Stephen King: If the US can't offer stability, then we're all in trouble
Weak dollar and equities mean the US cannot play the role of consumer of last resort
15 July 2002
news.independent.co.uk
How is the world economy faring? On a superficial level, rather well. A cyclical recovery that has, for the most part, been stronger than expected. A maintenance of low levels of interest rates to ensure that the cyclical recovery doesn't go wrong. Generally speaking, only a limited rise in unemployment relative to earlier economic setbacks. A rate of inflation that remains very well behaved compared with the bad old days of the 1970s and 1980s.
Somehow, though, the sum of the parts seems to be greater than the whole. Despite all these apparently good pieces of news, the overall story doesn't seem to stack up quite so well. One good reason is, of course, the persistent weakness of stock prices, perhaps the defining characteristic of the difficulties that have cropped up in our new, low inflation, world. There are, however, other concerns. Chief among these is the apparent lack of sustainability of the current global picture. More specifically, the US may no longer be in a position to consume or invest the rest of the world's excess savings.
Throughout the last decade, the US current account deficit widened dramatically. There was a partial reversal during the course of 2001 but the old trend appeared to have re-asserted itself in the past few quarters. Admittedly, the US current account deficit has been a hoary old chestnut for a long time, always promising to cause problems but never quite delivering. This time, however, there may be bigger difficulties ahead. And problems for the US current account deficit are likely to mean problems for the rest of the world as well.
The deal through the 1990s was simple. Europe and Japan couldn't deliver decent returns. Europe's problem was a lack of structural microeconomic reform. Japan's problem was a failure to deal with deflation. Either way, with open capital markets, it made sense for European and Japanese investors to pour their money into the US economy. After all, the US had a productivity miracle so surely foreign investors couldn't lose.
Right? No, wrong. As we've seen from recent events, foreign investors have been unable to extract the financial returns that should be their due for having invested in the US New Economy over the past few years. The benefits have instead gone to US consumers or have been siphoned off through the machinations of devious or downright fraudulent company executives who have cooked the books to make US companies look a lot better than they really are.
So, the pact signed by the US and foreign investors which gave rise to the ever-increasing US current account deficit and, with it, a persistent appreciation of the dollar, now looks null and void. Both parties to the agreement now have a potential problem. For foreign investors, the US economy has lost its allure. For the US, a rich seam of cheap capital has come to an abrupt end.
Let's take a few steps back. The US pact with the rest of the world was based on a number of simple "facts". First, the developed world had (and still has) a pension funding problem with lots of people wanting to save for their future. Second, Europe and Japan were unable to deliver the relevant returns to ease this pension problem. Third, the US was happy to step into the breach and use excess savings from elsewhere in the world to deliver financial returns that would ease the pension problem not just for US citizens but for would-be pensioners the world over. In effect, the US was the equivalent on a global scale of your fund manager who promises much better returns in, for example, equities, than can be found in your boring old bank account.
As long as these assumptions held, there was no real problem. But with the collapse in US corporate profitability and with the activities of Messrs Lay, Ebbers and no doubt many others no longer looking quite so clever, the whole story has begun to unravel. The deal between the US and the rest of the world might as well be torn up.
This leaves a number of problems. For the US, the tap that provided a cheap source of capital is being turned off. On the plus side – at least from a US perspective – that means a lower dollar and, hence, an improvement in competitiveness for US exporters. On the minus side, US consumers will suffer as import prices rise but, more importantly, US asset prices – notably equities – will end up a lot lower, reducing the ability of US companies to invest and expand. In effect, the rest of the world will be saying "We entrusted you with our savings and you could not deliver. We now want our money back."
For the rest of the world, however, the end of the deal is also fraught with problems. Suddenly the great investment opportunity that appeared to be a partial way out of pension problems no longer looks so attractive. Put another way, the failure of the US to deliver the required returns for the rest of the world simply removes a "get rich quick" scheme. If, after all the excitement of recent years, the returns that the US can offer are really not much better than those elsewhere, then we're all in trouble.
What needs to be done? From a longer-term perspective, more thought is needed on the implications of a world with lower capital returns and its implications for future pensioners. From a short-term perspective, however, we have a straightforward Keynesian deficient demand problem at the global level. The US had been the consumer of last resort, ensuring that excess savings elsewhere in the world were being spent thus propping up demand for the world as a whole. Now, however, through a combination of either dollar weakness, equity weakness or domestic demand malaise, the US is either unwilling – or, more likely, unable – to carry on playing this role.
The trouble is, nor is anyone else. The second chart shows the path for final domestic demand growth (consumer spending, government spending and capital spending) in the US, the eurozone and Japan in recent years. The US story has deteriorated a long way in recent quarters. Unfortunately, so too have the eurozone and Japanese stories. If we were living in an ideal world, the following events should be triggered. A lower dollar to improve the US current account deficit. A loosening of domestic monetary and fiscal policies in Europe and Japan to offset the effects of a weaker dollar. The eurozone and Japan beginning to become the global consumers of last resort.
Well, you can live in hope. For Japan, this is a very unlikely chain of events, if only because domestic monetary and fiscal support has already failed to stimulate a decent economic recovery. In Europe's case, the European Central Bank still seems to be fighting yesterday's battle against inflation and hence will be in no mood to cut rates. Meanwhile, although individual European governments are increasingly having doubts about the viability of the stability pact, it is difficult to imagine a co-ordinated and aggressive loosening of the fiscal reins.
A failure to co-ordinate policies in this way may, however, be to everyone's disadvantage. An excess of savings over investment will weaken global economic activity, leaving unemployment too high and profits too low. America's promise to the rest of the world may have been broken but it's for everyone now to get on their hands and knees and pick up the pieces.
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Stephen King is managing director of economics at HSBC |
