Roubini and Stetser discuss their reply in Foreign Affairs to Levey and Brown. This is the same issue in which H5N1 is extensively discussed.
Link to FA note and Levey and Brown's reply:
foreignaffairs.org
I read Levey and Brown's reply; much of it was other-worldy to me, particularly the notion that central banks do not care all that much about the value of their reserves, a statement in direct contradiction to the Asian's behavior post-1997, when they got caught with their pants down.
Link to Roubini and Stetser's blog:
roubiniglobal.com
Foreign Affairs has just published an article by Brad Setser and myself where we present a rebuttal of the David Levey and Stuart Brown's article "The Overstretch Myth” where they argued that the US current account deficits should not be a matter of concern.
Since Brad and I have extensively written on this topic (see here and here and here) readers of our blogs are well aware of our arguments on why the US Twin Deficits are unsustainable.
What I want to flesh out a little more here is the geopolitical implications of these twin deficits.
First note that usually throughout history the global geostrategic power is a net creditor country and a net lender (i.e. it runs a current account surplus). Indeed, considering the last hyperpower before the emergence of the U.S., the United Kingdom, the British Empire was a net creditor country that was also a net lender to the world, and especially to its colonies. The British Empire used to run a current account surplus by selling high valued added manufactured goods to the colonies in exchange for cheap raw materials and agricultural commodities. Also, the Empire ownership of a large stock of foreign assets in these colonies and around the world (FDI, land, credit in the form of loans and bonds, and equtiy) implied a steady flow of net factor income payments to the center of the Empire that contributed to the positive current account surplus. Being a net creditor and a net lender also implied that the status of the British Pound Sterling as the main international reserve currency (in addition to Gold) was firmly established for a long time.
It can also be argued that the decline of the U.K as the main global hyperpower and the decline of the British Pound as the main international reserve currency coincided with the large and growing fiscal and current accout deficits of the U.K. during World War II. To finance the war, the U.K was forced to run huge fiscal deficits and huge current account deficits that were in part financed by loans from the U.S., the then rising economic power and net lender and net creditor.
So, the decline of the U.K. as the main global hyperpower (and the decline of the British Pound as the main global reserve currency) and the emergence of the U.S. as the new leading global superpower (with the related emergence of the U.S. dollar as the new main international reserve currency) was associated with the rising British twin deficts that led to a massive increases in the U.K public debt and a steady decline of its net foreign assets.
Then, until the early 1970s, the U.S. as the new global economic superpower ran current account surpluses and modest fiscal deficits while being a net creditor country. The rising economic power and geopolitical prowess of the U.S. was accompanied with the rising role of the U.S. dollar as the main global reserve currency. The U.S. fiscal deficits and current account deficits accelerated in the early 1980s with the Reagan tax cuts that lead to twin deficits. With large external deficits, the net foreign assets of the U.S. shrank and, by the mid 1980s the U.S. became a net debtor country.
But, quite puzzlingly, until recently net factor income payments for the U.S remained positive in spite of the increasing net foreign debt of the U.S.. This paradox was due to the fact that the average return on U.S. assets abroad was greater than the average return on the U.S. foreign liabilities. Some of these lower returns on foreign ownership of U.S. assets were due to the composition of these assets: for a while, and again in recent years, non-residents owned more low-yielding U.S. private and public bonds than stocks and FDI while the U.S. foreign assets were mostly equity portfolio investments and FDI that tend to have higher returns. Non-residents also made some lousy mistakes in their purchases of U.S. assets as when the Japanese in the 1980s bought large amounts of U.S. land and real estate that went bust in the early 1990s with the S&L crisis. Also, in the last four years, most of the capital inflow to finance the U.S current account deficit has not been into equities and FDI but rather into very low-yielding U.S. Treasury bills and bonds. Foreign central banks that are insensitive to return kept on piling up US Treasuries with really low returns. So, even by the end of 2003, when the US net foreign liabiliteis were up to about 25% of GDP, net factor income payments for the U.S remained positive.
So, for a long time the new global empire, the U.S., could afford - given its position as the leading reserve currency - to free ride and earn more on its foreign assets than it paid on its foreign liabilities.
But this imperial advantage is bound to change very soon. The latest figures on the US current account deficit in Q1:2005 are most interesting not because, as some commentators have suggested, the U.S current account is worsening in spite of the 2002-2004 dollar fall. They are not even most interesting in showing a deficit - at $195 b in Q1 - that is trending to be above $800 b this year (as my co-author Brad Setser already predicted this sharp worsening a while ago). They are instead most interesting because the balance of net factor income payments is rapidly shrinking towards zero, and soon negative. While in Q1:2004, net factor income payments were still positive for the U.S to the tune of $30 b, by the first quarter of this year such net positive payments have shrunk to $5 b only, practically close to turning negative later this year. Once net factor income payments turn negative, they will become increasingly large and add to the U.S. current account deficit. In the next three years, these net factor payments on the U.S net foreign debt are likely to become as high as 1% of US GDP and even larger as the stock of U.S. net foreign debt increases over time while the large U.S. current account deficits persist.
