Chapter I Growth mechanism of the global economy and issues of imbalance

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1 Chapter I Growth mechanism of the global economy and issues of imbalance In this chapter, we will take a look at the growth mechanism of the global economy since the latter half of the 199s, which has been driven by the United States and China. We will then examine potential challenges that lie ahead, including the twin deficits of the U.S. and the issue of overheating in the Chinese economy. We will also look at the future growth potential of the BRICs economies, the presence of which is growing in the global economy, analyzing the mechanism for rising prices of energy and commodities, which are greatly influenced by expanding demand in such economies. Section 1 U.S. economic growth and the twin deficits <Section 1 Key points> Since the latter half of the 199s, global economic growth has been driven by the domestic demand-led U.S. economic growth, which by inducing exports and capital from Asia including Japan, and other countries and regions became a source of further U.S. economic growth, accounting for approximately 3% of the world s GDP. In the meantime, the so-called twin deficits the budget deficit and current account deficit have been expanding, raising concerns about the sustainability of the economic growth in the future. Viewing the twin deficits from the perspective of financial surplus and deficit, the government and household sectors have been incurring shortages of funds in recent years. The expanding social security costs stemming from the aging population in the future is seen as a cause of concern in the government sector. As for the household sector, which supports the U.S. economy through robust consumption, an increase in liabilities, a decline in savings rates, a substantial decline in housing prices and other factors are being pointed out as future causes of concern. It is necessary to pay close attention to future trends amidst concern that the expansion of the twin deficits, if that were to raise U.S. interest rates in the future, would have a negative impact on the global economy via increased interest payment burden, credit crunch due to worsening financial position, plunging dollar exchange rate, among other factors. Since the latter half of the 199s, global economic growth has been driven by U.S. economic growth, which accounts for approximately 3% of the world s gross domestic product (GDP), and China s economic growth, which, although small in scale, accounts for 4% of the world s GDP and has maintained a high growth rate at nearly 1% annually 1 (Table 1.1.1). The economic growth of Asia, including China, is in part being promoted by the domestic demand-led U.S. economic growth as it induces exports from these countries. It can therefore be said that U.S. economic growth is in effect playing a leading role in the global economy. Furthermore, the influx of capital into the U.S. from Asia including Japan, and other countries and regions is 1 In 23, the share of the world s GDP held by each country or region was as follows: U.S. 29.8%, EU 29.9%, Japan 11.7%, China 3.9%, NIEs 3.1% and ASEAN4 1.5% (WDI, World Bank and Statistical Database, Directorate-General of Budget, Accounting and Statistics, Executive Yuan, R.O.C., Taiwan). -3-

2 financing the robust U.S. domestic demand, which in turn becomes a source of further U.S. economic growth. Table Trends in real GDP growth rate of each country and region (Unit: %) Entire World Japan US EU China ASEAN Notes: For data consistency, EU is counted as 15 countries. Source: World Economic Outlook (April 25) (IMF), National Accounts (Cabinet Office), Gross Domestic Product (US Department of Commerce), Eurostat, China Statistical Yearbook (National Bureau of Statistics of China), ASEAN Statistical Indicators (ASEAN Secretariat). The U.S. economy is demonstrating its resilience, posting a real GDP growth rate of 4.4% year-on-year in 24, the strongest growth since 1999 (4.5%). In the process of domestic demand-led growth, however, the twin deficits the budget deficit and current account deficit are continuing to expand in the U.S. The increase in liabilities and decline in savings rates in the household sector, the locomotive for U.S. economic growth, as well as the increase in social security costs stemming, etc., from the progressively aging population in the government sector, are emerging as challenges and raising concerns about the sustainability of economic growth in the future (Figure 1.1.2). This section will first give an overview of the U.S. economic growth since the 199s as well as an overview of the current U.S. economic situation with a focus on the twin deficits the budget deficit and current account deficit. ($ billion) 3 Figure United States: Current account balance / Trade balance / Fiscal balance Fiscal balance 3 2 Trade balance Current account balance IT Bubble September 11, 21 Simultaneous terrorist attacks 2 1 Fiscal balance(percent of GDP, right scale) Current account balance(percent of GDP, right scale) March 19, 23 War begins in Iraq September 22, 1985 The Plaza Accord February 21/22, 1987 The Louvre Agreement October 19 Black Monday January 16-February 27, 1991 The Gulf War Fiscal Balance after 25: Projection by the US Congressional Budget Office Late spring 7 Currency crisis in Asia (year) Source: Gross Domestic Product, Balance of Payments (US Department of Commerce), "The Budget and Economic Outlook: Fiscal Years 26 to 215", "An Analysis of the President's Budgetary Proposals for Fiscal Year 26" (US Congressional Budget Office (CBO)). -4-

