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etwas frĂĽh, aber nicht leicht verdaulich!
International Perspective, by Marshall Auerback
Bergsten’s Five Horsemen Of The Apocalypse
September 28, 2004
By popular consensus amongst today’s market pundits, there any number of factors, either in isolation or some combination, which could conspire to bring about economic calamity. Few have discussed these problems more succinctly than C. Fred Bergsten, director of the Institute for International Economics in Washington, DC, notes the Mineweb journalist, Barry Sergeant. Sergeant drew our attention to a recent edition of The Economist, in which Bergsten cited five major risks posed to the global economy today: the US fiscal deficit, China, the growing possibility of an oil shock, a growing US current account deficit and, related to this issue, rising trade protectionism.
Sergeant very cleverly likens these conditions to the five horsemen of a possible new economic apocalypse. He notes Bergsten’s observation that the global economy “faces a number of major risks that, especially in combination, could throw it back into rapid inflation, high interest rates, much slower growth or even recession, rising unemployment, currency conflict and protectionism. Even worse contingencies could of course be envisaged,” such as further terrorist attacks or a collapse in US productivity triggered by an oil shock. The good news from Bergsten is that “fortunately, policy initiatives are available that would avoid or minimise the costs of the most evident risks.”
It is hear that we tend to part company with Bergsten. Rarely have so many individual economic conundrums given rise to something approaching macroeconomic policy checkmate. Taken in isolation, there may indeed be available initiatives which could alleviate each individual threat outlined by Bergsten. The difficulty, however, is that the correct policy response to one problem may exacerbate another, leaving global monetary and financial authorities in a position to embrace nothing better than a least bad option. This is hardly a comforting thought given today’s fraught global economic environment.
Onward to the “five horsemen”: Last week we discussed the growing risks posed to global economic growth and geopolitical instability as a consequence of rising oil prices, so we safely can move on the other four.
First, fiscal policy. As a matter of course, it is considered desirable for the US to reduce its large and growing budget deficit. This is clearly not the course of action adopted last week by the US government, during which Senate and House negotiators agreed to a fourth Bush tax cut package, which totaled $146 billion. Congress passed the measure with alacrity. Election politics obviously are trumping fiscal discipline.
The bill extends measures aimed at individuals and to lesser extent corporations. The $1,000 child tax credit was scheduled to revert back to $700 in 2005, but this new bill would extend the $1,000 tax credit until 2010. The 10% income tax bracket would be extended to 2011 and tax breaks for married couples would be extended until 2009. The bill also calls for the increased income exemption from the individual AMT (Alternative Minimum Tax) to be extended another year, thereby limiting the number of people snared by the AMT.
About two dozen corporate tax breaks that either have expired or will expire this year will be renewed, although certain depreciation allowances appear set to lapse. In any case, this partial tax cut lockdown is a political boon to Bush, and demonstrates a very wily and significant pre-debate tactical win for the existing Administration, although it will only place a small dent on the fiscal drag due to accelerate in 2005.
But it does fly in the face of a recent IMF report, which cited US fiscal policy as one of the major potential sources of financial instability going forward. Taken on its own, it probably would be desirable to reduce the country’s deteriorating public finances. But as a function of macro-financial accounting identities, a reduction in government deficits invariably implies a further deterioration in the cash flow of the US private sector. Increased saving on the part of the public sector means dis-saving somewhere else: this could take the form of (or some combination of) further debt accumulation on the part of the household sector (likely generating further dependence on foreign creditors, thereby exacerbating current account deficit pressures) or greater reliance on US corporate investment (difficult at a time when capital investment as a percentage of GDP is still well above historic trend).
To some extent, this is already occurring as of Q2 Fed Flow of Funds data illustrates. The private sector financial balance had already deteriorated some 1.6 percentage points of GDP over the past year, decaying from a peak financial surplus (or net saving position) of 0.6 per cent of nominal GDP in Q3 2003 to a financial deficit (or net borrowing position) of 1 per cent of nominal GDP. This swing in the US private sector financial balance is the result of a minor improvement in the government financial balance, with the fiscal deficit shrinking from 5.1 per cent of GDP to 4.5 per cent, combined with a trade balance that has deepened from 4.5 per cent of GDP to 5.5 per cent over the past four quarters.
