World Economic Outlook -
September 2004

Other issues of the World Economic Outlook

Research at the IMF

Transcripts of video presentations on the analytical chapters of the September 2004 World Economic Outlook
by Marco Terrones, Dalia Hakura, Xavier Debrun, and Nicoletta Batini,

Washington. D.C., September 15, 2004

Chapter II, Essay 1
The Global House Price Boom
Marco Terrones
Video Presentation

Hello, my name is Marco Terrones.

In the latest edition of the World Economic Outlook there is an essay that examines house price fluctuations in industrial countries, paying particular attention to the current house price boom.

In this short presentation, I would like to discuss the main finding and implication of this essay.

The essay finds that, even though housing is not traded internationally, house prices are highly synchronized across industrial countries.

This finding suggests that, just as the recent upswing in house prices has been a global phenomenon, it is likely that any downturn would also be highly synchronized, with important implications for global economic activity.

Let me start by providing some background.

House prices in industrial countries have increased unusually rapidly in recent years and in some cases -notably Australia, Ireland, Spain, and the United Kingdom-prices, adjusted for inflation, have risen by 50 percent or more since 1997.

According to some observers, these increases are difficult to explain in terms of economic fundamentals alone, including the record low interest rates.

Moreover, this house price boom has been associated with a dynamic housing market and record high levels in some housing indicators and mortgage debt.

This has lead these observers to suggest that a house price correction is imminent, possibly triggered by the tightening of monetary policy as recovery takes hold.

This correction would clearly weaken economic activity in the countries in which it occurred; however as noted elsewhere, an abrupt price correction could have significantly more serious adverse effects.

To put the current house price boom in perspective, this essay studies house price fluctuations in industrial countries during the past three decades.

The main findings are as follows:

* First, House prices in industrial countries are procyclical, generally rising in a boom and falling in a recession.

This feature reflects the strong co movement between these prices and private sector consumption and residential investment.

* Second, Although housing is not traded internationally, house prices across industrial countries are surprisingly highly synchronized.

The average cross-country correlation of house prices is 0.4.

Moreover, house price synchronization has increased during the 1990s.

* Third, The synchronization of house prices reflects the key role played by global factors -primarily through global economic activity and interest rates.

Indeed, global developments explain 40 percent of house price movements.

Across individual countries, however, the effects of global factors on house prices vary significantly and are especially important in the United Kingdom and the United States.

* Fourth, Not surprisingly, in the countries where house prices are less synchronized, country-specific forces affecting housing market developments play a significant role.

This seems particularly true in the cases of Australia, Italy, New Zealand, and Switzerland.

On average, country-specific factors account for half of the fluctuations in house prices.

* Fifth, The current house price boom in several industrial countries seems unusual in both its strength and duration.

The global housing component has been rising at a strong pace for several years and its momentum has continued almost unabated.

* And Lastly, the recent house price boom is unusual as prices have continued to rise, despite the bursting of the IT bubble and subsequent global downturn.

Moreover, there is evidence that in some countries-primarily Australia, Ireland, Spain, and the United Kingdom-the increase in house prices observed during the past seven years cannot be explained by movements in the underlying fundamentals, including the rapid increase in disposable income and low interest rates.

As already noted, an important implication of these findings is that, just as the current upswing in house prices has been a global phenomenon, any downturn is also likely to be highly synchronized across countries, with corresponding implications for the world economy.

One possible factor triggering a house price downturn is the tightening of monetary policy across industrial countries as inflationary pressures emerge.

Simulations suggest that the impact of rising interest rates from mid-2005, in line with futures markets, could be significant but manageable.

However, in those countries where house prices are richly priced (and where household debt has reached unhealthy levels) there is the risk that an increase in interest rates could trigger a sharp house price drop with more severe consequences for economic activity.

In these countries, the best compromise would appear to be "an early but gradual" tightening in monetary policy.

Given the importance of housing in modern societies, policymakers should give increasing attention to further developing mortgage market infrastructure and improve housing statistics.

In particular, policymakers should aim at creating the conditions for the introduction of a richer set of mortgage contracts while strengthening their financial sector regulation.

