Economic Trends
Edited by Michael J. Mandel
Has the Fed Saved the Day?
With an anemic economic recovery under way, many economists worry that the Federal Reserve has not done enough to stimulate the economy. The fear is that the U.S. will follow Japan's lead into a long-term deflationary spiral.
The good news is that real interest rates--short-term interest rates minus inflation--have dropped far more rapidly in the U.S. over the last two years than they did in the early 1990s in Japan. Since the U.S. stock market peaked in early 2000, U.S. real rates, which determine the effective cost of borrowing, have come down to almost zero (chart). By comparison, real interest rates in Japan in mid-1992 were barely lower than they were at the beginning of 1990, when the Japanese market started falling.
That makes a big difference. A new study by a team of economists at the Federal Reserve Board suggests that Japan's problems probably could have been avoided through more aggressive interest-rate cuts in the early '90s. Instead, the Bank of Japan waited to cut rates, already at historic lows, betting on a glimmer of recovery that occurred in 1994. By 1995, inflation was already so low that the central bank had lost its chance for further effective monetary policy, the study concludes.
For monetary policy to work, a rate cut has to generate very low short-term real interest rates. "The 1993-94 period may have been particularly crucial for monetary policy [in Japan], since that is the last time...that inflation rates exceeded zero by a reasonable margin," says the study.
It was easy enough for the BOJ to miss the cues back in 1993. It had already cut short-term interest rates, and most forecasters had a much rosier outlook for the Japanese economy than actually came to pass. It wasn't until the second half of the decade that economists around the globe got their projections in line with reality. By then, it was too late. Observes the study: "Deflation can be very difficult to predict in advance."
Still, while the Fed pushed down real rates much faster than the BOJ, Japan's example serves as a cautionary tale for U.S. policymakers, say the authors of the Fed paper. The moral of the story: When interest rates and inflation--which is now at 1.5% in the U.S.--are low, the central bank has to pay more attention to downside risks in the economy than it would normally.
College Grads: Not So Scarce
Economists regularly warned in the 1990s that the U.S. faced a shortage of educated workers. The fears were fed by official projections from the Education Dept. which seemed to show an impending decline in the number of new college graduates. For example, an Education Dept. report released in 1997 projected that the number of new bachelor's degrees granted each year would actually decline for the rest of the 1990s.
But the latest data and projections, released by the Education Dept. on Aug. 23, show that the number of new college graduates continued to increase in the second half of the 1990s. As a result, colleges and universities are churning out far more graduates than anticipated. For example, the latest report estimates that 1.3 million bachelor's degrees will be granted in 2002. That's about 10% higher than what was forecast five years ago. Moreover, the number of new college graduates is now expected to climb for the foreseeable future.
The differential is even bigger at two-year schools, such as community colleges. According to the report, the number of recipients of associate degrees in 2002 is estimated to be about 14% higher than previously forecast.
That implies fears of a shortage of educated workers were overblown. On the downside, however, college grads may face more competition for jobs, especially if slow growth continues.
The EU May Soon Put On Weight
The economic gap between the 15-member European Union and the 10 Central and East European countries that hope to join it in 2004 is narrowing by the day. At a time when the EU is flirting with recession, most of its formerly Communist neighbors to the east have respectable growth rates of between 3.5% (the Czech Republic) and 5% (Latvia). Only Poland, which may grow by only 1% this year, is lagging.
Looking at 16 variables, including productivity, real incomes, and inflation, Deutsche Bank has calculated "convergence indicators" for each candidate country showing the extent to which their economies have closed the gap with the EU average (chart).
Slovenia, the most prosperous country in the region, leads the pack with an indicator of 75%. It boasts a gross domestic product per capita of $17,000, calculated according to purchasing-power parity. That compares with an EU average of $23,000. All of the candidate countries now conduct more than half of their trade with the EU. That's not surprising: EU manufacturers have spent more than $100 billion in the region over the past decade making acquisitions or setting up new plants, and now treat their East European subsidiaries as integral parts of their EU operations.
Given the pace of convergence, it increasingly looks as if the EU will decide to let all 10 countries join at once in a Big Bang expansion. To be sure, Brussels still needs to hammer out some controversial issues, notably the size of the costly agricultural subsidies the new members will be eligible for. The EU also needs to streamline its ponderous decision-making processes. But officials in Brussels are confident most problems can be resolved in time for the Copenhagen summit in December, when they will decide whom to let into their wealthy club.
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Copyright 2002, by The McGraw-Hill Companies Inc. All rights reserved.
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