Will then the U.S. dollar soon lose its status as the main global reserve currency? Of course not, as these are longer term trends. But as the decline of the British Empire and the decline of the British Pound as the main international currency suggest, a persistent period of budget deficits, current account deficits, public and external debt accumulation and a weakening currency will eventually erode and finally undermine the role of the U.S. dollar. And regarding the risks and consequences of "imperial overstretch" it may be worth re-reading the insightful observations of Niall Ferguson who wrote two books on the British and on the American empires (see here and here and here).
More generally, for how long the U.S. can remain as the only hyperpower when it is the biggest net debtor and the biggest net borrower in the world? At least, in the 1980s our twin deficits were being financed mostly by our allies, Europe and Japan. Instead, it is quite paradoxical that in the last four years the main financer of the U.S twin deficits has become a country, China, that from a geo-strategic point of view is the main long-term rival to the U.S. supremacy as the only global hyperpower. Having as the main financer of your defense build-up and the main financer of your external wars (on terrorism, in Iraq and Afghanistan) your main geo-strategic rival is quite a paradox for the U.S. hyperpower and a medium term threat. While China may not be willing yet to use its role as the main banker for the U.S. twin deficits for geo-strategic purposes, the leverage that this creditor role provides to China is potentially risky.
Also, the Chinese and Asian willingness to keep on financing the U.S. twin deficits will shrink over time - regardless of risks of geo-strategic leverage - as: a) this financing will eventually lead to massive capital losses once these Asian currencies appreciate relative to the U.S. dollar; b) this financing is creating - via partially sterilized forex intervention - excessive liquidity and feeding dangerous asset and investment bubbles in China and throughout Asia. Even traditional allies of the U.S. - such as South Korea - are becoming restless about the idea of keep on accumulating U.S. dollar reserves at such high rates. Also, the Bank of Japan has been out of the forex intervention business for more than two years now, while the ECB is not likely to start piling U.S. dollars any time soon given the recent weakness of the Euro. And other large financers of the U.S defciits are now the OPEC countries that include "U.S. friendly" and "stable" countries such as Russia, Venezuela, Nigeria, Iran, to name a few.
The Panglossian optimists - such as David Levey and Stuart Brown - may believe that there is not much to worry about these twin deficits. And other apologists for the "don't worry, be happy!" school are now pointing to the recent strengthening of the U.S. dollar and recent fall in U.S. long term interest rates as the proof that the twin deficits are sustainable at a cheap cost. But the recent strength of the U.S. dollar will turn out to be a curse rather than a blessing as it will further worsen the U.S. current account deficit at a time when this deficit should start to shrink rathen than increase. Moreover, the low long term interest rates are also a mixed blessing as they pospone the necessary adjustment towards fiscal discipline and they provide fuel to an asset bubble in real estate that has already led to dangerously low levels of U.S. private savings. So, let the Panglossians cheer the strength of the dollar and the low long term interest rates. Both of these asset price developments are feeeding the domestic and international imbalances that risk to lead to an eventual hard landing for the U.S. and the global economy.
And beware dollar and bond bulls: last year the dollar rallied for a good part of 2004 until the evidence that the U.S. current account was worsening and we needed to borrow $2 b plus a day to finance it sank in during the summer and fall. You can expect the same this year: once the realization that the U.S. current account deficit is headed above $800 b (well above the 2004 level of $ 650 b) expect the dollar to start weakening and the bond market rally to reverse itself. And with the Fed headed to raise the Fed Funds rate to at least 4% by year end (see the latest Berry Fed commentary on this), we will see whether 10 year Treasuries can still defy gravity and levitate around 4%. As such a sharp flattening of the yield curve would make only sense if the U.S. economy were to be headed towards a severe economic slowdown and an inflation easing that does not seem to be over the horizon, expect instead long rates to move towards 5% by year end. Then, it will take little to prick the housing bubble where the froth is reaching levels that make even Greenspan and his governors nervous by now.
In conclusion, the rise and decline of the British Empire show the risks of imperial financial overstretch. The U.S. is on a similar slippery path where the growing vulnerabilites are disguised by unsustainable private and public borrowing and bubbly asset prices in bonds, stocks and real estate. Landing back to reality from this increasing froth may end up quite hard and painful. The Emperor has no clothes even if it is still parading around blissfully blind to its own near-nakedness. |
