The Global Test

My harping on the fact that US economic policy now has to pass a global test is not simply meant to score rhetorical points. I suspect that the same folks who financed the expansion of the US current account deficit will end up having to finance a substantial chunk of the ongoing deficits that are associated with a gradual adjustment path.

As one market wag put it:

"Bush’s strong-dollar policy is, in practical terms, to maintain a pool of fools to buy it all the way down," a fund manager was quoted by Bloomberg news agency as saying."

The most likely "fools" are the same set of fools who are financing the United States now: the world’s central banks.

A 5% of GDP current account deficit is an improvement over what we have now, but it is still a big number, and implies lots of external borrowing. The US cannot suddenly go from say $450 billion plus in reserve financing (the actual number in 2003 was $440 billion, this year’s number could well be larger) to a more normal number of $100 billion without experiencing a lot of pain. Our friends in the private markets are not likely to extend new financing to the US as central banks withdraw their financing. They would rather wait until after the dollar has finished falling, and then snap up US assets on the cheap.

It is pretty clear that the central banks who financed the expansion of the US current account deficit recognize that it would neither be good for the US or for the world to put the US on a starvation diet overnight. But our official creditors also have every reason to want to be sure that they are providing interim financing to a country that is taking steps to correct its problems, not providing financing to a country that seems intent on making its short-term problems worse.

Put differently, our major creditors would rather provide $400 billion in financing next year to a country that is putting in place the policies needed to reduce its external deficit from $650 billion plus to $600, or $550 billion, and it taking steps to get its fiscal deficit under sustained control too (the deficit may fall to $350 billion on the back of strong growth and low interest rates next, year, but then it is on track to expand). The two, of course, are related. If the US fiscal deficit is falling on the back of very fast consumer led demand growth, the conditions that drive the fiscal deficit down also will drive the US external deficit up. There is less government dissavings (a smaller fiscal deficit), but also less personal savings.

What our creditors don’t particularly want to do is to provide $400 billion or more of reserve financing to a country whose current account deficit is set to expand, or a country that shows no signs of getting its fiscal deficit under control.

But where is the evidence of fiscal seriousness? Look at the guts of the CBO’s budget forecasts -- they show the budget moving toward balance by 2010, but to do so, discretionary spending has to fall as a share of GDP and taxes have to rise as a share of GDP. Cutting discretionary spending is inconsistent with Bush’s first term record, let alone with the fact that we are at war. I think we are going to spending a lot more on armored humvees and transport trucks, for example. Raising taxes as a share of GDP is inconsistent with Bush’s "mandate" to keep taxes low.

These forecasts were done without adding in the costs of Social security "reform." Partial privatization, as Fed watcher John Berry notes, will perhaps address a relatively small long term problem in the social security system (much depends on the details, some reforms would make the system’s long-term solvency much worse), while making an already large near term problem in the rest of the governments’ finances worse.

In a sense, the best outcome would be for a promise on the part of our official creditors - the world’s central banks - to continue to provide the US with financing while the US takes credible steps to puts its financial house in order. It is no accident that this sounds a bit like an IMF program: when the US and the rest of the G-7 lend to a profligate emerging economy through the IMF, they generally want to make sure that they are financing economic adjustment, not providing financing that allows the country to defer adjustment.

Does this mean that central bank reserve financing will stop if the US does not change its tune - for the moment, the answer looks to be no. There is a growing risk of a run by central banks, started by a few smaller central banks trying to diversify out of the dollar. But for the moment, that risk is offset by accelerating reserve financing from China - and the fact that other countries are very worried about seeing their exchange rates strengthen v. the renminbi in the context of slowing global growth. Look at Korea - now back in the foreign exchange market, buying dollars. Look at the talk coming out of Europe or Japan. The major Latin countries also have been intervening to prevent their currencies from strengthening against the dollar. There is not yet much evidence that non-oil exporting countries are diversifying their reserves out of dollars. The US is so big and so important a market that adjustment in the US, no matter how necessary for the long-term financial health of the globe, will be terribly painful for many outside the US.

What does this mean for 2005?

I think the dominant scenario is one where the Bretton Woods two system of central bank financing continues for a bit longer -- perhaps the entire year -- but with growing unhappiness on the part of America’s creditors. Everyone will be rather nervous, and some will be on a hair trigger. It is always better to be the first one out than the lost one out ...

