The drama surrounding the U.S. Federal Reserve Board's open market committee meeting finally ended Wednesday with a quarter point reduction in interest rates but the plot thickens about the future of the U.S. and world economies. Many observers had hoped for more aggressive easing from U.S. monetary authorities and a signal to investors that this could be the final cut for many months to come. With no further rate reductions on the horizon it was believed investors might perceive the riskiness of continued deferral of capital investment and begin to spend more confidently. Instead, the Fed opted for a more moderate path to try to sustain consumer confidence while avoiding the perils of inflationary pressures. The Fed maintains its flexibility to loosen the monetary reins in coming months but many analysts fear this will simply encourage investors and consumers to postpone spending and investment and await lower prices.
The Fed's conundrum is complex. Excess capacity in sectors such as manufacturing, telecommunications and computers precludes a sharp spurt in capital investment. Indeed many economists now subscribe to the Schumpeterian view that long cycles of rapid innovation create excesses and severe corrections if not recessions. This week, the National Bureau of Economic Research hinted that the U.S. economy may have already entered a recessionary phase, but until excess capacity and inventories shrink further there is relatively little the Fed can do to stimulate private investment. This places the burden of economic growth on consumer spending, which accounts for two-thirds of U.S. gross domestic product. The Fed clearly wanted to sustain consumer confidence threatened by repeated layoffs and the prospect of rising unemployment. In light of tax reductions and recent softening in energy prices, the Fed provided as little and as much stimulus as it deemed necessary. Consequently, uncertainty will persist and the situation could deteriorate.
Profits in the first quarter of 2001 were down 12% from their peak and continued excess capacity portends more pressure on margins and profits. Companies are already revising earnings estimates for the second half of this year but many remain optimistic for 2002. Should the economy not show signs of increasing strength during the third-quarter earnings revision early this fall, it could shatter consumer and investor confidence, and prolong the downturn. This risk is heightened by the inability of Japan to fill the gap left by a weak U.S. economy and the unwillingness of the Europeans to envisage reform and provide more stimulus to the global economy. Some have argued that Japan became irrelevant during the past decade when it contributed nothing to world economic dynamism. However, Japan's stagnation was countered by an explosion of growth in the United States and modest improvements in Europe. Today, both continents are in the doldrums.
Macroeconomic weakness also threatens to exacerbate trade tensions, an unfailing recipe for economic disaster. The GE-Honeywell disagreement may have become a symbol of differences between the United States and Europe but discord is much more profound. In Seattle in 1999, the United States and its trading partners failed to agree on a trade agenda for a new round of trade liberalization. Europe favours a broad agenda that would include food safety, environmental standards, foreign investment, competition policy and working rights, but the United States wants a more targeted agenda focused on such issues as greater access for agricultural and industrial goods as well as services.
The feud has intensified in recent weeks as a result of President George W. Bush's actions to limit European steel imports into the United States. For their part, the Europeans scored a preliminary victory within the World Trade Organization when a disputes panel upheld a complaint against the U.S. Foreign Sales Corporation program. This program allows American corporations to shelter income from exports and other foreign sales from tax and confirmation of the initial judgment could allow the EU to impose trade sanctions. Robert Zoellick, the U.S. Trade Representative, called these potential measures a 'nuclear weapon.' The irony is that as the theory of Mutual Assured Destruction becomes less relevant to defence, trade wars may revive the notion. A spat of trade tensions, sanctions, tariffs and other esoteric forms of retaliation would transform a fragile world economic situation into a full-blown and sharp recession.
It is hoped that our respective leaders will show more restraint. This week, one Democratic and seven Republican senators introduced legislation to give President Bush trade promotion authority, formerly known as fast track authority. If adopted this would pave the way for a more fruitful round of talks under the WTO as early as November of this year. The stakes are extremely high and history bears the lessons of trade wars and the Great Depression. We may not be close to such disaster, but there is no need to test the resilience of the world economy any longer.