3 1. U.S. economy since the 199s and the twin deficits First, we outline the background of the U.S. economy and twin deficits. (1) U.S. economic growth in the 199s The U.S. economic expansion of the 199s, which began in March 1991 (economic trough), continued for ten years until March 21, lasted ten years and was the longest recorded growth in U.S. history. It is pointed out that the catalyst that prompted the economic recovery was the substantial interest rate cut by the Federal Reserve Bank (FRB) in October 199. From then until September 1992, the federal funds (FF) target rate, which acts as an economic indicator, was gradually lowered from 8% to 3% over the course of 17 interest rate cuts. In the initial stages, the economic recovery, coinciding with adjustments of company and household balance sheets, was weak and referred to also as jobless recovery (economic recovery without employment). Nevertheless, the U.S. economy steadily grew beginning in 1994 and employment also increased. In particular, the economy achieved robust growth in the latter half of the 199s when there was no inflation, and it was said to have marked the advent of an era of so-called new economy. This economic recovery was driven by domestic demand, namely, the rapid expansion of demand that accompanied the acceleration of technological innovation in the information technology (IT) sector, robust capital investment against the backdrop of rising share prices of IT-related startup companies, etc., and personal consumption. From 2, however, there was growing concern that the IT economy was overheating. With declining mining and industrial production, a rising unemployment rate and a plunge in the price of high-tech shares among other factors, the real GDP growth rate decreased to a large extent. Furthermore, in 21, a slowdown in orders and shipment of IT-related machinery resulted in a buildup of inventory, which in turn initiated inventory adjustment. Since the spring of 21, this inventory adjustment of the IT manufacturing industry triggered an economic recession, which had ripple effects on the entire economy. The simultaneous terrorist attacks on September 11, 21 occurred in the midst of this economic recession. Although it was feared that the terrorist attacks would further worsen the economic stagnation, macroeconomic policies that included substantial tax cuts and interest rate cuts had a positive effect on the U.S. economy and contributed to its recovery. The economic recession which began in April 21 was brought to an end in November 21. On the financial side, the FRB carried out a total of 11 interest rate cuts seven between the beginning of 21 and the terrorist attacks, and four more over a short span of three months between the terrorist attacks and December 21 significantly reducing the interest rate by 4.75% in total (a decline in the FF target rate from 6.5% to 1.75%). In addition, the current account balance played a large role: in June 21, the U.S. established an enormous 11-year, US$1.35 trillion income tax cut. Furthermore, household consumption, which accounts for 7% of the GDP, continued its steady performance in part due to mortgage refinancing against the background of a low interest rate. (2) Trends in the budget deficit and current account deficit in the 199s We will now examine the trends in the budget deficit and current account deficit in light of economic trends. First of all, in FY1992 2, the budget deficit reached a record high due to large-scale tax cuts and 2 The budget fiscal year of the U.S. federal government runs from October 1 to the end of September of the following year. -5-

