder than those of the past three decades. GDP contracted in only one quarter, falling just ¼ percent below the previous peak. Past recessions generally lasted four to six quarters with GDP declines of at least 1½ percent.

  • An investment collapse—particularly in the techology sector—triggered the downturn. Business fixed investment and inventories both fell earlier and by much more than in previous recessions.

  • Consumption remained relatively strong. Unlike in past downturns, consumption remained steady, sustained by low interest rates that boosted purchases of durables such as autos, as well as tax cuts, low energy prices, and strong wage growth.

  • Balance sheets have not acted as a significant constraint. Stock prices—which typically have rebounded in the initial phase of previous recoveries—remain weak but past stock market gains and the strength of housing prices have helped keep household net wealth relatively high. Although corporate indebtedness is at an unprecedently high level, low interest rates have kept debt service manageable.

  • Forceful counter-cyclical policies were facilitated by favorable starting conditions. Low inflation and a credible commitment to price stability allowed the Federal Reserve to cut interest rates more aggressively than in past recessions. At the same time, the fiscal surplus provided room for counter-cyclical tax cuts and spending increases reflected in a turnaround in the federal government’s structural balance projected at more than 3 percent of GDP from 2000 to 2002.

  • Productivity growth remained unusually strong. Productivity growth in the nonfarm business sector accelerated to 5½ percent (saar) in the fourth quarter of 2001 and 8½ percent in the first quarter of 2002. In contrast, output per worker has typically declined in past recessions.

uA01fig01

Real GDP

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

uA01fig001

Consumption

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

uA01fig02

S&p 500 Index

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

uA01fig002

Productivity

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

5. The bursting of the “IT bubble” helped trigger the recession (Figure 2). The tech-heavy Nasdaq composite index plunged by 60 percent in the year following its peak in March 2000 and corporate profits also weakened sharply. Investment in equipment and software—especially in communications equipment and trucks—slowed in the second half of 2000 and then fell sharply in 2001 before appearing to have bottomed out in early 2002. Spending on nonresidential structures also declined sharply, although declining mortgage interest rates have helped to sustain residential investment.

Figure 2.
Figure 2.

United States: Stock Market

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

6. Inventory adjustments played an important role in contributing to the slowdown and in the subsequent turnaround. Slowing sales in late 2000 and early 2001 left the inventory-to-sales ratio above its trend of the past decade. Production cuts combined with buoyant consumption in late 2001 caused inventories to fall sharply implying a significant negative contribution to growth (Figure 3). However, with stocks reaching relatively lean levels by end-2001, the pace of inventory adjustment slowed, contributing 3½ percentage points to GDP growth in the first quarter of 2002.

Figure 3.
Figure 3.

United States: Retail Inventories

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

7. Household demand held up unusually well during the downturn. Consumption growth slowed to an annual rate of around 3¼ percent during 2001 and through the first quarter of 2002, from an average of around 5 percent in recent years. Moreover, following the initial shock to confidence after the September 11th attacks, household spending rebounded strongly in the subsequent two quarters, with especially strong spending on consumer durables. Employment declines and the stock market correction acted to moderate spending growth but demand was bolstered by strong wage growth, interest rate cuts, mortgage refinancing, the June 2001 tax cuts and the associated tax rebate, and special incentives offered by automakers and other manufacturers late in the year.

8. Household and corporate balance sheets have remained relatively healthy, despite the downturn (Figures 4 and 5). While household net worth as a percent of disposable income declined to 537 percent in 2001 from its earlier peak of 622 percent in early 2000, this ratio remained well above its 1952–95 average of 470 percent, as the effect of the stock market correction was partly offset by the strength of housing prices. Although household debt has increased significantly, this largely reflected a rise in mortgage debt, much of which has been locked in at low interest rates. Corporate debt reached an unprecedented 48 percent of GDP in late 2001. However, firms have also taken advantage of low interest rates and lengthened terms to maturity, and the debt service-to-income ratio remained well below recent cyclical peaks and started to decline in late 2001.1

Figure 4.
Figure 4.

United States: Households

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

Figure 5.
Figure 5.

United States: Corporate Sector

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

9. Corporate profits have also begun to recover, although questions remain regarding longer-term prospects. Profit growth turned negative in the fourth quarter of 2000 and continued to decline to the third quarter of 2001. However, with employment and debt-service costs moderating, and continued strength in labor productivity, profits for the domestic nonfinancial sector as measured in the national accounts rebounded strongly in 2001Q4 and 2002Q1. Nonetheless, stock prices have remained unusually weak for the early stages of a recovery, reflecting lingering concerns regarding future earnings growth and accounting standards in the wake of Enron’s failure.

