Untangling the US Deficit: Evaluating Causes, Cures and Global Imbalances

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Untangling the US Deficit

Untangling the US Deficit Evaluating Causes, Cures and Global Imbalances

Richard A. Iley Senior Economist, US and Canada, BNP Paribas, New York, USA

Mervyn K. Lewis Professor of Banking and Finance, University of South Australia and Fellow of the Academy of Social Sciences, Australia

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© Richard A. Iley and Mervyn K. Lewis 2007 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited Glensanda House Montpellier Parade Cheltenham Glos GL50 1UA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Iley, Richard A., 1970– Untangling the US deficit : evaluating causes, cures and global imbalances / by Richard A. Iley and Mervyn K. Lewis. p. cm. Includes bibliographical references and index. 1. Budget deficits—United States. I. Lewis, Mervyn. II. Title. HJ2051.I63 2007 339.5′230973—dc22 2007000735

ISBN 978 1 84542 920 1 Printed and bound in Great Britain by MPG Books Ltd, Bodmin, Cornwall

Contents List of figures List of tables List of abbreviations Preface

vi viii ix x

1 2 3 4 5 6 7 8 9

1 16 44 86 119 138 170 201 230

The essence of the problem The trade perspective National accounting perspectives The international perspective Nature of the adjustment mechanisms The sustainability of the deficit The demand for US assets China and the United States Conclusion

245 265

References Index

v

Figures 1.1 1.2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 3.13 3.14

US current account, 1980–2006 1 US net international investment position, 1980–2005 2 US goods trade deficit decomposed, 1990–2006 23 US goods export shares, 1990–2006 24 US terms of trade, 1989–2006 24 US capital goods trade prices, 1989–2006 25 Real trade-weighted US dollar, 1973–2006 26 The ‘dismal arithmetic’ of US trade, 1948–2006 26 Global consumer price inflation, 1970–2006 36 US federal outlays and receipts, 1965–2006 47 US real federal receipts, 1970–2006 48 US federal government budget balance, 1960–2006 49 US household savings ratio, 1955–2006 50 US household sector financial balance, 1960–2006 50 US household sector borrowing, 1960–2006 54 US household net worth ratio, 1955–2006 54 Real US house prices, 1975–2006 57 Measures of US housing affordability, 1983–2006 58 Ex-ante real Federal funds rate, 1972–2006 60 US non-financial corporations’ indebtedness, 1955–2006 64 US non-financial corporations’ liquidity, 1955–2006 65 The US bond market ‘conundrum’ 67 US current account and government budget balances, 1960–2006 74 3.15 US and Japanese 20-year government bond yields, 1995–2006 81 4.1 US national savings and investment, 1948–2006 90 4.2 Gross and net US national savings, 1948–2006 91 4.3 Depiction of an increase in savings 95 4.4 Depiction of a monetary expansion 96 4.5 US nominal GDP and Federal funds rate, 1970–2006 97 4.6 Global US dollar ‘liquidity’ growth, 1978–2006 97 4.7 Foreign exchange reserves of developing countries, 1958–2006 102 4.8 Foreign exchange reserves relative to import demand, 1958–2006 104 vi

Figures

4.9 4.10 5.1 6.1 6.2 6.3 6.4 6.5 6.6 7.1 7.2 7.3 7.4 7.5 7.6 8.1 8.2 8.3 8.4

US gross cross-border capital transactions, 1977–2006 Measures of home bias for US investors Current account balances for selected countries, 2005–2006 US net investment income, 1980–2006 US gross external assets and liabilities, 1976–2005 US foreign direct investment out-performance, 1976–2005 US net international investment position, 1976–2005 US net foreign debt relative to export earnings, 1976–2005 Movements in NIIP due to foreign exchange channel, 1989–2005 US gross FDI flows, 1980–2006 US ‘official’ inflow measures compared, 1980–2006 ‘Official’ inflows as a per cent of total gross inflows, 1970–2006 Asia’s invested funds, cumulative flows 1998–2005 Investment in Japan, Germany and Switzerland, 1970–2005 ‘Anglo-sphere’ consumption and residential investment, 1965–2006 Chinese gross savings, investment and current account balance, 1985–2006 Composition of Chinese foreign exchange reserve accumulation, 1995–2006 Chinese ex-oil current account balance, 1995–2006 Representation of internal and external balance

vii

115 115 124 147 150 152 159 160 164 177 179 180 181 186 191 216 218 219 223

Tables 1.1 1.2 2.1 2.2 3.1 3.2 3.3 4.1 6.1 6.2 6.3 6.4 6.5 6.6 7.1 7.2 7.3 7.4 7.5 7.6 7.7 8.1 8.2 9.1

Components of the US balance of payments, 2003–2006 The US current account position and national income and product accounts, 2003–2006 Percentage trade shares by country or region, 1980–2005 Variety in US imports, 1972–2001 US household sector financial flows, 1980–2006 Savings – investment imbalances and the current account deficit, 2003–2006 Global saving and investment, 1984–2006 Saving and investment ratios, 2000–2004 US external sustainability trade offs Composition of US foreign assets, end 2005 Composition of US foreign liabilities, end 2005 Foreign and US cross-border direct and portfolio investments and average returns since 1976 US dollar asset and trade weights compared Components of changes in the net international investment position, 1989–2005 US gross capital account flows by decade, 1960–2006 US capital account flows, 2003–2006 Global current account balances, selected years 1997–2006 Holdings of US securities by foreign official institutions, selected years 1989–2005 US median net family worth, selected years 1995–2004 Currency composition of foreign exchange reserves, selected years 1965–2003 Use of the US dollar and euro for export and import invoicing, 2003–2004 Indicators of geo-political power Decomposition of Chinese foreign exchange reserve buildup, 2002–2006 Summary of explanatory factors for US current account deficit

viii

6 10 28 29 53 71 75 88 145 148 149 151 157 162 171 176 185 188 191 195 196 209 217 232

Abbreviations BEA BIS CNCI ECB FDI Fed FOMC FRBNY GDP GNP IMF MBS MEW NIID NIIP OECD PBOC PPP RMB TIC WTO

Bureau of Economic Analysis Bank for International Settlements capitalized net capital income European Central Bank foreign direct investment Board of Governors of the Federal Reserve System (Federal Reserve) Federal Open Market Committee Federal Reserve Bank of New York gross domestic product gross national product International Monetary Fund mortgage-backed securities mortgage equity withdrawal net international investment deficit (negative NIIP) net international investment position Organisation for Economic Co-operation and Development People’s Bank of China purchasing power parity renminbi Treasury International Capital Reporting System World Trade Organization

ix

Preface Writing a book on the US current account deficit was a challenge that neither of us could resist. With the United States absorbing four-fifths of the world’s cross-border savings, this imbalance is perhaps the biggest issue in the international economy. In addition, with the funds flowing from some of the poorest countries to the richest, the global imbalances take on an extra dimension, as summed up by the view of another author that the flow is ‘fundamentally perverse’. Subject matter of such significance and portent could hardly be ignored. Both of us have been involved with the question of current account deficits for some time. One of us – a market economist immersed in the daily ebb and flow of financial markets reacting to and affected by the US deficit – welcomed the opportunity that the book offered, to sit back and take a longer-term perspective. The other, an academic, who was involved in the debates on current account deficits in the Australian context some fifteen years ago, was glad of the opportunity to see how the literature had changed over the intervening years and to examine matters from the very different vantage point of the US economy. As it turned out, one major difference from the past comes from the sheer variety of views that US academics and others have put forward to account for the phenomenon of the US external deficit. One inspiration for the volume came from the observation of ex-Federal Reserve Vice-Chairman Roger Ferguson that there had been few attempts to evaluate the full range of explanations advanced for the US deficit. The first task we had was to develop an organizing framework to deal with the different hypotheses, with the aim of producing the most comprehensive account to date of the various views and how they contribute to the story of the evolution of the US current account deficit. Because the United States occupies such a central position in the world order, an analysis of the US deficit necessarily overlaps with global geopolitics and the United States’ relationships with China, Japan, the European Union, oil exporters and others. While we have not deliberately sought to emphasize such international geopolitical factors, they cannot be ignored and we have certainly not tried to interpret everything solely in economic terms. There is consequently coverage of some matters that might not be expected in such a volume, especially China’s global ambitions and x

Preface

xi

governance problems that, to us, condition its economic relations with the United States. How the authors came to work together may seem something of a puzzle but has a simple answer since they are son-in-law and father-in-law, and there is a precedent for such a connection in the form of two earlier Elgar volumes with another son-in-law. Mother and daughter were on hand to bring things to a close by setting an unbreakable deadline for the book’s completion of end-November 2006. Without this, it might still be in the process of draft and re-draft! To them we owe considerable gratitude, especially since one of them bore almost entirely the brunt of typing the manuscript and keeping the references under control. In fact, this is now the eighth book that the Lewis family connection has with Edward Elgar Publishing, an association that we are glad to acknowledge and continue. We thank Frank Warnock of Darden Business School, University of Virginia, for supplying us with the data series for Figure 4.10. Christian Upper and Nikola Tarashev of the Bank for International Settlements very kindly supplied us with the data for Figure 7.4. Finally, although this project was undertaken with the blessing of BNP Paribas, the views expressed here are entirely our own and we alone are responsible for the content.

1.

The essence of the problem

THE PUZZLING DEFICIT The US current account deficit is undoubtedly one of the most significant, and at the same time puzzling, events of our age. The magnitude and significance of the US deficit seems clear. Figure 1.1 shows that from a situation of near zero in 1991, the US current account deficit in 2006 had grown to $811 billion, or 6.1 per cent of GDP, an unprecedentedly high level. It dominates global financial flows, with the world’s largest economy buying imports and other services from abroad far in excess of its exports, and financing the difference using funds borrowed from the rest of the world, including some of the poorest countries – a flow of capital described as ‘fundamentally perverse’ (Cline, 2005b, p. 2). Moreover, according to some experts the imbalance is set to widen. Forecasts by various commentators are that, with unchanged policies and exchange rates, the US current account deficit will continue to grow and range between 8–12 per cent of GDP by 2010 (Mann, 2004; Roubini and Setser, 2005; Truman, 2005). Obstfeld and Rogoff (2005) regard the US deficit ‘as a sword of Damocles hanging over the global economy’. 1

100

0 –100

–1 –2

–300

–3 –500

–4 –5

–700

–6 –7

–900 1980

1985

1990

1995

US current account balance, $ billion US current account balance, as a % of GDP (RHS)

Sources: BEA; authors’ calculations; Reuters Ecowin Pro.

Figure 1.1

US current account, 1980–2006 1

2000

2005

2

Untangling the US deficit

2.0 1.5 1.0 0.5 0.0 –0.5 –1.0 –1.5 –2.0 –2.5 –3.0

15 10 5 0 –5 –10 –15 –20 –25 1980

1985

US NIIP, $ trillion

1990

1995

2000

2005

US NIIP, as a % of GDP (RHS)

Sources: BEA, authors’ calculations; Reuters Ecowin Pro.

Figure 1.2 US net international investment position, 1980–2005 (measured at current cost) Some consider that a US current account deficit even of this size is sustainable and can be continued indefinitely at such levels. Most observers, by contrast, accept that some correction must inevitably occur. Yet, there is no apparent urgency on either the lending or the borrowing side for the present, seemingly anomalous, situation to change. Alan Greenspan in November 2003 saw little evidence of stress in funding the current account deficit. Two years later, in December 2005, with the deficit and the funding considerably larger, he (along with other policy-makers) could only ‘marvel at the seeming ease with which the United States continues to finance its current account deficit’ (Greenspan, 2005e, p. 1). There are other puzzling aspects of the experience. Figure 1.2 shows the recorded US net international investment position (NIIP) which follows the path of the current account deficit, moving from a situation where the United States had net foreign assets in 1980 to one today where there are substantial net foreign liabilities. Nevertheless, despite being a net debtor country since the early 1980s (indeed, the world’s largest debtor country) and, by definition, needing to service its borrowings, the United States, until the end of 2005 at least, had maintained the remarkable position of receiving positive net investment income from aboard. In fact, the net income in 2004 when the United States was a net borrower was almost exactly the same as in 1980 when it was a net lender, and the position has changed little since. On this basis, it has been questioned whether the US deficit even exists in any meaningful sense – the so-called ‘dark


3

matter’ argument (Hausmann and Sturzenegger, 2005; Cline, 2005a; The Economist, 2006b). Reasons for the growth of the current account deficit abound. A highly visible component is the trade imbalance with China, which has more than doubled in the past four years. China exports five times as much to America as it imports from that country. Many Americans worry that China may be replacing the United States as the powerhouse of the world economy. Not so long ago the ‘twin deficits’ theory was popular, based on the observation that current accounts deficits and government budget deficits tend to go together. Earlier this decade, when the US government budget deficit peaked at 4.5 per cent of GDP in the third quarter of 2003, it was the obvious culprit to explain the rising external imbalance. But rapid tax revenue growth and the economic recovery of 2003–2006 have seen the federal deficit shrink rapidly and, in the first half of 2006, it averaged less than 2 per cent of GDP. This particular ‘twin deficit’ explanation for the widening current account balance has inevitably faded, only to be replaced by one involving the household sector. Imbalances seem increasingly concentrated in the private sector, particularly the US consumer. Paralleling the trend of the current account balance is the household sector financial balance – the difference between total spending and income. In the late 1990s, spending of US households in aggregate began to exceed income for the first time on a sustained basis and the shortfall has accelerated to reach an unprecedented 4.5 per cent of GDP in the first half of 2006. This household sector financial deficit and the smaller, but still significant, government budget deficit together absorb the small surplus of the corporate sector with the difference being the net foreign finance, which is the financial counterpart of the current account deficit. Concern has grown about the financing of the current account deficit and how this requirement will build, in particular the United States’ reliance on foreign central bank purchases (mainly China and in the recent past, Japan) and the surpluses of oil exporters (especially Saudi Arabia, Russia and Iran). For a long time the US deficit was viewed in purely domestic terms. To finance a current account deficit there must be a matching inflow of funds (‘borrowing’) from abroad. However, these international capital flows do not respond exclusively to what is happening on the trade front. Although the financing of the US deficit has been described by Larry Summers (2004) as ‘international vendor finance’ (at least in the context of foreign governmental purchases of US securities), many of those supplying the funds do not buy US assets solely (if indeed at all) for the purpose of financing US purchases of goods from abroad but rather because US claims (such as securities, land, equity, direct investment) offer attractive characteristics

4


(safety, liquidity, prospective returns). An increasing number of studies have seen developments in overseas capital markets as causal factors driving the US current account. These developments revolve around an increased willingness to hold US assets due to globalization and an associated reduction in home bias (Greenspan, 2005e) or because of a ‘global savings glut’ in countries outside the United States which have a large amount of savings eager to be put into safe dollar assets and insufficient investment to make use of those savings (Bernanke, 2005). Foreign government and central bank purchases of US government bonds and bills are also attributed to countries at the periphery of the international system adopting export-led growth strategies by using capital controls and undervalued exchange rates linked to the dollar, with China again the prime suspect, limiting the movement of the yuan vis-à-vis the dollar and making Chinese goods artificially cheap. Together, the export of savings and the accumulation of dollar reserves have combined to keep US interest rates low and have presented US consumers with cheap finance and cheap goods that constitute a bargain thought to be too good to pass up (Dooley, 2005). Because observers disagree on what factors have produced the deficit, there is little agreement on what actions are needed to bring about an adjustment and when they will occur. Those who give emphasis to US domestic forces typically look for an adjustment in US public sector and private sector savings. Those who focus on developments abroad as the cause invariably place the onus on foreign governments to boost domestic spending and purchase more US exports. However, the problem may be thought to be too large for one or the other side to correct, prompting calls for a coordinated international approach, in effect a new Plaza agreement (Cline, 2005b). Or, it might be considered better to leave the adjustment to the market, which seemed to be the position of Alan Greenspan (2005a) who described the current account balance as ‘essentially a market phenomenon that is not readily subject to rebalance by targeting one or more policy variables’ (p. 2). These and other such related matters form the backdrop to this volume, which will seek to untangle the various issues and analyse them in a systematic, rigorous manner. Causation can run from domestic US factors to the foreign (as under ‘international vendor finance’), or from foreign influences to the domestic (under the ‘global savings glut’ argument), or be intertwined in quite complex ways (due to the pivotal position of the dollar in the international order). A number of studies have drawn attention to the unwritten rules of the current international system in terms of a ‘balance of financial terror’ (Summers, 2004, p. 8) between the United States and creditor countries that is being relied on by both sides to postpone adjustment, and the special role of the US as world banker and


5

repository of short-term liquidity and other balances (‘collateral’) held by those countries participating in the world trading system (Dooley et al., 2004; Gourinchas and Rey, 2005). Richard Cooper (2006) has drawn attention to the importance of demographic changes in generating structural capital flows. To these factors can be added the windfall gains of the oil exporting countries whether transitory or permanent. Thus a distinction needs to be drawn between autonomous and induced changes, on the one hand, and those due to the monetary use of the dollar as a temporary abode of purchasing power, between transitory and longer-term structural influences, on the other. As these comments indicate, there are many explanations each offering a different perspective on the causes of the US deficit. However, ViceChairman of the Federal Reserve Board Roger Ferguson noted that there have been relatively few attempts to assess and compare the full range of explanations that have been advanced for the emergence of the US deficit. Our aim in this volume is to address this absence and survey the factors that have been put forward to explain the US external deficit, while not forgetting that ‘it is possible and even likely that the deficit is the outcome of several different developments’ (Ferguson, 2005, p. 2). In the final section of this chapter we outline the framework that we employ to classify and analyse the explanations for the US current account deficit, based around a 4 2 matrix that serves as our essential reference point. Before doing so, however, we provide some summary statistics of the US deficit, and its implications, to put the issues into some perspective.

PERSPECTIVES ON THE US DEFICIT An obvious starting point is the current account of the balance of payments statistics. The balance of payments, or balance of international transactions as it is otherwise known, simply provides an historical record of transactions between the residents of one country, in this case the United States, and the rest of the world (Howard, 1989; Cumby and Levich, 1992; Higgins and Klitgaard, 1998). This accounting record is designed to reflect the flow of international transactions over a period of time, usually one quarter or one year, and transactions are included if they are between residents and non-residents, regardless of whether domestic currency or foreign currency is used for the transaction. Four major items make up the current account balance – merchandise trade, services, net income and other current transfers. The trade balance measures the domestic currency value of exports minus imports of goods, essentially manufacturing and agricultural products. Net services comprise

6


the domestic currency value of exports minus imports of invisibles including payments to holders of patents, royalties, tourism, air transport and shipping, and the overseas earnings of multinational firms. Net income reflects interest, dividends, rents and profits on past overseas investments, net of debt servicing by US residents on foreign liabilities. Finally, other current transfers include foreign aid, development grants, social security paid to retirees who reside overseas, private donations and private remittances by guest workers. Of these four, the trade balance is the most widely cited measure of the US external imbalance, and with good reason. Table 1.1 shows that in recent years the trade balance and the current account balance have been largely synonymous, with service flows and net overseas income roughly equal to net current transfers to non-residents. This position may change in the future if net income from overseas investments (previously a credit item) Table 1.1 Components of the US balance of payments, 2003–2006 (US$ billion) 2003

2004

2005

713 1264 551

808 1477 670

895 1682 787

1023 1861 838

Services Goods and services balance

54 497

57 612

73 714

80 759

Net income Net current transfers Total current account balance

45 71 522

56 84 640

48 89 755

37 90 811

86 84 474 3 233 2 13 522

133 25 616 2 96 3 86 640

117 54 653 4 48 14 18 755

55 4 643 4 238 2 18 811

Current account Exports Imports Goods balance

Capital account Net foreign direct investment Net equity portfolio investment Net portfolio bond flows Net capital transfers Net banking and other flows1 Change in official reserve assets Statistical discrepancy Total net inflows Note:

1In

2006 includes net financial derivatives flows of $28.7 billion

Source: Bureau of Economic Analysis

2006


7

becomes net debt servicing of overseas borrowings (a debit entry). The factors that have allowed the United States to preserve a net investment income surplus for so long in the teeth of rising net foreign indebtedness and that may continue to help insulate the economy from the increasingly harsh consequences of mounting foreign indebtedness are examined in depth in Chapter 6. Until this change around occurs we can jointly focus on the trade and the current account balance and note the following trends: ● ●

● ● ● ● ●

The US trade account has been persistently in deficit since the late 1970s; The current account deficit in 2006 had risen to a record level, both in absolute terms ($811 billion) and as a per cent of GDP (6.12 per cent); The deficit in 2006 greatly exceeded the twentieth-century peak of 3.3 per cent of GDP in 1987; The trade deficit in 2006 averaged $64 billion per month or over $2 billion per day; The US trade deficit was equivalent to $6690 per household in 2006; For every $1 of goods that the US exported in 2006, it bought $1.80 of imported goods; The US current account deficit in 2006 absorbed nearly 80 per cent of the cumulative current account surpluses of the world’s surplus countries.