4 expanded military spending in the 198s (US$29.3 billion, 4.7% of GDP). From then on, the budget deficit began to decrease and continued to improve. In FY1998, a budget surplus was recorded, and in FY2, there was a budget surplus of US$236.2 billion (2.4% of GDP). The main reasons for the upturn were, as stated above, an increase in revenue due to an economic expansion centered on the IT sector, and a decrease in expenditure due to lower national defense costs with the end of the Cold War and curtailed social security costs. Furthermore, financial policies such as CAP adjustments and the pay-as-you-go rules 3 also contributed to improving the current account balance. Meanwhile, in contrast to the fiscal balance, the current account balance, which after posting a surplus in 1991 for the first time in ten years, has continuously and consistently expanded its deficit. This is because the deficit, which had shrunk in the latter half of the 198s due to the weak dollar and sluggish domestic economy, expanded again as a result of the economic recovery in the 199s which was propelled by a rise in imports, among other factors. In particular, while the surge of the so-called new economy in the latter half of the 199s worsened the current account balance due to expanded domestic consumption, the strong U.S. economic growth induced an inflow of funds from overseas which financed the current account deficit. Examining this with respect to IS balance, we can see that the reduction of household savings which strengthened the dependence on capital gains (expansion in consumption) and expansion of corporate investment centered on the IT sector worsened the macroeconomic balance in terms of savings and investment, and thereby, expanded the current account deficit. However, the circumstances surrounding the twin deficits changed following the economic recession in 21. First, the budget surplus turned to a budget deficit only five years after the fiscal balance posted a surplus due to such factors as the revenue curtailment associated with the worsening economy, large-scale tax cuts, and increase in military spending triggered by the simultaneous terrorist attacks. As for the current account balance, the fact that the short period of time that was required for the fiscal balance to post a deficit, coupled with personal consumption which has remained relatively strong, worsened the savings and investment balance on the macroeconomics side and further widened the current account balance deficit. 2. Current U.S. economic situation We will examine the current status of the twin deficits described above from the perspective of financial surplus and deficit by sector of the U.S. economy. In recent years, the government and household sectors are incurring a shortage of funds (Figure 1.1.3), and there has been a growing trend to depend on increased inflow of funds from overseas. The following will outline the current situation that the government and household sectors are in as they face a shortage of funds, and then look at the future causes of concern. 3 U.S. federal government spending may be divided into discretionary spending and mandatory spending. Discretionary spending is based on current budget authority and requires annual legislation in accordance with the Appropriation Act. Mandatory spending is based on permanent budget authority and is stipulated by laws other than the Appropriation Act. Once legislation is passed, spending is automatically approved every year thereafter. The CAP adjustments split discretionary expenditures into three categories (national defense, international, and domestic expenditures) and set a ceiling for each. The pay-as-you-go rules require off-setting, in cases where an increase in mandatory spending or revenue curtailment is approved, by reducing other mandatory expenditures or increasing revenue. While both were legislated in 199, they are currently not in effect as extension procedures were not taken at the time of their expiration at the end of September

5 9 6 Figure United States: Balance of assets by sector (percent of GDP) Household sector Non-farm non-financial corporate business Rest of the world Federal government Source: Flow of Funds Accounts of the United States (FRB), Gross Domestic Product (US Department of Commerce) (1) Government sector (a) Expanding budget deficit The fiscal balance shifted to a surplus in the latter half of the 199s and posted a record high surplus in FY2. Between FY2 and FY21, however, the budget surplus decreased by half, and the fiscal balance again fell into a deficit in FY22. The FY24 fiscal balance was in a deficit of US$412 billion (3.6% of GDP), marking a record high for the second consecutive year, and the deficit is expected to reach US$427 billion (3.5% of GDP) in FY25 4. The underlying factors that explain why the fiscal balance deteriorated again include the economic recession resulting from the burst of the IT bubble in 21, the impact of the tax cut policies, and the expansion of military costs for the fight against terrorism. In terms of revenue and expenditure, the fiscal balance worsened due to the following factors: a decline in income tax revenues on the revenue side (Figure 1.1.4), and expansion of national defense costs on the expenditure side (Figure 1.1.5). With regard to revenue, personal income tax and corporate tax which stood at 1.3% of GDP and 2.1% of GDP respectively in FY2 both declined thereafter to 7.% of GDP and 1.6% of GDP respectively in FY24. As for expenditure, the total amount accounted for 18.4% of GDP in FY2 and this figure rose to 19.8% in FY24. A breakdown of the expenditures indicates that discretionary spending including defense costs rose significantly. Discretionary spending, which accounted for 6.3% of GDP in FY2, increased every year from then onwards and accounted for 7.7% of GDP in FY24. Given the planned implementation of long-term tax cut policies 5, etc., the budget deficit is expected to continue into the future. (year) 4 US Office of Management and Budget (OMB) (25). 5 The following tax cut policies were decided under the Bush administration: June 21 (around US$1.35 trillion over 11 years), March 22 (around US$42 billion over 11 years), May 23 (around US$35 billion over 11 years) and 24 (around US$15 billion over 1 years). -7-

6 12 Figure Trends and projection of the breakdown of US Federal Budget revenue (percent of GDP) Personal income tax Corporate tax Overall revenue (right scale) (Fiscal Year) Source: The Budget and Economic Outlook:Fiscal Years 26 to 215 (US Congressional Budget Office (CBO)). ($ billion) Figure Others Medicine Social Security Military expenditures Spendings (year-on-year change) Trends in breakdown of US Federal Budget spending (year-on-year change) Source: US Congressional Budget Office (CBO) data. (Fiscal Year) (b) Future causes of concern With respect to the U.S. financial sector, the rise in social security costs stemming from the aging population is pointed out as a future cause of concern. In the U.S., the baby boom generation born between the years 1946 and 1964 will reach retirement age beginning in 21 and the aging of the population is expected to advance rapidly (Figure 1.1.6). -8-

