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FOR RELEASE ON DELIVERY FRIDAY, JUNE 3, 1983 11:00 A.M. E.D.T. Prospects for Recovery in the World Economy Remarks by Lyle E. Gramley Member, Board of Governors of the Federal Reserve System at the International Conference Miami Branch of the Federal Reserve Bank of Atlanta Miami, Florida June 3, 1983 Prospects for Recovery in the World Economy These past four years have been difficult ones for the U.S. economy, for the economies of other industrialized countries, and for those of developing nations as well. The travail of the recent world-wide recession is by no means over. But the economic horizon looks brighter now than it has for some time, and the prospects for launching a prolonged recovery, free of inflation, seem to me quite good. My talk today will focus principally upon prospects for the U.S. economy, because it plays so vital a role in shaping the course of economic and financial developments in all Western nations. But I will also touch on the problems of major debtor countries, which are of interest and concern to all of us. Recovery in the U.S. Economy The U.S. economy began to emerge from the prolonged recession of 1981-82 in the closing months of last year. Since December, industrial production has increased 5-1/2 percent; employment has increased significantly, and the -2- average length of the work week in manufacturing has also risen. Real GNP in the first quarter of this year rose just 2.5 percent at an annual rate, but the increase in nonfarm business product was actually 5.8 percent. The recovery is now spreading and gathering strength. In April, the increase in industrial output was the largest since August 1975; there were gains in employment at 73 percent of the nation's nonfarm industries, and new orders for durable goods advanced an additional 3-3/4 percent. The rise in real GNP during the current quarter will almost certainly exceed that of the first quarter. Efforts to replace inventories--which have declined more in percentage terms than in any prior recession of the postwar period--have been an important ingredient of recovery. But these efforts were preceded by a strengthening in private final sales that began in the housing industry last summer and spread to consumer spending more generally in the fall. Lower interest rates have been a dominant factor in the resurgence of home buying and residential construction, and the runup in stock prices that has accompanied the decline in interest rates contributed importantly to the strengthening of consumer spending. -3- In other major industrialized countries, the recovery in economic activity is lagging behind that in the U.S., but heartening signs of an upturn have developed. In West Germany real GNP expanded at an annual rate of about two percent in the first quarter, following four successive quarterly declines. Industrial production in the first quarter of this year has increased strongly in Canada, and moderately in Germany and the United Kingdom. Recent consumer and investment intention surveys and sales data in Canada, Germany and the United Kingdom also provide indications of a more favorable economic climate. In both the U.S. and abroad, the most important ingredient fostering recovery was the progress against inflation. Reduced inflation contributed directly to lower interest rates through reduction in demands for money and credit and greater willingness of lenders to accept smaller inflation premiums. Progress on the inflation front also permitted monetary authorities in a -4- number of countries to move away from the restrictive policies put in place earlier to reduce inflation, and to adopt policies more conducive to expansion. The U.S. has made more progress against inflation than most other industrial countries over the past several years, and more progress, also, than had been expected by most observers. Our inflation rate has declined from the double-digit range in 1979-80 to below five percent presently. Progress has been almost as rapid in the United Kingdom, and Canada has enjoyed a substantial reduction of inflation since the middle of 1982. Japan, Germany and Switzerland continue to enjoy low rates of inflation; wholesale prices actually declined in the first quarter in all three of these countries. In the U.S., one of the most heartening developments has been the reduction in the rise of unit labor costs--from around eleven percent a year in 1979-80 to five percent in 1982 and probably still lower in 1983. Moderation of wage increases has occurred in nearly every major industry, in every region of the country, and among all classes of workers. Restraint is likely to continue to dominate wage bargaining in the near future. Productivity, moreover, has begun to improve because of tremendous efforts of businesses to cut costs--efforts which will bear even more fruit as the economy recovers, since rising output will be spread over a smaller and more efficient labor force. Recoveries typically gather momentum in the early stages, and this recovery will probably repeat that pattern. In the U.S., business fixed investment is widely expected to turn up in the second half. Consumer spending will be bolstered by the tax cut at mid-year. But there are some areas of weaknesses that will dampen the rate of economic expansion. The energy industry, for example, has been hit hard by declining world oil prices, and farm income is only beginning to improve from an exceptionally lower level. The chief weakness, however, lies in the