10. Employment fell sharply in response to the economic slowdown, but labor market conditions have shown signs of stabilizing. After dropping to a 30-year low of just under 4 percent during 2000, the unemployment rate rose rapidly, reaching 6 percent in April 2002 (Figure 6). Job losses were initially concentrated in the manufacturing sector, but following the September 11th attacks, significant employment declines were felt in the service sectors. However, employment seemed to have bottomed out by May 2002, and the unemployment rate eased to 5¾ percent.

Figure 6.
Figure 6.

United States: Employment

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

11. The economic slowdown, strong productivity growth, and declines in energy and non-oil import prices helped contain inflation (Table 2 and Figures 7 and 8). With the level of output falling an estimated 1½ percent below potential by the end of 2001, consumer price inflation fell to 1½ percent by December 2001 (12-month rate), from about 3½ percent during 2000, and fell to 1¼ percent in May 2002. Core-CPI inflation has remained around 2½–2¾ percent, although inflation measured by the chain-weighted price index for core personal consumption expenditures (PCE) slowed to 1½ percent during 2001, from just under 2 percent during 2000, and remained at around 1½ percent in May 2002. Despite a 4¼ percent increase in the employment cost index during 2001, unit labor costs fell in the fourth quarter of 2001 and the first quarter of 2002, reflecting strong gains in productivity growth, which surged over these two quarters (Figure 9).2

Figure 7.
Figure 7.

United States: Inflation

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

Figure 8.
Figure 8.

United States: Real GDP and Potential Output

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

Figure 9.
Figure 9.

United States: Productivity

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

Table 2.

United States: Key Economic Indicators

(Percent changes from previous period, unless otherwise indicated)

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Sources: U.S. Department of Labor, Bureau of Labor Statistics; U.S. Department of Commerce, Bureau of Economic Analysis; U.S. Department of Commerce, Census Bureau; and U.S. Federal Reserve.

Monthly date dervied from census data; quarterly date and prices derived from NIPAs, 2002Q1 merchandise trade data are from monthly census data.

12. Despite the weakness in domestic demand, the current account deficit narrowed only modestly from its recent peak of 4¼ percent of GDP in 2000 to about 4 percent in 2001 (Table 3). Imports of goods and services—particularly capital goods—fell by 6 percent. The decline was partly offset by a 6¼ percent drop in exports of goods and services, especially exports of high-technology goods and machinery, reflecting the slowdown in global demand and the strength of the U.S. dollar (Table 4). However, the current account deficit widened to 4¼ percent of GDP in the first quarter of 2002, partly reflecting a pickup in import demand as U.S. economic conditions firmed.

Table 3.

United States: Balance of Payments

(In billions of dollars)

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Source: U.S. Department of Commerce, Bureau of Economic Analysis.
Table 4

United States: Indicators of Economic Performance

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Sources: World Economic Outlook; and staff estimates.

Composites for the country groups are averages of individual countries weighted by the average value of their respective GDPs converted using PPP weights over the preceding three years.

13. With continued market confidence in U.S. medium-term growth prospects, net private capital inflows have remained robust (Figure 10). However, inflows eased somewhat in 2001, reflecting a drop in net direct investment and equity inflows, partly due to the turnaround in sentiment toward IT investments, which outweighed a pickup in foreign purchases of corporate and agency bonds.

Figure 10.
Figure 10.

United States: Global Net Inflows

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

14. Reflecting strong capital inflows, the dollar appreciated in real effective terms until early 2002, when it began to give up some of its earlier gains (Figure 11). The dollar had risen against most major currencies during the past two years, appreciating by over 20 percent in real effective terms. However, the dollar began to weaken in early 2002, especially against the euro, the Japanese yen, and the Canadian dollar, falling by just over 4 percent in real effective terms during February–May, with further losses in June. Market commentary suggests that the dollar’s recent decline reflects less optimistic assessments of U.S. growth prospects, concerns regarding accounting and governance irregularities following Enron’s failure, and questions regarding the financing of the large U.S. current account deficit.3

Figure 11.
Figure 11.