So look for economic unhappiness directed at the US on top of the lingering political unhappiness in "old Europe." Euroland countries already feel like they are (unfairly) bearing the brunt of dollar adjustment, and that European growth is slowing because of an overvalued euro, not because of the absence of reforms in Europe. I suspect the policy changes needed for Europe to contribute more to global demand may not be the standard set of structural reforms aimed at increasing labor market flexibility. Rather, the biggest boost to demand might come from monetary easing and a package of reforms - more credit cards, extended retail hours, home equity loans to let Europeans borrow against the rising home values, see Friday’s Wall Street Journal - that support a US style consumption binge. The short-term impact of greater labor market flexibility on European demand is not very clear to me: it might lead to more uncertainty, and less consumption. Think fewer Germans taking six weeks vacation abroad, and more unhappy Germans spending the summer at home. Trichet might need to start blowing a few asset price bubbles as part of Europe’s contribution to global rebalancing.

Look for unhappiness in Japan, if Japanese growth stalls out and the yen still seems intent on rising, forcing the Japanese back into the market. $150 billion in reserve financing in 2003 and 2004 won’t be replaced easily, and remember, if the financing is not there, the dollar has to fall - no matter what is happening in other economies.

Above all, look for unhappiness in China. If looks like the pace of Chinese reserve accumulation accelerated from $10 billion a month in the spring to $15 billion a month in the third quarter to $20 billion a month in the fourth quarter. That is, in a sense, the price of being the last economy to adjust v. the dollar, or more precisely, to be the biggest economy to have joined the dollar’s slide v. the world. Even if the pace of China’s reserve accumulation does not accelerate further in 2005, China is on track to provide the US with $240 billion next year - a royal sum, even for China (it is well about 15% of China’s GDP). Roughly $60 billion would be financed by China’s current account surplus, roughly $180 billion would be financed by capital inflows to China. All that has to be sterilized: China’s central bank ends up issuing high interest rate renminbi debt to effectively finance to finance the purchase of low-yielding dollar debt. That is not exactly how it wants to deploy its balance sheet.

China would prefer to keep its current exchange rate, or something close to it - but also accumulate far fewer reserves. Look for more steps to encourage Chinese private capital outflows, as well as efforts to try to staunch speculative inflows. But don’t look for these steps to succeed. Look for a small revaluation at some point - but also look for a revaluation that is too small to make much of a difference. China could well still have an undervalued exchange rate and rapidly growing exports to the US after a 10% renminbi revaluation. Europe is not in the midst of a productivity boom, and its exchange rate has moved by 40% since 2002 ...

All three big players feel that a US that talks the dollar down is not looking after their (economic) interests. All three would rather see fiscal consolidation in the US than an aggressive - and costly - attempt to remake the US tax system and partially privatize social security. All are not likely to appreciate the fact that W is putting a priority on solving a small gap in the social security system (1.5% of GDP, max) after 2042, but not trying seriously to address a bigger immediate hole in the general government’s budget. Social security privatization won’t increase national savings if it is financed by debt; cutting the general government’s deficit would.

At the same time, all three major players also are reluctant to do their own bit to support a new global economy, one less dependent on the US consumption engine. China worries that a renminbi revaluation would choke off its export growth engine, The Europeans remain unwilling to use monetary policy to support growth agressively. The ECB is modeled on the Bundesbank, not the Fed: Trichet is Tietmeyer’s heir, not Greenspan’s. And Japan, well, it’s Japan. It probably should be running a current account surplus and building up external assets that it can draw down on once its population starts to shrink - but it also probably should be financing emerging Asia, not the US (Right now, capital is flowing from old Europe to new Europe, allowing Eastern Europe to run large current account deficits).

The likely outcome - growing unhappiness, growing risks but continued financing for the US at least for a bit longer - sort of what is happening now. China lectures the US. But China’s growing reserves imply it is also still financing the US.

What could cause the system to break? A US that seems oblivious to the global test. A decision from China to take losses now rather than bigger losses in the future, no matter how painful. A US current account deficit that keeps on expanding on the back of consumption growth fueled by low interest rates beyond the amount of financing that is available from China and those countries that feel compelled to match China to keep their own currency from appreciating.

This is no way to run our global economy. I am looking forward to reading Martin Wolf’s suggested way out.