7 (1 million people) 1 Figure Trends and future predictions of the aged population in the US 21 8 Aged population Ratio of aged population (right scale) Notes: Aged population refers to 65 years and older. Source: International Data Base (US Department of Commerce, Bureau of Census). 9 25(Year) Advance in the aging of the population will be a large strain on the country s finances as it raises its expenditures on public pensions and items related to health insurance. The U.S. Congressional Budget Office predicts mandatory spending, which includes social security costs, to increase over the long period of time (Figure 1.1.7). 12 Figure Trends and projection of the breakdown of US Federal Budget spending (percentage of GDP) 9 6 Mandatory expenditures Discretionary expenditures Interest payments for government bond (Fiscal Year) Source: The Budget and Economic Outlook:Fiscal Years 26 to 215, An Analysis of the President's Budgetary Proposals for Fiscal Year 26 (US Congressional Budget Office (CBO)). -9-

8 In addition, the Annual Report released by the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds (OASDI) points out that the system may collapse in the 23s at the earliest according to long-term forecasts based on the trust fund ratios for the OASDI (Figure 1.1.8). 6 Figure Long-range OASDI Trust Fund Ratios Under Alternative Assumptions (Assets as a percentage of annual cost) High Cost Intermediate 2 Low Cost 1 Trust Fund is estimated to be exhausted within the 23s (Year) Notes: OASDI are the programs for Old-Age and Survivors Insurance and Disability Insurance. Funds ratio refers to the OASDI trust fund ratio in terms of assets as a percentage of annual cost. Source: The 25 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds (The Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds). In order to cope with this issue, the Bush administration is also proposing to reform the social security system. However, introducing individual accounts as has been proposed is expected to generate substantial costs (system transition costs) 6. Therefore, it is pointed out that a reform of the social security system will cause the budget deficit to expand in the short term. Furthermore, neither the substantial system transition costs associated with the social security system reform nor the additional war costs in Iraq and Afghanistan are included in the fiscal outlook indicated in the FY26 Budget Message of the President. There is a strong belief that the Bush administration s pledge to halve the budget deficit by FY29 (halve the forecasted FY24 budget deficit amount by FY29 (US$233 billion, 1.5% of GDP)) would be difficult to achieve, and the U.S. Congressional Budget Office is also predicting that actual expenditures will further increase (Table 1.1.9). In this way, a prompt improvement of the budget deficit poses many difficult challenges. 6 Under the proposal of the Bush administration to reform the social security system, individual subscribers will set aside a portion of the social security tax in their individual accounts at their own discretion and they are permitted to manage these accounts. As a result of the introduction of personal accounts, insurance fees would be deposited in individual accounts, leaving insufficient funds to pay for benefits. Hence, additional funds would be necessary, and system transition costs refer to this additional financial burden. The costs over a seven-year period between 29 and 215 are predicted to reach US$754 billion including interest rate, and it is said that the transitional period will last over ten years. -1-

9 Table Expenditures not included in the US Congressional Budget Office (CBO) budget outlook (Unit: $billion) Budget outlook by the CBO Expenditures not included in the CBO outlook Additional military expenditures Permanent tax cuts Alternative minimum tax (AMT) cuts Interest payments for government bond Adjusted outlook Notes: AMT tax cuts are reduction measures for alternative minimum tax (AMT) (additional tax for tax payers with large tax cuts). Source: The Budget and Economic Outlook:Fiscal Years 26 to 215 (US Congressional Budget Office (CBO)). (2) Household sector (a) Household sector and current account deficit The expansion of the U.S. current account deficit indicates that U.S. consumption of the goods and services, which have been brought to the U.S. from around the world, is driving the global economic growth. However, a different way of looking at the situation is that it is global assets including those from Asia which are supporting this U.S. shortfall in savings caused by the continued U.S. consumption and investment exceeding income. Here, we will take a closer look at the household sector which accounts for approximately 7% of the U.S. GDP and at present is suffering from a shortage of funds, and examine the current situation and the future causes of concern. In 24, the current account deficit was US$665.9 billion (5.7% of GDP), setting a record high for the third consecutive year. As shown in Figure 1.1.3, while the corporate sector became cautious with regard to new borrowings and have acquired excess savings after the burst of the IT bubble in 21, the household sector, in contrast, which continues robust consumption, is incurring a shortage of funds, together with the government sector, which has an expanding budget deficit. The household sector began to have a shortage of funds in the end of the 199s, and while the extent of the shortage narrowed temporarily due to the fall in consumption in the period of economic recession in 21, the funds shortage expanded again in 22 with the economic recovery. And in 23 and 24, the shortage basically remained. As a result, the U.S. as a whole continued to have a shortage of funds, causing the U.S. current account deficit to expand. For the most part, this shortage of funds is offset by the overseas sector. In addition, there is another dimension to this picture. That is, due to factors including disparities in economic growth rates between the U.S. and the major economies including Europe and Japan, funds are flowing into the U.S. where the growth rate is higher. Furthermore, not only is the size of the current account deficit (record high) a characteristic of the present current account deficit, but so is the spread of the deficit into other countries and regions, i.e. global spread. As illustrated in Table 1.1.1, while the surplus of Japan and oil-producing countries ( Asia (excluding Japan and Australia) and Africa in the table) each accounted for one-third of the U.S. current account deficit in 1987 immediately after the Plaza Accords, in 24, Asia (excluding Japan and Australia) and Africa accounted for half of the U.S. current account deficit, with East Asian countries and regions including China having a growing share. Moreover, the ratio held by Latin American and Caribbean countries is also increasing, and it can be said that the spread of the deficit into countries and regions across the world is a characteristic of the present current account deficit. -11-