outlook for exports. -6- The vulnerability of the U.S. economy to weakness in exports became abundantly evident in 1982. The slow- down in business activity abroad, combined with the large rise in the value of the dollar relative to other currencies, led to a 16 percent drop in our exports of goods over the four quarters of 1982. The decline was actually larger than the overall reduction in U.S. real GNP during that period. More recently, demands for U.S. exports also have been adversely affected by internal adjustment programs of large developing countries, necessitated by their serious external debt problems. At the present time, demands for our exports are still quite weak, while imports—particularly of raw materials and industrial supplies—will increase with the expansion in industrial output. Our merchandise trade deficit is there- fore likely to increase substantially during the next several quarters, and our current account deficit would increase commensurately. Markets for U.S. exports should strengthen as the recovery in other industrialized countries gains momentum later this year. If the dollar's value in exchange markets declines with increases in the U.S. trade and current -7- account deficit, as may well happen, that will help to strengthen our competitive position over time. But for the near term, sluggish demands for exports will dampen the pace of recovery in the U.S. economy. Dependence of the U.S. Economy on Exports The role of export markets in shaping the course of economic developments in the U.S. has been growing, because the U.S. economy has increasingly come to depend on export markets as a source of demand. During the past two decades, exports (in volume terms) have risen from seven percent to twelve percent of the output of goods. Moreover, the destination of U.S. exports has been shifting increasingly toward the less developed countries. Ten years ago, their share in our total exports was 30 percent; today, it is 37 percent. Despite the emergence of major exporting centers in Asia, and the growing importance of petroleum in international trade, the Latin American countries have held their own in trade with the United States: -8- • They account for about sixteen percent of total U.S. exports and imports. • About forty percent of receipts from travel in the U.S. comes from Latin America, and forty percent of travel expenditures by U.S. residents goes to Latin America. • About seventeen percent of total U.S. direct investment outstanding abroad is in Latin America. These statistics indicate that the U.S. has a strong economic self interest in the economic health of Latin America. We cannot expect to enjoy a robust economic expansion if our friends and neighbors to the south are undergoing economic hardship. Obviously, the countries of Latin America want badly to emerge from the negative average growth of 1982 and to return toward the six percent annual growth that they enjoyed, on average, in prior years. It is in our best interests in the U.S. to help foster that development. External Debt Problems A major roadblock to restoring satisfactory growth in Latin America is the external debt problems of many countries in the region, particularly the larger ones. External debts were growing at a pace that could not be sustained -9- indefinitely, either from the standpoint of debt service burdens or of the gradually increasing exposure of lending banks. For a time, heavy borrowing helped to sustain rapid internal growth in much of the developing world, but increasingly the need for adjustment to reduce internal pressures and balance of payments deficits became apparent. Slowdown in world growth helped expose the increasingly precarious position of borrowers—as prices of commodity exports fell, markets for manufactured goods weakened, and higher interest rates led to sharply increased debt servicing requirements. Vigorous and highly constructive efforts are now underway to deal with these problems. Strong actions have been taken by borrowing countries to restore internal and external equilibrium; many of them have negotiated comprehensive stabilization programs with the International Monetary Fund. At present fourteen Latin American or Caribbean countries have either an IMF Standby or an Extended Fund Facility program in effect, and several other countries are in the process of negotiating such a program. 1/ Argentina, Barbados, Brazil, Chile, Costa Rica, Dominica, the Dominican Republic, El Salvador, Haiti, Honduras, Jamaica, Mexico, Peru, and Uruguay. -10- Commercial banks have a major role to play in dealing with the international debt situation. An uncoordinated attempt of individual lending banks to force immediate repayment would undercut the stability of borrowers, lenders, and the international financial system alike. We could not fully insulate our domestic banking and credit system--and our own economy--from such developments. Consequently, we have a common interest in measures to contain and deal with the threat. On the whole, banks have acted responsibly in arranging new credits and restructuring old loans, with encouragement in some cases by the IMF and some central banks. A third major element in dealing with the international debt situation is the International Monetary Fund. Progress has been made in reaching agreement in augmenting the resources of the Fund. A strengthening of the Fund's financial base will enable it to assist in the adjustment that is necessary to restore countries to sustainable payments positions. It is urgent that