from russell:
The following article appears in the current issue of the Economist, April 27, 2002: Please read it carefully.
The O'Neill doctrine. America's huge external deficit is an accident waiting to happen.
The International Monetary Fund says that America's current-account deficit poses one of the biggest risks to the world economy. Paul O'Neill, America's Treasury secretary, reckons that the Fund's economists do not know what they are talking about. He says the current-account deficit is a "meaningless concept": policymakers should pay no attention to it. Mr. O'Neill's views fly in the face of experience. A deficit that will require America to borrow from abroad almost $2 billion a day by 2003 can hardly be ignored. The consequences for the dollar if foreigners' appetite for American assets ever wanes would give a Treasury secretary who knew what he was talking about sleepless nights.
Mr. O'Neill argues that the deficit merely reflects the fact that foreigners, attracted by superior returns, want to invest in America. The current-account deficit is no more than the accounting counterpart of that net inflow of capital. The deficit is created by the rational saving and investment decisions of private firms and individuals: there is no reason why the government should know any better than they do. This argument will sound familiar to British readers. It was used by Nigel Lawson, then Britain's chancellor of the exchequer, in the late 1980s-just before Britain's economy turned south, taking the "Lawson doctrine" on current-account deficits with it.
Mr. O'Neill is right to think that the big current-account deficits are not necessarily bad, but his argument is flawed in three ways. First, America's current-account deficit is no longer a purely private-sector matter. Tax cuts and increases in defence spending have pushed the budget back into deficit too. Since the current-account balance equals the net saving of the private and public sectors, a budget deficit boosts the external deficit. Second, private sector decisions about saving and investment may sometimes be based on false hopes about profits and stockmarket returns-hard to believe, given Wall Street's fine record these past few years, but true nonetheless. Correcting these errors can then be a very painful business. And third, history suggests that big current-account deficits always collapse in the end. There is a limit to the willingness of investors to hold ever more dollar assets.
If capital inflows were to dry up, the current-account deficit would have to shrink, either through a slump in domestic demand or a fall in the dollar, or both. A study by the Federal Reserve of large current-account deficits in developed economies found that deficits usually began to reverse when they exceeded 5% of GDP. And this adjustment was accompanied by an average fall in the nominal exchange rate of 40%, along with a sharp slowdown in GDP growth.
American is likely to move into this danger-zone by the end of the year. In previous recessions America's deficit has narrowed as domestic demand and imports weakened. But last year America's deficit remained just over 4% of GDP. This year's surge in imports, as consumers continue to spend, will cause the deficit to swell. Morgan Stanley predicts that it could reach almost 6% of GDP by the end of 2003. That would be the biggest deficit run by any G7 economy in the past 30 years.
In recent years large capital inflows have more than covered America's current-account deficit. As a result, the dollar has become overvalued (see page 76). If, make that when, foreigners' desire for dollar assets fades, the dollar may zoom too far in the other direction. Will that also be of no concern to policymakers, Mr. O'Neill?
Russell Opinion -- If I were Bush, I'd get rid of O'Neill as soon as possible, like tomorrow. I don't think our Treasury Secretary has a clue as to what's going on. |
