Economic expansions end because households and businesses want to consume and invest too much now relative to available supplies of goods, services, and savings. When excess demand pushes up prices too rapidly, interest rates rise, or are increased by the Federal Reserve, to increase the demand for future goods, commonly known as saving.
In the second half of 1996, U.S. interest rates and perhaps U.S. inflation are being held down by fortuitous (from the standpoint of the United States) economic slowdowns in Japan and especially in Europe. These slowdowns have taken pressure off prices and, through global capital markets, have provided a needed increase in savings to fuel the U.S. expansion.
The new president--whose term will start with the seventh year of the current U.S. expansion--will need to understand the special role played by events in Europe and Japan in extending the U.S. economic expansion. In the short run, say, over the next several months, the extra foreign saving flowing into U.S. financial markets will hold down interest rates, support stock prices, and strengthen the economic expansion. Over the longer run, however, the extra liquidity inflow will increase the likelihood that the pace of U.S. demand growth will become too rapid to avoid increased wage and inflation pressure during 1997. Meanwhile, no one in the real sector or the financial sector of the U.S. economy is complaining about the tailwind provided by yield-starved savers abroad.
Before a look at the major economies outside the United States, especially in Europe, where a dramatic acceleration in monetary integration has increased deflationary pressure, the broad outlines of the response in financial markets to this unusual cyclical pattern must be clear. The best way to extend the U.S. recovery, by mitigating the need for higher interest rates here, is to allow the dollar to strengthen. Demand needs to be shifted away from U.S. producers, whose demands for labor are beginning to put upward pressure on wages, and onto European and Japanese producers, who are facing disinflationary and deflationary pressures. The stronger dollar would also encourage a continued supply of foreign savings to the United States at interest rates that would accommodate continued steady growth of U.S. investment. .
The Deflationary Impact of Broader European Monetary Union
The pace and the extent of monetary union in Europe have changed rapidly in the past month. The changes carry important implications for the nature of the new European currency, the Euro. By increasing fiscal drag and thereby increasing the deflationary pressure in Europe, the accelerated and broadened pace of European monetary integration will accommodate an extended U.S. recovery. When signs of late cyclical excess demand pressures begin to appear in the United States and real U.S. interest rates rise, however, the American government must not resist appreciation of the dollar, which will create a therapeutic shift of demand from the United States to Europe and to Japan. Understanding these and other events requires a fuller explanation of the dramatic changes that have occurred in Europe over the past month.
The main feature of the European monetary union, viewed from the continent of Europe, is a unification process more rapid and broader than many imagined even as recently as the runup to the late-September International Monetary Fund- World Bank meetings in Washington. First, large multinational companies located in Europe, such as Unilever, ELF-Aquitaine, Daimler-Benz, and BMW, along with major European banks, are clearly anxious for a single market that encompasses as much of Europe as possible. The broadest single market requires the broadest possible membership in the January 1, 1999, first round of union. Therefore, the European private sector is pushing governments to end their bickering and settle on a broad monetary union that includes Italy and Spain and possibly Sweden and the United Kingdom, along with the countries already accepted for the first round.
The acceleration of monetary unification will initially be deflationary for Europe since it will require tight fiscal policies in the core European nations, especially stringent measures in peripheral countries such as Italy and Spain to meet the budget criteria for union. In the space of the week spanning the end of September and early October, the Italians, who had been claiming somewhat optimistically that they could reduce their budget deficit from 6.7 percent of the gross domestic product in 1996 to 4.5 percent of GDP in 1997, suddenly claimed that they would achieve a budget deficit equal to 3 percent of GDP in 1997. On October 1, 1996, French Prime Minister Chirac suggested that the Italians might not make the first round of union. The Italian government protested and threatened to cancel the summit between France and Italy scheduled for the end of that week.
Significantly, within hours, Chirac had softened the tone of his comments on Italy, suggesting that the French were prepared to look kindly on Italian efforts to be included in the first round of the European monetary union. Coupled with earlier French comments encouraging first-round entry into the European monetary union by Spain, the French nod to Italy signaled a rapid change in French policy toward broadening the membership in the first round. The French are prepared to exchange first-round status for Italy for a revalued lira--about 950 lira per deutsche mark--that leaves French producers more able to compete with Italian exporters.
The requirement of rapid progress toward satisfying the criteria for monetary union gives governments leverage to undertake needed fiscal reforms that are both unpopular and deflationary. This fact will increase the desire to speed up the process of monetary union to get past the deflationary phase both for countries such as France, which has endured a deflationary bias for more than a decade, and for countries such as Italy and Spain, where the deflationary pressure over the next two years will increase sharply because of the sharp fiscal adjustments necessary even to approach satisfying the budgetary criteria for early entry into the monetary union.