United States: Exchange Rates

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

15. After rising steadily from 1993 to 1998, gross national saving as a percent of GDP fell by 1¾ percentage points to 17 percent during 1998–2001 (Figure 12). Government saving declined as a result of tax cuts, rising expenditures in the wake of the attacks, and the impact of slower growth on tax revenues. Business saving also fell in 2001 as corporate profits slumped. The personal saving rate—which has been trending downward since the 1980s—reached a historical low of 1 percent of personal disposable income in 2000, but rose to 1½ percent in 2001 and to 3 percent in early 2002, partly in response to the June 2001 tax cuts.

Figure 12.
Figure 12.

United States: Saving

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

16. Monetary policy was eased aggressively during the course of 2001, although several factors moderated the effect of interest rate cuts on monetary conditions. Following a series of tightening moves during the previous two years, which had taken the federal funds rate to 6½ percent by end-2000, the Federal Reserve lowered its interest rate target eleven times in 2001, bringing the federal funds rate to 1¾ percent (Figure 13). However, the effect of this easing on overall monetary and demand conditions was at least partly dampened by the appreciation of the dollar and the correction in stock prices.4 Moreover, spreads on long-term corporate debt rose sharply in 2000 and 2001, reflecting concern about the underlying strength of corporate finances, and credit standards applied by banks to household and corporate customers also tightened during this period. Since late 2001, corporate spreads and lending conditions appeared to have eased somewhat, but still remain restrictive.

Figure 13.
Figure 13.

United States: Interest Rates

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

17. Fiscal policy turned expansionary beginning in FY 2001, with the June 2001 tax cuts, security-related outlays after the attacks, and a stimulus package enacted in March 2002. The unified budget surplus declined from 2½ percent of GDP in 2000 to 1¼ percent of GDP ($127 billion) in FY 2001, and the staff estimates that the balance will shift to a deficit of 1½ percent of GDP in FY 2002. The economic slowdown accounted for only part of the fiscal deterioration, and the structural balance is estimated to have shifted from a surplus of 2 percent of GDP to a deficit of 1½ percent of GDP between FY 2000 and FY 2002. In addition to policy measures, lower capital gains realizations also contributed to a structural deterioration in personal income tax revenues. State budgets have also come under pressure, reflecting the effects of weaker economic conditions and federal tax cuts on revenues, but the impact on outlays has been partly mitigated by drawdowns from reserves and proceeds from settlements with the tobacco industry.5

III. Economic Outlook and Risks

18. The staff projects a gradual acceleration of GDP growth from 2½ percent in 2002 to 3¼ percent in 2003 as business activity recovers (see table below). Inventory restocking provided a substantial boost to growth in the first half of 2002, while business fixed investment is projected to gather strength in the second half of 2002 and into 2003. Consumption growth is expected to moderate in mid-2002—reflecting in part the waning effects of tax cuts—but pick up in 2003 as income growth strengthens. With the U.S. recovery leading that of its major trading partners, the current account deficit would widen to around 4½ percent of GDP in 2002 and 2003. Output would gradually return to potential in 2004, and with price pressures remaining subdued, CPI inflation would settle at around 2½ percent.

Medium-Term Projections

(In percent)

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Source: Staff estimates.

19. The staff’s forecast broadly mirrors the private sector consensus, but recent data have highlighted the downside risks. In particular, signs of a slowdown of household demand and an erosion of stock market sentiment underscore several key vulnerabilities in the near-term outlook:

  • Business fixed investment. Staff analysis does not suggest a severe investment overhang from the late 1990s, and there are early signs—including the pickup in orders for capital goods—of a turnaround (Box 3). Nonetheless, spending in some sectors, most notably telecommunications, will likely remain weak. Without a revival in final sales and a sustained improvement in corporate profits, an investment rebound could be short-lived.

Is There a Capital Overhang?

The investment boom of the late 1990s and its subsequent collapse have raised fears that a capital overhang would retard U.S. investment and growth. This concern has centered on the high technology sectors, given high profile bankruptcies and the tremendous growth in computer equipment investment in the second half of the 1990s (600 percent).

Surprisingly, however, the recent growth rate of the real capital stock has actually been lower than in previous decades. The average annual growth rate of private, fixed nonresidential capital accelerated to 3½ percent during 1995–2000, from 2 percent during 1990–95, but this was much slower than the 4 percent rate during the 1960s and 1970s. Unlike the 1960s and 1970s—when the stock of structures grew quickly—structures investment grew more slowly in the late 1990s. Indeed, equipment and software investment accounted for nearly 90 percent of investment growth in the late 1990s.