Policymakers should also improve housing statistics, particularly in the construction of adequate price indexes, that take into account changes in housing quality, and mortgage debt.

That concludes my discussion of the essay; I hope you enjoy reading it.

Chapter II, Essay 2
Learning to Float: The Experience of Emerging Market Countries Since the Early 1990s
Dalia Hakura
Video Presentation

Hello, my name is Dalia Hakura.

I would like to use this opportunity to present the main conclusions of a study I prepared for the latest edition of the World Economic Outlook.

The title of the study is "Learning to Float: The Experience of Emerging Market Countries Since the Early 1990s."

Let me start by providing some background.

Over the past decade, exchange rate flexibility in emerging market countries has increased substantially.

In the early 1990s there were virtually no emerging market countries with freely floating exchange rates.

By contrast, in recent years more than one-third of all emerging market countries allow their exchange rates to be determined by market forces.

For emerging market countries, moving toward more flexible regimes allows the monetary authorities to pursue a more independent monetary policy.

It can also help to mitigate the risk of currency crises that have characterized pegged exchange rate regimes in recent years.

However, and notwithstanding these advantages, policymakers in some emerging market countries have exhibited a fear of floating.

The fear of floating derives from the actual or perceived costs of exchange rate volatility.

For instance, currency fluctuations may cause a ratcheting up of inflation.

They may also adversely affect balance sheets and debt-servicing burdens by raising the domestic currency value of foreign-currency denominated debt.

The main motivation for writing this essay was to examine a recently proposed idea that stronger monetary and financial policy frameworks can facilitate the introduction of greater exchange rate flexibility by directly addressing the key vulnerabilities that give rise to the "fear of floating."

For instance, an independent central bank that has price stability as its main objective can help to reduce the pass-through of exchange rate volatility to higher inflation and hence allay the fears of policymakers that a more flexible exchange rate regime necessarily leads to higher inflation.

Similarly, strong financial sector supervision can help to reduce currency mismatches on banks' balance sheets.

Therefore, the essay examines the association between transitions to greater exchange rate flexibility, macroeconomic outcomes and monetary and financial policy frameworks in emerging market countries.

So what does the essay find? The essay has three main findings:

* First, the countries that voluntarily adopted a more flexible exchange rate regime did not generally experience an increase in macroeconomic instability.

Key indicators such as real GDP growth and the real exchange rate were not affected by the transition.

Inflation performance continued to improve after the transitions and, while exchange rate volatility increased somewhat immediately after the transitions, it soon returned to levels similar to that in the pre-transition period.

* Second, countries typically moved in steps from fixed to floating, and those who did it voluntarily made substantial and measurable efforts to learn to float, or in other words, to strengthen their monetary and financial policy frameworks.

For example, in the period before the transition, countries which voluntarily moved to a more flexible regime had strengthened bank supervision and-in the case of countries moving from an intermediate regime to a free float-had further developed their securities markets compared with countries not making transitions.

The countries which experienced crisis-driven transitions improved bank supervision and, in the case of countries making transitions from an intermediate regime to a free float, further developed their securities markets around the time of transition.

In addition, the emerging market countries that moved to more flexible regimes generally made their central banks more independent and adopted inflation targeting.

* Third, countries did not typically have all policy frameworks in place before moving to a more flexible regime.

For example, many emerging market countries who decided to float introduced an inflation targeting regime only after the transition.

This suggests that while countries feel they need to prepare for floating, some key policy frameworks have been and can be put in place after the transition to a more flexible regime.

That concludes the discussion of my essay.

I hope you enjoy reading it.

Chapter II, Essay 3
Has Fiscal Behavior Changed under the European Economic and Monetary Union?
Xavier Debrun
Video Presentation

Hello, my name is Xavier Debrun and I want to talk to you about the essay I wrote with my colleague Hamid Faruqee for the latest issue of the World Economic Outlook.

The essay is entitled: "Has Fiscal Behavior Changed under the European Economic and Monetary Union (or EMU)?"

The adoption of the euro by 11 member states of the European Union on January 1st 1999 marked an historic milestone on the path of European integration.

