Global: Torn Fabric, by Stephen Roach (New York)
Nov 21, 2003
In the end, it’s the only solution that macro can really offer: An unbalanced world needs a realignment in relative prices. As the most important relative price in a US-centric global economy, the dollar had to fall. And that’s exactly what has been happening over the past 21 months -- an 11% decline in the “broad” trade-weighted dollar index (in real terms) since February 2002. The risk, in my view, is that there’s a good deal more to come on the downside. It’s not just economics that drives me to that conclusion. It’s also the world’s faith or, in this case, lack of faith in its reserve currency. I fear there is a tear in the fabric of confidence that underpins the special role of the dollar -- a tear that is now getting larger under the stresses and strains of an unbalanced world.
Macro can provide us with a framework that defines the tensions bearing down on currency markets. It doesn’t guarantee the magnitude or the timing of the ultimate adjustment. But it does offer an analytical construct to understand the forces at work. The set-up for the dollar’s depreciation comes straight out of the traditional macro of the current account adjustment. Large and ever-widening current account deficits are not a stable outcome for any economy. It’s only a matter of when, and under what conditions, that a mounting overhang in the quantity of a deficit currency triggers a decline in its price. An oft-cited Federal Reserve study puts the typical current-account breaking point at about 5% of GDP (see Caroline Freund, “Current Account Adjustment in Industrial Countries,” International Finance Discussion Paper No. 692, Federal Reserve Board, December 2000). That’s, of course, precisely the threshold that the US hit in the first half of 2003.
But there’s far more to the US current-account adjustment than a correction in the dollar. As the world’s largest debtor nation, America currently needs about $2 billion of foreign capital per business day to finance ongoing economic activity. There are already warning signs that foreign investors are losing their appetite for dollar-denominated assets. In data just released, overseas portfolio inflows into dollar-based assets totaled only $4.2 billion in September 2003 -- far short of the $64 billion average inflows in the first eight months of the year and the $46 billion monthly bogey required to finance the US current account deficit at its prevailing rate. Moreover, with budget deficits on the rise and little hope of an offsetting surge in private saving, the daily foreign financing requirement could climb to $3 billion by the end of 2004. Such an increase in the offshore dollar overhang only reinforces expectations of a further currency correction. Eventually, there comes a point when foreign investors need to be compensated for taking such currency risk. That compensation invariably shows up in the form of higher real interest rates. That then completes the macro equation of the forces that drive the current-account adjustment. Not only does a cheaper dollar improve the competitiveness of US exporters, but it also triggers an interest rate response that leads to a compression in domestic demand. The resulting shift in the mix of aggregate demand -- more exports and less domestic consumption -- then leads to a narrowing of trade and current account deficits.
The trick, of course, is whether these adjustments occur in a benign or a disorderly fashion. Macro has nothing much to offer on that score. It defines the magnitude of the imbalances but not the means by which they are equilibrated. Magnitude, of course, is hardly a trivial consideration: The larger the imbalance, the greater the potential for a sharp adjustment. In the case of the United States, a current account deficit of 5.1% of GDP in the first half of 2003 breaks all records. In the case of the global economy, America’s external shortfall that hit an annual rate of $555 billion in the first half is also a record. In my view, this is a classic set-up for a big further drop in the dollar-- very much in line with the 20% deprecation in trade-weighted real currencies that can be expected in a standard current account adjustment, according to the Fed study cited above.
Ultimately, the speed of adjustment is where the rubber meets the road for broader financial markets. The soft landing is always the favorite outcome of investors, policy makers, and incumbent politicians. So far, that’s precisely the course a broad index of the dollar has followed over the past 21 months -- a gradual decline of about 0.5% per month in real terms. Fed Chairman Alan Greenspan has just endorsed such a scenario, maintaining “that spreading globalization has fostered a degree of international flexibility that has raised the probability of a benign resolution to the US current account imbalance (see his 20 November 2003 remarks at the 21st Annual Monetary Conference, Co-sponsored by the Cato Institute and The Economist). While central bankers can hardly be expected to sound the alarm, Greenspan has a special knack of being creative in rationalizing financial imbalances. That was certainly the case in his bubble-embracing rhetoric in the early months of 2000. To me, the Fed Chairman’s remarks have an eerie sense of déjà vu. Ultimately, orderly adjustments in currency markets are all about confidence. They presuppose that nothing really undermines the basic trust of today’s generation of foreign investors in dollar-denominated assets. By contrast, the case for a hard landing hinges on the possibility of a confidence shock that draws the character of a faith-based currency into serious question.
Therein lies the biggest risk, in my view. As the tide goes out in this post-bubble climate, one flaw after another keeps being exposed in the American system. The confluence of Wall Street misdeeds, an Enron-led accounting scandal, and the damaged credibility of the New York Stock Exchange points to nothing less than a full-blown crisis of corporate governance. Suddenly, serious questions are being raised about some of the most cherished icons of America’s free-market system -- the system that has long been held up as the model for other nations to emulate. At the same time, as the election cycle heats up, the politics of protectionism have become Washington’s favorite sport. Last year it was steel tariffs. This year, it’s China-bashing -- not just the Bush Administration’s recent imposition of quotas on selected textile products but also the legislation that has been introduced in both houses of Congress that would impose huge tariffs on all Chinese imports into the US. Then there are America’s misadventures in post-war Iraq. And finally there’s the fiscal train wreck in Washington -- strikingly reminiscent of similar blunders that were made some 35 years ago; today, the “guns and butter” of the war on terrorism and tax reform are not unlike Washington’s profligate desire to finance both the War in Vietnam and President Lyndon Johnson’s Great Society programs of the late 1960s.
In the end, currencies are relative prices -- basically an assessment of the intrinsic value of one system versus another. The calculus of relative valuation is hardly science. It has a number of different dimensions -- economic, financial, political, and yes, even ethical and moral considerations. It’s change at the margin that always drives pricing. And the marginal changes that are now occurring in many attributes of the American system have taken a sudden turn for the worse. That tear in the fabric of confidence has occurred in the especially ominous context of a record and ever-widening US current account deficit. Little wonder that financial markets are starting to look right through the transitory benefits of cyclical recovery. There could well be something far more sinister at work. The odds of a hard landing in the dollar are rising, in my view. |
