1

Are Cassandras right?

Riccardo Faini

Università di Roma Tor Vergata

2

Three main risks for the world economy

• The oil shock

• The current account imbalances

• The short run outlook for the three main economic areas

• The interest rate conundrum

3

The oil pricea medium run perspective

4

Will oil price remain high for long?

5

The Damocles’ word of external imbalances

• According to the IMF, the US current deficit will stand at 6% in 2006 and 2006; for the OECD it will reach 7%

• The counterpart to the US deficit are substantive surpluses in Asia, the EU and oil exporting countries.

• A dollar depreciation will cause a wealth loss abroad, aggravating the negative effect on aggregate demand

6

Taking a closer look at the US current account imbalances

• 1995 – 1999: the rise in investment is partly offset by a concomitant increase in saving

• 2001-2004: the investment rate falls, but saving drops even more

• Hence: foreign saving helped finance the technology led investment boom in the first period. Nowadays, it supports mainly the rise in private and public consumption

7

Saving Investment

Current account

8

What’s behind the current account surplus

• in emerging Asia?

• in Japan?

• in China?

• in oil exporting countries?

9

In emerging Asia

the current account surplus after 1998 reflects a major drop in investment

10

Also in Japan

the fall in investment (the red line) is the main factor behind the rise in the current account surplus

11

While in China

the strengthening of the current account balance reflects mainly the rise in saving (the blue line)

12

Finally, in the oil exporting countries..

the oil price bonanza has so far been associated with a rise in the saving rate (the blue line), while the investment rate is still lagging behind

13

Why are real interest rates so low?

• A saving glut?– Saving went up only in China and in oil exporting

countries. – Even there, the increase in saving may not last long

• A drop in investment?– Investment fell in Japan, emerging Asia and in the oil

exporting countries– In (most) cases, though, the fall in investment may be

temporary

• A portfolio reallocation effect?– Again, a temporary phenomenon?

14

15

The interest rate conundrum

-1

0

1

2

3

4

5

6

7

8

80 82 84 86 88 90 92 94 96 98 00 02

real interest rates in the G7 countries

16

Has fiscal policy become irrelevant?

• In the eighties real interest rates responded sharply (from 0% in 79-80 to 6.9% in 84-85) to fiscal imbalances.

• In the early 2000’s the interest rate response is almost muted.

• In Europe, domestic spreads seem to be little affected by fiscal indiscipline

17

Real interest rates and debt ratios in Europe

20

40

60

80

100

120

140

-1 0 1 2 3 4 5

(GDBT_AUT,LTRIR_AUT)(GDBT_BEL,LTRIR_BEL)(GDBT_DEU,LTRIR_DEU)(GDBT_ESP,LTRIR_ESP)(GDBT_FIN,LTRIR_FIN)(GDBT_FRA,LTRIR_FRA)

(GDBT_IRL,LTRIR_IRL)(GDBT_ITA,LTRIR_ITA)(GDBT_NLD,LTRIR_NLD)(GDBT_PRT,LTRIR_PRT)(GDBT_GRC,LTRIR_GRC)

18

The pessimist’s perspective

• Fiscal indiscipline is no longer associated with higher interest rates, presumably because of greater global financial integration

• However, low global real interest rates mainly reflect temporary phenomena, such as unusually high saving rates in China and oil producers and low investment rates in other areas

• Moreover, individual countries with a high and rising debt may suffer relatively more from tighter financial conditions

19

European countries with a large and rising debt face higher spreads

-10

-5

0

5

10

1 2 3 4 5 6 7 8 9

(PSVAR_BEL,LTRIR_BEL)(PSVAR_ITA,LTRIR_ITA)(PSVAR_GRC,LTRIR_GRC)

20

Who is more vulnerable?

• The rise in interest rates will add to the burden of high public and foreign debt countries

• The increase in interest rates may lead to a rise in the level of spreads:– Greater risk of financial distress– Greater risk aversion by markets participants

• The rise in the debt ratios may further boost countries spreads

21

Is Europe falling behind?

0

0.5

1

1.5

2

2.5

3

3.5

US Eurozone

GDP growth in the US and in the Eurozone (1997-2004)

22

The picture is less worrying if we focus on per capita growth

0

0.5

1

1.5

2

2.5

US Eurozone

Per capita growth in the US and in the Eurozone (1997-2004)

23

Decomposing the income gap between the Euro area and the US

-20%

0%

20%

40%

60%

80%

100%

1979 1990 1997 2001

hourly productivity

employment rate

hours

24

Falling behind? Italy during the last decade

• The decline in relative GDP per person

• The loss in export market shares

• The behavior of productivity

25

The end of the convergence process? (ratios of per capita income in PPP)

62

64

66

68

70

72

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

96

97

98

99

100

101

102

103

104

Italy/EU (right scale)

Italy/US(left scale)

26

The loss in export market shares

-1.0

1.0

3.0

5.0

7.0

9.0

11.0

Italy France Germany

1996

2001 2004

1999

27

Productivity trends in Europe (growth rates, Hodrik Prescott)

-1

0

1

2

3

4

5

6

7

8

9

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Italy

France

GermanyUK

28

The outlook today

• Growth is unlikely to pick up on a sustained basis

• Inflation is higher than in the rest of the EU: the standard adjustment mechanism does not work for Italy

• Slow growth and lack of fiscal restraint have resulted in a significant deterioration of the budget

29

Losing competitiveness

Inflation

Italy Euro

2002 3.1 2.5

2003 2.9 2.0

2004 2.6 1.9

Productivity

Italy EU

2002 -2.0 1.6

2003 -0.8 1.1

2004 -0.4 3.0

30

An unpalatable combination

• Taken together, low growth, real appreciation, rigid markets, high debt ratios and large fiscal deficits are a cause of concern

• Structural reforms in the product markets and in the educational system should loom high in the policy agenda

• Fiscal consolidation should come soon before interest rates start rising