But if the fiscal picture continues to improve, by default, either the business sector or the foreign sector must be willing to deepen its deficit spending all things being equal, otherwise incomes will collapse as households cut back on consumption to try to rebuild savings out of income flows. A more stable outcome could develop were the trade deficit to shrink faster than the fiscal deficit in the quarters ahead, the reason being that in the absence of trade improvement, any attempted reduction in the US budget deficit will simply exacerbate the cash flow problems of the private sector. In the latter context, any attempted reduction of the US budget deficit will lower corporate cash flow and likely minimise discretionary consumer expenditures (as any attempt to reduce the budget deficit will probably involve some form of tax increases) and the US will remain ever more dependent on the “kindness of strangers”.
If trade improvement is a policy goal, then the role of China, the so-called third horsemen of the apocalypse, is key. While the U.S. currency has declined against the euro and the yen, it has not fallen against the currency of the nation that accounts for the largest—and most rapidly growing—segment of its trade deficit, China. Since 1994, China has effectively linked its currency, the Yuan, to the dollar. The government essentially guarantees that it will buy the local currency for dollars within a fairly narrow band.
President George Bush is now being urged by Bergsten and others to embrace an explicit policy of dollar devaluation to rebalance the global economy. Bergsten himself contends that “an immediate resumption of the gradual decline of the dollar, as in the period 2002-03, cumulating in a fall of at least another 20 percent, is needed to reduce the deficits to sustainable levels.” He argues that this action would provide the optimal policy response to deal with America’s growing current account deficit.
But if China chooses to keep the Yuan tightly aligned with the dollar, China will continue to perpetuate the cost advantage it has over the United States as a manufacturing centre, and effectively minimise the effectiveness of such action. When the dollar weakens against the euro and the yen, the Yuan weakens by roughly the same proportion. As a result, U.S. consumers will not find Chinese-produced goods to be any more expensive today than they were a year ago. Perhaps more significantly, a U.S.-produced dishwasher will not seem any cheaper to European or Japanese buyers than similar products made in China.
In theory, dollar depreciation should improve the U.S. trade deficit, although with a lag, since a falling dollar exchange rate means higher dollar prices for imports. This initially deepens the trade deficit, until domestic consumers, wholesalers, and producers react to higher import prices by either curtailing their purchases of imported products or switching their expenditures to domestically produced substitutes. If foreign producers lower their prices in their home currencies to offset the currency effect to the final purchaser of their products (as China effectively is doing by virtue of pegging the Yuan against the greenback), then there is no effect.
China could, in theory, accommodate the US by revaluing its currency, but, as we have noted previously, this cuts against the existing thrust of Chinese monetary policy. Just last week, a Finance Ministry official who declined to be said China was unlikely to announce any policy changes at the G7 meeting, which starts on Friday. China has repeatedly said it will loosen currency controls only gradually, and that it must first make progress in cleaning up its banking sector, turn around ailing state-run companies, and create tens of millions of new jobs.
To the extent that Beijing has moved toward reining in speculative domestic excesses, it has attempted to achieve this largely through a combination of moral suasion, administrative fiat and (in a more limited form) interest rate hikes. The jury is still out on whether the dreaded hard landing be avoided, but it appears that Beijing has made a conscious effort to address the country’s current boom excesses exclusively through domestic adjustments, such as in the credit area, rather than through the expedient of a revaluation of the renminbi. To curb export growth whilst attempting to rein in domestic capital expenditure and a corresponding real estate boom likely constitutes a bridge too far for the country’s financial and monetary authorities.
On the other hand, were China to embrace the panacea of cutting the link to the US dollar, it is possible that the cure could be worse than the disease. At a time when the authorities are already moving to choke off domestic demand, anything that would suppress export gains in an economy already struggling to engineer a soft landing (and with a widely acknowledged bank loan problem) would be very dangerous for Beijing and have unhealthy knock-on effects for Washington. If the Chinese were to sever their links with the US dollar, this would likely constitute an enormous vote of no-confidence in the dollar as a major reserve currency on the part of the world’s largest savings bloc.
