Lawrence Summers Comes Clean On The US Current Account
Hi Russ,
This too would be funny if it weren't so sick!
And I'm long gold shares...
International Perspective
Lawrence Summers Comes Clean On The US Current Account
by Marshall Auerback
November 16, 2004
Suppose they had a bond auction and everybody stayed home? We had a variant on that theme a few months ago. During a routine sale of U.S. Treasury bonds in early September, one of the essential pillars holding up the economy suddenly disappeared. Foreigners, who had hitherto been regularly buying nearly half of all debt issued by the U.S. government stayed home on September 9th.
"Thoughts of panic flickered out there," said Sadakichi Robbins, head of global fixed-income trading at Bank Julius Baer. To be sure, the foreigners returned in force at the next Treasury auction, and Sept. 9 was quickly dismissed as an aberration.
But the episode demonstrated something we have repeated on these pages ad nauseum: the extent to which the US remains dependent on the kindness of strangers in terms of sustaining its very way of life. We have posited the notion that a buyers’ strike, a foreign creditors’ revulsion, could arrive as a sudden thunderclap of financial crisis--spiking interest rates, swooning stock market and crashing home prices, a scenario which will not seem so absurd if we have a few more days like September 9th.
A few wise heads in finance, like billionaire investor Warren Buffett, have sounded the alarm--Buffett refers to the United States as "Squanderville" and has openly acknowledged shifting billions offshore into foreign currencies for safety. But for the most part, political leaders, monetary officials, and leading businessmen and financiers have remained silent on these dangers.
Which is why we found former US Treasury Secretary Lawrence Summers’s recent discussion of the issue so germane. At the 2004 Per Jacobbsson Lecture this past October 3rd, “The US Current Account Deficit and the Global Economy”, Summers addressed the question of global imbalances and the US current account deficit. Liberated from the constraints of active political life, he forthrightly addressed all of the relevant controversies surrounding this area:
“First, is the current US current account deficit a transient that will self-correct without a major discontinuity in the global economy? Second, is the large and growing US current account deficit a sign of economic vitality or an incipient problem? Third, is the current US account deficit and the associated reliance on official intervention from nations dependent on exports to the United States a desirable or sustainable state of affairs? Fourth, what is to be done?”
Amongst Americans, Summers, now President of Harvard, is probably uniquely positioned to comment on the issues raised, given his earlier role in diagnosing the disease of debt trap dynamics in the emerging world when he was chief economist at the World Bank and his later contribution to the very same symptoms in the US through the continued embrace of Robert Rubin’s strong dollar policy when he succeeded the latter as Treasury Secretary in 1998.
As chief economist at the World Bank, Summers built on the analysis of a group of World Bank economists led by Drag Avramovic, who wrote and edited a series of papers in the 1960s entitled "The External Debt of Developing Countries". In the essays, the contributors reached the conclusion that there was a limit to the stable external finances of the emerging economies and identified the limiting factor as "debt trap dynamics" whereby external debt rose inexorably relative to GDP. Their analysis was certainly vindicated in subsequent decades: in the late 1970s and early 1980s, in the wake of petro-dollar recycling, growing and persistent LDC current account deficits became an increasingly prominent feature of the global economic landscape, culminating with the Mexican debt default and the onset of the first of many third world debt crises. Summers himself suggested that a current account deficit equivalent to 5 per cent of GDP was the threshold at which such dynamics generally became operative. Given that the US deficit level now stands at 5.7 per cent, the timing of his remarks appears appropriate, to say the least. But does the analysis apply to a mature, developed economy such as the US? This is something his lecture seeks to address.
Summers begins by noting that the US is importing roughly 16 per cent of its GDP, and is exporting a bit less than 11 per cent. Exports, therefore, are two-thirds of imports, with the following disturbing arithmetic implication:
“If the global economy grows in a completely balanced way, with all imports and exports rising in proportion to the size of the global economy, the US current account deficit deteriorates. Each $1 increase in US exports is associated with an additional $1.50 in US imports. Or to put the point differently, if over a 5-year period, US imports and exports both grow at 6 percent (about in line with historic averages) and the US economy grows at 3 percent, the current account deficit on this account alone will increase by close to 1 percent of GDP.