A particular concern amongst many in the United States is the trade imbalance with China. Some measures of this position are as follows: ● ●

● ●

●

The trade deficit with China amounted to $233 billion in 2006;1 The US–China bilateral deficit increased in 2005 relative to 2004 by 25 per cent and widened by a further 15 per cent over the course of 2006; Chinese exports to the United States in 2006 were over five times larger than US exports to China; In February 2006, China displaced Japan as the largest single holder of US dollar reserve assets with reserves of $854 billion compared with Japan’s $850 billion; China’s total foreign exchange reserves at the end of March 2007 were $1.2 trillion.

As these last points indicate, there is necessarily a close relationship between trade transactions and capital flows (indeed, they are mirror images), since by accounting necessity the current and capital accounts of the balance

8


of payments sum to zero (allowing for statistical discrepancies) and a current account deficit will be matched by a capital account surplus of an equal amount. A current account deficit implies that a country’s receipts fall short of its expenditures on current account items. In order to support this pattern of spending, the country must finance its deficit by borrowing from abroad or by running down its previously acquired holdings of foreign assets. Apart from the capital gains or losses, the current account, therefore, measures the rate of change in the country’s stock of net foreign assets. Accordingly, the capital account balance measures the excess of exports over imports of financial obligations including equity shares, bonds and bank liabilities. Capital account transactions can be subdivided into several categories. One distinction is between portfolio investments involving securities and bank liabilities and direct investments that imply control over productive resources. Portfolio investments, in turn, can be split between short-term and long-term, between private and official, and between equities and bonds. From the bottom part of Table 1.1, it is apparent that the capital inflows are dominated by portfolio investments in US bonds, which have covered a large part of the financing requirement for the current account deficit. Although differing data sources tell different stories, it is clear that a substantial portion of these inflows came primarily from foreign governments, foreign central banks or foreign government instrumentalities (Feldstein, 2006). Some features of the capital transactions are: ●

●

● ●

●

From being the world’s largest creditor (capital exporter) in the 1950s, the United States is now the world’s largest debtor (capital importer); Foreigners have acquired an extra $2.4 trillion of US assets from 1990 to 2005, based on the changes to the net international investment position; In 2005, Asian central banks bought $500 billion of US assets; By mid-2006, 43 per cent of the stock of US Treasury bonds were in foreign hands compared with less than 5 per cent as recently as 1970; At September 2006, China and Japan combined held in excess of $900 billion of US Treasury bonds.

So far we have focused on the current and capital accounts of the balance of payments statistics. However, from another perspective, imports of goods (and services) allow domestic spending to exceed domestic production and incomes. In effect, all other things being equal, an increase in domestic


9

spending, whether government spending or private expenditure, absorbs production that could otherwise be exported or used to replace imports, increasing the trade deficit. Contrariwise, a reduction in spending releases (‘disabsorbs’) resources that can now be devoted to import replacement or used for expanding exports, and tends to reduce the trade deficit. From this way of looking at things, some developments are: ● ●

● ●

The federal government budget has been in deficit since 1970 (except for the years 1998–2001); The fiscal position changed from a surplus of $236 billion in 2000 (2.4 per cent of GDP) to a deficit of $412 billion in 2004 (3.4 per cent of GDP) before narrowing again to a $248 billion shortfall in 2006 (1.8 per cent of GDP); Personal consumption spending has grown from 67 per cent of GDP in 1995 to 70 per cent of GDP in 2005; On average, perhaps 40 per cent of each $1 of US consumption expenditure finds its way into imports.

Another way of linking the balance of payments with the national income and product accounts is in terms of savings and investment flows. Net inflows of capital from overseas, by drawing upon foreign savings, allow domestic investment by the corporate, government and household sectors to exceed the savings that those sectors in aggregate generate. Hence a current account deficit must equal the difference between US domestic investment, or capital formation, and total US savings emanating from the private sector and government sectors. Table 1.2 shows the current account deficit from the perspective of the national income and product accounts. Of course, the totals sum to the same amounts irrespective of whether the current account is looked at through trade flows or capital flows, or through saving and investment flows, or in terms of gross national expenditures (national turnover) and production. Considering the savings and investment flows, in broad terms for 2006 the government deficit (investment greater than savings for federal, state and local government) was about 2.4 per cent of GDP, the household deficit was around 4.5 per cent of GDP, the combined corporate sector (financial and non-financial) had a surplus of 0.8 per cent of GDP, with the difference being the current account deficit (or capital account surplus) of about 6.1 per cent of GDP. It needs to be emphasized what an unusual conjunction these circumstances represent. Not only is there an unusual flow of capital at the world level (from poor to rich), there is also an atypical situation in the United States where the corporate sector (usually a net borrower) is now supplying funds to the household sector (usually a large

10


Table 1.2 The US current account position and national income and product accounts, 2003–2006 (US$ billion) 2003

2004

2005

2006

11460 10961 499

12326 11712 613

13173 12456 717

14009 13247 763

23 522

27 640

38 755

49 811

Savings and investment Gross domestic saving Gross domestic investment Net foreign investment2

1459 2020 561

1544 2259 716

1612 2454 842

1843 2644 801

Statistical adjustment Current account balance

39 522

76 640

88 755

11 811

Domestic absorption Total domestic demand Gross domestic product Excess demand for goods and services1 Net other items Current account deficit

Notes: 1. This figure is the counterpart to the trade (goods and services) balance shown in Table 1.1 with some minor statistical differences. 2. Net foreign investment is conceptually equivalent to the current account balance shown in Table 1.1 with some measurement differences from the flow of funds data Sources:

National Income and Product Accounts, Flow of Funds Accounts.

net lender). Some other distinctive features from a savings–investment perspective are as follows: ●

●

●

● ●

In the third quarter of 2005, US net national savings temporarily became negative, meaning that for the first time the United States was not saving enough even to maintain its existing capital stock; During 2005, US households actually dissaved out of current income. That is, their savings relative to their after-tax income was 0.3 per cent compared with an average savings ratio of 8 per cent from 1950–2000. Residential investment relative to GDP peaked at 6.3 per cent in the second half of 2005, its highest level since the 1950s, before starting to fall rapidly in 2006; Household indebtedness has increased from 93 per cent of disposable income in 2000 to more than 130 per cent by the end of 2006; Household debt services payments in 2006 were at an all-time high of 14.5 per cent of disposable incomes as of mid-2006;

The essence of the problem ●

11

In total, the United States in 2005 was absorbing perhaps 80 per cent of the international savings that crossed borders.

OUR APPROACH IN THIS VOLUME The different ways of looking at the current account deficit given in the previous section are derived from basic accounting identities involving the current and capital account items in the balance of payments, and from linking these with the national income and production accounts. As with any identity, no causation can be deduced from the various approaches. A nation with a current account deficit will have a capital account surplus. Whether this situation is caused by developments in goods markets or in financial markets, either at home or abroad, cannot be ascertained without additional information. The different perspectives do, nonetheless, highlight some linkages between spending, consumption, savings and investment behaviour in one country and its payments position with the rest of the world. While the expenditure data and the balance-of-payments data cannot offer any prescriptive advice to either private or public decisionmakers, knowledge of the magnitudes and the alternative viewpoints may be useful for private decision-makers (for example, indicating a change in competitiveness in goods or services, or a change in savings and investment behaviour), or they may suggest the need for some microeconomic or macroeconomic policy adjustments. For these reasons, our analysis is based around the four alternative ways of thinking about a country’s current account balance and how it adjusts to policy and other changes (Artis and Lewis, 1991; Lewis and Mizen, 2000; Truman, 2005). These viewpoints are: Trade balance approach A country’s current account position measures the balance between exports and imports of goods and services plus the income from or the cost of servicing existing net international assets and liabilities and net transfer payments. This approach focuses mainly on the determinants of exports and imports (economic activity, relative prices and exchange rates) with an emphasis on real exchange rates and the competitiveness of exportables and import replacement industries. Absorption approach A country’s current account position reflects an imbalance between total domestic use of resources (‘absorption’) and total domestic production or availability of goods and services. This perspective emphasizes policies that

12


affect total domestic demand and supply – consumption and government spending and fiscal and monetary policies with respect to demand, and structural or supply-side policies with respect to output. Savings and investment approach A country’s current account position indicates an imbalance between domestic saving and domestic investment. This viewpoint concentrates on the determinants of domestic private sector and government saving, and the relative attractiveness of domestic investment opportunities. Portfolio balance approach Since a country’s current account position is mirrored by the capital account position and a change in net foreign assets, it reflects the balance between the net external demand for and supply of a country’s financial assets. This capital account perspective focuses on relative rates of return, liquidity, risk and wealth allocation decisions. Each of these four analytical perspectives, equally valid because of their definitional equivalence, can be thought of as having a ‘domestic’ version and a ‘global’ or ‘international’ version (or ‘Nth country’ version). Consider, first, the trade balance view. From a domestic point of view, US producers may have lost competitiveness vis-à-vis Chinese firms. In the international interpretation, China might be thought of as maintaining the yuan at an undervalued level in order to boost exports to the United States. Amongst many US congressmen especially, China’s cheap currency policy, lack of respect for intellectual property rights, and other trade barriers, are the cause, with the rapidly growing US–China bilateral trade deficit seen as ‘proof’ that China is an unfair trader (The Economist, 18 February 2006, pp. 32–3). However, China is not the only country seemingly resisting increases in its exchange rate to stimulate export-led growth. In the extreme case, since global trade positions must sum to zero, if N1 countries have running trade surpluses, the Nth country (say, the United States) will necessarily have a trade deficit. In terms of the absorption approach, the US current account deficit might be attributed to a fiscal deficit and a residential housing investment boom fuelled by historically low real interest rates resulting from Federal Reserve monetary policy under Chairman Greenspan. On an international interpretation, much of the rest of the world is producing more than it wants to consume. In particular, ‘disabsorption’ due to slow economic growth in Japan and the Euro area may have contributed to trade surpluses in those regions and a trade deficit in the United States, which has been left to take on the role of international spender of last resort.


13

Under the savings and investment viewpoint, the domestic version would focus on the dramatic reduction in household saving, the equally rapid increase in residential housing investment, and abundant other investment opportunities in the United States. By contrast, the international dimension would emphasize an excess of savings over investment in many other countries, especially in East Asia, creating a ‘global savings glut’. This view was popularized in 2005 by Ben Bernanke, then a Federal Reserve Governor, now Chairman of the Board of Governors (Bernanke, 2005). In the Economic Report of the President, 2006 (Chapter 6) that largely reflects this view, even the terminology changes and the current account deficit becomes the US capital account surplus. For the portfolio balance story, a domestic explanation might begin with high productivity and a strong ‘home bias’ in the United States for dollar assets, particularly real estate. An international interpretation would look to the strong world demand for dollar assets, especially due to reserve holdings by foreign central banks. In total, net foreign purchases of US securities amounted to a massive $890 billion in 2004. This 4 2 classification provides our basic frame of reference. However, the competing explanations surveyed by us are not confined to this number. For example, there are at least seven different hypotheses that come under the portfolio balance ‘international version’ alone: a changed world preference for dollar assets (Obstfeld, 2004); revisions to risk premia (Ferguson, 2005); precautionary reserves holdings (Feldstein, 1999, 2006); the ‘collateral’ view (Dooley et al., 2004); the ‘exorbitant privilege’ idea (Gourinchas and Rey, 2005); the world financial intermediary argument (Poole, 2004) and the ‘empire of debt’ narrative (Bonner and Wiggin, 2006). Also, a number of the explanations, while giving prominence to one strand of analysis, overlap some other categories, which is only to be expected since they are ultimately all different parts of the same story.

AN OUTLINE OF THE BOOK The plan of the book is as follows. Chapters 2 and 3 focus on the causes of the US current account deficit. The analysis is built around the four major analytical strands: the trade balance view (related to exports, imports and debt servicing); the absorption view (revolving around domestic demand and supply); the savings and investment view (concerning the imbalance between investment and savings); and the portfolio balance view (involving the demand for dollar financial assets). Chapter 2 considers the trade perspective, while Chapter 3 looks at the other three approaches. Each of these analytical frameworks, as we have said, needs to be examined and assessed

14


from a US domestic perspective and from a global viewpoint. The current account deficit is an endogenous variable, affected by both policies and financial decisions in the United States and the rest of the world. The international dimension is the subject of Chapter 4. In addition to the ‘global savings glut’ view espoused by Federal Reserve Bank Chairman Ben Bernanke (and strongly endorsed by his then counterpart in Australia, Reserve Bank Governor Ian MacFarlane), a number of economists have christened the current configuration of international capital flows as ‘Bretton Woods II’. Various hypotheses built around this theme are surveyed in this chapter. Chapter 5 focuses on the nature of the adjustment mechanisms to payments imbalances in the context of a world system of independent currencies and ‘international financial laissez-faire’, the term used by Max Corden (1983) to describe the new policy environment post-Bretton Woods. Thanks to the arguments of Alan Greenspan and others to the effect that there has been a ‘sea change’ recently in the degree of globalization and reduction in home bias of investment portfolios, there is now emerging a greater appreciation of the implications of this environment for global imbalances. The upshot of these views is a marked change in the rules of the game for debtor countries (and the sustainability of imbalances) due to capital’s much greater ability to flow across borders. This leads us to the question of sustainability and Chapter 6 considers alternative scenarios of the extent and sustainability of the US current account position. The orthodox analysis of the dynamics of the current account balance serves as the starting point, but the conclusions of this analysis are found to be compromised by the ‘unorthodox’ behaviour of the United States’ external balance sheet. There then follows a detailed examination of the ‘investment income riddle’, the ‘net international investment position enigma’, the ‘dark matter’ debate and the ‘black hole’ in the global financial system. Sustainability turns out to be a much more complex matter than is commonly appreciated. What becomes apparent is that the sustainability of the US deficit is conditioned by the nature and composition of international holdings of US dollar assets. For this reason, Chapter 7 concentrates on the demand for US assets, starting with the implications of a reduction in home bias for the financing of the US deficit. The chapter then goes on to examine the main sources of capital flows to the United States over the last decade. Four main sources are identified. Two of them are well discussed in the literature, these being the vast increase in invested funds emanating from non-Japan Asia and the surpluses of the oil-exporting countries. The two less well known sources are the ‘old’ economies of Japan and Europe, and the private and official capital responding to financial innovations in US financial markets.


15

Funds are attracted to the United States because of the sophistication and innovation of US capital markets, but the monetary role of the US dollar underpins the demand. The final section of the chapter considers whether the euro might eventually displace the dollar in its international monetary role. Chapter 8 is concerned with the China–United States relationship. For many Americans the US trade deficit is synonymous with China and there are many who see the balance of economic power shifting across the Pacific to Asia, with China at its head as the next ‘superpower’2. Already, the contribution of Asia (China, India, Hong Kong, Indonesia, Japan, Malaysia, Singapore, South Korea, Thailand, the Philippines, Taiwan) to the growth in world GDP from 2001–2005 at 21 per cent exceeds America’s 19 per cent (The Economist, 21 October 2006, p. 72). The chapter tries to put these issues in perspective, and examines the economic issues that confront China and the question of whether its own agenda matches this vision. Finally, the chapter takes up what is for the United States, the vexing issue of China’s exchange rate regime. Finally, Chapter 9 presents our conclusions and recommendations for policy.

NOTES 1. To put this figure in perspective, the trade deficit in 2006 was equivalent to $2833 for each household. 2. As reflected in the title of the lead article in The Economist, ‘America’s fear of China’, (The Economist, 19 May, 2007, pp. 11–12).

2.

The trade perspective

TWO APPROACHES This chapter and the next examine the causes of the US current account deficit (or, if preferred, the US capital account surplus). There is no shortage of hypotheses put forward to account for this phenomenon which, from the perspective of the United States at $811 billion in 2006, is at an historically unprecedented high and, from the viewpoint of the international economy, absorbs perhaps as much as four-fifths of cross-border world savings flows. Our analysis seeks to untangle the various explanations that have been offered and analyse them in a systematic manner. As noted in the previous chapter, there are two broad ways to approach a country’s current account position. One is in terms of the imports and exports of goods and services (along with other current transfers and income flows) and the associated financing implications in terms of capital flows. The other starts with the national income and production accounts to show how an imbalance between total domestic demand for goods and services and domestic production or, equivalently, between domestic investment and domestic savings, gives rise to net imports or net exports of goods and services to fill the gap. The first tends to look more narrowly, although not exclusively, upon trade flows and the financial aspects of capital inflows and outflows, whereas the second introduces a wider range of factors both within and across countries. The trade flow perspective is the topic of this chapter. Chapter 3 considers the national income accounting approaches. Putting the two aspects together, four equivalent definitions can be provided for a current account deficit (CAD): CAD Z X K R (C I G) Y (I S) (G T)

(2.1) (2.2) (2.3) (2.4)

The first is obtained from the balance of payments identity and defines the current account deficit in terms of imports (Z) relative to exports (X), which is matched, on the second definition, by the non-official net capital inflow 16


17

and borrowings from overseas (K) net of the authorities’ addition to international reserves (R). The third definition relates the deficit to the excess of absorption, ACIG, over domestic income (Y). In the fourth equality, the current account deficit is presented as equal to the excess of private sector investment (I) over private sector savings (S) and the government budget deficit (G – T). These four definitions provide the springboard for what we have described as the trade balance approach, portfolio balance approach, absorption approach and savings–investment approach. A number of different hypotheses fall within these four categories. These hypotheses are necessarily not confined to any one nation. For any country open to trade and with a reasonable degree of capital mobility, the current account balance can be understood fully only within the framework of a general equilibrium involving the spending and saving decisions of nationals of many countries. The deficits which the United States incurs on the current account of the balance of payments must be twinned by surpluses on the part of countries with which it has trading and financial relationships. These individual national relationships should be seen as part of an overall pattern of global saving and investment and not viewed purely in domestic terms. This is the basic insight of the ‘Bernanke thesis’ or ‘glutof-savings’ view. His argument is that the US current account deficit is not all made in the United States. Rather, it is also, and from his viewpoint, mainly, due to a glut of savings elsewhere, particularly amongst Asian countries. As the major recipient of these surplus savings, the United States has experienced a current account deficit, which ought to be seen as the balance-of-payments counterpart of the net inflows of funds. Bernanke’s thesis makes relevant the policy conclusion succinctly put much earlier by another Princeton economist, Richard Cooper: In the context of overall savings – investment analysis, countries should not take any particular view of their current account positions at all. Some will draw savings from the rest of the world, others will invest in the rest of the world. Nothing is wrong with this. It is as it should be. (1981, p. 269)

This benign attitude to the sustainability of the US deficit relies on the view that, if there are substantial national differences in inter-temporal time preferences and the marginal efficiency of capital, those areas with low savings propensities and/or high investment propensities will export financial assets and attract an inflow of capital carried, in effect, by an inflow of goods and services that constitutes the current account deficit. Such interaction of investors in search of the highest rate of return with the behaviour of savers seeking to maximize inter-temporal utility determines the efficient worldwide distribution of savings and investment with its counterpart on the

18

Untangling the US deficit

goods side being national current account imbalances. It then follows that if the comparative advantages in present and future goods differ widely across countries (as it has been suggested that they do between China, Japan and the euro area vis-à-vis the United States), then even large current payments imbalances among countries can persist, contrary to the conventional view that focuses only on the current transactions section of the balance of payments accounts. Such a conclusion rests on acceptance of one particular view of the causes of the US deficit, and to this extent we have run well ahead of ourselves. We need to backtrack and look at some of the alternative hypotheses under the framework we employ, encompassing four approaches (trade, absorption, savings–investment, portfolio balance) and two interpretations for each (domestic and global). We begin with the trade view and move on to the others in the next chapter.

