Growing, At Last

By Peter Gumbel

Ah, the sweet smell of economic recovery. Stock markets around the globe are resurgent, corporate spending looks set to rise, and optimists are even talking about a return to the golden years of noninflationary growth in the mid-1990s. But how strong is this upturn, really--and is it sustainable?

That may depend on where you stand. When TIME's Board of Economists met during the World Economic Forum in Davos, Switzerland, late last month, the perspectives varied according to geography. "The U.S. economy is on steroids," said a worried Pascal Blanque, chief economist at the French bank Credit Agricole. Blanque fears an America bulking up on dangerous deficits, a lax monetary policy and the falling dollar. "The European economy is on tranquilizers," retorted Laura D'Andrea Tyson, dean of the London Business School and former chair of the Council of Economic Advisers in the Clinton Administration. She argues that Europe is both too complacent about its weak growth and strong common currency, and too slow to boost its international competitiveness in response to surging U.S. and Chinese productivity.

The face-off between Blanque and Tyson highlights a sharp divergence in risk perceptions at the board session, which also included Moises Naim, formerly Venezuela's Trade and Industry Minister, who is editor of the Washington-based journal Foreign Policy; Fang Xinghai, the deputy chief executive of the Shanghai Stock Exchange; and Slawomir Sikora, president of Poland's Bank Handlowy w Warszawie--now part of Citigroup.

All five economists seemed upbeat about the resumption of growth worldwide and relieved that investment is picking up and confidence appears to be returning to both consumers and business. But while the U.S. focuses on jobs and obsesses about the emergence of China as a low-cost economic colossus, European Union nations have turned inward. They are preoccupied by the addition of 10 new E.U. members this year, by the tussle over a new European Constitution and by the collapse of the Growth and Stability Pact, which imposed rigid discipline--overly rigid, critics say--on governments to curb deficits. Europeans are concerned about the impact of the falling dollar on their exports, but they have yet to take action to stem the tide. "Be patient with Europe," pleaded Blanque. After all, he said, economic-reform efforts in France, Germany and elsewhere are under way, but they will take time to yield tangible results.

Too much time, said Tyson and Naim. "Europe has a tsunami coming its way this year," warned Naim. He predicted that as the weak dollar undermines European companies, European countries will be paralyzed by a clash between businesses urging far greater flexibility and unions and other groups seeking protectionist barriers. "This is the clash we're going to see emerging powerfully in Europe in the next 24 months," Naim said.

For all such sparring, the sentiment this year is far better than it was 12 months ago. Then, as the Iraq war loomed, the board was worried that a "culture of caution" had taken root among consumers and businesses alike. Today world trade is up; oil prices didn't spike, as was feared; mergers and acquisitions are back in fashion; and U.S. consumers, boosted by President Bush's tax cut, are buying the whole world out of the doldrums. Even Japan's economy, mired in recession for much of the past decade, is growing at a healthy pace again. "There's a remarkable degree of consensus" among forecasters for U.S. growth between 3.5% and 4% this year, Tyson said. If they're right, that could be the fastest growth in four years (and a big boost to Bush's reelection prospects).

Not everyone is buying that opinion. "I have some doubts" about those growth predictions, said Blanque. "Recovery is a bet on investment, and investment is running out of steam." He believed the U.S. still suffers from overcapacity--not to mention consumer indebtedness. Tyson agreed that the American consumer's ability to keep on spending will prove decisive.

There are other risks, none greater over the long term than the estimated $521 billion budget deficit. That's the biggest ever in dollar terms and, at about 5% of gross domestic product (GDP), the largest in more than a decade. The U.S. current-account deficit, which measures the combined balances on trade in goods and services, income and currency transfers, is also at a record high: about $550 billion for 2003. Last month the International Monetary Fund warned that these deficits pose "significant risks" for the U.S. and the world economy. Why? Because they are so large, they could inflate interest rates worldwide and potentially destabilize foreign-exchange markets.

The critical issue, Tyson said, is this: At what point does a growing structural federal budget deficit undermine international confidence in the U.S. economy? For the moment, Asian central banks are helping fund the deficit by buying dollars. That's keeping their trade with America on track and U.S. interest rates low, and effectively financing the worldwide expansion. But, Tyson asked, "how long can they keep doing this?" The U.S. Federal Reserve gave a partial answer recently when it abandoned a five-month-old commitment to keeping rates low "for a considerable period"--a statement widely interpreted to mean that rates are headed upward later this year. That's a growth brake.

The primary focus of U.S. attention today is China, whose economy continues to grow apace and attracts huge amounts of foreign direct investment--an eye-popping $53.5 billion last year. For months now, American economists and politicians have been fretting publicly over whether China is overheating, whether it is the next Asian meltdown-in-waiting and how long its currency can remain so blatantly undervalued against the dollar.

