Jump-starting the Global Economy Bold Policy Recommendations for the G7 Countries Nariman Behravesh Chief Economist Global Insight October 28, 2002

The Global Economy Today The global economy’s mediocre recovery is running out of steam. The global economy’s mediocre recovery is running out of steam. A “crisis of confidence” and overly restrictive policies have increased the risk of stagnation, and possibly a double-dip, in some G7 economies. A “crisis of confidence” and overly restrictive policies have increased the risk of stagnation, and possibly a double-dip, in some G7 economies. Domestic demand, particularly in Japan and the Eurozone, is extremely weak - North America and non-Japan Asia are the only sources of sustained growth. Domestic demand, particularly in Japan and the Eurozone, is extremely weak - North America and non-Japan Asia are the only sources of sustained growth. Weak growth increases the vulnerability to geopolitical shocks (terrorism, Iraq, North Korea, South Asia). Weak growth increases the vulnerability to geopolitical shocks (terrorism, Iraq, North Korea, South Asia). Bold policy actions are necessary to jump-start the global economy and reduce this vulnerability Bold policy actions are necessary to jump-start the global economy and reduce this vulnerability.

The Case For Action G7 economies account for about 70% of global output G7 economies account for about 70% of global output Recent estimates by Global Insight show that large, coordinated interest rate cuts, plus sizeable fiscal boosts, are enough to increase growth rates in the G7 countries by approximately: Recent estimates by Global Insight show that large, coordinated interest rate cuts, plus sizeable fiscal boosts, are enough to increase growth rates in the G7 countries by approximately: 0.7 percentage points in percentage points in 2004 These actions are not without risk: These actions are not without risk: Bold policy actions are associated with a number of potential costs: higher inflation, higher deficits and a worsening of the housing bubbles in the United States and the United Kingdom. However, the asymmetric nature of the dangers facing the global economy suggests these actions carry smaller, more manageable risks than those associated with doing nothing.However, the asymmetric nature of the dangers facing the global economy suggests these actions carry smaller, more manageable risks than those associated with doing nothing.

Bold Policy Action - United States Impacts + Real GDP growth increases by 0.8 in 2003 and 1.3 percentage points in Inflation is higher by about 0.4 points for two years, compared with the baseline. + The budget deficit, after rising to 3% of GDP in 2003 (following a surplus of 1% in 2001), returns to surplus by The current account deficit is smaller, both in absolute terms and as a share of GDP, compared with the baseline. + The U.S. dollar falls against other major currencies - slightly faster than the baseline. Policy Actions Fed funds rate cut by 75 basis points. Additional fiscal stimulus of approximately $50 billion in 2003 and 2004: Personal and corporate tax cuts Increased grants to state/local governments Risks – – Worsening of housing “bubble” – Slower progress on reducing household and corporate debt levels – Improvement in the current account deficit still too gradual

Bold Policy Action - Canada Impacts + + Real GDP growth increases by 0.3 points in 2003 and 0.1 points in Small impact on inflation and other economic indicators (given both the limited policy action and small boost to an economy).Risks – – Higher inflation, as the output gap closes at a faster rate than the other G7 economies. Policy Actions Overnight interest rate cut by 50 basis points. Investment tax credits provided to multinational corporations.

Bold Policy Action - Japan Impacts = = Growth rates in 2003 and 2004 see little boost since the stimulus is offset by lower consumption (due to higher unemployment). + + However, thanks to aggressive restructuring, growth from 2005 to 2007 is nearly 1.0 point higher. + + The yen depreciates in the near-term, eventually strengthening again. – – The budget deficit soars in the short term, then falls as growth picks up.Risks – – Uncontrollable budget deficit – – Negative effects of restructuring overwhelm any positive impacts Policy Actions Tax cuts of 2.5 trillion yen Supplementary budget of 4 trillion yen Large bank bailout and debt write-offs Bank of Japan accommodating fiscal stimulus (0.8% of GDP) and bank bailout

Bold Policy Action - Europe Policy Actions The European Central Bank slashes its key interest rate by 150 basis points. The Bank of England cuts overnight rates by 100 basis points. More flexible fiscal policies in the Eurozone: Germany, France, and Italy allow their budget deficits to exceed the 3% of GDP. Germany restores 2003 income tax cuts, while accelerating the cuts scheduled for 2005 and eliminating the 2003 corporate tax hike. France slashes income taxes by 30% over the next few years. Italy cuts taxes in 2003, while increasing government spending, especially on infrastructure.

Bold Policy Action - Europe (continued) Impacts + + Boost in growth during 2003 and 2004 for Germany, France, and Italy in the range of 0.8 to 1.4 percentage points. + + U.K. growth rises by a smaller 0.4 points in 2003, and 0.8 points in 2004 (as compared with the baseline), due to lack of additional fiscal stimulus. + + Eurozone inflation rises briefly to nearly 2.5% in 2004, before dropping back down to around 2% in 2005; the inflationary impact is a little larger in the U.K. + + All three Eurozone economies breech the 3% ceiling on their respective deficit-to-GDP ratios; however, each ratio falls to 2% or less by 2005 (thanks to faster growth). + + Gradually, the euro rises against the U.S. dollar – at a slightly faster pace than the baseline.Risks – – Delays in progress on structural reforms – – Entrenchment of higher inflation – – Worsening of U.K. housing bubble

Bold Policy Action - Europe (continued)

Good News for Emerging Markets Asia + + Faster growth, thanks to a strong export pull from the G7 + + Capital spending recovers + + Stock markets and consumer confidence boosted + + Less pressure to provide more fiscal and monetary stimulus Latin America + + Prospects for Argentina and Brazil improve. + + Risks of another financial crisis diminish. + + Capital begins flowing back into the region.

Good News for Emerging Markets (continued) Emerging Europe + + Stronger EU imports boost growth and reduce pressure to boost fiscal policy. + + More capital flows into the region, boosting investment. + + Relaxation of Eurozone fiscal targets facilitates accession of candidate countries. Middle East and Africa + + Strong export growth to the G7 helps region recover more quickly. + + Rising commodity prices improve both trade and fiscal balances.