THE TRADE VIEW Discussion of external imbalances has traditionally focused on trade flows, based on the elasticities approach that dates back to the early post-Second World War period (Robinson, 1947; Metzler, 1948; Meade, 1951). From this perspective, the emphasis is on the underlying economic conditions that determine whether a country runs a deficit in trade in terms of the factors governing the export and import of goods and services. The capital account of the balance of payments is commensurately downplayed and simply records the accommodating financial transactions that take place in response to trade flows, with investors passively providing vendor finance for what is happening in the trade account.1 Application of the trade view lends itself to the use of the basic tools of demand and supply analysis, involving relative prices and incomes as determinants of the demand for imports and the supply of exports. In the case of imports, the quantity of goods and services that a country obtains from overseas depends on income and the relative price of imported products, which is determined importantly by the exchange rate. Exports depend on the responses of a country’s trading partners to changes in their income and exchange rate movements. The analysis can be applied to a relatively fixed exchange rate world, with devaluation as a policy option, or to a system of floating exchange rates. Certainly, when Milton Friedman (1953) and Harry Johnson (1969) presented the case for flexible exchange rates they envisaged that the exchange rate for any country would adjust to the point where the demand for foreign exchange to buy imports (Z) and make other current payments would equal


19

the supply resulting from exports (X) and other current receipts. Suppose that exports and imports both depend on relative prices and real income. Equilibrium requires: X(y, EP*P) Z(y, EP*P)

(2.5)

and for a given yy0, this is defined by: EP*P

(2.6)

If 1 we have absolute purchasing power parity (PPP) and when 1 we have relative PPP when (2.2) is expressed in terms of rates of change. Strictly speaking, PPP is applicable if national output is internationally tradable with no restrictions upon trade such as tariffs and quotas. In this case, perfect international commodity arbitrage (the ‘law of one price’) requires that: P EP*

(2.7)

p e p*

(2.8)

Or in growth rates:

where P* is world prices in terms of US dollars or an index of world currencies, P is the domestic price level, and E is the exchange rate (price of international currencies in terms of domestic money), while p*, p and e are the growth rates. However, if goods arbitrage enforces parity across a sufficiently wide range of individual goods, so that the price of each good, expressed in terms of US dollars or a basket of international currencies, is equalized across countries, PPP may extend to aggregate price levels. In that case, PPP is ‘the disarmingly simple empirical proposition that, once converted to a common currency, national price levels should be equal’ (Rogoff, 1996, p. 647).

THE DOMESTIC PERSPECTIVE In general terms, the trade view and the estimated demand relationships they imply can explain much about the fluctuations in trade and associated capital flows that are observed across countries. However, when applied to the United States, two puzzles emerge. One is in terms of ‘elasticity pessimism’ and the role of the exchange rate in bringing about adjustment to

20


the trade deficit. The other puzzle is that US import demand appears to respond more strongly to changes in income growth than corresponding income responses in other countries. This finding suggests that, in the long run, with exchange rates equal, the US is predicted to run a persistently widening current account deficit (Poole, 2004). Elasticity Pessimism Elasticity pessimism arises in the context of the Marshall–Lerner requirement for a depreciation to improve the balance of trade. In US dollar terms, a depreciation of the dollar increases foreign demand for US goods since every unit of foreign currency now exchanges for more dollars. In this case, the US currency value of exports cannot fall. At worst, if foreign demand is completely unresponsive to the real exchange rate, the dollar value of US exports would remain unchanged. The same result may arise in the short run for US agricultural products (e.g. wheat) sold in fixed quantities for US dollars on world markets. However, in general, some expansion of US exports would seem likely to result over time. By contrast, US dollar depreciation may increase, decrease or leave unchanged the US dollar value of imports. Depreciation reduces the demand for imports in terms of foreign currency (or increases the supply in terms of US dollars). Whether the US dollar value of imports will rise, fall, or remain unchanged depends upon the elasticity of demand for imports. If this elasticity is unity, the value of imports will remain unchanged. If it is less than one, it will increase. If it is greater than one, it will fall. These relationships are summarized by the Marshall–Lerner condition (developed by Marshall, 1924, and Lerner, 1944) to the effect that depreciation will improve the balance of trade of a country so long as the sum of the elasticities of demand for a country’s exports and of its demand for imports is greater than one. At one extreme, suppose that the elasticity of demand for exports is zero. Exports in US dollar terms are no smaller than before. If the sum of the elasticities is greater than unity, this must be because the elasticity of demand for imports is greater than one, so that the value of imports falls. With no reduction in the US dollar value of exports and a decline in the value of imports, the balance of trade must improve. Vice versa, should the demand for imports have zero elasticity, the value of imports will rise in US dollars by the full percentage of the depreciation. But if the demand for exports is greater than unity, as it has to be if the sum of the elasticities of demand is greater than one, the value of exports will expand by more than the percentage of depreciation and the balance of trade will again improve. If each elasticity of demand is less than one, but the sum is greater than one, this will lead to an improvement in the balance


21

of trade expressed in US dollars because the expansion in US exports in dollars exceeds the expansion in the value of imports. The Marshall–Lerner condition serves as a useful litmus test, although for substantial improvements in the trade balance with an exchange rate depreciation, the sum should desirably be higher, perhaps four or five. The smaller the sum of the elasticities, the larger the price changes needed to effect a given balance-of-payments change. A fuller account would also take account of supply elasticities and the extent of the trade imbalance. The value of unity for the sum of the demand elasticities is broadly correct if supply elasticities are relatively large and if the balance of trade is in equilibrium to begin with. If imports are larger than exports (as seems likely in the case of a depreciation), more weight falls on the size of the elasticity of the demand for imports.2 This last condition assumes significance in the light of present conditions in the US balance of payments, where imports are roughly double the value of exports, and also in view of the estimated elasticities. The standard ‘workhorse’ model for estimating trade elasticities relates the volume of exports and imports to movements in real foreign and US domestic income and relative prices (usually in log-linear form). Various measures of the real exchange rate have been employed, using various trade-weighted indices of the dollar and different measures of prices, covering producer prices, consumer prices and unit labour costs. Typical of the most recent estimates are those of Chinn (2005) who finds that the price elasticities for US exports range from 0.68 to 0.84 while for US imports the price elasticity is low (between 0.11 and 0.27) and not statistically significant. In fact, a statistically significant price elasticity for imports can be found only by disaggregating the totals and excluding oil and computers (which together account for over 15 per cent of total imports). Even then the Marshall–Lerner condition barely holds, with the sum of the elasticities ranging from below unity to a high of 1.33. The implication is that in the absence of income changes, a relatively large exchange rate adjustment is needed to alter the trade position. One possible explanation for these findings is provided by Goldberg and Tille (2006) on the basis of currency of invoicing in international trade. They find that more than 99 per cent of US exports and 92 per cent of US imports are invoiced in US dollars. This finding assumes importance in terms of ‘exchange rate pass-through’. Strictly speaking, the two need not be connected. For example, a European firm selling into the United States could invoice in dollars, but adjust this price to make up for any fluctuations in the dollar–euro exchange rate. In practice, however, prices are frequently not reset. The European exporter, say, sets a price in dollars and leaves this price unchanged even if the dollar–euro rate changes. When import prices

22


are not affected significantly by exchange rate movements, a US dollar depreciation does not lead to much of a decline in import quantities. In this way the trade adjustment may be asymmetric. US importers may not adjust demand for imported goods when the US dollar depreciates. By contrast, the dollar depreciation renders US-produced goods (invoiced in dollars) cheaper to euro-zone consumers, enhancing the price competitiveness of US enterprises. Depending on the size of the exchange rate changes, the adjustment in real trade volumes may be largely restricted to exports of US goods and services, and the foreign products that these exports displace.3 The Houthakker–Magee Asymmetry When the response of exports and imports to real income movements is considered, the second puzzle emerges. This is the Houthakker–Magee income elasticity asymmetry. Those authors (Houthakker and Magee, 1969) estimated the US income elasticity for total imports of 1.7 and the foreign income elasticity for US exports of around 1. Subsequent studies have tried different measures, different estimation techniques and different data samples, but the Houthakker–Magee asymmetry persists. For example, in one of the more recent studies, Hooper et al. (2000) report long-run income elasticities for US exports and imports of 0.8 and 1.8 respectively. While some other research finds much higher export and import income elasticities than these, the ratio of the import to export income elasticity varies little from the 1.7 found by Houthakker and Magee in 1969 (Mann and Pluck, 2005). The implication seems clear: if the United States and the rest of the world grow at the same pace, and there is no trend change in relative prices, the US trade deficit would continue to increase (Krugman and Baldwin, 1987). Doomed to Deficits? In combination, the ‘elasticity pessimism’ and the Houthakker–Magee asymmetry would suggest that the United States is ‘doomed to deficits’ (Chinn, 2005). In the absence of a realignment of income trends in the United States vis-à-vis those abroad, a mild depreciation of the US dollar would be unlikely in itself to bring about a major correction to the trade imbalance. At the same time, boosting foreign income may do little to expand US exports. Far more effective, it would seem, would be a lowering of US income and a dampening of the US demand for imported goods. This somewhat pessimistic assessment of the prospects for turning around the US trade deficit is underscored by recent trends in the US trade account. The rising price of oil has been a key factor in the widening trade

23

The trade perspective 0 –10 –20 –30 –40 –50 1990

1992

1994

1996

1998

2000

2002

2004

2006

US petroleum and related products trade balance ($ billion) US non-petroleum goods trade balance ($ billion)

Sources: Federal Reserve Flow of Funds; authors’ calculations; Reuters Ecowin Pro.

Figure 2.1 US goods trade deficit decomposed, 1990–2006 (monthly data) deficit in recent years, accounting for about two-thirds of the increased deficit in 2005. Figure 2.1 divides the trade deficit into that for petroleum and non-petroleum products. Data for 2006 show that both the petroleum deficit and the non-petroleum deficit changed little. The latter was in the face of a strong expansion in exports. US exports grew strongly over the course of 2005 and 2006 despite signs of major structural problems in the US export sector. These problems are evidenced by the US share of world exports dropping from 14 per cent in 1997–2000 to under 11 per cent in 2004. The lion’s share of this drop was produced by a disproportionate fall in real capital goods (except autos) exports (see Figure 2.2). It would seem that foreign competitors have been able to undercut US exporters in their traditional area of strength – capital goods. Notably, the growth of ‘tech’ exports (the computers, peripherals and parts subcategory) has been particularly low. Beginning in the mid-1990s, the United States’ terms of trade in capital goods (the ratio of export to import prices) began to rise sharply, implying a steady loss of competitiveness in this key area of exports. Indeed, as shown in Figure 2.3, by the end of 2005 the United States’ terms of trade in capital goods had strengthened by 27.5 per cent since 1995. To put this rise in context, the terms of trade for US consumer goods excluding autos rose by only 8 per cent over the same period. Importantly, the higher increase in the terms of capital goods trade was not a product of aggressive price rises by US exporters, seeking to boost profitability at the expense of market share. Export prices for capital goods declined by some 6 per cent over this decade. Rather, this terms of trade ‘shock’ has been the

24


9

(as a % of potential GDP)

8 7 6 5 4 3 2 1 1990

1992 1994 1996 1998 US goods exports US capital goods exports excluding autos

2000

2002

2004

2006

Sources: BEA; CBO; authors’ calculations; Reuters Ecowin Pro.

Figure 2.2 US goods export shares, 1990–2006 (as a % of potential GDP, monthly data) 130

(Ratio of export to import prices, 1995 = 100)

125 120 115 110 105 100 95 1990

1992

1994

1996

1998

2000

2002

2004

2006

US terms of trade in capital goods US terms of trade in ex-auto consumer goods


Figure 2.3 US terms of trade, 1989–2006 (Ratio of export to import prices, 1995 = 100, monthly data) result of a deflation in the price of imported capital goods in the wake of the ‘Asian crisis’ of 1997, as indicated in Figure 2.4. Ultimately, two factors determine export performance – export market growth and competitiveness. The export ‘boomlet’ of 2005 and much of 2006 reflects a buoyant export market backdrop and, most probably as well, the

25

The trade perspective 105

(1995 = 100)

100 95 90 85 80 75 70 1990

1992

1994

1996

US capital goods export prices

1998

2000

2002

2004

2006

US capital goods import prices


Figure 2.4 US capital goods trade prices, 1989–2006 (1995 = 100, monthly data) lagged impact of the dollar’s trade-weighted depreciation over 2002–2004 when the Federal Reserve Board real effective dollar index dropped by 16 per cent. Figure 2.5 graphs both the broad and major trading partner real effective indices for the dollar. While the dollar in 2006 was broadly in line with its 30-year average level, its value against a broad range of currencies has not been as low for nearly ten years. Some researchers, for example Pettersson (2006), suggest that competitiveness may be less important than it used to be for foreign trade, or that it takes longer to impact upon export performance. However, the failure of this changed competitiveness, and associated export expansion to make more of an impact on the trade imbalance (see Figure 2.4) can be seen as a corollary, at least in a proximate sense, of what can be termed the ‘dismal arithmetic’ of the trade deficit. With imports of goods around 80 per cent larger than exports, as shown in Figure 2.6, exports need to grow that much faster than imports just to stabilize the trade deficit at its present (historically high) level. Given the strength of US final demand until the second half of 2006, the strong export expansion was not adequate to do the job. In order to stabilize the trade deficit, imports can grow no faster than around 6 per cent at an annual rate. Using an elasticity with respect of gross final expenditure (domestic demand plus exports) of around 2, this implies that final expenditure needs to grow at a sub-trend pace of around 3 per cent if the trade deficit is to stop growing. Productivity has a major bearing on competitiveness, and popular beliefs in the United States to the effect that the US industrial base is being

26


140

(2000 = 100)

130 120 110 100 90 80 70 1974

1978

1982

1986

Real ‘broad’ US $ index ‘Broad’ average 1975–2005 Sources:

1990

1994

1998

2002

2006

Real ‘major currencies’ US $ index ‘Major currencies’ average 1975–2005

Federal Reserve; authors’ calculations; Reuters Ecowin Pro.

Figure 2.5 Real trade-weighted US dollar, 1973–2006 (monthly data)

200 175 150 125 100 75 50 25 1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

US total imports as a % of total exports US goods imports as a % of goods exports


Figure 2.6 The ‘dismal arithmetic’ of US trade, 1948–2006 (quarterly data) ‘hollowed out’ by foreign competition seem an overstatement. The reality is that the productivity in US manufacturing grew by 4 per cent per annum between 1995–2000, and from 2000 to Q1 2006 accelerated to 5.1 per cent per annum (The Economist, 1 July 2006, p. 62). There may be important


27

structural factors at work in the American economy underpinning these developments. Whereas US productivity in 1995 to 2000 was largely driven by the information technology sector, higher productivity growth since then would appear to have been more broadly based (Jorgenson et al., 2006). In fact, it was predicted back in 1999 that the greatest impact of ‘new economy’ technologies may well be in a wide range of ‘old economy’ applications. Technical progress most often comes from a myriad of improvements, and general purpose or enabling technologies such as the computer often require further developments, or ‘micro inventions’ in Mokyr’s terminology, to make them broadly applicable (Mokyr, 1999). This was the case with the steam engine, first, and then the electric dynamo, or generator, later. Decades elapsed between their introduction and widespread use in industry. Much the same lag may have occurred with the computer (which was first built before the Second World War). Perhaps only now are we beginning to see the impact on a broad front of the technological breakthroughs, in the form of widespread commercial applications, due to innovations that allow firms in many sectors to produce new goods and services or reduce the cost of existing goods and services. It may be true that developing nations can now manufacture and export products that high-income countries once dominated, but equally the digital revolution enables services once thought to be non-tradable to be traded, while manufacturing processes can be unbundled in ever more efficient ways (Lewis, 2003). Firms such as Caterpillar, General Electric and Boeing may have remained powerhouses in US and world markets because of the knowledge embedded in their products and processes, but there are undoubtedly many other US firms that have raised productivity through the sophistication of their equipment and the skills of workers. As we shall see, such embedded knowledge in US enterprises is one possible source of the ‘dark materials’ discussed in Chapter 6.

THE OVERSEAS PERSPECTIVE So far we have looked at the US trade deficit from a largely US orientation. In the global system, the US trade position is necessarily influenced by what is happening abroad. Since the 1970s when the US trade balance moved consistently into deficit there have been large changes in the composition of US exports and imports, both in terms of country and type of goods and services involved. There have also been large swings in competitiveness due to relative productivity movements and exchange rate swings. A recent theme that has emerged is unfair trade competition. Most usually China is

28


the target as ‘currency manipulator’ and for not respecting intellectual property rights. However, American car producers in 2006 charged Japan with ‘currency manipulation’ due to a fall in the yen against the US dollar which they blamed on market intervention by the Bank of Japan ‘to encourage the exports of Japanese cars’ (Gapper, 2006).4 Consider, first, the changes in the structure of trade. Rather than look at the trade imbalance in terms of categories of goods, as we have above, it is instructive to look at the deficit by country or region. The data are given in Table 2.1. It is apparent that the geographical pattern of US trade, especially for imports, has changed significantly. US trade with the industrial countries overall has fallen, with the share of imports at 53 per cent (down from 74 per cent) and that of exports falling from 66 to 58 per cent over the period 1980–2005. The share of exports to (non-China and non-Japan) Asia increased to 16 per cent, and the share of trade with Latin America (excluding Mexico) contracted, while both exports to and imports from Mexico have expanded. However, the most dramatic change is the share of imports from China, which increased from less than 1 to 16 per cent over the period. Table 2.1

Percentage trade shares by country or region, 1980–2005 Exports

Imports

Total trade weights

1980 2005 Change 1980 2005 Change 1980 2005 Change Europe ex-UK1 Canada Japan Mexico China UK Other Asia2 Other Latin America3 Australia Other

26.6

18.5

8.1

21.4

18.8

2.6

24.6

20.7

3.9

21.7 11.2 8.1 2.1 6.3 11.7 7.8

25.9 7.2 15.1 4.7 4.7 15.7 4.1

4.2 4.1 7.1 2.7 1.6 4.1 3.8

25.2 20.6 4.3 0.6 5.2 16.1 4.2

18.9 10.8 11.3 16.3 3.4 15.3 2.7

6.3 9.8 7.0 15.7 1.9 0.8 1.5

18.8 16.7 4.4 1.3 7.2 14.4 6.1

16.3 10.0 9.8 13.4 4.8 17.3 3.9

2.6 6.7 5.4 12.1 2.4 2.9 2.2

0.8 3.7

1.9 2.2

1.0 1.6

1.7 0.7

0.6 1.9

1.1 1.2

1.7 4.8

1.2 2.6

0.5 2.1

Notes: 1. Europe ex-UK defined as Euro area, Switzerland, Sweden. 2. Other Asia includes Taiwan, Korea, Singapore, Hong Kong, Malaysia, Thailand, Philipines, Indonesia, India. 3. Other Latin America includes Brazil, Argentina, Venezula, Chile and Colombia. Source: Federal Reserve.

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Another feature of the US trade experience over recent decades has been the increase in the variety of goods imported (Broda and Weinstein, 2005). Table 2.2, based on those authors’ work, shows that the variety of goods entering the United States increased by more than threefold between 1972 and 2001. Notably, China is the country the export base of which has diversified most over recent decades. In the 1980s and early 1990s, China’s exports were concentrated mainly in clothing, footwear, toys, and other light manufacturing products. Since then, its shares of world exports have risen in nearly all categories and have grown especially rapidly in office machinery and telecommunications products (including electronics), as well as furniture, travel goods, and industrial supplies. More recently, China has made substantial gains in more hi-tech export categories, including automated data processing equipment. Electronic goods now account for as much as 25 per cent of China’s exports. Another example of this diversification is the number of broad product lines in which China’s share of US imports exceeds 10 per cent, which has risen from 5 in 1990 to 16 in 2002 (Prasad and Rumbaugh, 2003). Capital good diversification has been a feature of China’s recent export drive. The standard international measure for product and variety diversification is the United Nation’s Standard International Trade Classification (SITC). In the case of China, the growth in variety was especially great for capital goods – with the number of SITC categories contributed by China having grown by more than 250 per cent between 1980 and 2003. In 1980, China provided only 46 categories under the capital goods heading, ‘metalworking machine tools’ being the biggest in nominal dollar terms ($18 million). By 2003, China supplied 125 goods out of 136 four-digit categories in capital goods, with $9 billion worth of Table 2.2

Variety in US imports, 1972–2001

All 1972 goods1 All 1988 goods1 All 1990 goods2 All 2001 goods2

Number of goods

Total number of varieties3

7 731 12 822 14 572 16 390

74 667 173 937 182 375 259 215

Notes: 1. Based on the seven-digit classifications of the Tariff Schedule of the United States Annotated (TSUSA) system. 2. Based on the ten-digit classifications of the Harmonized Tariff Schedule (HTS) system. 3. According to good–country pairs. Source: Broda and Weinstein (2005).

30


‘peripheral automatic data processing units’ as the largest and $6 billion of office-machine accessories as the second largest category (Mann and Pluck, 2005, p. 11).