The increase in the investment rate can be viewed as a rebound from unusually low levels in the late 1980s and early 1990s (see figure). This earlier period of low net investment also resulted in a decline in the ratio of net private capital to net private GDP, which was arrested only late in the 1990s.

Recent empirical evidence also does not support the hypothesis of a widespread capital overhang, and staff analysis supports these results.1 A simple neoclassical model that relates the long-run trend in the capital stock to output and the relative price of capital to output (which reflects borrowing costs, inflation, depreciation, and taxes) suggests that the capital stock fell below its equilibrium level during 1992–98, reflecting low net investment. By end-2000, the noncomputer capital stock remained below equilibrium, but over investment of computer equipment of $43 billion—equivalent to less than ½ percent of GDP, but almost 13 percent of the capital stock in computers—emerged. However, high technology goods have very high rates of depreciation, suggesting that most of this excess capital would be erased by the end of 2001. Other studies report a capital overhang of a similar size.2

Prospects appear favorable for an investment rebound in late 2002. Strong productivity growth, low unit labor costs, continued declines in the relative price of capital, and the March 2002 investment incentives are widely expected to boost purchases of equipment.

Nevertheless, there remain uncertainties about the outlook for investment. Capacity utilization is low, and profits have yet to fully recover. While unit labor costs moderated at the end of 2001 and early 2002, productivity growth will need to remain high to sustain profit growth and net cash flow, especially as debt service rises with the expected tightening of monetary policy. Borrowing may also become more difficult in the face of accounting and corporate governance concerns. Finally, overinvestment in selected sectors and cities, especially in structures, could restrain spending.

uA01fig03

Net Investment and Capital

(In percent of private GDP)

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

Source: BEA and staff estimates. All data are nominal.
uA01fig04

Computer Capital Stock

(In billions of chained 1996 dollars)

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

Source: BEA and staff estimates.
1 A forthcoming selected issues paper explores these issues in greater detail.2 See Macroeconomic Advisers, 2002, Economic Outlook, February, p. 15.
  • Household demand. The unusual strength of consumption during the downturn means that there is a lack of pent-up consumer demand that usually helps drive recoveries. The U.S. personal saving rate is expected to rise gradually over the medium term, but a more rapid increase in the saving rate cannot be ruled out, especially in the face of a weaker labor market or asset market conditions.6

  • Asset prices. Although valuation assessments are sensitive to assumptions regarding the equity premium, price-earnings ratios still look high relative to historical standards (Figure 14). Uncertainties about earnings prospects have been exacerbated by recent accounting scandals. Moreover, while the recent strength in housing prices is generally viewed as consistent with underlying fundamentals, some metropolitan areas may be vulnerable to correction.7

  • Current account. Staff projections are for the current account deficit to remain above 4 percent of GDP over the medium term, and for the U.S. net foreign liability position to rise from around 19½ percent of GDP at end-2001 to around 35 percent of GDP by end-2007, an exceptional level by post-war standards. This suggests potential vulnerability to a sudden loss of confidence or a shift in portfolio preference that could trigger a substantial dollar depreciation, upward pressure on interest rates, and a disruption of recoveries both in the United States and abroad.

  • Oil shocks. The energy intensity of U.S. production has declined by over 44 percent since 1970, but per capita consumption has increased since the early 1980s and sharp increases in world oil prices would squeeze profit margins and discretionary household incomes.

Figure 14.
Figure 14.

United States: 12-month Forward P/E Ratio for S&P500

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

20. The resolution of these risks depends critically on whether the strong U.S. productivity growth since the mid-1990s can be sustained. Recent evidence suggests that IT played an important role in boosting productivity growth, and the economy’s strength during the past year provided encouraging evidence that earlier productivity growth can be sustained. This assumption underlies the staff and most other forecasts.8 However, it remains an open question whether innovation and the diffusion of technology will be sufficient to justify these forecasts, or whether even mainstream growth projections will be sufficient to generate corporate earnings growth sufficient to support current stock valuations and a turnaround in investment, or provide the sustained growth of labor incomes necessary to restore saving rates while maintaining strong consumer demand.

