Best To Sort Out Medium Term In Good Times

The Age

Friday April 21, 2006

RAGHURAM RAJAN

Too few are taking economic policy reform seriously and it has gone into remission, says IMF economist Raghuram Rajan.

WE HAVE revised world growth for this year up by 0.6 percentage points to 4.9 per cent. That this is the fourth consecutive year of about 4 per cent growth.

Upward revisions for China, Russia, and India account for two-thirds of the revisions, but prospects in Japan have also improved noticeably while hope is growing for the euro area. We expect the US economy to slow in the second half.

Risks to the strong central forecasts are tilted to the downside. They include possible inflationary and growth consequences of high and volatile oil prices, rising real interest rates and possible exchange rate volatility. To these add the risk of a global avian flu pandemic.

My greatest concern is of a growing implementation deficit. During strong growth is the perfect time to address the medium-term problems that every economy faces, including adjusting to a competitive integrated world.

But far too little is being done in far too many places. Serious policy reform has gone into remission. Instead of facing the implementation deficit squarely, politicians are aiming at soft targets, like the foreigner who supposedly competes unfairly or the immigrant who works too hard and for too little, hoping that by shooting the messenger they will somehow avoid the competitive challenges posed by globalisation.

In the US, first-quarter gross domestic product growth will probably rebound from last year's slow fourth quarter and then slow to trend. The primary risk is of a greater slowing of house-price growth than anticipated. We estimate the effect of house prices staying flat as opposed to growing by about 5 per cent could lop 1 percentage point off US growth.

The US deserves to be complimented for setting a medium-term target for fiscal consolidation. But its consolidation plans are over-optimistic and unambitious. It will be important to rein in the costs of healthcare entitlements even while providing health insurance to all, especially the 8 million children who are uninsured.

When I say over-optimistic, I mean there is not enough accounting for hurricane-related expenditure and the effects of war. Revenue-enhancing measures need to be taken.

We would like the US to reach budget balance without social security by about 2010 - and what it has targeted is really halving the budget deficit by 2009, a substantial difference. We think the pressures are going to get worse. There is the tremendous amount of spending needed on Medicare and Medicaid. Social security has a large gap. If you go into these problems without a balanced budget, you are really pushing problems into the future.

Indicators such as business confidence continue to signal that the recovery in Europe is strengthening, but this is yet to be confirmed by concurrent data. Also, consumption is still weak. We are optimistic that euro growth will pick up about 2 per cent this year and will be broad-based.

Europe's challenge is to increase its potential growth rate to a level that enables its citizens to continue their enviable blend of work and leisure. But more insecurity in the workplace may well be the cost.

In Japan, the economic tide continues to increase inflation, land prices and bank lending. Improving labour market conditions are likely to support consumption growth. For Japan, the challenge is how to normalise monetary and fiscal policy without setting back recovery.

China's economy is expected to continue to grow at a blistering 9.5 per cent. The underpinnings of growth, however, need to move from investment in net exports towards consumption.

It is good news the People's Congress wants to promote health and education spending and build social safety nets, all measures that should increase consumption in the medium term. Such steps will be most effective if supported by financial sector reforms and more exchange rate appreciation.

India is growing rapidly and steps are being taken to improve services. Reform of labour laws are urgently needed if jobs are to be created in labour-intensive sectors. Opportunities for higher education need to be expanded if India is to maintain its competitiveness in skill-intensive sectors.

The rest of emerging Asia has benefited from China and Japan's good performance, and from the recovery of the IT sector.

Growth in Eastern Europe has been strong, but high current account deficits and rapid credit growth in many countries need to be monitored. In the Middle East and many central Asian countries, a key challenge will be to channel the high oil export receipts into productive investment. High commodity prices support many economies in Latin America, permitting welcome reductions in external debt levels and accumulation of foreign currency reserves.

Most heartening is sub-Saharan Africa's recent performance, where real growth exceeded 5 per cent for the second consecutive year. We predict African growth to attain its highest level in 30 years.

It would be fair to say to the world, you have never had it so good, but challenges are building. For instance, global competition may not continue to be a supportive crutch for central bankers in holding down inflation. Spare capacity is decreasing worldwide, as evidenced by rising commodity prices. These are increasingly being seen as permanent and more will be passed to final goods prices.

Tight domestic labour markets in several industrial countries, including the US and Japan, will attenuate the effects of global competition on wages. That inflationary expectations are well anchored suggest markets expect central bankers to justify the credibility they have. With less support from the forces of globalisation, their job will become more difficult.

Plentiful liquidity has prompted a world search for yield that has held down long rates and risk premiums. With the change in Japanese monetary policy, the liquidity cycle is turning.

The reduction in corporate excess savings will push real interest rates higher. High real rates will further slow the search for yield, and the extreme tolerance for risk we have seen in financial markets is likely to dissipate. All this should be seen as a normalisation of financial conditions from the current benign ones.

Nevertheless, rising interest rates and risk spreads, however normal, should be of concern in markets where asset prices, such as housing, are inflated.

As the US deficit continues to be financed easily, the optimists who think there is nothing to worry about are gaining ground over the pessimists who think that an abrupt and costly adjustment is likely. The optimists have to be right every day, while the pessimists need to be right only once.

Since adjustment is inevitable, would a risk-management approach not suggest putting in place a policy framework to support smooth private sector-led narrowing of the imbalances over the medium term?

Such a framework encompassing all the major players in the world would have two additional effects. First, it will reassure financial markets that a policy framework supporting adjustment is in place, limiting the risk of an abrupt and costly market-induced adjustment. Second, it would indicate the imbalances are a shared responsibility and help prevent concerns about the imbalances degenerating into protectionism.

The pace of private sector globalisation has prompted a public sector reaction. Some governments see their role as pandering to vociferous interest groups by obstructing change rather than educating citizens to accept it. Economic patriotism is protectionist old wine in a mislabelled new bottle.

The beggar-thy-neighbour policies contemplated by some in the capital account - that is, shielding large portions of their own economy from corporate takeovers while encouraging their own companies to take advantage of the continued openness of others - deserves to be roundly condemned.

People tend to dismiss these as minor frictions. History, however, suggests there is a short distance from economic patriotism to unbridled nationalism.

Raghuram Rajan is economic counsellor and director of the International Monetary Fund's research department. This is an edited extract of a speech he gave in Washington yesterday.

© 2006 The Age

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