CHINA’S EXCHANGE RATE SYSTEM China’s exchange rate policy is often portrayed as the prime culprit for Americans’ apparently almost insatiable appetite for Chinese goods. By first pegging the renminbi to the dollar and then limiting the movement of it vis-à-vis the US dollar under the basket float, the Chinese authorities are said to have made Chinese goods artificially cheap and have hampered the tendency of a depreciating dollar to limit US imports of Chinese products. If Americans are purchasing more foreign goods, and more dollar assets are passing into overseas hands, the growth of foreign-held dollar assets should decrease the dollar’s value relative to other currencies. Eventually, foreign goods would become more expensive for Americans and the trade balance would become more equal. However, if other countries follow the downward path of the dollar to keep their exchange rate low to encourage export-led growth, the US dollar will be too high and US exports will continue to languish and US imports will continue to grow. While not alone (as the earlier reference to Japan indicates), China is seen in some US policy circles as the principal exponent of such a policy. By way of background, the renminbi (RMB), which means literally ‘the people’s money’, is the Chinese currency issued by the People’s Bank of China (PBOC). The standard unit of renminbi is the yuan, with jiao (10 jiao1 yuan) and fen (10 fen1 jiao) as the subsidiary units. Thus yuan and RMB are used interchangeably. The Chinese yuan has a managed float. From 1998 to July 2005 the exchange rate was allowed to vary less than onehundredth of 1 per cent from a peg of 8.277 yuan to the US dollar. On 21 July 2005 the yuan was revalued by 2.1 per cent to 8.11 to the dollar and the Chinese authorities switched to a new exchange rate system under which the yuan is linked to a basket of currencies, the central parities of which are set at the end of each day. The basket contains 11 currencies: US dollar, yen, euro, Korean won, Singapore dollar, Malaysian ringgit, pound sterling, Russian rouble, Australian dollar, Thai baht and Canadian dollar. It has been estimated by one analyst that the first three have the largest weights: 43, 18 and 14 per cent respectively (The Economist, 13 August 2005, pp. 60–1). The new system works as follows. In response to a fall in the US dollar relative to the other basket currencies, the PBOC would let the yuan rise against the dollar if the overall value of the basket is to be held steady. However, being a managed float, this response is not axiomatic. At the


31

discretion of the PBOC, the value of a yuan could be altered against the basket. In American eyes, China’s ‘sin’ was in pegging its currency to the US dollar and following the same currency policy that they have been pursuing for years. A fixed peg is not unusual in monetary history. It was required of countries under the gold standard and gold exchange standard (although China then preferred to stay on silver), and was expected of countries under the resurrected gold exchange standard that constituted the Bretton Woods system. Admittedly, if we are to invoke this parallel, then it can be argued that China has not kept to the gold standard ‘rules of the game’. Under the specie-flow mechanism, countries with balance of payments surpluses were to allow the inflow of specie to expand the monetary base and the money supply, creating inflationary pressures that would erode the competitive advantage and help correct the balance of payments surplus. By the same token, if the analogy is to be pursued, the United States has not done its part either, since a deficit country must either raise interest rates to attract capital inflows or allow a contraction of the money supply to deflate the economy. Under the revived gold exchange standard of Bretton Woods, there were also established rules of the game. Countries which were part of the IMF system were to maintain a fixed peg to the US dollar, which was the only country to keep its currency convertible into gold at a fixed parity ($35 per ounce). While fixed parities with the dollar were again the norm, a country experiencing a ‘fundamental disequilibrium’ could always apply to the IMF for its dollar parity to be adjusted. No such application was ever refused, but the privilege was rarely invoked since countries came to the view that a parity realignment would cause greater problems ‘next time round’ if speculators were encouraged to expect an alteration of parity in response to future payments imbalances. Maintaining the credibility of the policy and discouraging ‘self-fulfilling expectations’ induced by destabilizing speculation pointed to the desirability of using the adjustable peg provisions of the IMF system as seldom as possible (Lewis and Mizen, 2000, Chapter 2). China may have come to much the same conclusion when it observed the difficulties that currency speculation posed for South East Asian currencies during the course of the Asian financial crisis of 1997. Hong Kong’s currency board link with the US dollar came under severe speculation in the immediate aftermath of the crisis that began in July 1997, and the fixed link was retained only by some unconventional measures such as intervention by the Hong Kong authorities in the equity and land market, and by borrowing the People’s Republic of China’s (PRC) extensive reserves as potential backing for its own holdings (Lewis, 2002). The formal institution

32


subsequently of the PRC’s own fixed peg to the US dollar not only supported Hong Kong’s currency board system, but also was hailed at the time as helpful to monetary stability in the region by preventing a round of further currency depreciation amongst South East Asian countries seeking to rebuild their economies by keeping their export sectors competitive in world markets. Those who accuse the Chinese of pursuing a cheap-yuan policy overlook that during the East Asian crisis, China (along with Hong Kong) did not devalue although almost all of its neighbours did, and that the policy then was a dear-yuan stance that generated deflationary pressures and slowed export growth. It was only later, as Chinese exports to the United States burgeoned and the trade deficit of the United States with China grew to be larger than that with any other country or region, that the undervaluation of the yuan has emerged as a policy issue and charges that China may be a ‘currency manipulator’ have arisen. As it turned out, the US Treasury in its sixmonthly report to Congress in May 2006 decided not to list China as a ‘currency manipulator’ and invoke embargoes on Chinese goods, although ‘China came close, but not close enough’ (The Australian, 12 May 2006, p. 25). US pressure on China to raise the value of the yuan is virtually certain to persist for a number of reasons. As the Treasury Department’s report stated: China’s advances are far too slow and hesitant given China’s own needs, and its responsibilities to the international financial community. The delay in introducing additional exchange rate flexibility is unjustified given the strength of the Chinese economy and the progress in China’s transition. China needs to move quickly to introduce exchange rate flexibility at a far faster pace than it has done to date. With a still rigid exchange rate, China lacks effective monetary policy tools to avoid the boom-bust cycles it has experienced in the past. Given our strong disappointment and the importance of China to the world economy, the Treasury Department will closely monitor China’s process in implementing its economic rebalancing strategy. (US Treasury Department 2006, p. 2–3)

In effect, the Treasury delivered the Scottish legal judgment of ‘not proven’ on the issue of currency manipulation, and the bill to impose a 27.5 per cent tariff on Chinese goods if the yuan is not revalued by the same amount has been withdrawn, although a more modest law that would not break WTO rules has been foreshadowed (The Economist, 9 November 2006, p. 7). One important aspect of the ruling not to brand China a ‘manipulator’ (and one that seems to have been largely neglected) is that it focused exclusively on the second half of 2005. Over that period China exhibited a fair bit of exchange rate flexibility thanks to the 2.1 per cent revaluation and subsequent slight appreciation. Moreover, with the dollar appreciating against


33

the euro and yen, the trade-weighted value of the renminbi appreciated by almost 10 per cent in 2005. China could have felt rightly aggrieved to be branded a currency manipulator in a year when it abandoned an eight-year exchange-rate peg and its trade-weighted exchange rate appreciated by almost 10 per cent, and when it also eliminated as well, the licences that were required for the importation of many goods. Nevertheless, strong growth in the Chinese current account surplus and its continued accumulation of foreign exchange reserves present easy targets for US critics. In addition, the United States now has the support of the group of G7 countries which stated that ‘in emerging Asia, particularly China, greater flexibility in exchange rates is critical to allow necessary appreciations, as is strengthening domestic demand, easing reliance on export-led growth strategies and actions to strengthen financial sectors’ (Financial Times, 11 May 2006, p. 30). Precisely why China should be expected to abandon its longstanding strategy and adopt the United States’ exchange rate system of choice is unclear. Nor is it clear that the world (or the G7) would necessarily be better off for it, as we shall argue in a moment. Certainly, it is true that China takes some extraordinary measures in order to maintain a relatively close relationship between the yuan and the dollar. China’s overall trade surplus in 2005 was $101.9 billion and in 2006 the trade surplus rose to $178 billion despite, like the United States, being a net oil importer and therefore suffering a significant widening of its oil import bill. Remarkably, China’s ‘basic balance’, defined as the sum of the current account surplus and net foreign direct investment flows was 11.6 per cent of GDP in 2006, meaning that ‘hot money’ outflows of an even larger amount would be required to prevent foreign exchange reserves from rising. The large inflows of foreign currency that result are purchased by the PBOC at the exchange rates set, increasing the amount of yuan deposited in banks. In order to curb the growth of credit, the PBOC raised interest rates in April 2006, announced guidelines for credit supply and raised the reserve ratio that banks must keep. If this is tantamount to currency manipulation, then it is little different from those actions taken by Germany and the Benelux countries, Switzerland and Japan to prevent their currencies appreciating against the dollar in the last stages of the Bretton Woods system, when they exercised their preference to retain fixed dollar parities by special taxes on foreign capital, raising reserve ratios and levying dual exchange rates (one rate for trade transactions and a higher rate for capital inflows). Then the United States was pressuring Germany5 and the others to appreciate or inflate, and ended up itself devaluing. Now the target is China.

34


SHOULD THE YUAN APPRECIATE? To argue that the yuan must appreciate substantially to correct the global imbalances (the major one being the US trade deficit, one quarter of which is with China) rests on a number of assumptions: 1. 2. 3. 4. 5.

The yuan is considerably undervalued; Adjustment must be in the value of the yuan rather than the US dollar value; Appreciation of the yuan would aid the United States; Changing relative prices requires changes in nominal exchange rates; and No other adjustment mechanisms exist.

Each of these assumptions needs discussion and exploration. Is the Yuan Undervalued? Consider, first, the assumption that the yuan is undervalued. The 27.5 per cent tariff proposed by the Schumer–Graham bill as part of the raft of measures planned should China have been declared a ‘currency manipulator’ was pitched in the middle of a range of estimates, from 15 per cent to 40 per cent, of the yuan’s undervaluation against the dollar (The Economist, 1 April 2006, p. 60). Estimates of this magnitude are given by Goldstein (2005) who in February 2005 suggested a 15–30 per cent appreciation of the yuan was needed to restore equilibrium to China’s current account and that an appreciation of 25–35 per cent was required for equilibrium to China’s overall balance of payments. An appreciation of this order, he calculates, results from the high import content of China’s exports (around 35–40 per cent), so that there is less of an export response than would otherwise be the case, and a larger exchange rate change is needed to alter the trade balance. Although few question that the yuan is undervalued, some recent estimates question the extent of the undervaluation of the renminbi. For example, Cheung et al. (2005) find that, because of the large structural changes to the Chinese economy, the calculations are dependent on the base period chosen as the starting point. Their approach uses absolute PPP, relative PPP, and Balassa–Samuelson criteria (involving productivity differentials). Some measures imply substantial undervaluation of the yuan, others imply little or no undervaluation, and in some instances overvaluation is indicated (although of modest magnitudes). The authors conclude that claims of large renminbi undervaluation should be treated with


35

caution, as reflected in the title of their paper: ‘Why the renminbi might be overvalued (but probably isn’t).’ As well as allowing for structural changes to the Chinese economy and the issue of the starting point, two other factors have complicated the calculation. One is that since 2003 China has gradually removed export rebates, effectively revaluing the yuan by over 5 per cent. Second, China’s accumulation of international reserves – seen as an indicator of yuan undervaluation – has been swollen by ‘hot money’ speculating on a yuan revaluation. These hot money flows show up in capital movements but may also enter China via the trade account through leads and lags and the overreporting of exports to obtain foreign currency to speculate on real estate (Financial Times, 18 October 2006). It is difficult to quantify the precise importance of these factors. We will revisit the question of yuan undervaluation in Chapter 8 when we look at the matter from the perspective of China’s macroeconomic balance. Should the Yuan or Dollar Change? Second, there is the question of whether the adjustment ought to be in the renminbi or the dollar. As we have noted, this issue can be seen in some ways as a replay of the last days of Bretton Woods when the question was whether Germany, Switzerland, Benelux and Japan would revalue or the United States devalue. Although the trade deficit of the United States with China is larger than with any other country, and is one-quarter of the total US trade deficit, in fact more than one-half of China’s exports go to markets other than the United States or to countries with currencies not pegged to the dollar. Obviously, the yuan–dollar rate cannot be used in isolation to judge whether China is undervaluing its exchange rate to boost exports. Rather, allowance must be made for the yuan’s effective rate against the currencies of all of China’s trading partners, and in these terms the RMB’s real effective exchange rate (adjusted for inflation differentials) actually appreciated between January 1994 and July 2004 (Goldstein and Lardy, 2005). Further, in the context of the US Treasury Department’s May 2006 report on currency manipulation, the real RMB effective rate appreciated by close to 10 per cent in 2005. Of course, since the RMB has been held relatively steady against the US dollar, some part of the movement of China’s real trade-weighted exchange rate is simply a reflex of the movement of the dollar vis-à-vis other major currencies (euro, yen). This fixed dollar link, maintained in the context of the vast increase in the supply of goods produced at low cost in China, has undoubtedly exerted a downward pressure on world inflation, the dramatic reduction in which is shown in Figure 2.7. In the World Economic Outlook

36

Untangling the US deficit 35

(%)

30 25 20 15 10 5 0 1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

Source: IMF International Financial Statistics.

Figure 2.7

Global consumer price inflation, 1970–2006 (quarterly data)

released in April 2006 with the title Globalization and Inflation, the IMF devoted a chapter to the topic ‘How Has Globalization Affected Inflation?’ This chapter might well have been sub-titled ‘the impact of “the China price’’ ’ for globalization was found to have reduced inflation, on average over the past decade, by 0.25 per cent in the advanced economies and 0.5 per cent in the United States, via lower import prices. The Federal Reserve’s estimates of this effect are even more portentous, gauging that the decline in import prices since the mid-1990s has shaved between 0.5 to 1 per cent off US core inflation over the last decade (Kohn, 2005). Also, the fall in the price of US capital goods imports over the last decade has been even more significant as we noted earlier. With consumer inflation rates averaging only about 2 per cent in these economies, a reduction of this magnitude must be viewed as a substantive contribution to global price stability. The emergence of the ‘China price’ can be attributed to two factors: the sudden surge in the supply of Chinese goods onto world markets and the way China has managed the exchange rate. In a world of floating exchange rates, one would expect a country with a rise in productivity, a considerable expansion of production, and a large trade surplus to experience an appreciation of its currency. The rise in the value of its currency would, in turn, make its goods more expensive on world markets and in this way offset some of the low inflation benefits of the supply of cheap exports. Because China has not followed this route, and has kept its exchange rate rigidly fixed to the US dollar over nearly a decade, goods that are inexpensive in terms of renminbi have remained low cost in dollars, and to a lesser extent in other currencies such as the euro. Were China to relent to US pressure


37

and agree to allow the yuan to appreciate substantially against the US dollar, a key restraint on world inflation would be lost and in its place there would be rising import prices in the United States (ameliorated only partially by lower import prices in China) passed on to the rest of the world as an upward price shock (Baker, 2006a). Also, by worsening the economic growth–inflation ‘trade off’, attainment of the Federal Reserve’s ‘dual mandate’ of price stability with maximum sustainable growth would almost certainly require a higher level of policy rates than otherwise with attendant consequences for corporate profitability and asset prices. Would a Yuan Appreciation Help the USA? Third, there is the question of whether such a yuan appreciation would do much for the US trade deficit and the US economy. There are grounds for thinking that America’s preoccupation with China is largely misplaced. China has accounted for only about one-third of the increase in the United States’ current account deficit over the five-year period 2001–2005. Because China has become an attractive location in which to assemble and produce goods that were previously made in other parts of Asia, Chinese exports to the United States have replaced many goods that were manufactured in Taiwan and South Korea. Reflecting this attractiveness, China now accounts for some 40 per cent of all foreign direct investment (FDI) into Asia and, in turn, Japan and the emerging economies of Asia now account for over two-thirds of China’s FDI inflows (Prasad, 2005). As a result, while America’s trade deficit with China has widened extensively in recent years, its deficit with the rest of Asia has narrowed, as can be seen clearly in the evolution of the trade shares in the Federal Reserve’s trade-weighted dollar index (see Table 2.1). There are other reasons for questioning the United States’ focus on China. Since China accounts for only around 13 per cent of US total trade, a 10 per cent appreciation of the RMB would reduce the dollar’s tradeweighted value by little more than 1 per cent. Changing the yuan is not an efficient way to make dollar goods more competitive on world markets. The story of the US trade imbalance involves a loss of export competitiveness, not just rapidly expanding imports. Many of the goods that China exports to the United States, such as toys, shoes and office equipment, are no longer made in the United States. If Americans buy less of them from China, they are more likely, at least in the short run, to import them from elsewhere rather than buy from home producers (The Economist, 1 April 2006, pp. 11–12 and 19 May 2007, p. 72). Popular opinion in the United States tends to roll into one the US–China bilateral trade deficit, the value of China’s currency and the off-shoring of

38


jobs and production, with the consequence that China is held to blame for US imbalances and economic problems, in what is almost a replay of US–Japanese competitive economic tensions 20 years ago. A Brookings Institution study by Martin Bailey and Robert Lawrence found that trade accounts for only about 12 per cent of US manufacturing job losses since 2000, with most of the losses due to trade being the result of the collapse of exports not stronger imports (Tyson, 2005). Much of the anti-China lobbying comes from sectors such as the textile and apparel industries that have been severely hit by low-priced Chinese goods. However, this sector is very much a special interest. Together, the textile and apparel industries employ less than 0.5 per cent of working Americans. Many more Americans have a vested interest in seeing off the protectionist quotas on textiles. For example, more than 25 million US households (comprising over 80 million people) have an annual income of less than $25 000. For them, saving on clothing – a basic necessity – is a welcome benefit. In fact, it has been estimated that US consumers benefited by $100 billion in 2004 from the availability of inexpensive Chinese goods (Fortune, 16 May 2005, p. 42). Then there are the interests of the US enterprises engaged with China. It is estimated that US firms invested more than $15 billion in China in 2004 and that corporations which are partly US-owned or linked in some other way to the United States account for 49 000 of the 530 000 foreign firms that have established operations in China since 1979 (The Australian, 26 April 2006, p. 36). The great bulk of the other foreign firms are owned by Overseas Chinese from Taiwan, Hong Kong and other South East Asian countries (Huang, 2003; Chiu and Lewis, 2006). Over one half of China’s exports emanate from the foreign-funded enterprises operating in China. Although the magnitudes are not known, some part of the US trade deficit with China is contributed by US imports of goods made or assembled in China by US firms. These facilities are sought so that US firms can remain competitive in world markets. Such an investment strategy by US firms has been aided by the fixed renminbi–US dollar link that has ensured relatively predictable US dollar income from Chinese earnings, since much of the cost structure of operations is denominated in yuan. It is difficult to resist the conclusion of Art Rolnick, Vice President and Director of Research at the Federal Reserve Bank of Minneapolis, writing in August 2005, that the Chinese currency peg is ‘a good policy than can reduce the cost of currency volatility. Given the level of trade between the United States and China, such a cost could be quite high, and reducing it could promote trade’. He also went on to add that ‘a peg makes sense and it doesn’t even matter exactly where it’s set, so long as it’s credible’ (The Region, December 2005, p. 37).


