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Deficits are the Achilles heel that may fell the US
March 14, 2004
By The Independent
Almost two decades ago the US racked up a current account deficit of more than 3 percent for two years in a row. To get its external position back to balance, the US endured a 50 percent slump in the dollar and three years of fiscal tightening, but the transition was relatively painless.
A few years later the UK found itself with a 5 percent deficit as the economy boomed and house prices surged. The UK reverted to balance only thanks to massive interest rate rises, a deep recession and the eventual humiliating exit from the European exchange rate mechanism.
Fast forward to this year and the US is again running a massive current account deficit, IOUs to the rest of the world, and the question once again is whether a return to balance will involve painful or painless restructuring in Europe and the US.
The US, Japan and the euro zone have seen their currencies gyrate wildly over the past 12 months amid fears over the imbalances across the world economy.
The pound has been caught in the crossfire. Sterling has ranged between $1.91 (R12.60) and $1.79 per dollar and between 69p (R8.28) and 66p against the euro. These 5 percent-plus swings hurt companies' profits and sales, and destabilise business plans.
The story begins in the US in a different century and under a different US president. During the 1990s the US wallowed in the Clinton boom that sent shares and the dollar soaring. The stock market created trillions of dollars of wealth while the strong dollar cut the price of imported goods, which US consumers lapped up, in turn delivering a record current account deficit driven by private borrowing.
As the economy turned into recession the Federal Reserve acted by cutting rates from above 6 percent to 1 percent. At the same time the White House started to roll out a $1.6 trillion package of tax cuts. The net effect was to put a concrete floor under the US economy, allowing consumers to carry on borrowing and spending like there was no tomorrow.
But as the economy returned to growth, a bulging government surplus was transformed into a huge deficit. The latest manifestation of this trend was brutally exposed this week with news that the US notched up a record trade deficit of $43.1 billion in January.
How far can this go? To use the aphorism from Herbert Stein, who was chairman of the council of economic advisers under presidents Nixon and Ford: "If something cannot go on forever, it will stop."
Certainly history indicates that a significant reduction in the external deficits that economic theory would call for generally occurs through a combination of slower domestic spending and a fall in the exchange rate, which forces consumers to switch from imports to home-produced goods.
So far the US has been happy for its currency to devalue slowly and is uninterested in which currencies appreciate as a result.
Japan wants to keep the yen low to avoid killing off its embryonic recovery. Other Asian countries such as China and India also want to keep a lid on their currencies either through intervention or a currency peg.
Which leaves the euro zone. Alone among the major powers it has fully bought into free-floating currencies and as a result has seen the euro surge by 40 percent in two years at a time when its economy is in the doldrums.
Since the start of 2002, Asian central banks, led by Japan and China, have bought almost $240 billion of dollar assets to keep their currencies low. China now has $420 billion of foreign reserves and Japan a staggering $620 billion. In the short term this has been a benign policy for both Asia and the US. Japan, for instance, gets two benefits: it keeps its currency down and by effectively printing money it is helping reflate the economy.
Daragh Maher, a senior economist at ING Barings, said: "Japan is fighting deflation and has zero interest rates so it can intervene without limit to weaken its currency."
Meanwhile, the US benefits from having a brake applied to the fall in the dollar each time Japan intervenes while, in addition, the heavy buying of treasury bonds pushes down the yield, so cutting long-term market interest rates.
Maher said: "The status quo is something the US is happy with. It's hard to see the White House removing a lever propping up the economy."
With elections across the Asian democracies in the near future and domestic growth "OK at best", there was little incentive for them to strangle their export recoveries at birth.
He said this had left Europe to shoulder the burden of the fall in the dollar that economic theory dictates is necessary to unwind the deficits - by making imports more expensive, forcing consumers to rein in spending and at the same time boosting exports.
The big question is whether it must be unwound in a disorderly way. "Not necessarily," Maher said. A cut in interest rates by the European Central Bank would boost domestic demand and remove a prop for the euro.
"Europe would no longer be the release valve," he said.
Ernst Welteke, the head of the German central bank, this week broke ranks to say there were more downside than upside risks to euro zone growth.
Meanwhile, as US economic data start to improve, the Federal Reserve will have to raise interest rates, pushing the dollar back up.
"If that's the path [of events] then you end up with a current account deficit not narrowing that much but running at a level that the financial markets believe is reasonably acceptable."
He had a powerful supporter of that argument, Federal Reserve chairman Alan Greenspan himself, who said earlier this month that he drew confidence from the flexibility of the US economy and its markets, contrasting it with crises that struck the UK's post-war "extensively regulated economy".
But Greenspan warned that the monetary consequences of Japan's persistent intervention could become problematic while China must eventually deal with its overheating economy.
Michael Hume, a senior economist at Lehman Brothers, said the key moment when Asian central banks ended their intervention could come within six months to 12 months.
If central banks stopped buying US assets then the world's largest economy would have to find alternative buyers at a time when the rest of the world has already taken on dollar-asset debts.
Hume said the dollar would have to fall, as far as $1.40 against the euro and probably further on Lehman forecasts, to encourage investors to invest in the US.
While this would boost US exports it could have a profound effect on the domestic economy, perhaps even delivering a consumer recession, some economists fear.
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