21. Staff simulations illustrate the implications of these risks (Box 4).9 In particular, if productivity gains are not sustained, corporate profitability would be adversely affected, stock prices would be depressed, labor market conditions would deteriorate, and household balance sheets would become strained. International investor portfolio preferences would likely shift away from U.S. assets, weakening the U.S. dollar and helping to spur net exports. Although monetary policy could provide some further support to domestic demand, U.S. real GDP would fall well below baseline over the medium term, with adverse spillovers to the rest of the world, including to developing countries. These spillovers would be exacerbated by the capital losses that foreigners would suffer on their U.S. dollar-denominated holdings of U.S. assets.

22. Despite the generally high quality of U.S. data, large revisions and statistical discrepancies add to the uncertainty surrounding the current situation and prospects. Revisions to the quarterly GDP data can be large, and gross domestic income has grown significantly faster than GDP raising questions about underlying productivity growth and the size of the saving-investment imbalance.10 Substantial GDP revisions are expected in July—recent data suggest that personal income has been overstated by as much as $90 billion (nearly 1 percent of GDP) in 2001, which would also imply a downward revision to the personal saving rate.

The U.S. Current Account Deficit and its Multilateral Implications

The U.S. current account deficit is again approaching 5 percent of GDP, which is expected to take the U.S. net foreign liability (NFL) position to over 20 percent of GDP this year. Federal Reserve Chairman Greenspan has suggested that “eventually the current account deficit will have to be restrained,” and empirical analysis also suggests that current account deficits of this magnitude tend to trigger adjustments.1 The critical question remains, however, when and how such an adjustment might take place, and what implications it might have for the U.S. dollar and the global economy.

uA01fig05

Alternative U.S. Net Foreign Liability Paths

(In percent of GDP)

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

A large current account adjustment would undoubtedly be required to stabilize or reduce the NFL position. Simulations of the dynamics of U.S. debt accumulation illustrate that a rapid adjustment of the current account deficit from 4½ percent of GDP to around 2 percent of GDP would be required to stabilize the NFL/GDP ratio at around 40 percent. Even with a much larger adjustment of the current account—to zero—the NFL ratio would still not return to its 2002 level within five years.

It is useful to consider the factors underlying the widening of the current account deficit. Simple trade elasticities suggest that the 2½ percentage point increase in the deficit during 1995–2001 is largely explained by the roughly 30 percent real effective appreciation of the dollar, which contributed as much as 2 percentage points, and the relative weakness of partner country growth, compared with the first half of the decade, which contributed a further 1 percentage point.

Thus, the current account deficit primarily reflects the relative strength of U.S. productivity growth, which spurred investment and attracted capital inflows that supported dollar appreciation. Over the past decade, foreign holdings of U.S. assets have doubled as a share of GDP to around 80 percent. Capital inflows have been largely directed toward private assets, particularly in the form of foreign direct investment and equities. The composition of inflows shifted somewhat recently toward corporate and government debt, in response to the economic slowdown and the bursting of the IT bubble. Nonetheless, the share of equities and FDI in total nonresident holdings reached 37 percent by 2000, compared with 30 percent in 1990.

Simulations of the IMF’s multi-country model (MULTIMOD) illustrate that a relatively smooth and protracted adjustment could result from a gradual pickup in productivity growth abroad and a rebalancing of investor portfolio preferences.2 This scenario would involve a potentially large but gradual depreciation of the U.S. dollar over time, and strong growth both in the United States and in partner countries.

Less benign adjustments can also be envisaged. If U.S. productivity growth were to disappoint relative to current expectations and/or portfolio preferences shifted rapidly away from U.S. assets, a much more rapid depreciation of the dollar could ensue, with potentially weaker U.S. growth and demand. Since most U.S. liabilities are denominated in dollars, the adverse balance sheet effects would fall mainly on the rest of the world. For example, if all nonresident holdings of U.S. assets (80 percent of GDP at end-2001) were dollar-denominated, and all U.S. resident holdings of foreign assets (62 percent of GDP at end-2001) were foreign-currency denominated, the effect of a 20 percent depreciation would be to lower the U.S. NFL position by 12½ percentage points of GDP, and to lower foreign investors’ wealth by 16 percent of GDP.

1 A. Greenspan, 2002, Speech before the Independent Community Bankers of America, March 13. The empirical result is based on examination of 25 episodes of current account adjustment in industrial countries over the 1980s and 1990s by C. Freund “Current Account Adjustment in Industrialized Countries,” Board of Governors of the Federal Reserve System, IFDP No. 692 (December 2000). See also C. Mann, 2002, “Perspectives on the U.S. Current Account Deficit and Sustainability,” Journal of Economic Perspectives, forthcoming.2 MULTIMOD simulations of the current account are presented in past and forthcoming U.S. selected issues papers and the World Economic Outlook. The forthcoming WEO will also address these issues in detail.