39

Putting aside the issue of whether the stable yuan–dollar link is detrimental or beneficial to American interests, there is the further question of whether a steady appreciation of the yuan beyond the 3.4 per cent change between July 2005 and May 2006 – whether undertaken to appease the Americans (an example of what Baker (2006b) calls ‘Through the Looking Glass’ currency diplomacy) or to prevent overheating of the Chinese economy – will make an appreciable dent in the US trade deficit. There are some question marks on a number of grounds. One is the marked decline in exchange rate ‘pass through’ – the impact of exchange rate changes on import prices and, in turn, consumer prices – over the last 15 years. Recent research finds that for the G7 countries, while a 10 per cent depreciation would have increased import prices in these countries by nearly 7 per cent on average in the late 1970s and 1980s, it would have increased them by a mere 4 per cent in the last 15 years. For the United States specifically, ‘pass through’ from a 10 per cent depreciation is estimated to have declined from around 6.6 per cent in the period 1975–1989 to just 3.2 per cent in the 15 years to 2004 (Ihrig et al., 2006).6 A number of reasons have been advanced for the smaller effect of currency movements on trade flows. Importers may wish to retain their share of the US market, built up over time with considerable sunk costs. Or, they may use some ‘average’ exchange rate for pricing, or adopt a strategy of ‘local cost’ invoicing in which companies adjust price tags to keep in line with competitors rather than in line with exchange rate movements. Obviously if the relative prices of imported goods do not rise extensively, there is less incentive for US consumers to switch to US-made goods. Another explanation is that the composition of import demand increasingly is weighted towards goods the prices of which are less sensitive to exchange rate swings. Notably, some research (e.g. Ihrig et al., 2006; Marazzi et al., 2005) on the decline of pass through in the United States (and, indeed across the G7 countries) sees the 1997 Asian financial crisis and the stepped up presence of China in many export markets as ‘watershed’ events in producing a shift in the export pricing behaviour of Asian firms. This research allies with the considerable change to the United States’ terms of trade in capital goods from the mid-1990s onwards, already noted above. Obviously, if Asian exporters, including the Chinese, have suffered narrower export margins to gain market share over the last decade this is a finite process. There must be some size change in the nominal exchange rate change that will depress already reduced margins to the point that dollar prices must be lifted, but the change required may be very large. A further factor to be considered is that an appreciation of the renminbi would not necessarily improve the US trade balance if the impact on China

40


itself is sufficiently strong. Ronald McKinnon (2005b) argues that a rising yuan could lead to a reduced world demand for Chinese exports, slowing China’s economic growth (which may be the purpose of the policy change). However, this slowing of economic growth, along with deflationary pressures in China, could in turn rebound on the United States by reducing the Chinese demand for US products. Must the Exchange Rate Change? Fourth, there is the question of how an adjustment of relative prices is to take place. An obvious solution is for currencies to be realigned either by an appreciation of Asian currencies vis-à-vis all others (including the dollar) or by a dollar depreciation against the rest of the world (presumably including Asian currencies). Both are distasteful to some Asian countries. During the annual meeting of the Asian Development Bank in May 2006, at a governors’ seminar on global payments imbalances, Yong Li, China’s Vice-Minister of Finance, referred to ‘rumours that the US dollar might depreciate by 25 per cent’ as shocking. Similarly, Sadakazu Tanigaki, the Japanese Finance Minister, warned the ADB seminar that ‘overemphasising realignments of exchange rates could invite market speculation and deal a blow to the global financial markets’ (Wolf, 2006a). In principle, it is possible for relative prices to alter in the absence of parity changes. Under the gold standard, parities were irrevocably fixed, yet relative prices were not. The ‘specie flow’ mechanism envisaged that the money supply would rise in surplus countries accumulating gold reserves, and contract in deficit countries losing reserves, causing differential movements in prices (rising prices in one, falling prices in the other) helping to correct the initial payments imbalance. To what extent this specie flow mechanism of classical monetary theory (it dates back to David Hume, 1752) brought about stability of exchanges under gold is unclear, and – to judge from the extent of gold flows – problematical. To a large degree, the gold standard was a managed system with central banking policy in some cases facilitating, and in other cases overriding, the ‘automatic’ adjustment mechanism (Lewis and Mizen, 2000, Chapter 2). Anyone who thinks that falling prices cannot occur under present-day conditions should reflect on the experience of Hong Kong, with its gold standard-type link to the US dollar, in the wake of the depreciations of other Asian currencies after July 1997, when Hong Kong’s real estate prices, office rentals and retail prices were heavily discounted to stay competitive with those other locations. Whether a deflation on this scale could be engineered in the United States across the board is a much more remote possibility,


41

although the recent cutting of automobile prices by Detroit to attempt to halt the decline of market share to Japanese producers indicates that many individual prices are far from inflexible in a downward direction. At a more practical level, of course, the monetary authorities in the United States are not as resistant as those in Hong Kong to allowing the exchange rate to depreciate for current account re-balancing. However, there are other options that are also available. What Other Adjustment Mechanisms Exist? Fifth, an adjustment to relative prices, either by changing the exchange rate or by movements in prices, is not the only way to eliminate the deficit. There are two other possibilities. One is an increase in interest rates. This was the classical adjustment mechanism employed by central banks when adherence to the gold standard ruled out parity realignments. Changes in ‘bank rate’ had two purposes. One was to attract short-term capital flows which acted as a palliative for the situation by reducing gold losses. Walter Bagehot once remarked that ‘8 per cent will bring gold from the moon’. The other side to an increase in interest rates was to tighten credit, discourage spending and slow home demand for imports and other goods, reinforcing the ‘automatic’ workings of the specie flow mechanism. In present circumstances, the lifting of interest rates is more likely to come from foreigners requiring higher interest rates before they will agree to roll over existing US debt or before they will lend more. In turn, higher interest payments by US consumers will mean lower consumption and reduce the demand for imported goods. This could conceivably result without a fall in the value of the dollar, although it is more likely to go hand-in-hand with dollar depreciation. It is also possible to visualize adjustment to the trade imbalance without exchange rate or interest rate changes, although again it is unlikely to occur in isolation of the other mechanisms. Foreign incomes will increase and foreign wealth will rise because of higher debt payments by Americans and as more US assets pass into foreign hands. As their income and wealth increases, foreigners will demand more US exports. On the American side, growing indebtedness will eventually result in some curtailment of consumption of imports from abroad. Consequently, a depreciation of the dollar is one possible, indeed likely, result of the US trade deficit but it is not the only avenue of adjustment to the imbalance, nor indeed is it necessarily the most important one. This is also the message of the other approaches to which we turn in the next chapter.

42


NOTES: 1. According to Lutz this downplaying of the capital account was a largely post-Second World War phenomenon. in the older theory of international trade, it was explained that an export of capital would, as a rule, lead to a surplus in the balance of payments on current account. The capital account commanded and the current account obeyed, and not the other way round as many people have it today. (1966, p. 40) It would appear from the Bernanke thesis and other views examined in chapter 3 below that there has been a return to the ‘older’ position. 2. The following is based on Kindleberger (1958). Let: X Z px, pz qx, qz r x z

physical quantity of exports physical quantity of imports foreign prices of exports and imports, respectively domestic prices of exports and imports exchange rate, expressed as units of domestic currency paid per unit of foreign currency (foreign) elasticity of demand for exports (domestic) elasticity of demand for imports.

In terms of foreign currency, the balance of trade is: B X (qxr). qxr Z (pz.r).pz A depreciation is indicated by an increase of r. To improve the balance of trade, it will have to result in a rise of B, the balance of trade. The condition for a successful depreciation is therefore: dBdr 0 or, after some rearrangement: X.qxr Z.pz x z 1 where: X .qx/r is the value of exports, and Z .pz the value of imports, both expressed in terms of foreign currency. If trade was balanced to begin with, the above condition says that the sum of the demand elasticities has to exceed unity if a small depreciation should be successful. This is the Marshall–Lerner condition. If there is an import surplus (Z .pz X .qx/r), a (small) devaluation will still result in an improvement even if the sum of the demand elasticities falls below unity. The permissible deficiency depends on the size of the trade deficit, as indicated in the condition above. Hence we have Machlup’s (1969) conclusion that ‘the larger the excess import demand for foreign exchange relative to the value of exports, the lower will be the critical value of the sum of the demand elasticities for imports and exports’ (p. 58). 3. There is also the old ‘J-curve’ effect which may come into play even if the exchange rate pass-through to import prices occurs. The J-curve effect is mainly ascribed to trade prices adjusting faster (depending on the exchange rate pass-through) than trade volumes to changes in the exchange rate (Giovannetti, 1992). Following an unexpected devaluation, the dollar value of existing imports rises due to the increased cost of an unchanged quantity of imports while the value of existing exports remains constant (the price of


43

exports in domestic currency does not change). This will cause the trade balance immediately to worsen. Somewhat later higher export and lower import volumes hopefully generate a favourable trade balance response (i.e. a J-shaped path), assuming that the Marshall–Lerner condition actually applies. Earlier evidence from the US economy suggests that, if a J-curve effect operates, the perverse impact has a duration of one to three years (Krugman and Baldwin, 1987). 4. In fact, of the 5.4 million Japanese cars sold in the United States in 2005, 3.7 million were manufactured in America and 1.7 million imported from Japan (Gapper, 2006). 5. Consider the commentary of Lutz: countries with balance-of-payments deficits expect the restoration of the ‘right’ relationships between cost levels to come from action by the countries with the balanceof-payments surpluses, on the grounds that an expansionary policy is easier to follow than is its opposite. A typical case in point is the pressure that was put on Germany in recent years to inflate in order to get rid of her balance-of-payments surplus. . . . the surplus countries will object that the other countries were originally responsible for the balance-of-payments difficulties, because they followed excessively expansionary monetary policies, and that it is therefore up to them to take steps to rectify the situation. Observers of the international scene will hardly regard this as an exaggerated description of the events of the last few years. (Lutz, 1966, pp. 49–50) 6. Hellerstein et al. (2006) question this finding. While accepting the general point that pass through is almost always incomplete (in the sense that a 10 per cent depreciation of the dollar will lead to a less than 10 per cent increase in the dollar price of imports), they argue that failure to allow for intrafirm transactions and other methodological problems have led to an overstatement of the decline in pass through over the last decade or so.

3.

National accounting perspectives

INTRODUCTION This chapter, like the previous one, is concerned with the causes of the US deficit. In Chapter 1 we outlined our way of classifying the causes of the deficit in terms of four approaches (trade, absorption, savings and investment, and portfolio balance) and two perspectives for each (domestic and international). Chapter 2 looked at the trade approach. When viewing the current account deficit in these terms we found there to be certain anomalies – in particular, elasticities pessimism and the Houthakker–Magee income elasticity asymmetry – that suggest difficulties in trying to account for the deficit from the viewpoint of trade flows alone. One reason is inherent in the analysis itself. Consider the condition that a deficit ‘improving’ devaluation depends on the size of the sum of the price-elasticities of demand for exports and imports. This is an example of Marshallian partial equilibrium analysis, which requires that the market be small. Smallness in this context means that the repercussions of it on the rest of the economic system can be ignored. However, even in the relatively ‘closed’ United States, the market for all exports and imports is not a tiny part of the economy and the income and other effects on the rest of the system cannot be neglected. For such reasons, in this chapter we broaden the analysis beyond trade flows by linking up the basic accounting identities of the balance of payments statistics with the national income and production accounts in order to examine the absorption approach, the savings and investment approach, and the portfolio balance approach.

THE ABSORPTION APPROACH According to the absorption approach, a country’s trade balance (surplus of exports over imports) will increase only if the country’s output of goods and services expands by more than its absorption, where ‘absorption’ means expenditure by domestic residents on goods and services. Let Y, C, I, G, X and Z stand for output, consumption, investment, 44


45

government expenditure, exports and imports respectively. The standard income–expenditure identity, YCIGXZ

(3.1)

X Z Y (C I G)

(3.2)

may be rewritten as:

From this identity it follows that the balance of trade will increase if output, Y, increases ex post by more than domestic absorption, (CIG). Developed by Sidney Alexander (1952, 1959) of the IMF, the absorption approach arose in the context of the postwar debate about the question of whether a devaluation will ‘improve’ a country’s trade position. The ‘elasticities approach’ posed the answer in terms of the elasticities of the demand and supply of exports and imports, which must be such that the increase in exports sold to foreigners and the reduction in imports bought by domestic residents together more than offset the terms of trade loss caused by the devaluation. The Marshall–Lerner conditions summarize the special case that focuses on the demand elasticities alone. By contrast, Alexander argued that for the devaluation to succeed it must widen the gap between domestic output and domestic absorption. A ready explanation is thereby provided for the appearance of ‘elasticity pessimism’. Exportables and importables cannot respond to the change in relative prices if those sectors are at full capacity. There is the need to ‘make room’ for exports to expand and to release resources for import substitution to take place. In these circumstances, in terms of the Swan (1955) diagram, the change to the trade position requires both the expenditureswitching effects of relative prices and expenditure-changing policies, since both influence output and absorption. A fuller analysis still would need to take account, first, of the inflationary effects of devaluation, since one way in which devaluation suppresses absorption relative to output is through the reduction in real wages of consumers and, second, monetary conditions, for the rise in prices may result in higher interest rates that help to curtail absorption (Vines, 1992). In this respect, the absorption approach is one part of a more general theory of the balance of payments. Nevertheless, the special merit of the absorption approach for the present discussion is in altering the focus from the microeconomic, revolving around the movement along demand and supply curves in the particular markets for exports and imports, to the macroeconomic, based around expenditure and production in the economy as a whole, in the domestic perspective, and world production and spending patterns, in the international perspective.

46


The Domestic Perspective Viewed through the prism of absorption, an increase in the trade deficit would be occasioned by total demand in the economy outstripping supply. This is the position shown in the top panel of Table 1.2 and the line of reasoning would run as follows. More of domestic production is absorbed by domestic expenditure, leaving less available for export and sucking in imports to make good the excess of expenditures over production. Consider the US domestic position of mid-2006. In broad terms, Wolf (2006a) described it in the following way: ● ● ● ● ●

Total demand is 107 per cent of GDP; Total output of tradable goods and services is 25 per cent of GDP; Total demand (and supply) of non-tradables is 75 per cent of GDP; Total demand for tradable goods and services is 32 per cent of GDP; and The difference between the demand and supply of tradables, and between total demand and supply, is equal by definition to the trade deficit, or 7 per cent of GDP.

Reasons for this state of affairs abound. Before looking at some of these, it is worth noting that any attempt to bring about a correction by means of expenditure-reducing policies alone would impose a heavy cost on the US economy, as Wolf observes. Suppose that a reduction of just 3 percentage points in the ratio of the trade deficit to GDP (from 7 to 4 per cent of GDP) is sought. This represents around 10 per cent of total demand for tradables. Assume, for simplicity, that the change in demand for tradable goods and services is proportionate to that for non-tradables. Without any alteration to relative prices, overall demand in the economy needs also to fall by about 10 per cent to generate the desired reduction in the trade deficit. This would create a fall of about 7 per cent in GDP, all of which would fall upon industries producing non-tradables. In order to avoid some of this recessionary impact, a decline in the real exchange rate would see the price of non-tradables fall relative to that of tradables, and shift expenditure toward non-tradables and potential supply toward tradable sectors. For these reasons, most policy prescriptions for the US deficit combine ‘expenditure-switching’ and ‘expenditure-changing’ adjustments. For example, Cline (2005b) emphasizes that two key economic changes are needed to curb the US external deficit. One is that the dollar needs to depreciate substantially to make US exports more attractive to foreign buyers and imports less attractive to American consumers. The

47


other is that US domestic demand needs to be curtailed to make room for a shift toward output for exports (disabsorption). As to the sources of the excess absorption, a catchall description is that the United States has become the ‘spendthrift nation’ (Lansing, 2005), alluding to the widening of the federal budget deficit since 2000 but primarily to the record indebtedness of the household sector. This latter development has shifted the focus from the federal budget deficit (under the ‘twin deficits’ hypothesis) as a prime driver of the record current account deficit. The government budget deficit Paul Samuelson (2005) considers budgetary spending to be ‘out of control’. In nominal terms, federal government outlays rose from $1.8 trillion in 2000 to over $2.7 trillion by the end of 2006. In inflation-adjusted, ‘real’ terms, however, Samuelson’s characterization looks stretched, with federal spending averaging 3.7 per cent per annum growth between 2000 and 2005, higher than the 2.1 per cent per annum real growth of federal spending between 1990 and 2000 but lower than the 4.0 per cent per annum average in the 1980s. Figure 3.1 puts this decade’s federal spending more firmly in historical context, and the argument that it is careering out of control becomes even harder to sustain. In truth, the ‘surge’ in federal spending this decade has done little more than return federal outlays to their longer-run share of national income. Indeed, were it not for the greater defence spending that the entanglements in Afghanistan and Iraq have produced, federal outlays might be below their long-run share of national income.

25

(NIPA basis, as a % of GDP)

23 21 19 17 Bars mark recession

15 1966

1970

1974

1978

1982

1986

1990

1994

Federal outlays (40-year average = 20.5%) Federal receipts (40-year average = 18.5%)


Figure 3.1

US federal outlays and receipts, 1965–2006

1998

2002

2006

48 20

Untangling the US deficit (Deflated by GDP deflator, four-quarter moving average, % y/y)

15 10 5 0 –5 –10 –15 Bars mark recession –20 1970 1974 1978

1982

1986

1990

1994

1998

2002

2006

Inflation-adjusted federal receipts Note: Deflated by the GDP deflator, 4-quarter moving average. Sources: BEA; authors’ calculations; Reuters Ecowin Pro.

Figure 3.2

US real federal receipts, 1970–2006

Rather as Figures 3.2 and 3.3 indicate, it was a rapid fall-off in federal tax receipts resulting from the stock market collapse, the attendant recession and the substantial tax cuts delivered by the Bush administration to counter these trends that accounted for the lion’s share of the budget deficit’s near 6 per cent of GDP deterioration between 2000 and 2004. In its turn, a combination of faster economic growth, booming house prices and a recovery in stock prices has seen a resurgence in federal tax receipts in 2005 and 2006. As a result, the federal budget deficit narrowed to $318 billion in 2005 and below $250 billion in 2006. As a share of GDP, the deficit had fallen to less than 1.5 per cent of GDP by mid-2006, actually below its 45-year average of around 2 per cent of GDP. The Bush tax cuts may have given some stimulus to the housing market. Nevertheless, in general terms, with the budget deficit now at more ‘normal’ levels and the current account continuing to move deeper into deficit, it seems unlikely that the ‘twin deficits’ explanation can be allotted a central role in our task to untangle the causes of the deficit. The household financial position While the notion of government profligacy would appear to be exaggerated, there can little doubt that the financial position of the household sector has entered uncharted territory with consumers’ dramatically increased indebtedness. In claiming that American society has become a ‘me–me, now–now, consume–consume people’, Samuelson in the same

49

National accounting perspectives 3 1 –1 –3 –5 Bars mark recession –7 1960 1965 1970

1975

1980

1985

1990

1995

2000

2005

Federal budget balance (as a % of GDP) Average 1960–2005 = 2.1% of GDP Sources: BEA; authors’ calculations; Reuters Ecowin Pro.

Figure 3.3 US federal government budget balance, 1960–2006 (quarterly data) article is on much firmer ground. Certainly, the figures are compelling. Personal savings rates have been in decline for over two decades. In the 1980s, the personal saving rate averaged 9.0 per cent of disposable income. During the 1990s, the personal saving rate averaged 5.2 per cent. Since 2000, it has averaged only 1.9 per cent. In 2005, as shown in Figure 3.4, it actually tipped into negative territory, in the ‘red’ to the tune of 0.3 per cent of disposable income. A negative saving rate means that US consumers are spending more than 100 per cent of their monthly after-tax income. Households do not spend only to consume, they also ‘invest’ by spending to acquire assets, either financial or housing. As a result, the household saving ratio is an imperfect gauge of the true balance between household spending and current resources. An alternative barometer is the household sector’s ‘financial balance’, defined as the difference between total household spending (consumption and investment) and income, expressed as a percentage of household disposable income or GDP, essentially the accountants’ ‘free’ cash-flow. The household sector’s financial balance, by definition, represents the ‘flow’ into the household balance sheet. If households’ spending is greater than income then the flow into the balance sheet must be negative. In other words, borrowing exceeds the acquisition of assets. Until recently, the household sector had always been in financial surplus. The balance is shown in Figure 3.5, and the excess of income over spending averaged 3.5 per cent of disposable between 1955 and 2000. As a result, the household sector had

50


12.5 10.0 7.5 5.0 2.5 0.0 Bars mark recession –2.5 1955 1960 1965 1970

1975

1980

1985

1990

1995

2000

2005


Figure 3.4

US household savings ratio, 1955–2006 (quarterly data)

12.5 10.0 7.5 5.0 2.5 0.0 2.5 5.0 Bars mark recession 7.5 1960 1965 1970 1975 1980 1985 1990 1995 2000 Household sector financial balance as a % of disposable income Mean 1955 2000 = 3.5% surplus of disposable income

2005


Figure 3.5 US household sector financial balance, 1960–2006 (quarterly data) always played the role of a ‘net lender’, with surplus funds out of current resources to lend to the other sectors of the economy, namely the corporate and government sectors. In terms of the flow of funds, the financial surplus/deficit represents net lending/borrowing. But in the late 1990s, the household sector began to slip into financial deficit for the first time since


51

the Second World War, and the ‘net borrowing’ has progressively accelerated. By the end of 2004, the financial deficit had widened to 3 per cent of household disposable income. By mid-2006, the deficit had expanded further to 6.5 per cent of household disposable income. The following identity links household income, spending and financial transactions: Cp Yd NFA NHA NFL

(3.3)

where Cp is personal consumption, Yd is personal disposable income, NFA is net acquisition of financial assets, NHA is net acquisition of housing assets, and NFL is net acquisition of financial liabilities. This simply says that, in aggregate, household disposable income plus borrowing (net acquisition of financial liabilities) can be spent on consumption or on housing or on the acquisition of financial assets. In turn, household borrowing can be decomposed into secured (i.e. mortgage) debt and unsecured (i.e. consumer credit). Mortgage equity extraction or ‘withdrawal’ is the difference between the secured borrowing and net investment in housing. If mortgage equity withdrawal (MEW) is then added to consumer credit, this yields ‘total household borrowing available for consumption’. It is ‘available’ for consumption as this borrowing can be used to finance either consumption or investment into financial assets. Both MEW and, in turn, ‘total household borrowing available for consumption’ have soared since the late 1990s as the household saving ratio has fallen. MEW was a record 5.25 per cent of household disposable income in 2005 and total borrowing for consumption also a record at 6 per cent of household disposable income. It appears therefore that unprecedented amounts of secured borrowing (mortgage debt) have been fuelling an unprecedented level of household consumption. From (3.3), it follows that, when household consumption is greater than the sector’s disposable income (the household saving ratio is negative), there are no current resources left for other spending i.e. investments in financial assets and housing. All of the household sector’s investments (and the excess of consumption over spending) must therefore be debt financed. Consequently, just as the household saving ratio has moved into uncharted territory in recent years so too has the composition of their investments. A simple rearrangement of (3.3) allows us further to explore swings in household consumption relative to disposable income in terms of the sector’s investments and borrowing.1 Dividing through by disposable income yields the following identity: CpYd 1 NFAYd NHAYd NFLYd

