With signs of a slowdown in the U.S. economy casting a shadow over the global economy, the Group of Seven finance ministers and central-bank governors who gathered in Palermo, Italy, last weekend emphasized the need for coordinated action to ensure sustainable growth worldwide. That appeal for cooperation, however, was underscored by a shared sense of self-responsibility and self-help, imparting a certain detachment to the joint statement issued at the end of the meeting. As U.S. Treasury Secretary Paul O’Neill said of Japan, the G7’s underlying message is: Consider what you can do to solve your own problems.
The statement is cautiously optimistic about the slowing U.S. economy, saying that its fundamentals remain strong. A less upbeat assessment could have further unsettled already nervous stock and currency markets, given continuing fears that the world’s largest economy might be slipping into a recession. The guarded optimism also reflects the fact that U.S. fiscal and monetary policy is well positioned to stimulate growth. The Federal Reserve Board has already cut interest rates several times in rapid succession, while President George W. Bush’s administration is committed to a 10-year, $1.6-trillion tax reduction. However, the G7 statement, in a veiled reference to the massive tax-cut plan, makes the right call in urging fiscal moderation.
The euro-zone economy, by contrast, appears to be in fairly good shape. The overall assessment is that regional growth, though interrupted by temporary slowdowns, remains healthy. Growth prospects are described as “favorable” due largely to strong domestic demand in the 15-member European Union.
Japan was the chief concern, the “problem child” in the G7 class. “While a modest recovery is expected,” warns the joint statement, “prices continue to decline and downside risks remain.” That is another way of saying that Japan’s economy risks falling into a deflationary spiral — a continuous decline in prices accompanied by falling output. A two-part prescription is recommended: first, “monetary policy should continue to ensure that liquidity is provided in ample terms,” and second, “efforts to strengthen the financial sector should be enhanced.”
The Japanese economy contracted in the third quarter of 2000, July through September, reversing an earlier estimate of positive growth. Consumer prices have continued to decline for two straight years. Earlier this month, prior to the G7 meeting, the Bank of Japan reduced the official discount rate and created an emergency-credit facility for private banks. The central bank seemed to have no choice but to take these steps. Had it taken no action, merely repeating its theory of “gradual recovery,” Japan certainly would have come under heavy pressure from other G7 partners.
Japan’s monetary policy is already stretched to the limit, as is its fiscal policy. The enormous budget deficit and debt burden effectively rule out any further spending increase as a way of boosting growth. The marginal discount rate cut, from 0.5 percent to 0.35 percent, will probably have little effect on the economy. Another fractional cut may be possible, but it would have little more than symbolic meaning.
The central bank has other options, such as bringing interbank overnight-borrowing rates back to zero, expanding the money supply under a given target, and purchasing long-term government bonds without a repurchase agreement. These measures may become necessary should the economy sink into a deflationary spiral. The danger is that they could have crippling side effects.
Zero interbank rates, which were scrapped last August amid signs that the economy was on track to recovery, mean that banks can borrow money from each other without paying any interest. But free money could present “moral hazards” to borrowers, undermining discipline. Money-supply targeting would create a glut of liquidity in the economy — inflation — unless there is enough demand for cash. Business borrowers in declining industries would only put off tough decisions. Outright bond purchases could drive up long-term interest rates, a development that would cool off business capital investment.
Given the severe limitations of monetary and fiscal policy, it will be much better to take the other part of the G7 prescription — strengthening the financial sector. More specifically, banks should step up efforts to clean up their remaining bad debts and restore health to their balance sheets. And they should stop bailing out debt-burdened clients, notably those in the construction and retail industries. The government, for its part, should carry out bold plans for deregulation and structural reform.
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