The Long View: Bet your bottom dollar
By Philip Coggan, Investment Editor
Published: September 17 2004 17:30 | Last updated: September 17 2004 17:30
news.ft.com
The US current account deficit chalked up another record in the second quarter. Americans bought $166.2bn more of goods and services than they sold overseas, equivalent to 5.7 per cent of US economic output.
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In other words, Americans are dependent on the kindness of strangers. A current account deficit must be matched by a capital account surplus. The US must raise $166.2bn-worth of capital per quarter to balance the books.
Many people think this spells doom in the long run. Last year, I devoted a column to Richard Duncan's book The Dollar Crisis which argued that the eventual result will be a US recession and an international financial crisis. Warren Buffett, the highly successful US investor, has built up a big foreign currency position in anticipation of a sharp fall by the dollar.
But the US has been running big deficits for much of the past 20 years. Crisis has yet to set in. The dollar has lost some ground in recent years, but there has been nothing that could be described as a collapse or a crisis.
There can be little doubt that, had any other country run a prolonged deficit akin to that of the US, it would have faced disaster long ago.
But the US has important advantages. It is the world's largest economy and has the most developed financial markets. This creates natural demand for US assets. Furthermore, the dollar is acceptable as currency in almost any country, particularly in black markets. Its credibility has not been dented by the deficit.
Furthermore, the debts of the US are in its own currency. Think back to the Asian crisis of 1997 and 1998. Back then, many Asian companies had borrowed in dollars, comforted by fixed exchange rates. As their trade deficits deteriorated, Asian authorities then faced a real dilemma. Their currencies were pegged at too high a rate, and a devaluation was needed to boost exports. But a devaluation would boost the value of dollar debts, and prompt a financial crisis.
The US government, corporate and banking sectors do not face the same problem. If the dollar does fall, the bulk of their debts will remain unchanged.
A further benefit for the US is that the dollar is the world's most used reserve currency. Central banks hold large quantities of dollars in their foreign exchange reserves. Indeed, in recent years, Asian central banks have been big buyers as they have attempted to keep their currencies from rising against the dollar. This is part of an informal deal, under which the US buys Asian exports and Asia agrees to fund its deficit.
All of these advantages are well known. But there is another little-remarked factor. Americans appear to be much better investors than anyone else.
There was a $9.6bn decline in investment income during the second quarter, much greater than expected, but that still left the US with a $2.6bn surplus, quite remarkable after all the years of current account deficits.
Professor Tim Congdon of Lombard Street Research has in the past been very gloomy about the implications of the US current account deficit, but has changed his mind. "I have spent 15-20 years talking about the unsustainability of the US current account deficit," he says. "When you make projections, it is natural to assume the same rate of return on US assets as on its liabilities. Thus, as the liabilities grow, you get a deterioration in the investment income account which makes the situation worse."
"But if you look at what has actually happened, the US still has an investment income surplus," adds Prof Congdon. "That raises wider questions." What Prof Congdon thinks has happened is that US companies have moved operations overseas and have indulged in "transfer pricing" to ensure that their subsidiaries in low-tax countries earn high profits. This cuts the value of US exports (as the US parent undercharges its overseas subsidiaries for components), but increases the country's investment income as high overseas profits are remitted. As evidence for this trend, Prof Congdon cites the huge growth of trade within US multinationals.
In contrast, overseas investors have earned a fairly low return on their US assets. One reason is that many of those assets are held in official hands, thanks to those central bank intervention policies. US Treasury bonds or cash deposits have provided returns of only a few per cent a year.
The above factors indicate why the US has been able to "get away with it" for so long. They suggest that any warnings of an imminent dollar collapse should be treated with caution.
But they may still mean that the negative impact of the dollar has been postponed, not cancelled. One issue, highlighted by my colleague Martin Wolf, is that the inflow of capital from abroad has been used to fuel consumption rather than investment. In the long run, this places constraints on the ability of the US to increase its standard of living.
As if to emphasis this problem, the US government has plunged into deficit in recent years. Capital flows into the US are largely being used to fund government spending rather than business opportunities.
Furthermore, any country dependent on foreign capital inflows is vulnerable to a change in sentiment. Asian central banks could decide to diversify their reserves into euros or gold, though there is little sign of it happening as yet. Even central bank support could be overwhelmed if the private sector suddenly became nervous about the dollar's outlook.
The evidence of the latest capital flows numbers from the US is that Asian central banks have cut back on their Treasury bond purchases. But this is probably because the dollar has been fairly steady this year; they have had no need to intervene. As yet, there is no sign that overseas investors are losing confidence.
This does not mean it will not happen eventually. The current account deficit is a ticking time bomb with a very long fuse. It may not blow up for several years, but it could still cause a lot of damage when it does.
philip.coggan@ft.com |
