Published: December 8 2004
The growing external deficits of the world's "sole superpower" have put the global economy on a path that is not merely unsustainable but also dangerously so. This has been the theme of my last two columns. US and Asian policymakers seem determined to take no decisive action in response. This is understandable, but a big mistake.
This year, according to last September's forecasts from the International Monetary Fund, the US deficit should reach $631bn (see chart). It will absorb close to a sixth of the rest of the world's gross savings. The biggest suppliers of funds are Japan ($159bn), "old Europe" (the eurozone, plus Denmark, Norway and Sweden) ($138bn), the Middle East ($104bn) and non-Japan Asia ($154bn).
It is hardly surprising that Japan and continental western Europe run surpluses, since these are rich, ageing societies. Nor are the surpluses of the oil exporters of the Middle East astonishing, given high oil prices. What should be astonishing is the behaviour of non-Japan Asia. This region is the world's most economically dynamic. Its biggest countries are still poor. But, instead of importing capital, it is sending sizeable quantities to the world's richest country.
Apart from bemoaning the perversity of such investment by poor countries in a very rich one, why should one worry? One reason not to do so is that the alternative looks worse. It takes two sides to create huge surpluses and deficits. It is senseless to blame the global pattern of deficits and surpluses on the US alone. A more sensible view is that the US is accommodating the rest of the world's surplus savings. This is the argument put forward last week on this page by Wynne Godley and Alex Izurieta. The sum of the financial deficits in the US public and private sectors must equal its external deficit. If the US tried to reduce the latter through tighter monetary and fiscal policies, it would merely generate a world recession.
Up to the end of 2001, the US was accommodating the behaviour of private investors who pushed the dollar up in their misguided enthusiasm for US assets. Since then, markets have come to their senses. Left to themselves, they would bring adjustment through a sharper decline in the dollar and higher US interest rates. But they have not been left to themselves. Between the end of 2001 and September, foreign governments accumulated $1,400bn in official reserves (see chart). They also financed 43 per cent of the $1,318bn cumulative US current account deficit in 2002, 2003 and the first half of 2004. This, as I remarked last week, has been the biggest aid programme in history.
Yet, however understandable, there are big dangers in present trends, as Nouriel Roubini of the Stern School at New York University and Brad Setser of Oxford University have explained.*
First, since 1991, the share of exports in US GDP has remained static, at close to 10 per cent, while the share of imports has jumped by five percentage points (see chart).
Second, US gross external liabilities are some 11 times export earnings, while net liabilities are about three times exports. The latter figure is similar to those of crisis-hit Latin American economies such as Argentina and Brazil.
Third, the current account deficit could, on present trends, reach 8 per cent of GDP by 2008. At that point, the US could be adding 80 per cent of the total value of its exports of goods and services to its net liabilities each year.
Fourth, the US ability to run a small surplus on net investment income, despite net liabilities of three times GDP, reflects the desperately low returns earned by its foreign creditors: last year the average return on gross assets held by foreigners in the US was only 2½ per cent. Yet the risks, particularly when lending vast sums in the debtor's own currency, increase with exposure. The higher the risk, the higher the return investors need. If interest rates on US gross liabilities were to rise by a mere 2 percentage points, the current account deficit would automatically worsen by 2 percentage points of GDP.
Fifth, internal price changes must, as explained last week, be a part of the overall adjustment. As investors ought to realise, the dollar depreciation needs to be large enough to bring these about. Since the pass-through from the exchange rate to prices is itself low, the dollar will have to fall a long way.
Sixth, the longer the delay, the bigger and more painful the ultimate adjustment must be, since net liability and net income positions will be worse and the required expansion in exports and contraction of imports even bigger. Adjustment will come via a mixture of exchange rate depreciation and measures to reduce spending. The latter will probably come from higher interest rates, rising household bankruptcies and weak investment.
Finally, these threats are not just to the US but also to the world economy as a whole. The immediate danger is growing protectionist pressure in the US. Should the dollar continue to slide against the euro, that pressure will shift across the Atlantic as well. The shock to the creditor countries will also be worse the longer adjustment is postponed. At present, to take just one example, a 40 per cent devaluation of the US dollar against the renminbi would cost the Chinese government up to $200bn, as the domestic currency value of its dollar reserves fell. In a few years' time, that cost might double. Even China's government might be embarrassed by losses on that scale. What is certain is that its reserves already far exceed what is required by the dictates of reasonable prudence.
The challenge to the world is to wean itself off ever-rising US indebtedness sooner rather than later. Yet this is clearly not what the significant policymakers intend. Europeans may well moan. But US policymakers are happy with their aid programme from abroad, while Asian policymakers seem content to subsidise their exports to the US. The result is what Laurence Summers, the former US treasury secretary, has called a "balance of financial terror", with both sides preferring continuation of the status quo to the risks of change. But the behaviour that is creating this balance is unstable, because the predicament is worsening. The world needs a credible plan for escape from its reliance on the US debt trap. That will be the subject of next week's column.
* The US as Net Debtor: The Sustainability of the US External Imbalances, www.stern.nyu.edu/globalmacro