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MIT 14 02 - THE GLOBAL IMPLICATIONS OF THE U.S. FISCAL DEFICIT AND OF CHINA’S GROWTH

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CHAPTER II. THE GLOBAL IMPLICATIONS OF THE U.S. FISCAL DEFICIT AND OF CHINA’S GROWTHHow Will the U.S. Budget Deficit Affect the Rest of the World?China’s Emergence and Its Impact on the Global EconomyAppendix 2.1. Modeling the Impact of China’s Emergence on the Global EconomyReferencesThis chapter consists of two essays: thefirst examines the global implications ofthe U.S. fiscal deficit, while the secondanalyzes the impact on the world econ-omy of China’s emergence.Specifically, the first essay investigates thepotential medium-term impact of the U.S.budget deficit on economic activity in the rest ofthe world, global long-term interest rates, andthe U.S. dollar. The essay finds that the U.S. fis-cal expansion has so far provided important sup-port to the global recovery without apparentadverse effects on long-term interest rates, butthat there are reasons to be concerned that thiscannot last. At some point, as U.S. governmentdebt rises, the beneficial effects will almost cer-tainly be eroded through some combination ofwithdrawal of fiscal stimulus and higher long-term interest rates. The latter concerns areparticularly important for emerging marketeconomies with high levels of foreign currency–denominated debt, as such countries are particu-larly sensitive to higher global real interest rates.The results presented in the essay suggest that,with growth in both the United States and globaleconomies accelerating, a phased withdrawal offiscal stimulus over the next few years, in a man-ner that pays due attention to incentives to workand invest in the United States, would be a sensi-ble and prudent way to balance short- and long-term economic goals.The second essay evaluates the global impactof China’s rapid growth and continuing integra-tion into the world economy. Although China’sexperience so far is broadly in line with previoushistorical episodes of rapid integration, includingthe post–World War II experiences of Japan, theAsian newly industrialized economies (NIEs),and ASEAN-4 countries, in the long run China islikely to play a much larger role in the globaleconomy as its per capita income levels catch upwith other emerging market economies in theregion. While China itself clearly stands to gainthe most from its growth, the impact on the restof the world as a whole will also be beneficial,although likely smaller than the impact of otherprospective global changes, such as multilateraltrade liberalization, over the next decade or two.In particular, advanced economies will benefitfrom cheaper labor-intensive imports and greaterdemand for skill-intensive exports, while develop-ing countries will see increased opportunities forexports to China, both of primary commoditiesand of manufactures for re-processing and re-export. However, countries whose factor endow-ments are similar to China’s, and which competemost closely with it in world markets, will need toundertake sizable adjustments and display flexi-bility in product and labor markets, in order toavoid significant losses. In general, to maximizethe gains from China’s emergence, countries willhave to increase the flexibility of their economiesthrough structural reforms and speed up theirown integration into the global economy. Theadvanced economies could significantly help anycountries affected adversely by removing con-straints on world trade, for instance in agricul-tural products.How Will the U.S. Budget Deficit Affectthe Rest of the World?The main author of this essay is Nicoletta Batini.Ercument Tulun and Sarma Jayanthi providedresearch assistance.Between 1992 and 2000, U.S. real output andaggregate demand grew rapidly, propelling theglobal economy. The favorable cyclical positionand prudent fiscal policies led to a strong fiscaloutlook, while higher productivity growth and arapidly advancing stock market resulted in aninvestment boom and an expansion of the U.S.external deficit. From mid-2000, however, the63CHAPTER IITHE GLOBAL IMPLICATIONS OF THE U.S. FISCALDEFICIT AND OF CHINA’S GROWTHU.S. and global economy weakened significantly,following one of the largest stock marketdeclines in the postwar period, the terroristattacks of September 11, 2001, major corporatefailures, and the war in Iraq. Active fiscal policiesby the federal government to help restart theU.S. economy, together with extraordinary mili-tary and security-related spending linked to thewar on terror, as well as the cyclical move fromhigh to low growth, have resulted in a 7 percent-age point deterioration in the U.S. ratio ofbudget deficit to GDP relative to FY2000—thelargest such deterioration over such a short timespan since World War II and equal to about 6percent of world gross savings. Interest rates,however, have remained low as monetary policyhas been accommodative and global investmenttepid. The U.S. fiscal position is expected toremain in deficit for the next several years.To date both the United States and the rest ofthe world have benefited from the U.S. fiscalstimulus. It has had a positive impact on U.S. out-put and foreign output—as the United States hasincreased imports from the rest of the world—without yet putting significant pressure on long-term interest rates. The U.S. fiscal expansionprovided important support for global demandat a time when monetary policies—particularly inthe United States and Japan—were alreadystretched. In its absence, the global recoverywould most probably not have been as strongand broad as it has been in practice. However,many observers, including IMF staff, haveexpressed concern about the medium-termeffects of the U.S. fiscal expansion, pointing tothe potential implications of sustained and largeU.S. fiscal deficits for global interest rates, pro-ductivity and income—especially as monetarypolicy returns to a more neutral stance andinvestment revives—as well as for the U.S. cur-rent account deficit, which has reached record-high levels, and the value of the U.S. dollar goingforward. This essay discusses these issues byaddressing the following questions.•What will be the medium-term impact of theU.S. budget deficit on economic activity in therest of the world?CHAPTER II THE GLOBAL IMPLICATIONS OF THE U.S. FISCAL DEFICIT AND OF CHINA’S GROWTH642000 02 04 06 08-6-4-20246Figure 2.1. United States: Fiscal Balance(Percent of GDP; fiscal years) Sources: FY2001, FY2003, and FY2005 budgets of the U.S. government.January 2001FY2005 budgetFebruary 2003From an extremely strong position


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MIT 14 02 - THE GLOBAL IMPLICATIONS OF THE U.S. FISCAL DEFICIT AND OF CHINA’S GROWTH

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