Fair use...How the US economy runs the world
By Joanne Gray
It makes sense for Americans to be smug about their lot. The economic might of the United States - its abundant jobs, low inflation, high productivity and unstoppable growth - has not only been good for the US, it's also benefited the rest of the world. By buying up exports indiscriminately, the US has powered global growth for the past few years.
Yet if you were to ask a European or even an Australian central banker, they'd say the dark underside of this gilded American age is starting to show. The irrepressible greenback is in danger of suffocating growth in the rest of the world.
To slow the tearaway US economy and keep a lid on emerging wage inflation, the governor of the Federal Reserve, Alan Greenspan, has set about increasing interest rates. The Fed will lift rates again, possibly by as much as half a percentage point next Tuesday - the sixth time since last June. More rises are in the pipeline, making the already magnetic US dollar even more alluring.
Panicked central banks around the world, from Europe to Canada to Australia, have been forced to match some of the Fed's rate rises to stop their currencies from losing further ground against the US dollar. They worry that devaluations will increase import prices and ramp up inflation.
At the same time, the US is growing more dependent on foreign capital to finance its boom in investment and consumer spending, partly because American households, feeling wealthy, aren't saving anything.
Luckily, eager foreign investors are taking up the slack. They can't get enough of the US high-growth, high-tech miracle. The US has been able to run chronic current account deficits - importing more than it exports - because even though sharemarket returns in Europe and Japan last year were greater than those in the US, money is flooding out of Europe and Japan, and into US companies and US dollar securities.
"Why is the US continuing to suck funds in as the rest of the world is recovering?" asks Diane Swonk, president of the National Association of Business Economists. "Even though the expansion has gone on a long time, we still have very high productivity growth and high returns on capital. It's still one of the most efficient economies in the world.
"As long as the US grows faster, invests heavily and produces outsize returns on investment, we're going to continue to suck in these funds."
The US's buy-everything-in-sight consumers certainly have done wonders for European, Japanese, Latin American and Asian exports, and have helped lift those economies out of the doldrums. German exports to the US, for example, are up 40 per cent on a year ago.
But the torrent of investment pouring into US assets has pumped the US dollar so high that it may be starting to suck the oxygen out of other economies.
Europe's new currency - designed to show off European solidarity - is wilting. The euro has plunged 15 per cent in trade-weighted terms this year. Since its birth 16 months ago, it's lost a quarter of its value against the US dollar, falling as low as US88.5½, a level that stunned European officials have described as "ridiculous".
Fearing that further devaluation will create a new round of inflation, the European Central Bank has raised interest rates, even though Europe's economies are only just starting to grow with gusto.
The US, which is approaching its 10th year of expansion, is under immense pressure from Europe's worried economic officials to join forces to prop up the euro.
In 1985, the Group of Seven industrialised countries agreed to work towards a devaluation of the US dollar. Some argue the Plaza Accord set the scene for the US industrial resurgence in the '90s, because it slowed the hollowing out of US industry.
But in the '90s, the US grew leery of attempts to change the direction of currencies through central bank buying and selling. Failure can be expensive. Worse, the G7 could trigger a stampede out of US dollars by buying euros.
The US Treasury Secretary, Larry Summers, "is reluctant to be seen knocking the dollar down when the US has a massive current account deficit", says the global chief economist for Zurich Group, David Hale. "When you are running such a deficit, you don't want people to think that you really want a soft currency."
The US has benefited mightily from the strong dollar policy it adopted when Robert Rubin, the former Goldman Sachs (now Citibank) chairman, took the Treasury's helm in 1985. And the powerful US dollar is still playing into the Fed's hands - keeping inflation in check.
In any case, the US sees the severe currency swings as a European problem and doesn't think the European Central Bank needs a hand just yet.
"There's a perception in Washington that the Europeans have not done a good job in managing their rhetoric," says Hale. The ECB doesn't have a single spokesman and its message is incoherent, reflecting varying economic pressures across the continent. "With so many players speaking in so many languages, it kind of creates confusion."
"I think they seem very conflicted," says Janet Yellen, who until last year was chairman of the US President's Council of Economic Advisers, and before that a governor of the Fed. "I think the ECB are having a really hard time with this. They liked the path they were on for monetary policy [and were] finally getting good growth and recovering. I think they are bothered by a weak euro from a pride and prestige point of view, which is coming into conflict with the economic bottom line."
The Australian dollar, too, has been caught out by the surging greenback, though not because of a confused message from the Reserve Bank. The Australian dollar hasn't appealed to investors because Australia lacks a technology industry, and more recently because of the interest rate gap with the US.
Not that this is attracting a fraction of the attention of the euro-US dollar spat.
