We Can Do This The Nice Way......Or The Nasty Way
We can do this the nice way ... or the nasty way
Larry Elliott, economics editor
Tuesday September 27, 2005
Two hurricanes in a month, petrol prices at $3 a gallon, a current account deficit of enormous proportions, a housing market that defies gravity: little wonder that the mood in the United States is a little edgy.
The International Monetary Fund made it clear last week that it saw the world's largest economy as an accident waiting to happen. The US could not continue to live beyond its means indefinitely, and there were only two ways to deal with the unsustainable imbalances in the global economy: the nice way or the nasty way.
The nice way, according to simulations by IMF staff, would involve a gradual slowdown in the pace of consumption in the US, accompanied by slightly higher real interest rates and a modest 15% devaluation in the dollar over a few years.
The US current account would decline from 6% of GDP to 3.5% of GDP by 2010 and to 3% over the long run. The other main component of the soft-landing scenario would see a 15% appreciation of currencies in the developing countries of Asia - China, for the most part - which would result in their current account surpluses shrinking to 2% of GDP.
The nasty way involves a much sharper contraction in US activity. Under this scenario, the overseas investors who have been funding the American trade deficit by buying US assets decide they have had enough. The result is a large and sudden devaluation of the dollar, which adds to inflationary pressure and forces the Federal Reserve to raise short-term interest rates aggressively. Protectionist pressures mount and this, together with the big appreciation of China's currency, leads to much slower growth. With both the world's two big growth engines - the US and China - faltering, Europe and Japan also suffer. Financial markets suffer hefty losses, adding to the gloom.
The IMF does not know how this will pan out - nor, to be honest, does anybody else. On the plus side, it points to the fact that the past year has seen some progress on the agenda it has proposed for each key part of the global economy: the US budget deficit has been reduced, the Chinese have taken the first steps towards a more flexible exchange rate regime, the Japanese and the Europeans have committed themselves to structural reforms of their economies. On the negative side, however, there has been no evidence thus far that the moves have been accompanied by an improvement in the global imbalances. On the contrary, they appear to have got worse.
The communique issued by the G7 at the weekend aptly summed up the mood of uncertainty. Although the global economy has continued to expand and the outlook was "positive for further growth", it stressed that higher energy prices, growing global imbalances and rising protectionist pressures "have increased the risks to the outlook".
Oil prices are a real concern, despite relief that Hurricane Rita caused less damage than feared. Prices have now remained higher for longer than policymakers expected, and the futures markets suggest they are going to stay high. Demand is expected to remain strong and it will take years for investment in new fields and refineries to increase supply.
The inflationary impact of dearer energy is already becoming evident, with consumer confidence dented by falling disposable incomes and policymakers fretting about the effects on inflation. Central banks will only take a relaxed view of higher oil prices when they can be really confident that activity will not be impaired. Some analysts believe that it will not be long before the economy is affected. Janet Henry of HSBC said that if petrol prices stayed at pre-hurricane levels, American consumers would spend an extra 1% of disposable income just on fuel in the final quarter of 2005, compared with the fourth quarter of 2004. She said: "The current bout of high oil could finally spell the end of the US consumer-leveraged expansion and a near-term end to the Fed tightening."
It has certainly been the consumer that has kept the US afloat over the past few years. As the IMF put it: "Fiscal and monetary policies in the United States became sharply expansionary - both absolutely and relative to other countries - thus sustaining domestic demand."
America's spending habit has been fed by exports from the rest of the world, with China playing an increasingly important role. The forces of globalisation have given both sides of the transaction what they want: the US has been able to suck in low-cost goods while the developing countries of Asia have been able to enjoy export-led growth. In the process, they have built up a huge stock of US assets, while the US has increased its stock of liabilities.
"Looking forward, the global imbalances are clearly unsustainable in the long term. If the US external current account balance excluding investment income remained at its current level of more than 5% of GDP, there would be an unbounded accumulation of external liabilities," the IMF said. It noted that so far the US had experienced little difficulty in financing imbalances but that there was no guarantee that this benign state of affairs would persist. It is right to be wary. On any reasonable assessment, a central part of any unwinding of the global imbalances will be a considerable devaluation of the dollar, which would leave those holding US assets nursing substantial losses.
To trigger a crisis, holders of US assets don't necessarily need to sell them; all they need to do is to stop buying more. To be sure, the US can be allowed to continue along its current path, with the cooperation of the central banks of China, Japan and other Asian countries, but this would mean an even bigger adjustment in exchange rates when the day of reckoning finally arrived, and an even bigger haircut for those awash with US assets.
Apart from the dire consequences for the global economy that would result from a disorderly unwinding of the imbalances, there are two additional causes for concern. One is that while the IMF has analysed the dilemma with aplomb, neither it nor any other body involved in global economic governance seems to have the clout to do anything about preventing a meltdown. There is a vacuum that needs to be filled and urgently.
The second concern is this: underlying the policy recommendations of just about every global analyst is the belief that the rest of the world needs to emulate the economic model of the US. The calls for structural reform in Japan and Europe stem from the belief that the Americans and the other "Anglo-Saxon" economies have the sort of flexibility that breeds success. Yet that hardly squares with the IMF's notion that the US economy could be going down the pan at any moment. As Mark Weisbrot of the Centre for Economic and Policy Research, a Washington-based thinktank, points out, nor does it square with the long-term needs of sustainability. Europe's energy consumption per head is half that of the US: Weisbrot says the idea that the Europeans should work longer so that they can buy more things is dangerous and he's right.
Perhaps the Germans were a lot smarter than they've been given credit for in their scepticism about the need for neo-liberal structural reform.
Russia left out in the cold
All sorts of rumours were swirling around in Washington at the weekend when it was announced that Gordon Brown was to chair yet another meeting of the G7 in London in December. One theory was that it was to give political impetus to the world trade talks in Hong Kong, which start two days later. Another was that it was a special send-off to Alan Greenspan, who retires from the US Federal Reserve in January. The neatest explanation, however, was that the G7 wanted to shaft Russia.
At the moment, Russia's political clout means it is a member of the G8, which last met at Gleneagles in July, but it is not deemed an important enough economy to join the finance ministers and central bank governors of the US, Britain, Germany, France, Italy, Canada and Japan at G7 meetings.
For the first time next year Russia will hold the presidency of the G8. Since meetings of the G7 are by tradition held in the country that is hosting the G8, the Russians thought this was a chance to get into the rich man's club by the back door. But instead of holding the next meeting in February, the G7 has cunningly brought it forward to December in the UK, making it possible to leave the Russians out in the cold. In reality that's a sensible decision. There is a strong case for membership of the G7 to be expanded, but China and India have a stronger case than Russia.