But of course, as we all know, the reality is far graver. Historically the elasticity of US exports in respect to foreign economic growth is less than the elasticity of US imports in respect to domestic growth (the so-called Houthakker-Magee effect). Although the reasons for this are not fully understood by economists, we think this is largely because US policy makers have hitherto remained captive to the ideology embodied in the so-called “Washington Consensus”: globalisation, trade liberalisation, deregulation in all forms are invariably viewed as unalloyed positives for an economy . These are the sorts of ideologues who have long dismissed worries about deficits in manufactured goods by pointing to the smaller but growing surplus in services. The problem today, however, is that as more service jobs are offshored, even that surplus is shrinking rapidly. The services surplus declined from $90 billion to $60 billion over the past seven years (as of the end of 2003), concomitant with US manufacturing continuing its descent into economic irrelevance as it became increasingly hollowed out by vigorous overseas competition.
Of course, other advanced economies have faced comparable global pressures and engage in the same sort of dispersal when required, but their governments (and societies) do not yield so willingly. Through industrial policy and numerous informal barriers, America's European rivals have managed to avoid both trade deficits and the thirty-year stagnation of wages that US industrial workers have suffered. As a consequence, American economic growth in general sucks in more imports than Euroland’s growth sucks in American exports. Only in America do the experts believe these consequences have no meaning for overall prosperity.
In addition, US economic growth vastly exceeds the economic growth rate of its major trading partners, and this trend, coupled with the Houthakker-Magee effect, jointly create an unbalanced, US-centric growth that significantly exacerbates the ongoing external imbalance now faced by America. As Summers notes, not only does this imply an even more rapidly exploding current account deficit, but it also makes its resolution more problematic. When US tries to improve its trade balance through devaluation or through restrictive demand management, its sheer size affects the economies of its trading partners adversely and to an appreciable degree. Understandably, they object and resist. When foreign economies resist dollar devaluation and the dissipation of their current account surpluses, the risk is that the U.S. may therefore have to raise interest rates in order to induce creditors to continue financing its debt build-up, a highly dangerous policy, given overall debt levels in the domestic economy.
Summers goes on to respond to the common apologists’ view of the US current account: namely, that this deficit is somehow a sign of economic strength, as many, such as Dallas Fed President, Robert McTeer, have suggested: “Perhaps the sharpest formulation that I have heard is: ‘We live in a country that capital is trying to get into. Would you rather live in a country that capital is trying to get out of?’”
That clever formulation, Summers notes, grossly understates the problem. It is necessary to examine the underlying nature of the capital flows flooding into the country. FDI is a very different proposition from speculative capital flows. In an environment of heavily leveraged turbo-charged credit, hot money inflows, however desperate to get into a country today, could become tomorrow’s precipitating conditions for a currency crisis in the event that such capital begins to cut and run en masse a la Korea or Thailand in 1997. Summers argues that
“in looking at a large current account deficit in the classic emerging market context, [it is important to distinguish] whether than investment…is taking place in the traded goods sector, where it is generating the export capacity that can ultimately service debt, or whether investment is being allocated increasingly to the non-traded goods sector. Here, too, the record is clear: an unusual interest rate environment and heavy foreign competition in manufacturing has changed the composition of investments in the United States substantially toward the non-traded goods sector as manifested particularly in the dramatic increases in the price of residential real estate in and around most major American cities.”
Even if Messrs Greenspan and McTeer do not recognise the makings of a real estate bubble, Mr Summers clearly does. What makes the situation worse is that there are no offsetting national savings flows being directed to investment in the traded goods area. Noting that American net investment has declined over the last four or five years, Summers concludes that “all of the deterioration of the current account deficit can be attributed to reduced savings and increased consumption, rather than to increased investment”. In other words, no New Economy miracle, as the hapless Federal Reserve chairman proselytized for years.