IV. Policy Discussions

A. Economic Conditions and Prospects

23. U.S. officials broadly shared the staff’s views on the economic outlook. They agreed that activity had been remarkably resilient, especially in the face of the September 11th attacks. Although the Administration’s forecast would not be finalized until the summer Mid-Session Review, growth seemed likely to remain at around 3 percent for the balance of 2002, with the economy accelerating to its potential growth rate of just over 3 percent in 2003. The recovery would be underpinned by a rebound in investment from presently very low levels, and sustained but moderate consumer spending.

24. Officials acknowledged that significant uncertainties remained, with several factors weighing on business investment. These included lingering concerns over the strength of final demand and profits, the considerable excess capacity in the manufacturing sector (especially in telecommunications), and some signs of an overhang in the commercial real estate market. Moreover, Enron’s collapse had increased risk aversion and affected credit conditions, especially for second-tier borrowers in the commercial paper market. Nonetheless, these risks were balanced by the likelihood that corporate profits would continue to rebound strongly, given the lagged effect of last year’s interest rate cuts, and the investment incentives contained in the 2002 stimulus bill, and continued productivity gains.

25. The U.S. representatives did not view the condition of household balance sheets or the low personal saving rate as major downside risks. The recent strength of consumer spending had been broadly consistent with normal empirical relationships and the level of household debt was not expected to restrain spending, especially given low interest rates and a still relatively high level of household net worth. The full effect of last year’s interest and tax rate cuts had yet to be realized and therefore would also support demand. Thus, while the personal saving rate was expected to rise, the adjustment was likely to be gradual rather than abrupt.

26. A disorderly adjustment of the current account was seen as unlikely (Figure 15). Officials viewed the high current account deficit and the dollar’s buoyancy in recent years as reflecting the response of capital flows and market forces to the fundamental strengths of the U.S. economy and relatively weaker growth prospects abroad. They agreed that foreign investors would not remain willing to take on additional U.S. assets at present rates indefinitely, and that a depreciation of the dollar would eventually be required to narrow the deficit and stabilize the U.S. net foreign investment position. Nonetheless, they expected the adjustment to be gradual, especially since it was unclear which partner countries’ currencies were presently in a cyclical position to appreciate against the dollar. While rapid movements in the dollar could not be ruled out, the experience from the mid-1980s and mid-1990s had illustrated the financial system’s ability to absorb even large and rapid adjustments in bilateral exchange rates without a major impact on activity. U.S. market participants were particularly well-placed to weather significant exchange rate volatility since most U.S. liabilities were denominated in dollars and risk management and capitalization in the U.S. financial system were strong.

Figure 15.
Figure 15.

United States: Saving, Investment and the Current Account Balance

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

27. The staff suggested that the large current account deficit underscored the need to raise national saving—including through more disciplined fiscal policies—in order to reduce the risk of a disorderly adjustment. The U.S. representatives broadly agreed that an increase in national saving would be helpful, but they saw no need for U.S. policies to respond specifically to the large current account deficit. In their view, gearing domestic policies toward exchange rate or current account objectives would be inappropriate, especially in the absence of major policy imbalances. Moreover, they did not expect that fiscal instruments would have significant leverage over the U.S. saving rate. In their view, the U.S. current account deficit would best be resolved by partner countries pursuing structural and other policies necessary to yield stronger growth.

28. Officials agreed that the economic outlook hinged on continued productivity growth. They presently assumed annual productivity growth of around 2 percent, and given that capital deepening was not expected to provide as large a contribution to growth as in the late 1990s, this implied potential GDP growth of around 3¼ percent, broadly in line with the staff estimate. They acknowledged the considerable uncertainty surrounding these forecasts, but the fact that productivity growth had remained robust during the past year in the face of considerable shocks suggested that the benefits of the IT revolution were likely to be sustained, and could possibly be larger than presently projected.

B. Monetary and Exchange Rate Policies

29. The Federal Open Market Committee (FOMC) has kept its policy stance on hold thus far in 2002. Since January, the FOMC has maintained its target for the federal funds rate, but announced in March that the risks had become balanced and were no longer tilted toward economic weakness. In May and June, the FOMC again left its target and its characterization of the balance of risks unchanged, noting that although the stance of monetary policy was accommodative, the degree of strengthening of final demand in the coming quarters was still uncertain.