Fang was bemused by such talk. A Stanford man who joined the board for the first time this year, he said there is no reason to think that China's economy will soon boil over simply because it's growing at about 8% to 9% a year. Japan, he pointed out, averaged a growth rate of about 10% for 25 years during its big developmental leap starting in the 1950s. China's inflation is relatively low, and a huge surplus of workers in China keeps the labor market humming--and cheap. The starting salary of an average Chinese college graduate today is one-third lower than it was three years ago, Fang said, and 30% or more of graduates can't find jobs despite the 9.1% growth rate. "Wage pressure is nowhere to be seen," he said, and the foreign investment in the Chinese economy may sound huge but still represents only 10% of total investment. That suggests China is less dependent on foreign investment for its growth than other Asian economies have been and thus is less likely to fall victim to the meltdown that hit them in the 1990s, when investment dried up.

Sure, there are signs of overheating in some sectors. The number of cars sold in China doubled last year, to more than 2 million, for example, and the real estate market in some coastal regions is frothy. But the central bank is trying to thwart overspeculation. Fang regrets not buying an apartment in Shanghai when he moved there a year ago; prices have jumped 60% since then. "The room for policy maneuver is very big, and we shouldn't be concerned about overheating," he said.

Should the Chinese currency--now pegged to the U.S. dollar--appreciate against the dollar? China is under growing pressure from the U.S. to adjust the rate or let it float. The argument, made vociferously by the White House, is that the current exchange rate artificially cheapens China's exports, to the detriment of American jobs and the U.S. trade deficit. The trade gap with China is more than $100 billion. Naim called the current rate of $1 to 8.3 yuan "the world's most dangerous number." At issue, he said, is whether it will change in an orderly manner "or suddenly, surprisingly, and unleashing a wave of instability."

Fang had a different perspective. The exchange rate "has served China very well, and we don't want to change voluntarily," he said, although none of the board ruled out the possibility that the country could eventually yield to U.S. pressure. But "it's wrong to focus so much energy on the exchange rate," Fang argued, noting that even a 5% movement wouldn't do much to help plug the U.S. trade deficit. It would be far smarter to address concerns like China's uncompetitive service sector--allowing foreign banks to set up shop, for example. "China can open up a lot more to the outside world. That's a much more constructive way to solve the problem," he said.

The other fearsome exchange rate, of course, is between the euro and the dollar. The euro has taken the brunt of the dollar's depreciation--the greenback has dropped more than 30% against the euro over the past two years. Naim foresees U.S. competitors grabbing European market share "and a wave of European companies investing in the U.S., where they'll find companies 30% cheaper." Blanque calculates that each 5% appreciation of the euro against all currencies translates into a loss of European-GDP growth of 0.5%.

Yet the French economist, like Fang, warned against excessive focus on currency. Governments, particularly in France and Germany, need to continue reforming their economies to boost productivity, reduce the relatively high cost of labor and find better investment uses for a huge pool of savings that is sitting in bank accounts that yield very low returns. France's savings rate is higher even than Japan's. "The strength of the euro highlights European structural problems; it doesn't cause them," Blanque said.

Naim and Tyson quickly took issue with him. "It's amazing how little worried the Europeans are about the euro," Tyson said, pointing to two controversial areas: the European Central Bank's relatively tight monetary policy and the E.U.'s battered Growth and Stability Pact, which long required governments to limit their debt and budget deficits. Exchange rates matter, she contends. The past 10 years were "a lost decade" for Germany because--among other reasons--the former West Germany reunified with the former communist East Germany at an exchange rate that was too high. "How many times do you go through this?" she asked, incredulously.

The sliding dollar is good news for Poland. "We're the only ones not complaining," said Sikora, president of Poland's Bank Handlowy w Warszawie. Reason: Poland's external debt is in dollars, whereas most of its exports are in euros, which means it benefits coming and going. "We dream about this situation," Sikora said. Poland is the biggest of the 10 nations set to join the E.U. later this year, and Sikora is hopeful that accession will boost growth. Poland's lower labor costs give it a competitive edge, and it continues to enjoy some foreign direct investment, although the amount has dropped off in the past few years. A recent McKinsey report suggests that Poland is well placed to create as many as 500,000 jobs over the next five years by becoming a new center for outsourced services for European companies. Already Lufthansa and GE, among others, have moved some back-office operations to Poland.

Still, the transition to E.U. membership could be tough, as Poland has an 18% unemployment rate and an inefficient farming sector. The nation's finances are also deteriorating, with total debt creeping up toward 60% of GDP. Sikora said most Polish economists believe Poland should adopt the euro as soon as possible, perhaps by 2007. But he says that uncertainties about the Growth and Stability Pact may push that date back a couple of years.

There are plenty of uncertainties about economic growth and stability in the U.S. too. But the doubts are more for the long term and linked to the big deficits. For now, at least, the economy is humming again. "The optimism is more real," said Tyson. The question is whether that optimism will be enough to lift everyone else out of the doldrums.