A Very Dangerous Game

"The US has the best recovery that money can buy. It has a very high fiscal stimulus, a huge current account deficit. It's borrowing a great deal in order to sustain this very high recovery." Thus did Kenneth Rogoff, the outgoing chief economist, say farewell at the annual meeting of the International Monetary Fund, in Dubai, earlier this month. But, as he explained, this is not just the best recovery that money can buy. It is the best recovery foreign money can buy. For how long will the foreigners continue to oblige?

Asia, in particular, is providing the US with goods and services in return for overpriced pieces of paper. The stock market is expensive, by historical standards, while US long-term interest rates provide little protection against a sizeable devaluation. It is hardly surprising that foreign governments have had to provide substantial funds: between December 1999 and June of this year, world foreign currency reserves rose by US$870bn, of which US$665bn was in Asia alone.

These transactions allow the world's richest country and sole superpower to spend far beyond its means. It is not as grateful as it should be. The fiscal deficit, forecast at 6 per cent of gross domestic product this year, is almost fully matched by the current account deficit, forecast to exceed 5 per cent of GDP in the IMF's World Economic Outlook. This year, according to the IMF, the US national savings rate will be an astonishingly low 13.6 per cent of GDP. The US gross investment rate, though much higher, at 18.3 per cent of GDP, will be below the rate in the eurozone, Japan and newly industrialized Asia, let alone Asian developing countries (see chart). Since the US investment rate has fallen, over the past three years, by almost three percentage points of GDP, the capital inflow should be viewed as a means of financing government and private consumption, not investment.

One might, if one were cynical, view what has happened as a brilliant US conspiracy. In the 1980s and 1990s, its policymakers persuaded a host of economies to liberalize their financial markets. Such liberalizations generally ended with financial crises, currency crises, or a combination of the two. These disasters lowered domestic investment in the afflicted countries, instilled deep fear of current account deficits and engendered a strong desire to accumulate foreign exchange reserves. The safest way was to invest surplus funds in the country with the world's biggest economy and most liquid capital markets.

When gullible foreigners can no longer be persuaded to finance the US, the dollar will decline. Since US liabilities are dollar-denominated, the bigger the decline, the smaller net US liabilities to the rest of the world will then turn out to be. In this way, the last stage of the "conspiracy" will be partial default through dollar depreciation.

How long can such a game go on? Not indefinitely, must be the answer. One can envisage three alternative developments: adjustment postponed; brutal and immediate adjustment; and smooth adjustment. The world needs the last. We cannot assume it is what it will get.

Under adjustment postponed, US domestic demand would pick up rapidly to reach annual growth of over 4 per cent a year, in real terms. This would pull GDP growth along at its sustainable rate and generate a still bigger current account deficit, probably rising to well above 6 per cent of GDP. The dollar is also assumed to stabilise. While this would represent a depreciation from its peak, it would leave the currency, on a trade-weighted basis, at much the same average level as between 1997 and 2000 (see chart). Since the US current account deficit would not fall, under this scenario, the rest of the world would, by definition, be willing to accumulate claims on the US at an increasing rate.

As Andrew Smithers of London-based Smithers & Co notes (Profits and Cash Flow Problems for US Companies, September 22 2003), if the current account deficit is to increase, net borrowing by the aggregate of the US government, corporations and households must rise as a share of GDP. But household savings are far more likely to rise than fall, given their already extraordinarily low level. So either the fiscal deficit, corporate cash flow, or both, would have to worsen. A further increase in the fiscal deficit is likely to undermine confidence in the US. A deterioration in corporate cash flow is likely to do the same, unless it reflects a surge in investment that seems much more likely to yield good returns than did the doomed surge of the late 1990s.

This scenario looks implausible. It would also merely postpone the day of reckoning. But no less undesirable would be a dollar rout. The communiqué of the finance ministers of the Group of Seven leading high-income countries in Dubai has, however, created some risk of such a rout. It stated, in particular, "that more flexibility in exchange rates is desirable in major countries or economic areas to promote smooth and widespread adjustment in the financial system, based on market mechanisms". Already the yen has risen to ¥111 to the dollar, from ¥117 in mid-September. Any substantial further appreciation would threaten Japan's fragile recovery. A big rise in the euro would also be dangerous for the eurozone. Moreover, a collapsing dollar would undermine foreign willingness to buy US bonds. The resulting jump in long-term US interest rates would threaten the US recovery.

That leaves the third outcome: a smooth global adjustment. This would require a sizeable strengthening of demand, in relation to potential output, in all the world's significant economies, including, not least, Asia, outside Japan. Instead of continuing to lend more money to the US Treasury, Asian governments, including China, would accept joint appreciation against the US dollar, combined with greater spending at home. Stronger growth of demand is no less an imperative in the eurozone, particularly Germany.

Both the providers and the users of the funds have, hitherto, been happy with the world of exploding US foreign liabilities. But the game has to stop. Another cycle similar to the last is neither plausible nor desirable. If the G7 has indeed triggered a widely shared process of adjustment, that is welcome. But that adjustment has also to be smooth, not brutally abrupt. It is, alas, too early to assume that it will be.