Global: Another New Paradigm, by Stephen Roach (from HKong)
Nov 7, 2003
Bull markets are very tantalizing and, in the end, quite persuasive. They encourage investors to jump on the momentum train -- lest they be left behind at the station. They also bring out the creativity in strategists, economists, and analysts to explain why the good times will persist. Sometimes that creativity goes to excess. That was the case in the Great Bubble of the Roaring Nineties. And I fear it is the case once again, today.
The current New Paradigm goes something like this: Global imbalances don’t matter. Never mind, America’s unprecedented current account deficit -- let alone massive current-account surpluses in Asia. Pay no heed to the shaky foundations of a saving-short US economy and its runaway federal government budget deficit that lies at the heart of America’s massive external imbalance. Don’t worry about the ever-rising overhang of private sector indebtedness in the US, especially for the household sector. This is what the New World Order is all about. America is supposed to consume beyond its means, as those means are delineated by the economy’s domestic income-generating capacity. Awash in surplus saving, a demand-deficient rest of the world will gladly finance America’s gaping external imbalance -- and will do so willingly and in a relatively costless fashion. The result will be open-ended foreign demand for dollar-denominated assets. US Treasuries -- the most riskless segment of this superior asset class -- will benefit the most. That will keep US interest rates low, providing even more support to American aggregate demand. In a unipolar world, the dollar -- the world’s reserve currency -- can’t fall. After all, what other currency could rise?
Asia is particularly enamored of this New Paradigm. That’s to be expected. After all, Asia has taken the lead in funding America’s gaping external imbalance. China and Japan, alone, accounted for over $150 billion of net purchases of long-term US securities in 2002; in the first half of 2003, their combined demand hit nearly $120 billion -- nearly double the pace in the first half of 2002 and enough to fund nearly 45% of the entire US current-account deficit over that period. The thinking in Asia is that this is a mutually advantageous relationship: China, for example, benefits from selling goods to American consumers, and the US benefits from getting low-cost, high-quality Chinese products that expand private sector purchasing power. China gets paper in response -- and US Treasuries have a natural bid. It’s the ultimate in global virtuous circles.
Nor is this New Paradigm without its own semblance of theoretical rigor. A recent research paper issued by America’s National Bureau of Economic Research lays out the analytics of a sustainable US-centric world (see “An Essay on the Revived Bretton Woods System” by M.P. Dooley, D. Folkerts-Landau, and P. Garber, NBER Working Paper 9971, September 2003). The authors argue that the model the world relied on to finance the post-World War II reconstruction of Japan and Europe is now hard at work in producing the same results in Asia. Undervalued exchange rates -- first in Europe and Japan, and now in Asia -- are thought to drive this next phase of an extended Bretton Woods era, the postwar arrangement of the modern day international financial system. The outcome is portrayed as nothing more than the accumulation of paper assets -- this time in the form of Asian foreign exchange reserves that can then be conveniently recycled back into Treasuries. As was the case in the early years of the post-World War II era, this newfound revival of the Bretton Woods system should simply be viewed as the means by which poor countries on the outside looking in (“the periphery”) reap the benefits of outward-oriented trade and eventually join the family of wealthy industrial countries (“the center”). According to this theory, the imbalances of a US-centric world economy are merely the paper trail of economic development. So why worry?
The ultimate trial of any New Paradigm comes from the unintended consequences that arise along the way. They provide the stress test that any theory must withstand. I firmly believe that such a test is coming for the US economy -- now the world’s debtor of first and last resort. And I also anticipate a challenge to Asian economies that are now accumulating massive reservoirs of official reserves. Such reserves don’t come out of thin air. They are the functional equivalent of excess liquidity creation that has the clear potential to spill over into product or asset markets. That, by the way, is a particularly important distinction between the first phase of the Bretton Woods era and the one we are supposedly in today. Richard Duncan, author of The Dollar Crisis (Wiley , 2002), points out that while total international reserves increased by only 55% over the 1949-69 period, since 1969, the increase has been more than 2000%. In other words, lacking the anchor of a gold-backed currency, today’s post-Bretton Woods system of international finance is far more biased toward excess liquidity creation and a related potential for asset bubbles. Unfortunately, the record speaks for itself -- Japan’s monstrous bubble, a multitude of asset bubbles in pre-crisis Asia, and, more recently, the property bubble in China. I have a hard time calling this the ultimate virtuous circle of a dollar-based world. Nor does there appear to be much virtue in a regime that encourages the United States to embrace a growth strategy characterized by an unprecedented drawdown in net national saving and a concomitant build-up of household sector indebtedness.
But the real problem with New Paradigm thinking always seems to come from the collision with a totally different strain of forces -- the external pressures that crack the self-reinforcing logic of the so-called virtuous circle. Look no further than the equity bubble of the late 1990s. It ended up infecting the real side of the US economy -- severely distorting IT capital spending to the upside and setting the stage for unexpected carnage on the earnings front. Today, in my view, it could well be the global labor arbitrage -- the root cause of a jobless recovery and a mounting political backlash. This tilts the playing field toward trade frictions and protectionism. It also undermines America’s domestic income generation -- having the potential to push the debt-servicing capacity of the overly indebted US consumer into the danger zone. For a US dollar that is valued largely on the basis of the perceived superiority of the American system, the impacts of the global labor arbitrage strike right at the heart of the latest in New Paradigm thinking. It draws the confidence in a faith-based currency into serious question.
Ultimately, the imperatives of global rebalancing could well pose the greatest challenge to those who believe that there’s nothing to fear from today’s unprecedented strain of massive external imbalances. A successful rebalancing must entail a broadening in the global support to domestic demand. But that then changes the terms under which the tradeoff between dollar- and non-dollar-denominated assets is based. To the extent that surplus saving in the non-US portion of the world would then be increasingly diverted into financing improved economic growth in home markets, there will be less left over from that saving pool to fund America’s current account deficit. In such a climate, the United States could well have to pay a higher premium in order to attract increasingly scarce global capital. That spells higher real interest rates in America -- precisely what the Old Paradigm of current account adjustments predicts and yet the very last thing this so-called virtuous circle and a still fragile US and US-centric global economy needs.
At the end of a two-week tour of Asia, I am struck by the region’s newfound confidence and complacency. As was the case when Nasdaq lurched toward 5000, new theories now abound as to why the fundamental rules of economics need to be re-written in order to accommodate a persistent state of global imbalance. I was early in resisting the frenzy back then and could well be in a similar position today. Yet the Old Paradigm tells me that ever-widening disparities between massive current account deficits and surpluses are not a recipe for sustainable global growth. It’s just a matter of when the music stops. Danger is most acute when market excesses give rise to well articulated New Paradigms. We have now entered that phase of this unbalanced world. |
