World economy on a knife-edge

As much as has been written about the “Dollar problem”, there still seems to be little understanding about how this issue can be worked out. Now that there is a growing awareness that the current account deficit in the US has become unsustainable, there is nothing more crucial to the markets or the world economy than how this is resolved. Leaving things as they are will only build on existing problems. Something has to change and soon. So it is worth thinking carefully through how this will play out.

As usual the main focus remains on the “dollar block”, the growth engine of the world economy. While this is natural it leaves out a great deal and risks missing the mark.

In the US consumers continue to over spend and in China over investment and over production continues, while the dollar reserves of central banks continue to climb. But all is well, so the world and policy makers have come to believe, just so long as there is economic growth. There seems to be some sort of problem with the current account deficit, so let’s just let the dollar fall gradually and hopefully everything will be alright. Beyond this there does not appear to be a great deal of thought being applied to how this will pan out. More than likely this is simply because it involves action that policy makers do not want to take and still hope will not be necessary. Unfortunately this will leave the world in a remarkably vulnerable state as we’ll explain.

Look at what is now happening outside the “dollar block”. In Japan it now looks like the economy barely missed recession in the last two quarters and has entered Q4 with signs of further weakness. Once again hopes for Japan’s escape from deflation have become no more than wishful thinking. In Europe growth forecasts for 2005 have been falling to below 2% and the unemployment level in Germany has risen to 10.8%, the highest reading since 1998.

In the UK, Australia, and New Zealand we can now find government bonds yielding less than short term interest rates. This is the strongest indicator we have of a weakening economy and potentially a recession ahead.

To make matters worse in the non-dollar block their currencies have been trending higher adding to the pressures on their economies, as the world has come to realize that the long term outlook for the dollar is so troublesome. How can a minor adjustment to the dollar solve the US imbalances if it pushes all non-dollar countries towards recession? If a weaker dollar boosts growth in the “dollar block” at the expense of everyone else how can an increasing growth disparity work to reduce current account imbalances? So many questions remain unanswered, but the idea that dollar devaluation by itself will solve the world’s imbalances is unrealistic at best.

So should we be encouraged by current continued growth in the “dollar block”, or should we be concerned by the emerging weakness elsewhere? Also, is everything really so great in the “dollar block”?

 

Problems in the “dollar block”

One major problem in the “dollar block” is the enormous dollar asset problem. For example, China is still a part of the dollar block but faces a real dilemma, as Brad Setser writes below.

“Not only does China, have a large stock of dollar reserves, but that stock is growing. Yet the value of that stock is also likely to fall in the future. China's over $500 billion in reserves are currently equal to about 1/3 of China's [annual] GDP, so a 33% real appreciation of the Yuan would generate capital losses equal to 10% of China's [annual] GDP. That is a big loss, by any measure. Defending the peg right now requires reserve accumulation of $150 billion a year (in the third quarter, China's reserves increased by almost $45 billion). If that continues, in four years, China's reserves would easily exceed $1.1 trillion. China's GDP is rising too, if the exchange rate stays constant and the IMF's growth path is right, GDP will be at $2.35 trillion in 2008. Reserves would then be equal to about 47% of China’s GDP.

A 33% real appreciation and reserves to GDP of 45% produces a capital loss of 15% of GDP. But that probably underestimates China's future losses, since over time, the scale of the real appreciation China needs also is rising. China's economy is becoming more productive very quickly -- and remember that Japan's economic miracle in the 50s, 60s and 70s was accompanied by substantial real appreciation in yen. A 50% real appreciation produces a capital loss of above 20% of GDP. That is real money, even for fast growing China.

This is why what Larry Summers has called the balance of financial terror  is fundamentally unstable. The "terror" aspect comes from the fact that if China were to start to sell (or just stop buying), the value of its existing holdings would fall rapidly and US interest rates would go up sharply. The balance refers to the fact that to date, China has opted to hold its Treasuries and other dollar assets, not to sell. But for the balance to stay stable, China literally needs to double its bet and double the central bank's expected loss -- over the next four years.”

This means that the current status quo of China’s fixed exchange rate with the dollar is also creating problems for China on the asset side. Furthermore, it is creating competitive and capital formation problems for the US economy, contributing to the ever widening trade deficit as we discussed in Market Notes 40. The status quo is no longer working well for either party.

Policy options

For the time being it is politically unacceptable for anyone to fully face up to the fall out from the US dollar “problem”, but the more we examine the issue the harder it is to see how this will not end up being a major problem for the world economy before too long. A weaker dollar simply passes some of the US’s problem onto other economies, who are already seemingly unable to cope with much further currency appreciation. This means that a great deal of the adjustment will have to come from a higher US savings rate, which is currently close to zero, and reduced US spending.  But then the US economy will struggle to avoid a deep recession.

In order to get a real grasp on this issue and how difficult it will be to resolve I would recommend some excellent research written on this subject in a remarkable article on the sustainability of the US External Imbalances that you can find at www.stern.nyu.edu/globalmacro. If you read this article you will likely conclude that we have now reached the point at which no-one can ignore this issue anymore. It poses an enormous economic challenge for the US, as the only solutions involve a much weaker dollar and/or a radical shift in favor of savings over spending within the US.

It is easier to see what needs to be done than it is to believe that sufficient political will and co-operation exists to bring about the necessary policy changes. But the following additional steps can probably no longer be avoided before too long.