30. The discussions focused on the likely pace and timing of the eventual withdrawal of monetary stimulus. The staff noted that interest rates appeared highly accommodative and with the expected absorption of slack in the coming year and the usual transmission lags, actions to begin withdrawing stimulus would normally be expected relatively soon. Indeed, at the time of the discussions market expectations, including those embodied in yield curves, suggested that monetary tightening would begin around August/September.11

31. Federal Reserve officials agreed that the policy stance would eventually need to tighten but saw room to wait until the recovery was more clearly established. In their view, the shocks that the economy had endured over the last year had left residual deflationary forces in the economy. As a result, inflation pressures were dormant, with PCE inflation well below 2 percent, inflation expectations well-anchored, and labor compensation decelerating. Since strong productivity growth was holding down cost pressures and there remained considerable uncertainty regarding the underlying strength of final demand, particularly with regard to investment, the risks associated with too early a withdrawal of stimulus seemed greater than those of waiting.

32. Officials noted that structural factors also supported a more cautious approach to withdrawing stimulus. The recent experience had made the FOMC mindful of the zero bound on nominal interest rates and—with U.S. short-term interest rates at very low levels—policy makers were ready to be more aggressive than otherwise to counter the risk that the zero bound could become binding. Indeed, they explained that this had been a consideration behind the decision to act in a decisive fashion following the September 11th attacks. There also appeared greater scope to wait given the apparent shortening of the transmission lags between monetary policy and activity. Although the importance and magnitude of this change were not well established, underlying factors could include increases in the share of financial assets in household balance sheets, the role of short-term funding in capital markets, and the size of the external sector.

33. Officials suggested that improvements in policy transparency might also have helped enhance policy effectiveness. Since the mid-1990s, the Federal Reserve had taken a series of steps to increase transparency, including the publication at the conclusion of every FOMC meeting; the Committee’s target for the federal funds rate, the policy bias, and the minutes of the previous meeting. In early 2002, the FOMC had taken the additional step of releasing a record of the committee members’ votes. These moves seemed to have helped anchor inflation expectations and increase policymakers’ leverage over real interest rates, and by enhancing the predictability of monetary policy, they had possibly increased the speed with which policy affected the economy.

34. In light of the dollar’s recent weakness and concerns regarding the large current account deficit, the mission inquired about the authorities’ exchange rate policy. The U.S. Treasury representatives responded that the authorities’ views on the exchange rate were unchanged—the focus of policies was on ensuring conditions to support strong domestic growth, and the authorities had no particular objective for the level of the exchange rate. They also reiterated their view that intervention in foreign exchange markets could have, at best, only a transitory effect on exchange rates. Federal Reserve officials commented that a sharp depreciation of the dollar also would not necessarily require a shift in the monetary policy stance. The relatively small share of trade in the U.S. economy meant that the exchange rate had a relatively modest effect on prices and inflation expectations, and—depending on the factors that might be contributing to the dollar’s weakness—the stimulative effect of improved competitiveness on overall financial conditions might be offset, including by softer equity prices.

C. Fiscal Policy

35. Policy initiatives, as well as cyclical and other shocks, have taken a large toll on the fiscal situation. Last year’s budget projected a FY 2002 surplus of about 2½ percent of GDP on a current-services basis and, with the surplus rising further over the medium term, net federal debt held by the public was projected to fall from 33 percent at end-FY 2001 to zero by the end of the decade. However, these projections were quickly overtaken by the economic slowdown, the June 2001 tax cuts, and additional outlays enacted following the September 11th attacks. Monthly tax receipts have also recently fallen well short of target—principally reflecting weaker tax payments by households for capital gains and other non-labor income—and the March 2002 economic stimulus legislation and the Administration’s FY 2003 budget issued in February 2002 have further eroded the fiscal outlook (Box 5):12

  • The stimulus package enacted in March 2002 included measures totaling around $50 billion (½ percent of GDP) in FY 2002.

  • The budget proposed tax cuts, amounting to nearly $550 billion over FY 2003–FY 2012. The majority of revenue losses would occur in the latter two years of the ten-year period, reflecting proposals to make permanent the June 2001 tax cuts that expire in 2010.