the legislation currently before Congress on IMF funding move along speedily. -11- A fourth important element in reaching a satisfactory solution to international debt problems is the recovery in the world economy itself. It cannot realistically be expected that the debt problems of Mexico, Brazil, Argentina, and other countries will readily be solved without the benefit of the increase in world trade and debt service capacity that accompany a sustained expansion in world economic activity. Here, too, the U.S. has an important role to play. We need to pursue policies that will encourage a prolonged expansion in the U.S. economy, sustain and extend the progress we have made to date on inflation, and effect a lasting reduction in real interest rates. Such policies would be of enormous benefit to all of our trading par triers-industrial nations and developing countries alike. They are also the policies that the U.S. would be well advised to follow purely in its own self interest. Economic Policy What does this mean for monetary policy? In the long- run, it would be widely agreed, monetary policy affects largely the rate of inflation—not the level of real economic activity nor real interest rates. In the short-run, and at the moment, however, the task of monetary policy is much more complicated. Sufficient liquidity must be provided to foster a good recovery, but extreme caution must be taken to avoid rekindling inflationary pressures later on. -12- There are some w ho think that monetary policy since around the middle of last year has been far too expansive— because growth of both M^ and M 2 have been in a double-digit range. I understand these fears, though I do not share them. Since the fourth quarter of 1981, the relationship between money growth and the growth of the economy has been miles away from historic norms. For example, over the past fifteen to twenty years, nominal GNP has typically risen, on average, by three percentage points more than the increase in M^. Over the past five quarters, however, the increase in nominal GNP has been five percentage points less than the increase in M^. There is no precedent in postwar history for this large a departure from trend. The Federal Reserve could, of course, have prevented the rapid rise in the major monetary aggregates since the middle of last year. Had it done so, in my judgment, the economy would now still be wallowing in recession, instead of enjoying a reasonably good recovery. -13- Let me acknowledge, however, that I would be concerned if recent rates of money growth were to continue in a rebounding economy. If historic relationships between money growth and GNP were to reassert themselves, the recent pace of money growth would, sooner or later, have to be slowed substantially to avoid a renewed outbreak of inflation. And it would be wise, in my judgment, to begin the process of slowing before inflationary pressures and expectations revive. Slowing money growth in a rebounding economy might put upward pressure on interest rates, at least for a time. But interest rates need not rise if steps are taken to deal with the enormous and growing deficit in the Federal budget. This fiscal year, the deficit will probably exceed $200 billion, and amount to 6-1/2 percent of GNP. Under current law, and assuming the President's proposed defense buildup, the deficit will increase, even if the economy grows at four percent a year, and will remain close to six percent of GNP over the next five fiscal years. -14- A federal deficit equal to roughly six percent of GNP will absorb about three-fourths of net private saving in the U.S. economy. Financing such a deficit poses no great problem during a recession--or even during the early phases of recovery. During the past two quarters, for example, business fixed investment has been weak, inventories have been liquidated on a large scale, and corporate profits have risen significantly because of increased productivity. As a consequence, external financing needs of businesses have been quite moderate. Before long, however, business long-term investment will strengthen, inventory accumulation will resume, and the rise in corporate profits history is any guide. will slow--if past cyclical Rising business and other private credit demands will then have to compete with the Federal sector for available credit resources. This is a most unhappy situation. The principal concern is not that rising interest rates will abort the recovery, but that tensions in financial markets will pose unnecessary problems for thrift institutions, for nonfinancial businesses heavily laden with debt, and not the least for many developing countries struggling to cope with severe external debt problems. \ -15- There is no satisfactory way for the U.S. to explain away its current fiscal posture. We can hardly expect other countries, particularly developing nations, to put their fiscal houses in order if we are unable or unwilling to do so ourselves. Fiscal imbalance in the U.S. is a dark cloud in an otherwise brightening horizon in the world economy. Recovery is underway and gathering strength. Inflation has come down dramatically and offers promise of further improvement. Interest rates have declined, and they have also become more stable. Severe external debt problems of large developing countries are being dealt with constructively through cooperative effort. We must now consolidate those gains and move on to a still brighter future. //////////////////////////
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