Given Australia's robust growth and the imminent imposition of the GST, the Reserve Bank has more reason than Europe to worry about the inflationary impact of a weak currency. To protect against that, it's also had to raise rates.
But what damage are these pre-emptive rate rises - the desire to ensure that the Fed doesn't move too far ahead - doing to economies that aren't growing as fast as the US?
"If world central banks feel they have to match Fed rate hikes ... then you certainly do pose a threat to growth outside the US," says Ed McKelvey, senior economist for Goldman Sachs in New York. The last thing the US Treasury Secretary, a former economics professor, wants to do is widen the growth gap between the US and the rest of the world.
For years, the US has been urging Japan and Europe to take more of the burden of generating growth. It wants structural reform of their economies so that they can lock into the kind of growth rates - at 4 per cent or more - that the US has been enjoying for the past four years.
From the US point of view, the best solution for Europe and Japan is to replicate US economic success and grow faster.
So when finance ministers from the G7 countries met last month in Europe, Summers' message was pretty simple. Let it rip, he urged other G7 officials.
The response of Europe's ministers was indignant. They argued that they were reforming and growing, and pointed to the unbalanced US economy, with its zero personal savings and a swelling current account deficit. It's true that many investors have been perplexed by the euro's weakness.
Officials and experts only recently became convinced that after years of lacklustre performance, Europe was back on track for robust growth, and was preparing to restructure its economy. Japanese insurance companies reportedly bought euros heavily. Currency watchers were gearing up for the coming clash between the dollar and the euro.
Higher interest rates may already be making it more difficult for Europe to remake its economy in the image of the US.
The Economic Cycle Research Institute in New York, which forecasts economic conditions, says that the ECB's moves "will bite on the cyclically sensitive pieces of the European economy - that is, the manufacturing sector".
Economists also acknowledge that high interest rates will make it harder for European companies and industries to restructure. "Our lesson of the '90s going through that kind of rationalisation," says Swonk of NABE, "was that it's actually advantageous to have a very accommodative monetary policy while you are doing it." But if the ECB and other central banks continue to boost interest rates, not to stymie inflation but to protect their currencies, they're making a big mistake, says Yellen, who is now a professor at the University of California, Berkeley.
The ECB, she says, "absolutely does not have to raise rates, and to my mind the declining euro is a stimulus to their growth. And it's going to make their growth more rapid. There's nothing in the whole world that says they have to raise interest rates in line with US rates to defend the currency.
"And if they choose to do that at the expense of their growth, I think that will be a foolish move. "If the response to the declining euro is going to stifle the recovery, that's having a misplaced set of priorities - worrying about your exchange rate ahead of worrying about your economy."
But even without the dampening effect that higher interest rates will have on spending and investment in Europe, the euro's slide may already be igniting inflation.
"In the past couple of weeks, we have started getting the first anecdotal evidence of damage" done by the euro's plunge, says Jim O'Neill, chief currency economist at Goldman Sachs in London. Large US corporations selling into Europe, he says, are already signalling that they'll have to raise prices significantly.
He estimates that a 10 per cent decline in the trade-weighted value of the euro after one year will raise euro zone prices by 1 per cent. "If the euro stays here [around US90½], you are looking at a boost to Euroland inflation of 1 per cent plus."
Without the currency woes, O'Neill argues the ECB wouldn't have to worry much about inflation because there is so much unused capacity among European manufacturers; the European economy could afford to grow at 3 or 4 per cent without setting off inflation.
The ECB is committed to making sure the euro doesn't fall much further. O'Neill foresees a bloodbath if the currency falls through recent lows. "The ECB would have to raise rates by half a per cent to stop it falling. And it is very dangerous to get into that type of cycle."
Summers is desperately hoping it doesn't come to that. He doesn't want to be swept up in a war against the $US1.5 trillion a day currency market in the last months of the Clinton Administration, and during the heat of the election campaign.
History shows that intervention by a single central bank that is not backed by fundamental policy changes can become "a disastrous mess", according to Yellen.
When central banks co-ordinate, intervention seems to be taken more seriously. "But still this is a very dicey affair."
Anyway, US policy makers are convinced that the US dollar is strong because the US is the best place to invest. They hope the coming European tax reform package and the Fed's rate rise to dampen growth will change the market psychology enough to halt the euro's slide.
The US may bend to European pressure to prop up the euro, says Hale, but only "very reluctantly". It will hold out for as long as possible. "If you are going to drive it down, where do you stop?"
As for the Australian dollar, there's no easy solution, and no help in sight from G7 intervention. Rate rises were inevitable because of the introduction of the GST, but "the combination of the currency devaluation and the GST does create more inflation risk than usual", Hale says.
"There's probably no alternative to rate rises, which the Government won't like," he says. "But I don't see any alternatives."
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