from Follow the Money

Enjoy the fourth. Take a break.

July 4, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Because I am. I don’t expect to post much -- if at all -- this week.

I need a small vacation.

I am pretty confident that all the "imbalances" that the BIS highlighted will still be here in a week -- and so too will be talk of a global savings glut.

In the interim, do check out the Center for Global Development for insightful commentary on the G-8 summit.

I’ll leave with two thoughts, or perhaps themes.

1. Have the market moves in the first half of 2005 reduced - or increased -- the risk of a hard landing?

My unambiguous answer: the risks have increased.

Why? Because to me a soft landing scenario hinged on the gradual emergence of market pressures that would prompt a gradual adjustment from a real-estate centric economy to an export-based economy. The trade deficit would peak in 2005 on the back of the J-curve -- as higher import prices offset a significant slowdown in import volumes.

That has not happened. The dollar has rallied, at least against the Euro and yen, though not the Brazilian real or Korean won. That takes some of the pressure off Europe to base its growth on domestic demand. It reduces the incentive for investment in US export industries -- and the incentive for European exporters to relocate production to the US as a currency hedge.

As the BIS notes, there is no sign of a surge in investment in new export capacity in the US -- be it manufactured goods or services. There is no shortage of signs, in contrast, of a surge in investment in residential real estate.

Interest rates on ten-year Treasuries hove around 4%. Mortgage rates are still low -- 5.53% for a 30 year fixed rate mortgage, v 6.21% a year ago. Innovative mortgage financing is sweeping America. The housing boom continues.

The longer the current trend continues, the more difficult -- I fear, the transition from a consumption and real estate driven economy to an export based economy will be. By the end of 2005, I suspect that the US trade and transfers deficit will be close to 7% of US GDP. That is a huge sum - particularly for a country with an export base of close to 10% of GDP.

There was an interesting article in the Wall Street Journal last week talking of a shortage of petroleum engineers. For a while there was not much demand for petroleum engineers, and new entrant to the profession dried up. Now, there is a mismatch between the skills the economy needs and the skills that are available.

When the US has to start paying for its imports with exports, I worry that the same will prove to be true -- there will be a gap between the country’s actual capital stock and the capital stock in needs (in simple terms, too many houses), and a gap between the available skills and the skills that are in demand in an export-based economy (too many mortgage brokers ... )

2. Is Andy Xie right: "Manufacturing is inevitably shifting from high-cost plants in the West to Asia" ( for the quote, see Henny Sender’s Ahead of the Tape Column in Friday’s Wall Street Journal; for more of Xie, check out Morgan Stanley’s Global Economic Forum)

My answer? No.

Of course, the shift will continue for some time if China follows Xie’s advice, holds firm to the peg, and adds at least $250 billion to its reserves in 2005 -- and far more in 2006, 2007, 2008. Think of the amount of "vendor financing" that China would need to supply to the US if a large share of the US automobile demand was met by Chinese production? $400 billion a year? $500 billion a year?

Eventually, the increase in reserves would be too much for even China to sterilize, and it would feed into higher inflation in China -- while the shift of production out of the US along with low-cost Asian imports would generate deflationary pressure in the US (and Europe). Real exchange rate adjustment would happen in the hard, old fashioned way -- through falling prices in the high-cost country and rising prices in the low-cost country. But that process would be painful, and might take some time.

My problem with Xie’s argument? Trade is just that, a trade. An exchange of a good for something else, be it another good, a service, an oil company or a Treasury bond.

Right now, the shift in manufacturing production to Asia, by and large, has not been offset by a surge in service exports from the US to Asia. Rather, it is balanced by the sale of IOUs -- debt -- to Asia. The process that Xie describes as inevitable can continue only so long as Asia accepts debt -- promises of future payment -- in lieu of immediate payment for its current production. That cannot continue forever.

No doubt, the US -- and Europe -- will pay for some manufactured goods imports with the export of services. Architects designing towers in Shanghai from New York export a service. Movie tickets sold in China to see an American movie count as a service export.

But even if China clamps down on pirated DVDs and the revenues Hollywood earns in China skyrocket, I personally doubt the US can export enough services to pay for all the goods it would need to buy if Xie is right, and all manufacturing moves to Asia. Among other things, for US movie exports to China to offset manufactured goods imports from China, the movies have to be (mostly) made in the US -- something that is not guaranteed.

Remember, the US imports services too -- including some high-end services. Every Hyundai made in Alabama or a BMW made in South Carolina combines US labor with Korean or German engineering and often Korean or German automobile design. Automobile engineering is a high end service.

So is software design, chip design or aircraft design -- areas where the US may be positioned to do well, so long as China and India and others pay the US for its design skills.

Still, the numbers have to add up.

The US already imports about 16% of GDP, and exports only around 10% of GDP. If Xie is right, imports will rise even higher as a share of US GDP. If Nouriel and I are right, over the next ten years, the US trade and transfers deficit has to head towards zero so that US net external debt stabilizes at 60%, or 70%, or even 80% of US GDP. If imports continue to rise at even a modest pace, US exports more or less double as a share of US GDP. Balance could come if the US exports 20% of GDP, imports 19% of GDP, and provides 1% of GDP to the rest of the world in the form of transfers (foreign aid, remittances).

I do wonder how Xie thinks the US will pay for all the additional Asian manufactured goods he expects the US to import. At some point, it cannot be with more debt. The "flexible" US economy has a demonstrated capacity to shift workers from manufacturing to domestic service industries, but that won’t help the US balance of payments.

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