Transcript MVEA2002 - Pearson Education

The Unsustainable Must
Surely End!
Michael Parkin
LECTURE
OUTLINETOPICS
 Consensus forecasts for 2003
 Unsustainable trends
 Inflation or deflation?
CONSENSUS FORECASTS FOR 2003
My previous forecasts
At the MVEA meetings in Kansas City in February 2001,
I predicted that 2001 would see recession.
At the MVEA meetings in Memphis in February 2002, I
predicted that 2002 would see falling stock prices and a
Dow of around 7000.
What’s next?
CONSENSUS FORECASTS FOR 2003
Average of 37 professional forecasts
2003(1)
2003(2)
2004
Real GDP growth
2.5
3.5
4.0
Unemployment rate
6.0
5.7
5.5
CPI inflation rate
2.2
2.2
2.4
GDP deflator inflation
1.7
1.7
2.0
3-month T Bill rate
1.25
1.8
2.8
10-year T Bond rate
4.0
4.6
5.1
UNSUSTAINABLE TRENDS
Unsustainable?
Three unsustainable trends that must surely end are
• Rising real estate prices
• Increasing household debt
• The external deficit
A fourth trend, the federal budget deficit and growing
federal debt is sustainable if the current official
projections are correct but might become unsustainable
if expenditures increase more rapidly than projected.
UNSUSTAINABLE TRENDS
Rising real estate prices
From 1995 through 1999, stock prices increased at
rates that were out of line with fundamentals.
From 2000 through 2002, stock prices decreased and
returned to their fundamental equilibrium levels.
From 1995 through 2002, real estate prices increased
at rates that were out of line with fundamentals.
During the next year or two, real estate prices will fall
and return to their fundamental equilibrium levels.
UNSUSTAINABLE TRENDS
Increasing household debt
As real estate prices increased, so did the amount that
households borrowed on mortgages and consumer
credit instruments.
When real estate prices return to their fundamental
equilibrium levels, a number of households will have a
balance sheet problem—their debts will exceed the
value of their assets.
UNSUSTAINABLE TRENDS
The external deficit
Each year since 1992, the United States has had a
current account deficit.
The deficit was small at first but it has relentlessly
increased.
By 2002, the deficit was running at more than $400
billion—4 percent of GDP.
Net foreign indebtedness increased by $2.25 trillion
during the past decade.
UNSUSTAINABLE TRENDS
Government deficit and debt
After only four years of surplus, the federal budget is
again in deficit and is projected to remain so indefinitely.
Net government debt is projected to grow from $3.6
trillion in 2002 to $5.1 trillion in 2008.
Net debt will grow from 34 percent of GDP in 2002 to 36
percent of GDP in 2008.
If expenditure follows the projected path, this situation is
sustainable.
INFLATION OR DEFLATION?
Internal adjustment pain
When real estate prices return to their fundamental
equilibrium levels and households cope with the
ensuing balance sheet problem, the saving rate will
increase.
Real GDP growth will slow and perhaps turn negative
for a year or so.
INFLATION OR DEFLATION?
External adjustment pain
While the rest of the world is willing to hold U.S. debts,
the international deficit is not a problem.
But when foreigners decide to move their wealth to
Europe, Asia, Central and South America, Australasia,
and Canada, U.S. debt will be dumped and perhaps
quickly.
The dollar will slide and perhaps quickly.
The dollar is even today beginning to look less robust.
INFLATION OR DEFLATION?
Conflicting effects
Falling real estate prices will be deflationary.
A falling dollar will be inflationary.
Which will occur first?
My guess is that the real estate bubble will burst first
and it will trigger a dumping of U.S. assets by
foreigners.
Will we have deflation or inflation?
INFLATION OR DEFLATION?
The critical role of the Fed
Whether we have deflation or inflation depends on the
response of the Fed.
If the Fed continues to mimic a Taylor rule, we’ll most
likely have no major change in the long-term inflation
rate.
All the current signs point to inflation of between 1 and 3
percent a year.
INFLATION OR DEFLATION?
If the Fed gets it wrong
If falling real estate prices bring financial stress and the
Fed doesn’t keep money growth strong, deflation could
occur.
If the Fed tries to resist a falling dollar with interest rate
hikes, deflation could occur.
There is a bigger risk that the Fed will err on the side of
deflation than on the other side.
The Unsustainable Must
Surely End!