Which invariably leads to growing trade protectionist pressures, the fourth horse of the apocalypse. Protectionism, to the extent it succeeds in reducing the imbalances in US trade, also reduces the increase in dollar savings held in the hands of foreigners. Assuming no change in their portfolio preferences away from US assets (a not entirely realistic assumption, as there may well be some form of retaliation which reduces the proclivity to hold dollars), there is in fact less foreign savings available then for them to disperse additional external financing requirements at the margin.
Today, there is no longer any attempt to deny the reality of America’s haemorrhaging current account deficit, but the efforts to diminish its significance have grown almost proportionately to the size of the deficit itself. To his credit, Bergsten does not fall into this camp. He argues that among the five biggest risks to the world economy “the most alarming new prospect is another sharp deterioration in America’s current-account deficit”, and claims it is “virtually inconceivable” that the markets will permit the deficit to simply keep growing, something echoed in these pages many times in the past.
So far, the long awaited “foreign creditors’ revulsion” has not occurred, buttressing the arguments of those pundits in the so-called “denial camp”. According to this school of thought, deficits “don’t matter” since they merely reflect what a great investment environment the US continues to be for the rest of the world (the Bob McTeer rationale). Common sense (granted, a commodity not found in abundance within the economics profession) tells us otherwise. Unless the historic meaning of debt has been repealed, it is hard to understand how any nation can borrow endlessly from others without sooner or later forfeiting control of its destiny, and also losing the economic foundations of its general prosperity, as any Mexican, Russian or Argentinean can tell you.
A more sophisticated “spin” takes the following form: American multinationals are major actors in generating America's trade deficits, since they"export" and"import" within the firms themselves--shipping components and materials back and forth between their overseas subsidiaries and US-based plants. Trade is commonly described as between nations, but fully half of US foreign trade, excluding oil, is composed of these intra-firm transactions. Therefore, the deficit is overstated and really “doesn’t matter”.
Leaving aside the questionable presupposition that American multinationals invariably serve American domestic political interests, the very structure of this trade creates additional problems for the US. When an American company moves production to Mexico or China, it still counts the output as its own, but its labour costs are reduced drastically while its foreign-manufactured products becomes imports, adding to the trade deficit and accumulating foreign debt. For years, apologists of the growing US trade deficit have sought to dismiss worries about deficits in manufactured goods by pointing to the smaller but growing surplus in services. As more service jobs move offshore, however, that surplus is shrinking rapidly too, declining from $90 billion to $60 billion over the past seven years, leading to a corresponding further deterioration in the current account deficit.
Whether through “industrial policy” or informal trade barriers, European policy makers have been less inclined to accommodate this hollowing process (the very speed at which this has occurred in America is invariably celebrated as a sign of the country’s great “economic flexibility”). “Offshoring”, job losses, and wage deterioration are becoming increasingly important themes in the American Presidential election and a resort to temporary general tariffs is now increasingly being mooted at the margin as one way out, albeit one which would likely be highly disruptive to the capital flows on which the US now so precariously depends.
If one considers the macro scenarios with a financial balance orientation, it is hard to retain Bergsten’s confidence that anything like the requisite policy measures can be put in place to minimise his five current risks posed to the global economy. The embrace of a solution to one invariably seems to exacerbate the problems of another. No wonder our political leaders remain conspicuously silent on these issues. There are really no easy answers with which one can comfort the electorate. The image of the five economic horsemen of the apocalypse seems sadly apposite: the only plausible conclusion one can draw that a global income contraction will come about unless and until households give up their desire to return to a net saving position (because lower incomes force them to draw down existing savings or borrow more credit to meet expenditures that are perceived to be nondiscretionary), or governments resist a temptation to get their fiscal houses in order, or the rest of the world resists the temptation to stop propping up American consumers to buy yet more things that they don’t really need or can ill-afford. Putting it in these terms in effect reveals the futility of what is on offer: to achieve a less than catastrophic outcome imminently, current policy remains wedded to a horrible status quo - the economic equivalent of sweeping more and more dirt under the rug (and hoping nobody will notice), against a backdrop of rising energy prices and growing geopolitical instability. This in reality means no genuine solution at all. It’s a polite way of saying that policy checkmate is upon us.
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