10 A detailed explanation of the imbalance of the current account balance with a focus on the relationship between the U.S. and East Asia can be found in Chapter 1, Section 5. Table U. S. Current account deficit by region (Unit: $billion) Difference between 23 and 24 Europe Japan Asia (excluding Japan and Australia), Africa Middle and South America Canada Australia International organizations, unclassified Total Source: Yoshikawa (24). (b) Trends of the household sector and future causes of concern After the burst of the IT bubble, housing purchases and personal consumption by the household sector supported the U.S. economy (Figure ). 1 8 Figure Trends in the rate of real GDP and contribution by demand component in the United States Private consumption Housing investment Export Government expenditures Capital investment Inventory investment Import Real GDP growth rate (Year on year) Source: Gross Domestic Product (US Department of Commerce) (Year)

11 By increasing borrowings through such means as cashing out 7 via mortgage refinancing and home equity lending 8 against a backdrop of rising home prices and low interest rates, the household sector has been continuing its robust consumption driven by increased disposable personal income due to tax cuts. As a result, while the liabilities of the household sector have been increasing consistently to date, the savings rate is continuing to decline (Figure ). Nevertheless, concerns are being raised as to whether robust consumption through increased borrowings is sustainable. 12 Figure US: Trends in liabilities (consumer credit and home mortgages) to disposable personal income and savings rate in the household sector Consumer credit (to disposable personal income ratio) Home mortgages (to disposable personal income ratio) Total liabilities ( to disposable personal income ratio) Savings rate (right scale) 24, 1.2% Consumer credit Home mortgages Savings rate (right scale) 24, 1.2% Source: Flow of Funds Accounts of the United States (FRB), Personal Income and Outlays (US Department of Commerce) (Year) One way of looking at the housing boom is that it was generated by demographic factors such as a rise in immigration or a higher birthrate or that it was based on actual demand brought about by the baby boomer generation who entered a stage in their lives to purchase a home. Meanwhile, there is also a skeptical view, which attributes the housing boom to a rising advantage of home equity as speculation due to the drop in share prices with the burst of the IT bubble. In other words, the boom was a sort of bubble. In view of the fact that spiraling housing prices are witnessed only in certain regions in the East and West coasts and that housing prices have remained stable in all other regions, it is also conceivable that the housing bubble, even if there is one, is restricted to a particular region. Whatever the case may be, we can consider housing prices as a future cause of concern given that a possible sharp fall in prices would not only lead to a decline in consumption but would also worsen the household financial position through lower asset prices. 7 This refers to a method whereby in refinancing a housing loan, the additional portion of home equity value that has increased since its initial appraisal is refinanced, and a part of this additional portion is turned into cash (cash out). 8 A home equity lending is a loan that takes the portion of the asset value of the home that exceeds the balance of the existing loan and uses it as collateral. Since it is a secured loan, it has several advantages, including a lower interest rate than a consumer loan. In addition, use of the loan is unconstrained and the interest paid on the first US$1, of the loan is tax deductible. -13-

12 As was illustrated so far, the rise in social security costs stemming from the progressively aging population is pointed out as a cause of concern in the government sector, and an increase in liabilities, a decline in savings rates, a decline in housing prices and other factors are pointed out as causes of concern in the U.S., where the so-called twin deficits composed of the budget deficit and current account deficit have been expanding. It is necessary to pay close attention to future trends amidst concern that the expansion of the twin deficits in the future, if that were to raise domestic interest rates, would have a negative impact on the global economy as well via greater interest payment burden, credit crunch due to worsening financial position, plunging dollar exchange rate, among other factors. -14-

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