(3.4)

52


Expression (3.4) enables us better to understand household spending, investment and borrowing trends and underscores the point made above that, when the household saving ratio is zero or negative (the left-hand side of 3.4 is 1 or greater), all household investments must be debt-financed. Also, (3.4) allows us to determine more clearly what portion of household borrowing ‘available for consumption’ has been spent or whether this item financed increased household investments in financial assets i.e. stocks and bonds. In Table 3.1 we see that household investments in financial assets, while inevitably volatile year to year have declined from 10–15 per cent of disposable income in the 1980s to just 5 per cent of disposable income in 2006. This decline confirms that a substantial portion of MEW has been used to finance consumption. By contrast, household net ‘investments’ in housing (purchases of new housing plus spending on home improvements) unusually exceeded investments in financial assets in both 2005 and 2006 following a post-Second World War high of 7.3 per cent of household disposable income in 2005, and with 6.7 per cent of disposable income in 2006. The conjunction of low household saving and high investment in housing means that the ‘net acquisition of liabilities’ by the household sector has grown commensurately, this borrowing being the flip-side to the household sector’s financial deficit. Figure 3.6 shows how the flow of ‘net lending’ to the household sector has ballooned in recent years, with US consumer borrowing at 13.4 per cent of disposable income in 2005, more than double the post-Second World War average of 6.25 per cent of disposable income and only receding marginally to 11.3 per cent of disposable income in 2006. Not unsurprisingly, the expansion of household borrowing has produced a sharp rise in household income gearing (the stock of household debt to personal disposable income) and household interest gearing (the ratio of household interest payments and disposable income). The Federal Reserve’s estimates of the household debt service ratio (the ratio of mortgage and consumer debt payments to disposable income) reached a level (again a record) of 14.5 per cent by the end of 2006, despite mortgage rates remaining at historically low levels so far this decade. Household net worth There can be little doubt as to what underlies the remarkable change in household cashflows, namely the sharp rise in household net worth shown in Figure 3.7. Household net worth was broadly stable at around 4.75 times household disposable income in the half century or so to the mid-1990s. Initially driven by the bull-market in equities in the late 1990s, this ratio rose to over six times disposable income by the end of 1999. The collapse in equity prices between 2000–2003 then saw the ratio fall back towards its

53


Table 3.1

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Average 1980s Average 1990s Average 2000s

US household sector financial flows, 1980–2006 Consumption (as % of disposable income)

Net acquisition of financial assets (as % of disposable income)

Net acquisition of housing assets (as % of disposable income)

Net acquisition of financial liabilities (as % of disposable income)

90.0 89.1 88.8 91.0 89.2 91.0 91.8 93.0 92.7 92.9 93.0 92.7 92.3 94.2 95.2 95.4 96.0 96.4 95.7 97.6 97.7 98.2 97.6 97.9 98.0 100.4 101.1

14.9 15.7 15.8 17.2 16.6 17.2 16.9 13.2 13.0 8.7 13.2 10.4 9.7 9.3 9.2 8.7 8.6 6.3 7.5 5.0 1.0 5.8 6.0 11.4 10.7 6.7 5.0

4.7 4.2 3.4 4.7 5.0 4.8 5.3 5.5 5.3 4.9 4.3 3.9 4.3 4.7 5.1 4.7 4.9 4.9 5.2 5.4 5.2 5.3 5.5 6.0 6.6 7.3 6.7

5.9 4.8 3.6 7.2 7.5 10.6 8.2 7.3 7.3 7.4 5.5 4.7 4.3 5.4 6.3 6.2 6.2 5.8 7.1 8.6 8.2 8.1 10.0 12.5 13.7 13.4 11.3

91.0

14.9

4.8

7.0

94.8

8.8

4.7

6.0

98.7

6.6

6.1

11.0

Sources: Federal Reserve Flow of Funds; authors’ calculations.

54


14 12 10 8 6 4 2 1960

Bars mark recession 1965

1970

1975

1980

1985

1990

1995

2000

2005

Households’ net acquisition of financial liabilities % of disposable income 1% of disposable income Average 1955–2000 = 6 – 4


Figure 3.6

US household sector borrowing, 1960–2006 (quarterly data)

6.5 6.0 5.5 5.0 4.5 Bars mark recession 4.0 1955 1960 1965 1970

1975

1980

1985

1990

1995

2000

2005

US household net worth (as multiple of disposable income) Average 1955–1995 = 4.7 times


Figure 3.7

US household net worth ratio, 1955–2006 (quarterly data)

long-run average by 2002 before recovering equity prices and, more importantly, the rapid run-up in residential house prices pushed the net worth ratio back up to around 5.5 times household disposable income. Since 1995, the market value of the stock of owner-occupied housing has risen from around $8 trillion to around $20.5 trillion by the end of 2006. Moreover, the home mortgage debt linked to these houses has grown even


55

faster with the result that, while household net worth has risen sharply, households have become ever more leveraged against the value of their homes. Put simply, house prices have never risen as quickly as over the last decade and households have never borrowed so aggressively against the market value of the residential housing stock. At the same time, mortgage interest rates have rarely been so low, averaging just over 6 per cent per annum between 2001 and 2005. It would seem that household saving has dropped as low interest rates have inflated asset prices (particularly house prices) to elevated levels, encouraging households to finance consumption by borrowing against these high asset prices rather than save as they had previously done.2 Having sketched out this background, we now turn to two key related questions in the quest to untangle the causes of the US current account deficit. One is the question of whether there has been a speculative ‘bubble’ in housing prices. And ‘bubble’ or not, the other question is the contribution of the Federal Reserve’s monetary policy under the chairmanship of Alan Greenspan to these developments. A housing price bubble? The connection between house prices and consumer spending has been made by none other than Alan Greenspan himself in February 2005 at the Adam Smith Memorial Lecture in Glasgow. He began by noting that ‘the growth of home mortgage debt has been the major contributor to the decline in the personal saving rate in the United States from almost six per cent in 1993 to its current level of one per cent’. Further, the rapid growth in home mortgage debt over the past five years has been ‘driven largely by equity extraction’. In fact, ‘approximately half of equity extraction shows up in additional household expenditures, reducing savings commensurately and thereby presumably contributing to the current account deficit.3 The fall in US interest rates since the early 1980s has supported home price increases’ (Greenspan, 2005a). In his closing remarks at the symposium sponsored by the Federal Reserve Bank of Kansas on ‘The Greenspan Era’ at Jackson Hole in 2005, the former Chairman went even further, explicitly linking the growth in home equity extraction to the widening of the current account and, in turn, identifying a cooling down of the housing boom to improvement in the deficit. Nearer term, the housing boom will inevitably simmer down. As part of that process, house turnover will decline from currently historic levels, while home prices increases will slow and prices could even decrease. As a consequence, home equity extraction will ease and with it some of the strength in personal consumption expenditures. The estimates of how much differ widely. The

56

Untangling the US deficit surprisingly high correlation between increases in home equity extraction and the current account deficit suggests that an end to the housing boom could induce a significant rise in the personal saving rate, a decline in imports, and a corresponding improvement in the current account deficit. (Greenspan, 2005b)

In effect, the argument is that with lending rates low and with little to be gained by putting money in savings accounts and a lot to be gained by borrowing, households did what might be predicted: they stopped saving and began borrowing. In the words of Michael Dooley, ‘it would be foolish to pass up such a bargain’ (Dooley, 2005). Households financed their spending by borrowing against the rising value of their homes – ‘equity extraction’ in Greenspan’s terminology. From the 67 per cent average that prevailed over the period 1975 to 2000, the consumption share of GDP rose to 71.1 per cent in 2003 and was still 70 per cent in 2006. A colourful description is that ‘people have being using their homes like an ATM machine, withdrawing cash by refinancing in order to supplement their wages’ (Swann, 2006, p. 26). Former Federal Reserve Chairman Paul Volcker has chimed a similar note: ‘homeownership has become a vehicle for borrowing and leveraging as much as a source of financial security’ (Volcker, 2005). The importance of residential property, and the equity invested in it, to the American consumer is apparent. In 2005, 69 per cent of households owned their own homes, up from an average of 64 per cent in the 1980s, while the equity locked up in the property makes up the great bulk of the non-pension assets at retirement (Venti and Wise, 1991). The course of residential property prices is thus a major concern to most households (including the 31 per cent who are renting), and the more so because of financial innovations that have made it easier and less costly to borrow, and to extract equity using second mortgages. For example, consider instruments such as option adjustable rate mortgages (option ARMS) and interest only (IO) loans. The former give borrowers the option to make partial interest payments and negatively amortize the loan balance. Doing so, while house prices rise, is effectively an automatic withdrawal of equity. IO loans enable borrowers to defer the start of their amortizing mortgage repayments. Choosing such a mortgage enables the household to qualify for a larger loan amount, leveraging their credit and gaining increased exposure to housing markets (Frankel, 2006). To some extent therefore, the house-price boom became self-reinforcing until valuations and the sheer amount of mortgage debt taken on began endogenously to cool the boom in 2006. In the second edition of Irrational Exuberance, Robert Schiller (2005) devotes a new chapter to the real estate market. His house price index (deflated by the CPI) for the period 1890–2005 is graphed and analysed by Michael Bordo (2005). There has not been anything in the 116-year history

57

National accounting perspectives (Deflated by the CPI excluding shelter costs, 1975 = 100)

190 170 150 130 110

Bars mark recession

90 1975

1980

1985

1990

1995

2000

2005

US existing home prices, inflation adjusted Sources: BLS, OFHEO; authors’ calculations (quarterly data, deflated by the CPI excluding shelter costs); Reuters Ecowin Pro.

Figure 3.8

Real US house prices, 1975–2006

of housing prices to match the increase from the mid-1990s to 2005. In real terms home prices in 2005 were 67 per cent above their 1950–1995 average and nearly 50 per cent higher than their previous peak (which was in 1894). Schiller makes the case for the United States being in a housing bubble, although Bordo is sceptical since nation-wide booms and busts in the housing market are a rarity in the United States. Certainly, by all of the most commonly employed measures, house price inflation has been exceptionally strong since the late 1990s. Perhaps the best measure of house prices is the purchase-only price index of existing homes published by the Office of Federal Housing Enterprise Oversight (OFHEO). Inflation adjusted, this index increased a mere 14 per cent between 1975 and 1997. Since 1997, when the current housing boom began in earnest, real house prices have expanded by over 60 per cent. Figure 3.8 gives details. Another measure used to assess housing price movements is the house price-to-rent ratio, akin to a price-to-earnings (p/e ratio) calculation for stock prices. The argument is that, just as the price of a share should encompass the discounted present value of future dividends or profits, the price of a house should be underpinned by the future benefits of ownership, either of rental income earned by the landlord or the implicit rent saved by the owner-occupier. In the United States, a housing p/e ratio can be calculated by dividing an index of housing prices by an index of rents included in the consumer price index (specifically the index of so-called owners’ equivalent rents). As shown in Figure 3.9, house prices have outpaced rents, driving the

58

Untangling the US deficit 150

3.9 140

3.7

130

3.5

120

3.3

110

3.1

100

2.9 2.7 1984

Bars mark recession 1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

90

2006

Ratio of median house prices to median household incomes Ratio of existing home prices to rents, 1983 = 100 (RHS)

Sources: Bureau of Labour Statistics; Office of Federal Housing Enterprise; National Association of Realtors; authors’ calculations; Reuters Ecowin Pro.

Figure 3.9 Measures of US housing affordability, 1983–2006 (quarterly data) price/rent ratio by mid-2006 to 45 per cent above its long-run average. Its inverse, the ‘cap rate’ or yield (net rental income divided by market price) was at an all-time low. Such numbers raise the question of whether real estate prices have been sustained more by expectations of future price gains than by the fundamental rental value. Stiglitz (1990) defined a ‘bubble’ when the price is high today only because investors believe that the selling price is high tomorrow, and fundamental factors do not seem to justify such a price. The third measure is the house price-to-income ratio, that is, average house prices to average or median incomes, which tracks the affordability. In contrast to the housing p/e ratio, measuring the relative costs of owning and renting, the price/income ratio gives a measure of housing costs relative to the ability to pay. Again the ratio for the United States is at a record level, about 14 per cent above its 25-year average. The IMF estimated that, relative to fundamentals such as disposable income per household, mortgage rates and the unemployment rate, US house prices were probably some 15–20 per cent above their ‘equilibrium’ range (IMF, 2006a). Whether these figures constitute a ‘bubble’ is more difficult to call. If so, by the same measures – real housing price growth, price/rent and price/income ratios – the bubble is very much larger in the United Kingdom and Australia and some other countries than it is in the United States (The Economist, 2003, 2006b). Fisher and Quayyum (2006) argue that much of the increase in home-ownership in the United States is due to ‘fundamentals’ such as changes in the demographic, income, educational and


59

regional structure of the population, rather than speculation or unusually expansionary monetary policy. Also, Himmelberg et al. (2005) consider that more precise measures are needed of the ‘imputed rental’ and the ‘opportunity cost of capital’ to determine the financial returns from owneroccupied property, allowing for taxes, expected house price appreciation, expected inflation, and real long-term interest rates. While they conclude that it is too early yet to state definitely that there has been a US housing bubble, the one thing that comes through is the critical importance of the real interest rate in housing investment because when this is low, homeownership is relatively attractive since mortgage payments are low and alternative investments do not yield much. In effect, on this interpretation, low interest rates have underpinned Dooley’s ‘bargain’ that it would have been foolish of American consumers to pass up. The role of monetary policy This leads us to the second possible contributor to excess absorption, in the shape of US monetary policy. By most accounts Alan Greenspan was, in the words of Milton Friedman, ‘the most effective chairman of the Fed since its inception’ (Business Week, 7 November 2005, p. 52). Despite a number of economic shocks (including the 1987 stock market collapse, the bursting of the dotcom stock market bubble, and the 9/11 terrorist attacks) the US economy experienced sustained economic growth interrupted by only two mild recessions during his tenure as chairman. Over that time, inflation fell gradually from 4 per cent per annum to around 2 per cent per annum, reflecting that achieving and maintaining price stability was seen by him as central to attaining sustainable growth (Kahn, 2005).4 Some commentators, however, question whether the long-run legacies of his policies might be seen in a different light. Greenspan’s philosophy of central banking has been described as ‘ride the booms, cushion the busts’ (Business Week, 7 November 2005, p. 52). He was one of the first economists to embrace the notion of a ‘new economy’ built around a technology-driven productivity boom in the second half of the 1990s. His willingness to run the economy ‘hot’ and tolerate the booms created an environment that fostered innovation and business start-ups. Equally, his subsequent willingness to start lowering the Federal funds rate from 6.5 per cent in 2001 and bring it down to 1 per cent in 2003 and keep it there for over a year was explicitly motivated by the Federal Reserve’s determination to insure at all costs against the small risk of the economy slipping into the painful debt–deflation spiral that so be-devilled the Japanese economy in the 1990s and early years of this decade. The ‘easy money’ policy of 2002–2004 did indeed generate a favourable backdrop to enable the heavily indebted corporate sector to restructure financially and work off the worst of the financial excesses of the

60


late 1990s, but at the cost of exacerbating other imbalances in the economy. The jury remains out on whether this has been a price worth paying. In order better to evaluate the balance sheet of the Greenspan years, it is worth investigating in more detail just how ‘loose’ monetary policy was set in the final years of the Greenspan Fed. Using a methodology developed first by Frederic Mishkin (1981) but used more recently by Christina and David Romer (2002), we estimate an ex ante real Federal funds rate. First, an ex post real Federal funds rate is calculated, subtracting the GDP deflator as the inflation measure from the effective Federal funds rate. The ex ante real rate is then estimated by regressing the ex post rate on a constant, time trend and four lags of the nominal Federal funds rate, the deviation of GDP from trend and inflation.5 The fitted values of this equation are estimates of the ex ante real Federal funds rate, shown in Figure 3.10. The results are striking. On this measure, the real Federal funds rate was set below zero for the first time since the 1970s and then held there for 12 successive quarters. Monetary policy was easily the most expansionary since the policy-makers’ misguided attempts to inflate the economy out of the first oil price shock in the mid-1970s – a parallel few modern policy-makers would be eager to acknowledge. The Economist (2006a) in its assessment of the Greenspan era suggested that his faith in the productivity miracle may have blinded him to the dangers of excessive monetary ease. Consequently, ‘his policies allowed domestic demand to grow faster than supply, causing America’s current account deficit to swell alarmingly’ (p. 68). To this must be added the emergence of the ‘China price’ and the disinflationary forces in the global 10.0 7.5 5.0 2.5 0.0 –2.5 –5.0 Bars mark recession –7.5 1975 1980 1985 Ex-ante real Federal funds rate (%)

1990

1995

2000

2005

Sources: BEA; Federal Reserve of St Louis; authors’ calculations, Reuters Ecowin Pro.

Figure 3.10

Ex-ante real Federal funds rate, 1972–2006 (quarterly data)


61

economy spawned by the Asia crisis that have helped restrain US inflation over the last decade and perhaps fostered a greater willingness to test the economy’s ‘speed limit’. Another serious charge is that the Greenspan era saw a reorientation of monetary policy away from ‘putting a floor under labour markets’ towards ‘putting a floor under financial markets’ (Palley, 2005). On this view, the so-called ‘Greenspan put option’ has generated moral hazard, triggered over-exuberance and the mis-pricing of risk in successive asset markets and so underwritten the explosion of household debt discussed above. In turn, rising asset prices and the enchanced access to credit of US households have pumped up the US economy by accelerating consumption spending. The legacy, in the shape of the biggest economic imbalances in American history (negative household savings, external deficit), will linger. To these can be added Greenspan’s support for the Bush tax cuts, and its early impact on another imbalance, the federal budget deficit. In the words of Tim Geithner, president of the Federal Reserve Bank of New York, ‘we will be living for the next decade with the shadow caused by these imbalances and also the risk they present of occasional volatility of asset prices and perhaps periods of slower growth here and elsewhere’ (Business Week, 15 May 2006, p. 110). To some degree, the Federal Reserve’s achievement in producing a long period of economic stability and low inflation, and hence low long-term interest rates, may have induced investors to demand less compensation for risk, pushing up asset prices. On the other hand, it may be argued that if the Fed always cuts interest rates when asset prices weaken, and never raises them when asset prices are inflated, such a policy will be ultimately destabilizing. Should investors come to believe that monetary policy will come to the rescue if things get too tough and asset prices fall too far, that expectation may encourage investors to sail closer to the wind. That, certainly, is the conclusion of The Economist: ironically it is perhaps his extraordinary popularity and perceived wizardry that best explain the problems he will leave behind. Investors’ exaggerated faith in his ability to protect them has undoubtedly encouraged them to take ever bigger risks and pushed share and house prices higher. In turn, American consumer spending has become dangerously dependent on unsustainable increases in asset prices and debt. (2006a, p. 69)

The view that ‘success breeds excess’ has also been made by William White, economic adviser to the Bank for International Settlements (White, 2006). He argues, as above, that periods of stable inflation are likely to be marked by an increasing willingness to take risks (‘irrational exuberance’), and the longer the period of macroeconomic stability, the greater the

62


underlying excesses in fixed investment and credit borrowings are likely to be. Inflation targeting offers no resistance to these upswings and the associated expansion of asset prices. Worse, the focus on inflation and the ‘asymmetrically aggressive’ loosening of monetary policy in downturns may, in his view, destabilize the system in the longer term. Over the last decade, for example, the dramatic reductions in the prices of computing and communications, the ‘China price’, and the productivity improvements in all sorts of manufacturing (e.g. automobiles, machine tools, household appliances) have all reduced prices and inflation expectations (Wolf, 2006b). Policies that sought to avoid deflation or keep inflation in a 2–3 per cent range may well have elicited monetary outcomes that fuelled asset price rises because the low inflation failed to signal overheating in key sectors of the economy, especially housing. In fact, minutes of the Federal Reserve Board’s Federal Advisory Council (comprising 12 representatives of the banking industry)6 held on 6 December 2002 (that is, at the ‘eye of the storm’), did indeed report that ‘inflation pressures have remained largely subdued’ (p. 20). At the same time, however, the Council conveyed the message of ‘strong consumer loan demand’ that ‘seems counterintuitive when viewed against four consecutive months of decline in consumer confidence’ (p. 20). Council members used words such as ‘boom’, ‘frenzied’, ‘soaring’ or simply ‘strong’ when describing the pace of mortgage refinancing which ‘accelerated dramatically during 2002’ (p. 20), as we showed earlier in Figure 3.6. Nevertheless, the predominant themes coming from Council members were the potential for a drop in housing prices and the increased levels of debt being shouldered by the consumer. Whereas evidence of a ‘housing bubble’ is anecdotal and regionalized, the Council does express concern that housing prices will not be able to rise at this pace forever. Levels of home equity have been supported by these increased housing values but should those values begin to fall, lenders will be faced with higher loan to value ratios and with little room for the problems created by a potential downturn in the economy. (pp. 21–2)