1.     China revalues its currency.

2.     The US tightens it’s private net saving ( i.e. cuts spending and/or increases savings)

3.     The non-dollar block eases monetary policy in order to offset a rising currency and boost domestic spending.

 

All this seems like a tall order at the current time even though there does seem to be some agreement that these measures do provide some kind of road map to better balance in the world economy. How this plays out is anyone’s guess as in each case it involves a significant change in policy. It is easy to pay lip service to policy changes but much harder to follow through, particularly if changes involve the probability of reducing growth and increasing instability. This is the case both in the US and China. No wonder there is some hesitation.

What does this mean for the US?

In recent years policy has been remarkably supportive of economic growth in the US. Whatever problem arose it was immediately fixed. During Greenspan’s stewardship of the Federal Reserve money supply and debt creation have been spectacular, and any economic weakness has been met with aggressive cuts in interest rates. The 2001/2 recession was remarkably mild as it was met with an extraordinarily arsenal of policy measures. Increasingly it has come to seem that in the US there are no lasting economic problems as there are always measures that can be taken to head off any major problems from lasting.

However, by short-circuiting periods of negative growth, this approach has, over time, led to a remarkable dependence on easy credit, rising asset prices and foreign capital. A high debt economy is a highly leveraged economy. If just allowing the dollar to fall will not solve the problem, then the US has to increase its savings from around zero at the current time and decrease spending. Ultimately there has to be an adjustment in favor or savings, investment and production and away from consumption.

 

This is where the rubber meets the road. Policy makers need to introduce these measures now while the economy is still growing. It will be too late if the economy weakens to introduce policies that will further weaken the economy. But these policies would be a complete reversal from the current administrations recent all out “growth” approach, and it may well not seem to be a sufficient priority given the dramatic policy change that would be required and it doesn’t fit well with the current political priority of sustaining tax cuts and growth.

While it is always the easiest political option to choose policies that boost growth there are limits and it seems we have reached them. The marginal benefit from finding a new temporary source of growth, needs to be set against ongoing deterioration in the trade deficit. Also with the election out of the way, this is the best time for bad news.

Everyone needs to play their part to restore balance to the world economy and it would be best if the US could lead the way. But it is hard to see any sign at the current time that this is the case. This means that the US is a hostage to fortune and the next downturn, whenever it occurs, could be severe.  

Market implications

For the time being the dollar devaluation has enabled policy to extend growth, at least in the “dollar block”. In dollar terms this has also supported the US equity markets, although on a currency adjusted basis these returns have been minimal.  This has encouraged a range of upgrades both in forecasts of US economic growth as well as stock market forecasts. Furthermore, there is now an almost universal conviction that inflation is rising, growth is strong and if the dollar is now going to fall precipitously then it is just a matter of time before the bond market collapses into a major bear market

These forecasts and optimistic sentiment on the US equity markets and economy are very understandable from a very short term perspective and from a narrow focus just on the US. However things look very different when viewed from Frankfurt or Tokyo or indeed anywhere else. This may well be a time when it pays to look at the whole world in aggregate before reaching any conclusions.

The fall in the dollar will not be able to go very far without creating recessions widely in the non-dollar block. This means that the hopes for unwinding the world’s imbalances just by devaluing the dollar will soon be disappointed and this will limit the extent of the dollar’s fall. In this case the US will then be forced to increase savings and/or reduce spending as the only means of reducing its imbalances. The world’s engine of growth based on over consumption in the US and over production in China will then almost certainly falter. In this case interest rates around the world will need to fall dramatically in order to handle a severe slowdown in world growth. The consensus may also be too bearish on the US bond market. Bear in mind that the Federal Reserve can provide enormous support to the bond market if necessary, and that restoring balance to the world economy will ultimately require highly restrictive policy measures in the highly leveraged US economy.

 

No-one can know how this will work out, but the world economic outlook is currently on a knife-edge. A more international perspective produces a very different outlook for markets than one focused mainly on the US. The risks to any forecast are currently unusually high.

Conclusion

It is highly unlikely that a dollar devaluation by itself will restore balance to the world economy. Already the extent of such a devaluation is limited by the emerging economic weakness in countries outside the “dollar block”. Furthermore, a downward shift in the dollar increases the growth disparity even further in favor of the “dollar block”, so it is highly unlikely to be very effective in restoring world economic balance, unless the other measures discussed above are also employed.

The dollar devaluation is by far the easiest part of the policy measures needed to restore balance and put the world economy on a more stable path. The other measures involve far more political risk. However, if you study the paper on the sustainability of the US external imbalances on the Stern web site, the longer this problem is left the deeper it gets. Far from going away this problem will just return with a vengeance.

For the time being growth in the US economy is holding up and the dollar devaluation is providing at least a short term boost. But it is dangerous to conclude that therefore all is well. The US has now become a highly leveraged and therefore highly vulnerable economy. Solving the US’s accelerating external imbalances needs a multi-year series of global measures that have barely begun.

It is also dangerous to focus solely on economic developments just in the US.  This has now become a world economic problem which needs a coordinated policy response. Shifting the problem from one country to another without addressing the main problem will only delay a resolution. Ultimately, the longer policy maker’s delay addressing the unwinding of the US’s external imbalances the harder it will become to avoid a deep world recession.

 

 

 

 

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