In the macroeconomic policy sphere, new institutions have profoundly affected the conduct of monetary and fiscal policies.

The fact that fiscal policy remains the only instrument available for macroeconomic stabilization at the national level led many observers to argue that EMU fiscal authorities would need more leeway, and that the Stability and Growth Pact (SGP) - which imposes numerical ceilings on deficits and public debts -- was therefore unduly constraining.

The stabilizing role of fiscal policy is generally passive - through automatic variations in tax revenues and social outlays, the so-called automatic stabilizers.

Yet, some have argued that participation in a currency union also calls for more activist policies, with governments deliberately stimulating the economy in bad times and cooling it down in good times.

This essay summarizes the current debate and provides new evidence on the behavior of fiscal authorities in EMU Member States.

But do euro area governments really need fiscal policy to stabilize their economy? Perhaps unsurprisingly, we found strong evidence that country-specific stabilization policies remain much needed in the euro area.

Despite convergence in interest rates, and inflation over the last two decades, disparities in business cycles remain important.

In response, market-driven adjustments have been weak.

Why? Because stabilizing changes in competitiveness - that is, higher inflation in fast growing economies and lower inflation elsewhere - have largely been offset by real interest rates û that is, lower real rates in fast growing economies and higher rates elsewhere.

Now, do governments deliberately try to stabilize their economy with fiscal policy?

The answer to that question is generally no.

Over the last three decades, most euro area governments have tended to take fiscal policy measures that exacerbate output fluctuations instead of dampening them; that is, fiscal policies have been procyclical.

This tendency is particularly strong in good times, when revenue windfalls facilitate new discretionary spending and tax reductions not accompanied by commensurate expenditure cuts.

Fiscal laxity in good times often forces painful budget cuts in bad times, when a fiscal expansion would in fact be most welcome.

What is more, as austerity in bad times falls short of laxity in good times, a growing bias towards deficits results, with possibly deleterious effects on long term fiscal solvency.

It should come as no surprise that the countries currently in breach of the deficit caps imposed by the Stability and Growth Pact have exhibited more procyclical fiscal policies than their partners in the euro area.

Procyclicality seems associated with factors that favor greater discretion in the conduct of fiscal policy, including good economic times (and the associated revenue windfalls), strong initial budget positions (who is not tempted to spend a big surplus?), and budgetary institutions conducive to such discretion.

These results suggest that a rules-based fiscal framework might in fact lead to less procyclicality, that is, to more maccro economic stabilization.

Have the rules enshrined in the Maastricht Treaty and the Stability and Growth Pact helped?

Well, since 1992, the area-wide fiscal framework has apparently helped reduce the destabilizing effect of discretionary fiscal policy; but this welcome trend reflected the greater prevalence of contractionary policies in good times during the pre-EMU fiscal adjustment phase and of expansionary policies in bad times over the last three years.

After the irrevocable selection of EMU founding members in 1998, some of them, especially large countries, reverted to destabilizing policies by enacting fiscal stimuli in good times.

This subsequently weakened their ability to further stimulate the economy during the downturn without being at odds with the discipline standards of the SGP.

So, what are the policy implications of this essay?

First, countries currently experiencing structural deficits should take full advantage of the upturn to consolidate their fiscal position.

At a minimum, all revenue windfalls should be allocated to reducing the deficit.

Second, regarding the reform of the SGP, a key priority should be to effectively enforce greater fiscal restraint in good times.

With its focus on overall deficit caps, the SGP is ill-equipped for that task, and greater emphasis on structural fiscal balances seems warranted.

A greater focus on debt sustainability would help European countries better prepare for the fiscal challenge of population aging but also prevent them from falling back into the trap of expansionary fiscal policies in good times.

I hope you will enjoy reading this essay.

Chapter III
How Will Demographic Change Affect the Global Economy?
Nicoletta Batini
Video Presentation

World Economic Outlook, September 2004?Chapter III on Demographic Change

How Will Demographic Change Affect the Global Economy?

Video Notes

[ N i c o l e t t a B a t i n i:

Hello, my name is Nicoletta Batini.