Also: While the growth in mortgage-related loans has been substantial, it is uncertain as to whether this ‘boom’ will continue indefinitely. Interest rates will inevitably start to rise. . . . It is unlikely that rates could fall much further to a level that would create an additional wave of refinancings. (p. 21)

Of course, as we know now, interest rates did fall. Despite what Council members called ‘the extraordinarily low interest rate environment’ at that


63

time, the Federal funds rate was cut by a further one quarter per cent in 2003 and held there for a year. Alan Greenspan, Ben Bernanke and Donald Kohn have delivered numerous detailed and spirited defences of their approach to framing monetary policy over the last decade and the challenges of how to respond to asset prices swings (Bernanke, 2002; Greenspan, 2005b; Kohn, 2006). All three argue the difficulty in identifying asset price bubbles and the high potential costs of extra action if a bubble is mistakenly identified. As to the charge of policy asymmetry – a willingness to ease policy more aggressively in response to asset price weakness than to counter high asset prices with tighter policy, all three policy-makers argue that this is justified given the profoundly adverse consequences that market corrections can have if they lead to price deflation. Kohn argues that the experience of Japan in the 1990s and the manner in which the Federal Reserve worsened the Great Depression in 1930 and 1931 by allowing the money supply to contract provide ‘object lessons concerning the wisdom of central banks easing promptly and aggressively following market slumps when inflation is already low, so as to head off the threat posed by the zero lower bound’ (Kohn, 2006). Bernanke also adduces the example of Hjalmar Schact’s aggressive attempt to bring down stock prices in the Weimar Republic in 1927 as an example of mistaken asset price ‘popping’ that contributed to sub-optimal economic out-turns (Bernanke, 2002). Alan Greenspan has explicitly laid out that the super-easy monetary policy of 2003–2004 was a deliberate attempt to ensure forcefully against the small, but corrosive risk of deflation. The so-called ‘maestro’ is worth quoting at length: In the summer of 2003, for example, the Federal Open Market Committee viewed as very small the probability that the then-gradual decline in inflation would accelerate into a more consequential deflation. But because the implications for the economy were so dire should that scenario play out, we chose to counter it with unusually low interest rates. The product of a low-probability event and a potentially severe outcome was judged a more serious threat to economic performance than the higher inflation that might ensue in the more probable scenario. Moreover, the risk of a sizable jump in inflation seemed limited at the time, largely because increased productivity growth was resulting in only modest advances in unit labor costs and because heightened competition, driven by globalization, was limiting employers’ ability to pass through those cost increases into prices. Given the potentially severe consequences of deflation, the expected benefits of the unusual policy action were judged to outweigh its expected costs. (Greenspan, 2005b)

As already argued, it remains too early to ascertain whether the costs of the 2003/2004 ‘deflation insurance policy’ will ultimately outweigh the

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90

(as a % of own GDP, bars mark recessions)

80 Total credit market debt

70 60 50 40

Corporate bonds

30 Bank loans

20 10 0 1955

Commercial paper 1960

1965

1970

1975

1980

1985

1990

1995

2000

2005


Figure 3.11 US non-financial corporations’ indebtedness, 1955–2006 (as a % of own GDP quarterly data) benefits, namely the successful avoidance of deflation and the significant de-leveraging of the corporate sector between 2001–2005. As Figure 3.11 underlines, private non-financial corporation debt has subsided, while the longer-term interest rate structure has enabled corporations to ‘term out’ their liability structure with the result that short-term liabilities like bank loans and commercial paper have fallen as a share of total debt. Measures of corporate liquidity, such as the ratio of liquid, short-term assets to shorter-term liabilities, shown in Figure 3.12, have risen to levels not seen for around 40 years. But while the corporate sector’s financial health has successfully been restored, the antidote of super-easy monetary policy has had obvious side effects: creating fresh imbalances by fuelling an already well-entrenched housing market boom with ‘extraordinarily low’ mortgage rates, further elevating household net worth, lifting consumption to more than 70 per cent of GDP and widening the current account deficit. In the context of the deflating of the dotcom boom and of September 11, US policy-makers may well have felt that they were on the edge of an abyss. But is this true of the circumstances of 2006 and the unwinding of the house price boom? Yet, Federal Reserve officials have signalled, once again, that they stand ready to ‘cushion the bust’ and could, and most likely would, begin to ease monetary policy once again in 2007 to help shore up asset prices and, in turn of course, the household sector’s balance sheet. Witness the following statement by William Poole, a voting member of the Federal Open Market Committee (FMOC).

65

National accounting perspectives 65 60 55 50 45 40 35 30 25 20 Bars mark recession 15 1955 1960 1965 1970

1975

1980

1985

1990

1995

2000

2005

‘Liquid’ short-term assets as a % of short-term liabilities

Source: Federal Reserve Flow of Funds; authors’ calculations; Reuters Ecowin Pro.

Figure 3.12 US non-financial corporations’ liquidity, 1955–2006 (quarterly data) With long-run inflation contained, the FOMC has flexibility to respond, vigorously if necessary, to economic weakness should it arise. The FOMC brought the target federal funds rate down aggressively in 2001 in response to incoming information. Aggressive easing kept the recession mild. If the economy comes in below the baseline forecast in coming quarters, the FOMC will have room to act as aggressively as required. I have no idea what scale of easing might be appropriate, for that will depend on the nature of the incoming information. Still, I believe forecasters should assign a relatively low probability to deep recession precisely because of the FOMC’s demonstrated willingness to act aggressively as necessary. (Poole, 2006)

Perhaps, like old generals, the officials are intent on fighting the last war. Claudio Borio (2006), of the Bank for International Settlements, notes that it is hard to find a period in the post-war era in which inflation-adjusted interest rates have been so low for so long and monetary and credit aggregates have expanded so much without igniting inflation. He wonders whether this experience – dubbed the ‘great liquidity expansion puzzle’ – may herald the emergence of new environment in which the main structural risk is not runaway inflation, but rather the build-up in financial imbalances. Borio’s hypothesis is that: financial liberalisation may have made it more likely that financial factors in general, and booms and busts in credit and asset price in particular, act as drivers of economic fluctuations. The establishment of a regime yielding low and stable inflation, underpinned by central bank credibility, may have made it less likely that signs of unsustainable economic expansion show up first in rising inflation

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Untangling the US deficit and more likely that they emerge first as excessive increases in credit and asset prices (‘the paradox of credibility’). . . . As a result, the current environment may be more vulnerable to the occasional build-up of financial imbalances, i.e. overextensions in (private sector) balance sheets . . . [The main structural risk is posed by the unwinding of the financial imbalances which] may occur either because inflation eventually does emerge and the central bank is forced to tighten or because the boom falters under its own weight. (2006, p. 3)

He argues, contrary to the Federal Reserve officials, that ‘the case for a preventive monetary response’ in such circumstances has been ‘gaining greater favour within the central banking community’ (p. 20). Indeed the Fed seems to be increasingly isolated amongst central bankers in its philosophy of ‘riding the boom’ and its opposition to ‘leaning against the wind’ to prevent an asset bubble inflation.7 The bond market conundrum One manifestation of the low inflation-adjusted interest rates referred to by Borio is the bond market ‘conundrum’. The emergence of this situation in the United States in the period from mid-2004, when the Federal Reserve began the long process of removing excess monetary ease and normalizing the level of policy rates, has to some extent hampered policy-makers in attempting to minimize the costs or long-run impact of the ‘deflation insurance policy’ on the economy. The ‘conundrum’ can be defined as the failure of longer-term interest rates to respond to changes in the Federal funds rate in the normal fashion. Figure 3.13 illustrates that in the six tightening cycles preceding the 2004–2006 episode, the yield on the ten-year Treasury note was on average almost 100 basis points ((bp) where 100 basis points equals one percentage point) higher after one year. By mid-2005, ten-year Treasury yields were some 70bp lower than at the onset of tightening. It was not until mid-2006, with the Federal funds rate having been raised 425bp to 5.25 per cent that ten-year yields had finally moved up by some 60bp two years after the onset of the tightening cycle. Speaking in September 2005, Alan Greenspan noted that ‘This decline in mortgage rates and other long-term interest rates in the context of a concurrent rise in the federal funds rate is without precedent in recent U.S. experience’ (Greenspan, 2005c). The factors behind the ‘conundrum’ remain controversial but, with much housing finance provided at fixed long-term rates, there can be no question that it has hampered the Federal Reserve’s attempts to remove the excess ease of 2003–2004 and so almost certainly raised the long-run costs of the ‘deflation insurance policy’. Two explanations have been offered for the generally low level of long-term interest rates. One is a ‘liquidity effect’

67

National accounting perspectives Percentage points 1.5 1 Average of last six cycles 0.5 0 –0.5 2004–2006 tightening cycle

–1

Weeks before and after first Fed Funds increase –1.5 –52

–40

–28

–16

–4

8

20

32

44

56

68

80

92

104

Sources: Federal Reserve; authors’ calculations.

Figure 3.13 The US bond market ‘conundrum’ (weekly data, change in ten-year Treasury bond yield) resulting from the increased purchases of US Treasury securities by foreign central banks (Warnock and Warnock, 2005). The other or ‘expectations effect’ attributes the low level of long-term rates to a lowering of the inflation risk premium built into real and nominal long-term rates as a consequence of reduced inflation uncertainty (Mehra, 2006). An OECD study (2006) opts for both in terms of global savings–investment balances, official reserve accumulation, ‘petro-dollar’ recycling and pension fund demand for long-term securities, along with shifts in expected short-term rates and a compression of term premia. There may be another foreign connection here, too, since the reduced risk of inflation may be due to the impact of ‘the China price’ across a wide range of goods. However, the Federal Reserve itself may be largely responsible for the lagged response of US long-term interest rates to the policy reversal. This response flowed from the revolution in the Federal Reserve’s communications strategy in the summer of 2003 after the Federal funds rate had been lowered to 1 per cent. To counter market expectations that policy rates could soon be lifted, the FOMC adopted a strategy of providing financial markets with an unusually high degree of short-term guidance about the policy outlook in order to keep interest rates at all maturities unusually low for as long as possible. Beginning in August 2003, market participants were put on notice that policy rates would be kept at the emergency level of 1 per cent for a ‘considerable period’ of time. The markets were then forewarned

68


that, while a change in policy was imminent, the FOMC would be ‘patient’ in removing the record degree of policy accommodation. Finally, the FOMC pledged only to raise the Federal funds rate slowly at the ‘measured pace’ of 25bp per FOMC meeting. This policy doubtless contributed to the ‘conundrum’ by telegraphing the Committee’s intentions to financial markets and so dampening risk premiums and market volatility (Woodford, 2005). Indeed, the commitment of the FOMC to first preserve for some time and then only slowly remove the ‘deflation insurance policy’ was almost certainly designed to ensure that the returns to the policy were the greatest possible. As Woodford emphasizes: The ‘considerable period’ language seems to have been intended to influence market expectations in a way that would stimulate additional spending – higher spending, that is, than would have occurred if expectations had been allowed to change in the direction that it was feared they would in the absence of such assurance from the FOMC. (Woodford, 2005, p. 432)

Viewed in this light, the Federal Reserve’s persistent astonishment at the ‘conundrum’ is disingenuous given that its adoption of a unique policy ‘signalling’ strategy in this period was explicitly designed to keep long-term interest rates at historically low levels. But some contribution has almost certainly been played by the improved inflation performance of the US economy (as built into expectations) and also by the unusual strength of capital inflows into the United States, particularly the strong demand for fixed-interest assets in recent years, a phenomenon over which the Federal Reserve may have had little, or no, control. It has been estimated that the ‘liquidity effect’ of capital inflows depressed ten-year Treasury yields by up to 150 basis points in 2005, greatly complicating the Federal Reserve’s task and further exacerbating the economy’s imbalances (Warnock and Warnock, 2005). It is to the international dimension that we now turn. The International Dimension The international influences on absorption have not been discussed in any detail in the literature, but the bare bones can be outlined. First, the counterpart to excess absorption in the United States is a rest-of-the-world excess supply of tradable goods over effective demand, at least in those countries following exchange rate policies that stimulate export-led expansion in the tradable goods sectors. Second, an early study of the US trade deficit found a considerable discrepancy between the actual deficit and what it would have been if the United States and its trading partners had been operating at their potential rather than actual output levels


69

(Papaioannou and Yi, 2001). The implication was that much of the deficit was due to the strong cyclical upswing in the United States in comparison with some other major countries. Things have, of course, moved on since then. Nevertheless, the general point remains, namely that the United States has been growing more strongly than Japan and the eurozone. Should the US deficit be attributed to excess absorption by the United States or to excess disabsorption by Japan and the euro area? For example, between 1995 and 2004, annual real GDP growth in the United States averaged 3.2 per cent compared to 1.1 per cent in Japan, 1.4 per cent in Germany, and 2.3 per cent among eurozone economies. The potential importance of this discrepancy in growth is illustrated by the strong expansion of US exports in real terms in 2005 (12.4 per cent relative to import growth of only 7 per cent) when Japan and Europe recorded stronger economic growth. Nevertheless, the ‘dismal arithmetic’ (the fact that imports are 80 per cent larger than exports) meant that the US current deficit still widened. The third factor, which operates indirectly, is the extent to which the expansion of US imports has been facilitated by a growth in the variety (and lessened cost) of tradable goods production overseas. The data were shown in the previous chapter, in Table 2.2. In 1972, there were 7 731 types of goods imported by the United States and 74 667 varieties of goods. In 2001, there were 16 390 goods and 259 215 varieties. This reflects the vast structural shifts that have taken place in developing countries, which have increased their manufacturing activities in virtually all categories of goods, from textile, garments, home appliances through to aircraft. Even the US balance of trade in agricultural goods has been altered substantially by imported perishables along with an array of processed fruit derivatives (Sacchetti, 2005). The ‘China price’ has, for the present, hastened the demise of some segments of US manufacturing unable to keep up with 50 per cent cheaper machine moulds, 25 per cent in networking equipment, 40 per cent in bedroom furniture, and 45 per cent in crepe paper (Business Week, 6 December 2004, pp. 102–25).

THE SAVINGS–INVESTMENT APPROACH The savings–investment perspective is the one preferred by many economists. Corden (1992), for example, states that ‘the current account of the balance of payments is the net result of savings and investment, private and public’ (p. 567). This approach also draws on the accounting identities in the National Income and Product Accounts. In general terms, the national accounts are structured such that the total output (GDP) is divided into its

70


principal components of consumption, investment, spending by government on goods and services, and net exports. Total income from production can be either consumed or saved or paid in taxes and transfers. These relationships imply that a current account deficit must equal the difference between US domestic investment, or capital formation, and total US saving by both the private sector and government. However, it is sometimes preferred to work in terms of ‘national’ identities (Higgins and Klitgaard, 1998). Specifically, the national income accounts treat gross national product (GNP) as the sum of income derived from producing goods and services under the following categories: private consumption (C), private investment (Ip), government goods and services (G), and exports (X). Imports (Z) are treated as a negative item to avoid the double counting of consumption or investment goods purchased at home but produced abroad. Thus GNP is given by: GNP C Ip G X Z

(3.5)

with X – Z representing net exports plus net factor income (capturing the returns on domestic and foreign assets). A second basic equation in the national income accounts is based on the truism that any income received by individuals has four possible uses: it can be consumed (C), saved (Sp, for private savings), paid in taxes (T), or transferred abroad (Tr). Because GNP is simply the sum of the income received by all individuals in the economy, we have: GNP C Sp T Tr

(3.6)

By equating the two expressions for GNP, and rearranging terms, we derive the following identity: Z X Tr (Ip Sp ) (G T)

(3.7)

with Z X Tr equating to the current account deficit. In other words, the current account deficit is equal ex post to the surplus of private investment over saving and the gap between government expenditure and government tax receipts on goods and services, that is, the government budget deficit. The Domestic Perspective Viewed from a US domestic perspective, the current account deficit can be attributed to the two right-hand-side terms of (3.7), the government budget

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Table 3.2 Savings – investment imbalances and the current account deficit, 2003–2006 (US$ billion) 2003 Corporate investment Corporate saving Balance

1067

Household investment Household saving Balance

597

2004 1204

1242

1280

1313 175

1550 134

778

410

2006 1444

1414 109

684

377

2005

105 768

259

164

221

274

519

605

31

180

385

487

530

536

457

314

Net foreign investment** Statistical adjustment

561

716

842

801

39

76

87

10

Current account balance

522

640

755

811

Private sector balance* Government budget balance

Notes: * Corporate and household balances do not add exactly to the private sector balance due to exclusion of non-profit organizations. ** Net foreign investment is conceptually equivalent to the current account balance shown in Table 1.1 with some small measurement differences from the flow of funds data. Sources: National Income and Product Accounts; Flow of Funds Accounts.

deficit and the excess of private investment over saving. The statistical counterparts are given in Table 3.2. One explanation that gained popularity in the 1980s was the ‘twindeficits’ view. While we doubt its importance in the context of the widening of the current account deficit in recent years, it warrants some consideration. The argument is that, other things equal, a budget deficit implies a decrease in national saving, which is the sum of private saving plus the government fiscal balance. When national saving falls and is insufficient to finance investment, requiring borrowing from abroad, the current account is in deficit. In effect, in order to finance the budget deficit, claims on US

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assets are exported and there is a capital account surplus. This indeed is the situation at present. The US capital account surplus has included a large accumulation of US Treasury debt by foreigners. The latest Flow of Funds data report that, by the end of 2006, over $2 trillion of US Treasury debt was held by foreigners, representing almost 44 per cent of the total outstanding, although foreign purchases of any US assets, and not just Treasury bonds, serve to help finance a government budget deficit. Despite the obvious appeal of the twin-deficits idea, other things are not always equal and, in particular, private saving and investment are unlikely to remain constant, although the precise nature of their response remains unclear because of the different causal links between the fiscal deficit and the current account deficit. One mechanism is through interest rates. A larger fiscal deficit increases domestic demand, pushing up domestic interest rates relative to foreign rates, which in turn attracts investors, raises the value of the dollar and widens the current account deficit. The government’s financing demands, however, seem likely to dampen private consumption and private sector investment, thus moderating to some degree the impact on the current account. Another channel operates through wealth. Under the ‘Ricardian equivalence’ theorem, people save more if the government saves less because of the future tax burden. A larger budget deficit due to increased government spending leads domestic residents to expect higher taxes in future. In order to pay for the future taxes, people will want to save and accumulate wealth either by spending less or by increased work effort. The former leads to some moderation, as above, to any impact on the current account deficit, while the latter makes the capital stock more productive which stimulates investment spending and widens the current account deficit. A larger government budget deficit due to a cut in taxes, rather than an increase in government spending, also raises work effort, the productivity of capital, investment and the current account deficit. Finally, as might be expected, a government budget deficit due to greater spending on non-traded labour services (health, education, public order) seems likely to have a smaller impact on the current account than one generated by expenditure on traded goods (Cavallo, 2005). These theoretical results suggest that some differentiation of the source of the budget deficit is needed to examine the twin-deficits idea. For example, Baxter (1995) studies first, an increase in government expenditure not matched by an increase in tax revenues and, second, a decrease in labour and capital tax rates not matched by a reduction in expenditure. Under both policies, the increase in the budget deficit is equivalent to about 1 per cent of GDP in the short run, and it dies out gradually over the longer run. Her results show that, following an increase in the budget deficit, the