  • The budget also proposed increased outlays, notably for defense and homeland security. Over FY 2003–FY 2012, discretionary spending would increase by around $295 billion—reflecting a $480 billion increase in defense offset by a $188 billion decrease in nondefense spending—and mandatory spending would rise by about $440 billion.

Budget Projections

(In percent of GDP)

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Sources: Budget of the United States Government, FY 2003; and staff estimates.

Recent Fiscal Policy Initiatives

Over the last year, important fiscal policy initiatives were implemented—most notably the June 2001 tax cuts and the March 2002 economic stimulus package—and further tax cuts and spending increases were proposed in the Administration’s FY 2003 budget, released in February 2002.

The June 2001 tax cuts—the largest cuts in 20 years—featured a phased reduction of marginal income tax rates, new targeted incentives, and the repeal of the estate tax. To keep the cost of the tax cut in line with the agreed level of $1.35 trillion over the period FY 2001–FY 2011, the legislation included a “sunset” provision, whereby the tax cuts are effective only through the end of 2010, and thereafter, the tax system would revert to the one in place before the new tax law was enacted. Specific measures include:

  • Individual income tax rate cuts are phased in over the period 2001 to 2006 with the top rate falling from 39.6 to 35 percent, and the 28, 31, and 36 percent rates falling by 3 percentage points (Table). A new 10 percent tax bracket was added for lower incomes in 2001.

  • A gradual elimination of the estate tax during 2002–10 with increases in exemptions and reductions in rates during 2002–09 and repeal of the tax in 2010. Also included were a gradual increase in the child credit; enhanced alternative minimum tax relief—through an increase in exemptions—for the period 2001–04; and additional relief for married couples phased in over 2005–09.

Scheduled Marginal Income Tax Rate Cuts

(in percent)

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An economic stimulus package—expected to cost $51 billion in FY 2002, and $46 billion in FY 2003—was signed into law in March 2002.2 The package:

  • Allows businesses to take an additional first-year depreciation deduction of 30 percent on certain investments made during the three years after September 10, 2001; temporarily extends the business loss-carry-forward rule from two to five years; provides tax cuts for New York City businesses damaged by the September 11th terrorist attacks; and introduces an additional 13 weeks of unemployment benefits in states with unemployment rates greater than 4 percent.

The Administration’s FY 2003 budget proposes increased spending, particularly for defense and homeland security, and further tax cuts, which together would reduce projected budget balances by about $1.7 trillion over the period FY 2003–FY 2012. Key proposals include:

  • Eliminating the “sunset” provision of last year’s tax cuts, which would reduce revenues as a share of GDP in FY 2011 and FY 2012 by ¾ percent and 1¼ percent of GDP, respectively; permanently extending the research and experimentation tax credit; temporarily extending most other expiring tax provisions; reforming the corporate alternative minimum tax; and introducing tax incentives for charitable giving, and tax credits for the uninsured, long-term care insurance, and single-family housing.

  • A $480 billion increase in defense spending over the ten-year horizon, which is partially offset by a $188 billion cut in nondefense spending; restructuring and expanding Medicare (including a prescription drug benefit), health insurance assistance, and increased spending on agriculture.

1 The Economic Growth and Tax Relief Reconciliation Act of 2001.2 The Job Creation and Worker Assistance Act of 2002.

36. As a result, the fiscal outlook has weakened considerably. The Administration’s FY 2003 budget estimates assumed a deficit of 1 percent of GDP in the current fiscal year, with a gradual narrowing of the deficit until FY 2005, when surpluses would be re-established (Table 5 and Figure 16). However, these surpluses would be relatively modest, implying that the Administration’s previous commitments to avoid spending the Social Security trust fund would not be met even by FY 2007. Moreover, as a result of more recent policy actions and tax shortfalls, the authorities’ projections appear somewhat optimistic. The staff expects the unified budget deficit to reach at least 1½ percent of GDP in FY 2002 and 1¼ percent of GDP in FY 2003, with only a very modest surplus achieved by the end of the medium term.

Figure 16.
Figure 16.

United States: Budget

(Unified)

Citation: IMF Staff Country Reports 2002, 166; 10.5089/9781451839593.002.A001

Table 5.

United States: Fiscal Indicators

(For fiscal years, in percent of GDP except where noted otherwise)

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Sources: Budget of the United States Government, FY 2003, February 2002; and staff calculations.

Gross debt held by the public minus excess government cash balances.

As a percent of potential GDP.