In the latest edition of the World Economic Outlook there is a chapter I prepared together with Tim Callen and Nicola Spatafora that examines "How Will Demographic Change Affect the Global Economy?".

In this short presentation I will summarize the main aspects of the demographic change that is confronting the world and will explain its global and regional economic implications.

I will also discuss what governments can do today and in coming years to avert the negative and maximize the positive consequences of demographic change.

Let me start with some background.

As emphasized by current and projected United Nations data on population growth, the world is undergoing a major demographic transition.

Not only is population growth slowing down, but the age structure of the population is changing, with the share of the young falling and that of the elderly rising.

Different countries and regions, however, are at varying stages of this demographic transition.

In most advanced countries, the aging process is already well under way, and a number of developing countries in east and southeast Asia and central and eastern Europe will also experience significant aging from about 2020.

In other developing countries, however, the demographic transition is less advanced, and working-age populations will increase in the coming decades.

This demographic transition will have wide-ranging economic implications.

Populations aging in industrial countries will indeed strain government finances and reduce growth.

In contrast, as the relative size of their working-age population increases, developing countries will enjoy a "demographic dividend" that should result in stronger growth over the next 20-30 years, before aging then sets in.

Demographic change will also affect saving, investment, and capital flows.

Japan and Europe--the fastest aging countries--could see large declines in saving and a deterioration in their current account positions if the elderly run down their assets in retirement.

What should policymakers do in response to the challenges posed by demographic change?

> In advanced countries, policies will need to focus on minimizing the economic and fiscal impact of population aging.

Steps to boost labor supply, saving and productivity, reduce public debt, and reform pension and health care systems will therefore be crucial.

> In developing countries, the challenge will be to maximize the growth benefits of the "demographic dividend", while preparing for eventual population aging.

This will require sound macroeconomic policies, improved governance, stronger financial institutions, and better education and training to provide the skills necessary for employment.

Pension and healthcare systems will have to be developed to ensure that they provide a safety net for the elderly that is adequate and fiscally sustainable--it will be important that governments learn from advanced countries and do not commit themselves to provide future benefits that will be difficult to finance.

> The movement of goods, capital, and labor between countries will be an integral part of the global adjustment to differing rates of population aging, and increased international cooperation will be needed to manage these flows.

Choices will need to be made about how these channels are allowed to operate, with policymakers having to weigh the economic and social implications of each.

A balanced approach, however, would help reduce the risks that may accompany large capital flows.

Two further key messages emerge from the chapter.

First, reform design will be crucial for ensuring an effective policy response to population aging.

Given the magnitude of the demographic changes facing us, there will be no single magic bullet.

For instance, if we intended to stabilize the labor force to population ratio at current levels by 2050 in a group of developed countries, using only an increase in labor force participation, we would require an average increase of 11 percent.

Using only immigration, immigrants would be more than 30 percent of population by 2050.

Relying only on an increase in retirement age, we would require an average extension of our working lives by more than 7 years.

These not only exceed the limits of what is politically feasible, in some countries they also exceed what is physically possible: in Japan, participation rates would have to be above 100 percent.

But if a multi-faceted approach is adopted, a solution seems well within political reach.

One would only require an increase in participation of 3 3/4 percent, an increase in immigration to 10 percent of population and an increase in retirement age of 2.3 years.

Importantly, since past population projections have consistently underestimated the degree of population aging in advanced countries, reforms will also need to be made as robust as possible to uncertainties about future population aging.

Measures that link increases in the retirement age to gains in life expectancy or that link pension benefits to life expectancy---as in Sweden---would make pension systems more robust to uncertainties about future increases in life expectancy.

Second, while the full impact of demographic change will not be felt in most countries for a number of years, the process of planning a response should not be delayed.

Reforms will involve difficult tradeoffs, take time to agree and implement, and will need to be phased in to allow people time to adjust their behavior.

Pension reforms in advanced countries will also become increasingly difficult to implement as populations age since older people--those over 50 years of age--will soon represent the majority of active voters in many advanced countries, once the differing voter turnout between age groups is accounted for.

Policymakers should therefore take advantage of current strong global growth to advance the reform agenda.

This is the end of my presentation.

I hope you enjoy this chapter.