Countries such as Italy, not yet either accepted for the monetary union or participating with the exchange rate mechanism, have some leverage over the core countries of the monetary union, such as France. If the Italians' desire to be included in the European monetary union is not accommodated, they can depreciate their currency against other currencies of Europe to offset the deflationary impact of tighter fiscal policies. Here lies the need for a deflationary France, uncompetitive with Italy at more than 1,000 lira per deutsche mark, to exchange a nod to Italy on first-round membership in the EMU for a stronger lira.
The point of recognizing the dramatic change in the pace and breadth of prospective union is to avoid being sidetracked by the inevitable bickering between European governments through 1999. Indeed, the realization that the deadline to start monetary and political union is rapidly nearing has intensified the discussion surrounding the many details that must be settled among European governments for the scheduled union. The fact that few, if any, participants in the monetary, economic, and political union will meet their fiscal targets is no longer interesting or relevant. The European Council of Ministers can waive any of the targets and will probably do so.
The Germans can control the process to some extent by insisting on some fiscal rules through measures like the Waigel Pact and by emphasizing the inflation targets in the criteria for union. Ultimately, however, what will take place in January 1999 will be more like the creation of a single market with a single money. The multinational banks and companies of Europe will make sure of this: they realize that without a large single market area, and the fiscal discipline that will lead to a significant downsizing of the European welfare state, they will no longer be viable global competitors.
The changes since summer in the pattern of the unification process are highly significant both for Europe and for the United States. Because the concept of monetary union evolved in the inflationary 1970s, the natural goal was a European currency modeled on a hard money like the deutsche mark. As the 1990s have developed into a decade of disinflation and, in some cases, deflation--which, in turn, has been accelerated by the increasing fiscal stringency undertaken by a broader group of European countries trying to achieve the budgetary targets of monetary union--the prospective tone of the Euro, the new European money, has begun to soften.
In a global economic environment where deflation is more likely than inflation, creation of a new European currency modeled on the hard deutsche mark may entail too much strain, especially for European companies burdened by high labor costs and the tax burdens necessary to finance the European welfare state. If joining the European monetary union means adding a new burden--the cost of converging to a hard-currency regime--the strain of currency union may be too great. A natural corollary would be to expand membership in the union to softer-currency countries such as Italy and Spain. This modification would offset the deflationary bias of tight fiscal policies and a Teutonic monetary regime.
The change in the nature of the prospective new European currency raises some interesting questions for European savers and for European financial markets. European savers, accustomed to storing wealth in hard currencies like the deutsche mark and the Swiss franc, can probably be forgiven for some uneasiness about the prospects of a softer Euro. This anxiety has already been signaled by a powerful rush into the Swiss franc, which is not to be included in the European monetary union. This move has caused the Swiss franc to appreciate against all European currencies, including the German mark. Efforts by the Swiss to resist depreciation of the deutsche mark by cutting interest rates to 1 percent have so far been unsuccessful. Given the pressure for the Swiss franc to appreciate even further against the deutsche mark, if the Swiss cut rates further, the attractiveness of the dollar as an alternative hedge currency will increase.
Switzerland in 1996 begins to look like Japan in 1995, with continued deflation pressures and a chronically strong currency requiring some official intervention to push the currency down against the dollar. The overappreciation of the currency has taken a toll on the Swiss economy. The second quarter of 1996 was the sixth consecutive quarter of economic contraction. The possibility of economic recovery has been put back from 1997 to 1998, while unemployment continues to rise. Somewhat ironically in view of the German rush to the Swiss "safe haven," a Swiss deflationary crisis that forces Switzerland to declare the dollar a stronger currency and to follow up with intervention to prove it would be popular in most of Europe as a means to increase the pressure for dollar appreciation against European currencies. The dollar appreciation would mean depreciation of European currencies, which would, in turn, help to introduce some reflationary pressure in Europe.
Given the deflationary tendencies in Europe, European focus on the U.S. economy is intense. The big fear in Europe is an overheating that forces the Fed to end the U.S. economic expansion and thereby to eliminate the much needed pull of the U.S. locomotive in a deflationary global economy. The broad economic slowdown during 1996 in Europe and Japan gives the U.S. train plenty of room to run. The numbers that suggest that U.S. growth is slowing to a sustainable 2.5 percent are good news for European markets. During October, the U.S. and European bond markets did not have to decouple since rates have been going down everywhere. They have been going down faster in Europe partly because of the rapid easing of monetary policy in periphery countries, which are, in turn, experiencing capital inflows from their prospective inclusion in the first round of monetary union.
These inflows into countries such as Italy and Spain are met with interest rate reductions, which, in turn, help strengthen the dollar, even as U.S. interest rates fall, because European interest rates fall even more. Given even weaker European (and Japanese) economies, a weaker U.S. economy strengthens the dollar since Europe and Japan must push harder on the exchange rate lever to get a larger piece of weaker U.S. growth. Some intergovernmental conflict over exchange rates is possible if the U.S. economy slows sharply.