The next question is whether such an arrangement of this kind is desirable, if it can be maintained and, if so, sustainable over the medium to longer term:
“For the United States, an arrangement of this kind, even if it could be maintained indefinitely, carries with it two substantial risks. One risk is the incipient protectionist pressures that are generated by a large trade deficit…The second risk of a system of this kind…is a more amorphous one but one that is no less serious…How long should the world’s greatest debtor remain the world’s largest borrower? I have previously used the term ‘balance of financial terror’ to refer to a situation where we rely on the costs of others of not financing our current account deficit as assurance that financing will continue.”
There is no question that protectionism is now on the rise in the US. The outsourcing controversy during the Presidential election campaign was clearly the latest manifestation of this trend. In regard to the latter point, the events of September 9th should put paid to that sort of complacency and illustrate that we may well be closer to the day in which the “balance of financial terror” is replaced by outright capital withdrawal. Although such flows have hitherto provided low cost financing for America at a time when the latter’s national savings are historically low, they have done so at a cost of a loss of domestic monetary control, acknowledges Summers.
Given the loss of control over domestic monetary policy, Summers then poses the question as to what is to be done. He notes the desirability of rebuilding US national savings, but concedes that “a significant increase in US national savings is a necessary but not a sufficient response to the imbalances I have described. It is a necessary response because it is difficult to imagine an adequate rate of US investment or an appropriate rate of interest in the United States with 1.3 percent or anything close to it in net national savings, and the removal of substantial foreign official finance.” And simply choking off US domestic demand in order to reduce the current account is not without substantial costs as well, given that “any attempt to adjust a large part of the US current account deficit by simply slowing down growth in the US economy will involve a slowdown in growth that would be unacceptable in the United States, and would have very severe consequences for growth globally.
Summers therefore advocates the establishment of a G20 Group to deal with these issues. The solutions require a global, rather than a domestic response, one which involves not just the G-7, but a far broader array of nations that include emerging Asia, China, and Japan, given that the “quasi vendor finance” largely behind this funding of the US current account is coming from non-G-7 sources. He also suggests that “an additional concomitant of a healthy strategy must be some adjustment and, I believe, coordinated adjustment of exchange rates that are currently quasi-linked to the dollar” – in other words, a generalised Asian currency revaluation, likely led by China and Japan.
How to “get from here to there” in as economically and politically cost-free a manner as possible? The Bush Administration must continue the delicate balancing act of convincing its major trading partners, especially China and Japan, to stay at the table and keep lending huge sums even as it encourages the dollar's decline in the hope of boosting US exports, discouraging imports from Asia and Europe and thus shrinking America's trade gap (with little success so far). If Asia refuses to concede a currency realignment, then the US may simply force deflation on the euro zone (as it appears to be doing now), given that the latter currency continues to bear the strain of US dollar devaluation. This is already creating manifest strains in Europe. The 12-nation euro zone's finance ministers, the European Commission, and the European Central Bank unanimously agreed at a meeting in Brussels that recent currency moves were unwelcome and could further undermine their stuttering economic recovery.
An Asian currency revaluation, however, is not without its risks, given the precarious state of China’s own financial system. China is now slowing somewhat, with a banking system riddled with bad loans to its domestic enterprises. If a banking crisis developed, Beijing might have no choice but to sell off its US bonds and use the capital at home to stabilize its financial system or to assuage political unrest among its unemployed masses. Similarly, Tokyo has for some years anticipated an eventual American reckoning but hoped to keep the United States from doing anything rash until the Asian sphere was strong enough to prosper on its own, without depending so heavily on American consumers.
Summers does not explicitly concede the point, but implicit within his analysis is that the status quo between Asia and the US will therefore go on UNTIL either Beijing or Tokyo conclude that the pain associated with ending it are outweighed by the costs of continuing it. Unfortunately for the US, creditor nations, such as China or Japan, naturally have the upper hand, like any banker who can call the loan when he sees the borrower is hopelessly mired. Such is the inevitable state of a country now subject to the vagaries of what Summers terms “international vendor financing”, which has steadfastly refused to pull back from profligate consumption and resign its role as "buyer of last resort" for the global economy. With foreign central bankers showing increasing signs of “buyers’ fatigue” in the US Treasury market, the day of reckoning for the US economy approaches ever nearer.
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