FROM THE OFFICE OF PUBLIC AFFAIRS

Good afternoon.  I appreciate this opportunity to talk to you about the US and the world economies.

The Outlook for the U.S. Economy

            As Assistant Secretary of the Treasury for Economic Policy, I analyze a wide range of economic data every day.   My staff and I talk to contacts in private industry on a regular basis.  We have developed a ‘real time’ econometric model to help assess the near-term prospects for GDP, final sales, and business investment.  All this work yields a clear conclusion: the US economy continues to grow and we expect the pace of expansion to pick up next year.

The economy grew at a 3.1 percent average annual rate in the first half of 2002, and the consensus among private forecasters is that it will grow at roughly that pace in the second half of the year.  Although real GDP rose at only 1.3 percent annual rate in the second quarter, the rise in exports, the pick-up in equipment investment, and the end the cycle in inventory contraction should contribute to stronger growth in the third quarter.  Also, we do not expect a repeat of the surprising surge in imports which was recorded in the second quarter and which subtracted substantially from growth.  Indeed, prospects for the third quarter growth are favorable.  Based on the evidence now available, many if not most forecasts are pointing to real GDP growth in the 3 to 4 percent annual rate range. 

The economy’s recent durability in the face of significant adverse shocks is derived from its sound and flexible structure as well as timely policy decisions made by the Administration and the Federal Reserve.   Thanks to hard work of President Bush, Secretary O’Neill and Congressional leaders, the tax cuts signed into law in June 2001 were well timed and have boosted household incomes, supporting consumption.   In March of this year, Congress finally passed and the President signed a bill providing companies with tax incentives to undertake investments in equipment.  As many have noted, a pick-up in investment is a key to supporting economic expansion.  The second-quarter increase of 3.3 percent in equipment and software investment suggest that this rebound has indeed begun and that the tax incentives, which boost corporate cash flow, are helping to support recovery.

Of course investment, both business and residential, has benefited from the timely and decisive monetary policy actions of the Federal Reserve, which cut short-term interest rates throughout 2001.  I also note the important, if perhaps under-appreciated stabilizing role that long-term interest rates have played.  Both last fall and this summer, as volatility and uncertainty in the equity markets rose sharply, a portfolio shift to government and agency bonds lowered long-term interest rates to 40-year lows.  This in turn was passed though to the mortgage market, triggering a wave of refinancings that put billions of dollars into the hands of households, significantly cushioning the otherwise dampening effect of the stock market on consumption growth.

Flexibility of our labor markets also contributed to a smaller decline in employment than in most recessions.  While the Administration will not be satisfied until full employment is restored, we are encouraged by signs of improvement.  The number of payroll jobs increased in August for a fourth straight month, and the unemployment rate eased to 5.7 percent from a high of 6.0 percent in April.  More recently, however, there has been an upturn in initial claims and the Conference Board series on consumers’ perceptions of job availability has weakened.  These developments highlight the fact that recovery of labor markets has not yet hit its stride. 

The Administration’s current forecast is for 2.6 percent real growth this year on a year-over-year basis.  That forecast, released in mid-July as part of the Mid-Session Budget Review, was much higher than expected in the February Budget but still below private-sector forecasts.  With the latest Budget Review, however, we found ourselves in the unusual position of both announcing much stronger real growth expectations and a deeper deficit.  The estimate for the Federal deficit for FY-2002 was raised from $106 billion to $165 billion, or 1.6 percent of GDP.  As we discuss in our Mid Session Review released July 15^th,

·                    The reason for the wider deficit is that last year’s recession and stock market weakness took a much heavier toll on Federal revenues than previously thought.  Non-withheld incomes and capital gains realizations were reduced substantially.

·                    The considerable change in circumstances from surpluses previously estimated to deficit is largely the result of the recession.  We estimate that it accounts for two-thirds of the shift.  Another 19 percent reduction was attributable to the vital needs of homeland security and the war effort.  Finally, the tax cuts enacted last year account for only 14 percent of the budget deterioration.  Even without the tax cut, the budget would still have been in deficit.  

U.S. and World Financial Markets

 Of course, the US is part of the global economy and the global capital market.  I would now like to discuss three important global economic issues that I am working on at Treasury.

Current Account

            The U.S. current account deficit reached an annual rate of $520 billion in the second quarter, or 5.0 percent of GDP.  That was above the 4.4 percent of the first quarter and the prior high of 4.5 percent of GDP in the fourth quarter of 2000.  It appears likely that part of the widening in the second quarter may have been related to efforts to bring goods in ahead of the potential West Coast Port dock-workers’ strike in July.  Certainly, the first decline in imports this year in July seems to support that case.  Even aside from quarterly volatility, however, the trade deficit has caused consternation is some quarters.  I believe that many of the concerns about the deficit are misplaced, and I think that we should devote some time to understanding what the US current account deficit actually means.