Alternatively, if the U.S. economy picks up speed later this year or early next year, thereby forcing the Fed to raise interest rates, the deflationary bias from tight fiscal policies in Europe will likely prevent the Germans from following the higher U.S. rates. The result will be some salutary reinforcement of the tendency for the dollar to strengthen even while European rates are falling less than they would have when the U.S. economy appears to be weakening. With a strengthening U.S. economy, the American tolerance for a stronger dollar rises while Europe and Japan need less dollar strength to hitch a ride behind the U.S. economic locomotive. Intergovernmental conflict on exchange rates is less likely.
Effects of Slowing Asian Economies
After six months of powerful fiscal stimulus, the Japanese economy is slowing again with no relief from the deflationary pressure that has characterized the past several years. Market fears of an economic pickup and a need for higher interest rates notwithstanding, the annualized inflation rate of the consumer price index in Japan during the three months ending in August was a minus 0.3 percent, down from a tiny positive 0.2 percent year-over-year inflation rate.
Japanese fiscal and monetary policy have been placed on hold during the runup and immediate aftermath of the Japanese election. The consumption tax increase already legislated to begin on April 1, 1997, will probably go forward. Meanwhile, the stimulative impact of the past year's large fiscal package has worn off. Japan's new government faces a period of fiscal consolidation after four years of heavy government spending aimed at creating a self-sustaining Japanese economic recovery.
While European savers may begin to store their wealth in dollars because of uneasiness about the properties of the new Euro, Japanese savers are beginning to store their wealth in dollars because of the low interest rates available in Japan coupled with an emerging sense that the dollar is no longer a chronically weak currency. Naturally, the efforts by Japanese savers to earn higher rates of return in the United States--to the extent that they are willing to leave their savings unhedged in dollars--creates a self-correcting tendency by weakening the yen. The weaker yen helps to increase demand for the output of Japan's highly productive manufacturing sector.
Like Europe, Japan needs a combination of a weaker currency and broad regulatory and cost reforms that will help to make its companies more competitive in a global environment. As the U.S. expansion moves into its seventh year, a weaker yen would serve both the United States and Japan by shifting demand away from a U.S. economy approaching capacity and onto a chronically weak Japanese economy.
The pattern of slowing growth in Japan and in parts of Europe is being repeated in China and in some smaller Asian economies late in 1996. Asian import growth has collapsed from a high exceeding 25 percent in 1995 to about 2 percent in mid-1996. Chinese efforts to bring down inflation pressures appear to be creating a hard landing in China and other parts of Asia. As a result, central banks in those countries have tried to reduce appreciation of their currencies by accelerating purchases of dollars.
Some Asian central banks may also be reducing their holdings of European currency reserves, primarily the deutsche mark, in exchange for dollars. The transition from European currencies to the Euro is getting closer. As the properties of the new Euro come into question, some foreign central banks wish to exchange deutsche mark reserves for dollar reserves. The result has been solid official demand for dollars and, in turn, for U.S. government securities to earn interest on increased dollar reserve holdings.
Global Deflation and U.S. Financial Markets
The increase in government saving in Europe and in Japan coupled with deflationary tendencies in those countries has produced an elevated flow of savings to the United States just at the time, late in the U.S. expansion, when those savings are needed to continue funding this expansion at moderate interest rates. There is nothing wrong with foreign accommodation of the U.S. economic expansion--provided that, as the U.S. economy approaches capacity, the dollar is allowed to appreciate freely to shift demand away from pressured U.S. productive capacity and onto redundant capacity in Europe, Japan, and Asia.
The asynchronous state of the world economies in 1996 could produce an unusual combination of events over the balance of this year and into 1997. We may see a combination of a rising U.S. dollar and a rising current account deficit, which mirrors the increasing flow of foreign savings to the United States as foreign savers seek either the refuge of the dollar as a store of value or the attractiveness of higher-yielding dollar assets. The increased flow of global liquidity toward the United States, by holding interest rates down and by extending the expansion phase of the U.S. cycle, will also produce continued increases in U.S. equity prices.
With an aging economic recovery financed by capital inflows from abroad, the U.S. economy is highly vulnerable to a sharp resumption of growth in Europe or Japan that cuts the flow of global saving to the United States. While the near-term risk of such a turnaround is low because of the deflationary bias of the move toward monetary union and the well-known structural difficulties of the Japanese economy, eventually a combination of lower interest rates and weaker currencies will cause growth in the industrial economies outside the United States to reaccelerate. When this occurs, probably sometime in 1998 or 1999, we may see an unusual turn of events whereby a U.S. economic expansion is brought to an end by a faster pace of economic expansion in Europe and Japan.
John H. Makin is a resident scholar at the American Enterprise Institute.