Global Economic Prospects, Risks and

Challenges for EuropeRobert F. Wescott, Ph.D.

SACEMilan

18 November 2005

2

Perceived Global Investment Risk

-80

-60

-40

-20

0

20

40

60

Canada UnitedStates

Japan WesternEurope

China EasternEurope

OtherAsia

LatinAmerica

Russia Africa MiddleEast

1998 2005

Source: UBS Index of Investor Optimism, August 2005

Percent rating the region “low risk”

minus percent rating it “high risk”

3

Economic Policy Floodgates Closing

-5

-4

-3

-2

-1

0

1

2

-5 -4 -3 -2 -1 0 1 2

2000-2004

2004-2005

US

Canada

Germany

US

Italy

Euro AreaGermanyFrance

UK

Euro Area

FranceItaly

JapanUK

Japan

Canada

Tighter Fiscal PolicyEasier Fiscal Policy

% change in real six month LIBOR

Change in structural f iscal balance as a % of GDP

China

China

Tighter Monetary Policy

Easier Monetary Policy

Source: IMF WEO, Author’s calculations for China

4

Oil: A Growing Burden on the World Economy

World Oil Expenditure as Percent of World GDP

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%Global Recession

Trigger Level?

Source: EIA, IMF WEO

5

Investors Concerned about Energy

0%

10%

20%

30%

40%

50%

60%

Great deal Moderateamount

Only a little Not at all

Percent giving each answer to the question, “how much are energy prices hurting the U.S. investment climate?”

Source: UBS Survey of Investor Optimism, Sept. 19, 2005

6

The Oil Price Pass-Through to Inflation is Falling

Percent change in CPI and core CPI divided by percent change in RAC of oil (during periods of 30%+ increases in oil prices)

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.1

1970s 2000s1990s1980s

CPI

Core CPI

CPICPI

CPI

Core CPI

Core CPI

Core CPI

Source: Bureau of Labor Statistics and Energy Information Agency

7

Why Isn’t the Dow at 12,800?(because of energy prices)

Change in DJIA when Corporate Profits are up 30% or More (Y/Y)

21.9

-3.3

0.8

31.1

-15.1

6.1

27.7

36.036.0

-20

-10

0

10

20

30

40

2000s1950s-1990s

Average:-4.5%

Average: 21.5%

Source: Bureau of Economic Analysis, Yahoo! Finance

8

Housing Prices Rising Worldwide

-75 0 75 150 225 300

Hong KongJapan

GermanySwitzerland

SwedenCanadaFrance

DenmarkBelgium

N. ZealandItalyU.S.

NetherlandsAustralia

BritainSpain

IrelandS. Africa

Percent Change, 1997-2005

Source: The Economist

9

Potential Impact of a Housing Crunch on GDPAssumed Price

DropAssumed Effect

on Real GDP

U.K. 9% -0.7%

Spain 8% -0.4%

Australia 7% -0.3%

France 6% -0.4%

Italy 5% -0.4%

U.S. 5% -0.3%

Canada 2.5% -0.4%

World N/A -0.3%

Source: Global Insight

10

Can Disequilibrium Continue? (China produces, the U.S. consumes?)

Current Account Balance (percent of GDP)

-8

-6

-4

-2

0

2

4

6

8

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Source: IMF WEO

11

Historically, Rising Interest Rates Add Financial Pressures

Monthly Fed Funds Rate

0

2

4

6

8

10

12

14

16

18

20

???

Black Monday

Continental Illinois Bank

Franklin National Bank

S&L Crisis

Penn Central Railroad

Latin American Crisis

High Tech Bubble

Mexican Crisis

Source: Federal Reserve

12

13

China’s Trend Has Been Sharply UpwardShare of World Economy, PPP Basis

0

5

10

15

20

25

30

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

pe

rce

nta

ge

Source: IMF

14

The Euro Area’s Unemployment Rate Exceeds

that of the Rest of the Industrialized World

Source: OECD, Standardized Unemployment Rates *South Korea 2000-2005

5.2%

9.5%

6.7%

3.8% 4.1%

0%1%2%3%4%5%6%7%8%9%

10%

U.S Euro Area U.K. SouthKorea*

Japan

Average Unemployment Rate, 1993-2005

15

Europe Lags the U.S. in Productivity

Eurozone 0.7%

Italy -0.3%

Germany 0.7%

France 1.3%

U.K. 1.8%

Japan 1.9%

Canada 0.7%

U.S. 3.5%

Average percent change in labor productivity, 2002-2004

Source: OECD

16

High Tech Manufactures: Asia Rising, Europe Declining

Source: National Science Foundation, “Science and Engineering Indicators 2004”

Share of World Production of High-Tech Goods

0%

5%

10%

15%

20%

25%

30%

35%

US Germany France U.K. Italy Japan China SouthKorea

India

1980 1990 2001

17

Greenspan’s Medicine Would Help Europe(Real short-term interest rates)

-2

-1

0

1

2

3

4

5

6

7

I 1

990

I 1

991

I 1

992

I 1

993

I 1

994

I 1

995

I 1

996

I 1

997

I 1

998

I 1

999

I 2

000

I 200

1

I 200

2

I 200

3

I 200

4

I 200

5

Fed funds / ECB policy rate deflated by “core” CPI inflation

EU real interest rate

US real interest rate

EU real interest rate

Sources: Federal Reserve, Bureau of Labor Statistics, European Central Bank, European Commission

18

Cross Country R & D Spending

0%

1%

2%

3%

Japan U.S

.

S. Kor

ea

Germ

any

OECD

Franc

eE.U

.U.K

.Ita

ly

Source: National Science Foundation, Science and Engineering Indicators 2004

Percent of GDP, 2000 (latest available year)

19

Percentage of 18-24 Year Olds in Science and Engineering Programs

0%

1%2%

3%4%

5%6%

7%8%

9%10%

U.K.

S. Kor

ea

France

Japan

Germ

any

U.S.

Italy

China

Source: National Science Foundation, Science and Engineering Indicators 2002