            As a matter of national income accounting, the US current account is just the difference between national saving and investment and is equal to the net accumulation of US assets (portfolio and direct) by foreign investors.  A deficit is not necessarily bad, nor a surplus good.

In my view, the best way to interpret the present situation is as follows.  The current pool of portfolio capital in the world has fewer places to invest than several years ago.  Many emerging markets have become less attractive, European experts are rightly concerned about long-standing structural problems (high average unemployment, sluggish productivity growth), and Japan is entering its second decade of operation well below its potential.  Not surprisingly in this setting, capital has been flowing into the US.  This process has been reinforced by the stellar productivity numbers in the US even during the recession.  Gains in productivity have confirmed the earlier bet by the markets in the durability of the new economy story for the US.  Even during the second quarter, as the stock market weakened, we did not see the flight from US securities that many anticipated but rather merely a shift from equities into fixed-income securities.

            We in the US government hope that over time imbalances in growth prospects will narrow, not because of any diminution in US fundamentals, but rather because of improvements in the relative performance of the rest of the world.   We would hope that Europe will put in place policies that will raise productivity and reduce unemployment; that Japan will resolve its structural problems and resume growth; and that more emerging market debt will once again become investment grade.  Such a progress in the global economy would be most welcome.  As it occurred, US exports would expand, some of the growing pool of world capital that would otherwise flow to the US would be attracted abroad, and the US current account deficit would naturally narrow.  There is every reason to expect that such adjustments in international capital flows would be accomplished in an orderly fashion.

Sovereign Debt Restructuring

             In April, the G-7 finance ministers met in Washington and found unprecedented unity on the need to develop a predictable process for restructuring sovereign debt. They reached agreement on an Action Plan to guide their efforts toward this goal.  G7 Deputies met Thursday night with representatives from the private sector and officials from emerging market countries.  Under Secretary Taylor reported that agreement was achieved to move forward with a framework for implementing collective action clauses.  While some concerns were raised about pricing effects of including the clauses, we're working through those concerns.

            The G-7 agreed to work together with emerging market countries and their creditors to incorporate new clauses into debt contracts, specifying the actions to be taken in the event a restructuring were necessary.   Such clauses are featured in bonds issued under UK and Canadian law.  The G-7 Finance Ministers agreed this past weekend that any sovereign that issues bonds governed by the jurisdiction of another sovereign should include such clauses.  (The Treasury has no plans or intentions to issue debt under the laws of any other sovereign.)  These clauses would specify a majority action provision for amending the financial terms of the bond, as well an engagement clause specifying how bondholders would be represented in a negotiation with a borrower.  The G7 emphasized that work on this contract-based approach should proceed in parallel with the statutory approach being developed by the IMF.

            It is important that both creditors and debtors themselves be included in the dialogue as we move forward on this approach.  I am pleased to report that this is taking place.  Secretary O’Neill has expressed his goal that emerging countries that borrow in the capital markets be rated investment grade.  By making the sovereign restructuring process more predictable and less uncertain, it is hoped that flows of portfolio capital to credit-worthy countries can be restored.

Strengthening Financial Systems in Emerging Economies

The Treasury has recently outlined an initiative to work with key emerging economies to strengthen their financial sectors, in (important) part by allowing the provision of financial services by foreign owned firms, usually through FDI in the financial services sector itself.  I should note that allowing foreign-owned financial firms to compete on equal terms with domestic-owned firms is distinct from a country’s decision to open its capital account.  It is not US policy to encourage any country to maintain capital controls.  After all, no developed country maintains them.  Nevertheless, it is countries that allow a foreign presence in banking, brokerage, asset management, investment banking, and insurance industries stand to benefit substantially—even those countries that choose to open their capital account at a slower pace. This goal is worthwhile for several reasons: more durable growth prospects as countries move away from an ‘export – led’ model; a more stable global capital market; improved access to international portfolio flows for those countries that desire them; enhanced efficiency as countries benefit from international best practices in the provision of financial services; and an expanded range of financial products that could not otherwise be provided efficiently by domestic firms alone.  The Treasury initiative will support other efforts to make real progress in the ongoing WTO Financial Services talks.

 Conclusion

The broad array of economic indicators that I regularly examine suggests to me that the economic fundamentals are sound, and that they set the stage for a future of economic expansion.