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current account balance deteriorates by about 0.5 per cent of GDP. Later studies focusing on tax cuts have found a much smaller impact (only 0.12 per cent of GDP). A Federal Reserve study has estimated that each dollar change in the fiscal deficit leads to a change in the trade deficit of approximately 20 per cent (Economic Report of the President, 2006). The Fed’s macroeconomic model suggests that the more expansionary fiscal policy since 2001 has primarily crowded out private investment and consumption rather than net exports (Ferguson, 2005). A Federal Reserve Bank of New York study (Bartolini and Lahiri, 2006) of OECD countries finds that each dollar rise/fall in the fiscal deficit is associated on average with a 30 per cent decline/increase in the current account. What then do we conclude about the twin-deficits argument? In theory, the budget deficit and the current account deficit should move together. Fiscal deficits are a form of dissaving, and reduce the availability of domestic saving to fund investment. Unless matched by an equal reduction in domestic investment, the net demand for foreign saving and the current account deficit will rise. There is also some supporting evidence for the proposition. Quite clearly, there are episodes such as in the 1980s when the fiscal position and the current account balance have moved in tandem, and others where they have diverged. Between 1992 and 2000, for example, the total federal, state and local budget balance shifted from a deficit of $297 billion to a surplus of $239 billion, but the current account deficit widened by over $365 billion, instead of falling as the twin-deficit story might suggest. This is apparent from Figure 3.14, which shows the government budget balance and the current account balance, both as a per cent of GDP. However, such trends ought not to be unexpected. In the face of a large productivity-driven increase in investment, the budget balance and the current account balance would not necessarily move in the same direction. Indeed, it is doubtful if anyone has said, or even implied, that the budget balance and the current account balance must always twin each other dollar for dollar. Jeffrey Frankel (2006) argues that the twin-deficits idea needs to be redefined as a shortfall of domestic saving, whether public or private. The fall in private sector savings has been as significant a contributor to the fall in national savings as has been the expansion in the budget deficit. Corporate sector savings have exceeded the increase in corporate investment, and that sector has been in surplus from 2003–2006. The big change has taken place amongst households. Residential investment has increased and household saving has fallen. By 2005, the household sector deficit exceeded the fiscal deficit. The dramatic decline in household saving has been documented in the previous section, along with household net worth which in gross terms has been buoyed up by the growth in house prices,

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Untangling the US deficit (as a % of GDP, four-quarter moving average) 3 1

–1 –3 –5 Bars mark recession –7 1960 1965 1970 1975 Government balance Current account balance

1980

1985

1990

1995

2000

2005


Figure 3.14 US current account and government budget balances, 1960–2006 (quarterly data) which has allowed the withdrawal of equity by borrowing. By the end of 2005, American households had given up saving out of current income entirely. This leads us back to the role of the housing ‘bubble’ and equity withdrawal and the reader is referred to the earlier discussion of the household financial balance (see pp. 48–59 above). The International Perspective The United States is not alone in the decline in its national savings. Table 3.3 shows trends in global savings and investment divided into various groupings of countries. The differences are striking. Savings ratios have generally fallen in the industrial countries and risen in the other countries. The differences are probably due (under the life-cycle hypothesis)8 to demographics (ageing populations in industrial countries), developed financial markets that allow people to borrow and thus dissave, and capital gains from housing wealth which has been a feature of most industrial countries. Emerging market economies generally have a younger fastergrowing population profile, while oil exporters have recently experienced a favourable oil price shock that (in terms of the permanent income hypothesis)9 is likely to increase savings. Another striking difference in the table is that the United States is the only grouping (although not the only country) for which savings are less than investment. For all other groupings, savings exceed investment, and

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Table 3.3

Global saving and investment as % of GDP, 1984–2006 1985–92 Average

1993–2000 Average

2000

2006

22.8 23.5

22.1 22.5

22.3 22.4

22.8 22.8

0.5 0.4

Advanced economies Saving 22.3 Investment 22.8

21.7 21.9

21.6 22.1

19.8 21.2

1.8 0.9

United States Saving Investment

16.7 19.3

16.8 19.4

18.0 20.8

13.7 20.0

4.3 0.8

Eurozone Saving Investment

21.4 21.1

21.3 22.0

21.3 21.3

0.0 0.7

Germany Saving Investment

24.0 21.5

20.7 21.7

20.1 21.8

22.8 17.7

2.7 4.1

Japan Saving Investment

33.6 30.8

30.0 27.5

27.8 25.2

28.0 24.1

0.2 1.1

Newly industrialized Asia1 Saving 35.4 Investment 29.1

33.5 30.7

31.9 28.4

31.3 25.7

0.6 2.7

Developing Asia Saving Investment

28.0 30.9

32.9 33.0

30.0 28.2

42.2 36.9

12.2 8.7

Middle East Saving Investment

16.8 23.2

24.2 22.6

29.4 20.0

40.4 22.5

11.0 2.5

Fuel exporters Saving Investment

26.9 29.1

24.8 22.5

33.3 20.2

37.0 22.2

3.7 2.0

World Saving Investment

2006 less 2000

Note: 1. Newly industrialized Asian economies comprise Hong Kong, Rep. of Korea, Singapore, Taiwan, POC. Source: International Monetary Fund, World Economic Outlook, April 2007, Statistical Annex, Table 43, p. 280.

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their current account balances are correspondingly in surplus. This stark contrast could be seen as evidence of American profligacy. However, under the ‘Bernanke thesis’, the problems are seen to originate in the rest of the world and are not primarily ‘made in the USA’ (Bernanke, 2005). In a world system of open economies and developed international capital markets, savings are relatively free to cross international borders and a country’s savings and investment need not be equal in each period. Indeed, in such a context, it may not be helpful to think in terms of countries, since the saving and investment patterns are the result of the decisions of many millions of individual households and firms, seeking the best use of their resources. But let us continue with countries or regions, as was done by Bernanke. If one region (the United States) has national saving that is currently low and falls considerably short of its capital investment (which includes residential construction as well as business construction and equipment), then this shortfall of savings relative to investment must necessarily be matched, in aggregate, by a surplus of saving relative to investment elsewhere. This result is a truism, and says nothing about causation. Is the US imbalance ‘made in the USA’ as the product of a precipitous decline in the US national saving rate (mainly the household saving rate), which the rest of the world has obligingly financed from its savings? Or, is there a dearth of investment and a surplus of saving in other countries which the United States has been ready to accept and willingly put to work? Put this way, many might respond by saying a little of both. However, it is the burden of Bernanke’s argument that the US imbalance is primarily a reaction to events external to the United States. The surplus of savings outside the United States, which Bernanke calls the ‘global savings glut’, is attributed to ageing populations and declining workforces in countries such as Japan and Germany, along with a lack of domestic investment opportunities. This is for the industrial countries. However, as was apparent from Table 3.3, there is also a strong growth of saving, in excess of investment, in the emerging markets group and amongst oil producing economies. Countries that were once borrowers are now net lenders. This swing is explained by two major factors. One is a determined policy amongst those countries that experienced financial crises in the 1990s (Asian, Latin America, Russia) to avoid a repeat performance by reducing their vulnerability to foreign capital and by building up a ‘war chest’ of international (mainly dollar) reserves. To this end, the countries have tapped domestic savings by issuing debt to their citizens, and then used the funds to accumulate US Treasury bonds and other securities as strategic reserves. The other factor is the sharp rise in oil prices that has boosted the current account surpluses of oil exporting countries.


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The next step in the argument is to explain how the savings glut generates the US imbalance. As Bernanke points out, the emerging market countries can increase their current account surpluses only if the industrial countries (presumably mainly the United States) reduce their current account positions correspondingly. At issue is how this process occurs. Bernanke saw it facilitated by asset price changes and exchange rate movements, in two stages. First, there was the equity price upswing in the late 1990s that acted as a magnet for foreign capital and drove the dollar up in value. Higher stock market wealth, in turn, encouraged Americans to consume more. In savings–investment terms, investment increased and saving declined. After the dotcom crash in 2000, the US current account deficit continued to widen, as the second influence took over. The global savings glut saw interest rates fall, and low real borrowing rates on home mortgages came into effect. US households went into debt and strong gains in housing prices, rather than stock prices, then seemingly became the principal driver of lower US saving. The final question is why the United States, amongst industrial countries, should have been especially favoured as the recipient of the surplus savings. A number of factors are advanced: the technology boom and the Silicon Valley phenomenon; the depth, sophistication and rapid pace of innovation of US financial markets; and the special status of the US dollar. It can also be noted that the United States is not the only advanced country to have run up large current account deficits in recent years. The Australian current account balance has followed an almost identical path. France, Italy, Spain, New Zealand and the United Kingdom have also had their current account deficits widen over the period from the mid-1990s to 2006. Some of these factors are explored in the next chapter which focuses on the ‘international’ explanations for the US external deficit. The structural factors that have helped make the United States the natural home for ‘excess’ savings will also be discussed later in this chapter in the context of the portfolio balance approach and again in Chapter 7 which takes a yet more detailed look at the demand for the US assets. The Bernanke thesis is undoubtedly the most important of the ‘made abroad’ theories of the deficit due to the positions occupied, then and now, by the person who advanced it, but it is by no means the only explanation and we review five different perspectives in the next chapter. While we thus defer our assessment of the Bernanke view to the next chapter, in the meantime we make a number of observations. First, the term ‘global savings glut’ is evocative, but inaccurate. In reality, relative to GDP, both saving and investment have been on a downward trend for the past 30 years in the world economy as a whole. Second, the ‘once-bitten-twice-shy’ explanation for international reserve accumulation does not obviously

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apply to China, which survived the Asian financial crisis. Instead, other arguments have been advanced for China. Third, the global savings glut was not the only factor driving down world interest rates. Monetary policy was loosened in the three major currency blocs. In 2003, central bank policy rates were set at levels not seen for decades in what some market practitioners dubbed the ‘0–1–2 structure’, that is, 0 in Japan, 1 per cent in the United States and 2 per cent in the euro area. Fourth, as will be explored in Chapter 7, demographic factors and poor economic performance have produced sharp falls in investment and hence boosted net savings in much of Europe and Japan. The underlying picture is, in practice, more variegated than the sometime monolithic characterization drawn by some proponents of the savings ‘glut’ thesis. Fifth, in this particular aspect, but also in general terms, it has to be conceded that there are obvious political (and thus policy-making) benefits in blaming others for the US trade deficit, since the other countries can then be enjoined into sharing the adjustment costs. This is not to say that there is not some merit in the Bernanke position. Rather, it needs to be treated with some scepticism (because it is so convenient for US policy-makers).

THE PORTFOLIO BALANCE APPROACH Returning to equations (3.5)–(3.7), a final step is needed to clarify the link between the current account balance and the net flow of foreign investment capital. When running a current account deficit, the United States uses more of the world’s output than it produces, and imports more goods than it produces. In exchange, the rest of the world is offered financial claims against future US output and income. These financial claims consist of stocks, bonds, Treasury issues, bank accounts, and other types of securities. Private individuals and organizations hold most of these claims, but foreign governments, their central banks, and international organizations often acquire a large portion, as has been the case in recent years. Contrariwise, US residents accumulate financial claims when the United States has a current account surplus and, as we established earlier, an excess of saving over investment. Each dollar of saving can be classified according to the type of asset it buys. In particular, saving can be used to purchase domestic physical capital, domestic government debt, or a foreign asset (FA) of some kind. Since the net issuance of government debt is equal to the government budget deficit, G T, we derive: Sp Ip (G T) FA

(3.8)


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Rearranging: FA (Sp Ip ) (G T) X Z Tr

(3.9) (3.10)

These equations represent that a country runs a current account surplus and accumulates foreign assets (or equivalently, is a net lender to the rest of the world) when domestic private saving is more than sufficient to finance private investment spending plus the government budget deficit. The next step is to address the issue of causation and recognize that, from this perspective, these capital account adjustments can play an important independent role that is governed by the motivations of both foreign and domestic investors. In particular, the capital market flows can be thought of as the equilibrium outcome of investors worldwide seeking to acquire portfolios that balance risk and return through diversification. Even though millions of people make independent decisions about saving and investment choices and about which financial instruments to buy, if their actions do not match up, a whole host of economic parameters – exchange rates, interest rates, prices, etc. – will adjust to pull them into alignment. This balancing up through the market is the essence of the portfolio balance approach. A particular insight of the portfolio balance approach relative to the others is that greater attention needs to be given to the role of international capital markets in the evolution of global imbalances. Put simply, the liberalization and global growth of financial markets has led to the creation of entirely new investment opportunities for investors in both the United States and abroad. These new opportunities have almost certainly given rise to a rebalancing of portfolios. Further, this rebalancing may have involved the net export of claims on US assets, i.e. the US capital account surplus and the associated current account deficit. Such might be the result of a swing by US investors towards domestic assets combined by a swing by foreigners towards US assets. The Domestic Perspective Home bias (i.e. a preference by residents for domestic investments) is a feature of most economies, but may have been accentuated in the United States over the years 1995–2005 by two developments. One was the surge in labour productivity growth that increased from an average 1.5 per cent per annum in the two decades up to 1995 to around 3 per cent per annum from then to 2005. This expansion raised perceived rates of return on

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US investments, and these expectations in turn boosted equity prices (Ferguson, 2005). The resulting increase in household wealth and consumption undoubtedly pushed expected returns higher. Coming in the wake of the Asian, Latin American and Russian financial crises, funds that might have flowed to emerging market mutual funds and other investment avenues could well have returned home. They might have been kept at home by the slow recovery in the emerging economies and, more particularly, by the strong growth of residential real estate prices and household net worth. Americans have poured both their own and borrowed money into housing, and residential investment as a share of GDP stands at its highest level since the 1950s. Financial market innovations have made extracting housing equity easier in the United States. We documented earlier the change in mortgage debt as a per cent of GDP, along with estimates of mortgage equity withdrawal. To what extent such developments reduced the flow of private US investment capital overseas remains an open question. The International Perspective What is apparent, however, is that foreign capital has flowed to the United States. These inflows may also have been attracted by the dotcom boom and American real estate, but in addition other factors almost certainly have played a role. First, there was the structure of interest rates. Long-term interest rates may have been low in the United States, but they were lower still in Japan. In early 2005, ten-year bond yields in the United States were hovering around 4 per cent per annum, and had been for over 12 months. In Japan, they were also stable, but at a fraction over 1 per cent per annum. Anatole Kaletsky of The Times presented some calculations based on 20-year bond yields in Japan and the United States (the yields are graphed in Figure 3.15). A Japanese retiree buying and holding US bonds would get a return 23 per cent higher than from Japanese bonds. To eliminate this additional return, the US dollar would have to fall below ¥57 over the 20-year period. Obviously it might, but he considered the odds are that it would not (The Australian, 26-27 February 2006, p. 42). To that potential source of demand can be added that from the ‘carry trade’, where money is borrowed in a country where it is cheap, like Japan, and invested in a country where rates are higher. US bonds are thought to have gained most from the yen carry trade, with investors borrowing yen to buy American Treasury bonds (The Economist, 8 April 2006, p. 170). Second, there is the role of demographics, as mentioned earlier. Europe and Japan, in particular, have populations that are ageing more rapidly than that of the United States. A retired household typically consumes


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8 7 6 5 4 3 2 1 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Japanese benchmark 20-year JGB yield (%) US benchmark 20-year Treasury yield (%) Sources: Federal Reserve; authors’ calculations; Reuters Ecowin Pro.

Figure 3.15 US and Japanese 20-year government bond yields, 1995–2006 (quarterly data) more than its income, drawing down retirement savings in the process. In the same way, an entire country may draw down international investments to finance the consumption of its retired population. Japan has a high saving rate relative to its domestic investment rate and a large current account surplus. It is thus accumulating assets abroad that may be run down in future years to support its elderly citizens. This process is one that will evolve over many years. What may appear to be an imbalance now may make perfect sense over a longer-term horizon (Poole, 2004). A third influence is that, as a result of high oil prices, oil producers are investing a large amount of the windfall in global bond markets. When oil prices soared in the 1970s and early 1980s, their surpluses were largely deposited in banks in America and Europe, which then lent the money to oilimporting developing countries. This time, most of the money has gone into bonds, as well as equities, property and hedge funds. A lot of it is thought to have ended up, via intermediaries in London, in America’s bond market. Higgins, Klitgaard and Lerman (2006) find that ‘most petrodollar investments are finding their way to the United States, indirectly if not directly. The IMF estimates that the oil exporters’ investments have shaved one-third of a percentage point off American bond yields. This has reduced yields, supported American house prices and hence consumer spending, and so helped to sustain the US external deficit (The Economist, 22 April 2006, p. 74). Fourth, underpinning these developments is what many see as a reduction in home bias (the disinclination of investors to invest outside their own

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country) and that this trend has permitted larger current account imbalances than would have been possible previously because national savings increasingly are being used to finance investment in other countries. A growing capacity of global financial markets to finance current account deficits does not necessarily mean that the United States would tap this enlarged capacity. However, it has been suggested that the unusually favourable investment climate, protection of investor rights and prospects for rates of return make it likely that when international financing constraints are lifted, the United States would enjoy larger capital inflows (Ferguson, 2005). Fifth, a major attraction factor is that the US dollar serves as both a medium of exchange and a unit of account in many international transactions. In addition, US financial markets are among the most highly developed in the world, offering efficiency, transparency and liquidity. This is particularly true of the markets favoured by those investors, especially central banks, seeking liquidity and safety. While economists are used to thinking of equity markets as being highly liquid, they are in fact highly illiquid relative to government securities markets for bonds and Treasury bills. In the United States over the 21-year period, 1980–2000, the average turnover rate for US government bonds and Treasury bills was 13.9 times per annum compared with 0.575 times per annum for equity on the New York Stock Exchange (Wood, 2006). Many overseas private and governmental investors rely on the US capital market as the best place to invest in extremely safe and highly liquid securities. The United States as a whole earns a return from providing these safe and liquid investments in the form of a higher income on its investments abroad than foreigners receive on their investments in the United States. In this respect, Poole (2004) argues that it is useful to think of US financial markets as a whole serving as a world financial intermediary. Much like a bank, or a mutual fund, channels the savings of many individuals toward productive investments, the US financial markets undertake a similar role for large numbers of investors from around the world. Individuals, companies and governments abroad accumulate dollar-denominated assets which serve as a vehicle for facilitating transactions and safely storing liquid wealth. A bank makes its return on capital by paying a lower interest rate to depositors, after covering the costs of intermediation, than it earns on its assets. Similarly, the United States receives income from its longer-term direct investments overseas in excess of that which it pays out. A simple example is currency, which provides a zero pecuniary return. Over one-half of the total amount of US currency on issue is circulating abroad (Coughlin, Pakka and Poole, 2006). By contrast, only a trivial amount of foreign currency is held in the United States.


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There are a large number of explanations for the global imbalances that revolve around these themes, namely shifting world preferences for dollar assets and the extent to which the special role of the dollar contributes to this demand. These different hypotheses have a considerable bearing on the sustainability of the US external deficit. For example, if there has been an increased demand for dollar assets that has provided ready finance for US spending, is it a temporary phenomenon (due to oil prices or accumulating a ‘war chest’ of reserves) or does it signal a permanent change in international financing conditions (due to a reduction in home bias)? If the latter, what are the circumstances in which the increased demand for dollar assets might slow down or even reverse? How responsive is the demand to interest and exchange rates? Is the demand for the dollars conditional implicitly on the United States following a particular course of action? Questions such as these are explored in the following chapters.

NOTES 1. Stephen Nickell, among others, has profitably used this identity better to disentangle the web of the household sector’s spending, investment and borrowing trends, see Nickell (2004). 2. A large body of research has examined the causes and consequences of the declining personal saving rate (an overview of which is provided by Marquis, 2002). In line with this work, a recent statistical model of household saving behaviour (Lansing, 2005) finds that the savings ratio can be modelled by three explanatory variables: 1. The ratio of household residential property wealth to personal disposable income; 2. The ratio of household stock market wealth to personal disposable income; and 3. The yield on a 10-year Treasury bond. The wealth ratios capture the notion that households perceive asset appreciation to be a substitute for the practice of saving out of wage income. The ten-year Treasury yield is a measure of the perceived return to saving and captures the idea that asset valuation ratios are strongly influenced by movements in nominal interest rates. 3. As the household saving rate is measured relative to disposable income, any spending financed with the proceeds of capital gains will increase consumption spending but not income, thereby lowering the measured saving rate. It is a ‘rule’ of national accounting that only book saving, rather than paper gains, can finance capital investment and so ultimately increase real national output. Capital gains therefore do not add to GDP and also cannot supply any of the saving needed to finance gross domestic investment. Spending financed by capital gains will lower saving relative to investment and so boost the current account deficit, hence the close relationship between mortgage equity extraction and the current account balance. This point has been emphasized by Alan Greenspan on numerous occasions. 4. This is consistent with the monetary policy objectives. The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to

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Untangling the US deficit promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. Federal Reserve Act [12 USC 225a. As added by act of 16 November 1977 (91 Stat. 1387) and amended by acts of 27 October 1978 (92 Stat. 1897); 23 August 1988 (102 Stat. 1375); and 27 December 2000 (114 Stat. 3028).]

5. Following Mishkin (1981) and Romer and Romer (2002), we construct an ex-post real federal funds rate by subtracting a two-quarter moving average of the GDP deflator’s annual growth rate from the federal funds target rate. This dependent variable is then regressed on the usual constant and time trend plus four lags of the nominal federal funds target rate, the GDP deflator inflation rate and the ‘output gap’, which is calculated by applying a Hodrick–Prescott filter to real GDP. The equation is estimated over the period of 1972Q1 to 2006Q3. 6. This meeting was attended by Chairman Greenspan, Vice Chairman Ferguson, and Governors Gramlich, Bies, Olson, Bernanke and Kohn. 7. The Economist (2 October 2004 and 25 March 2006) discussed the two views at some length. The recent surge in house prices around the world has revived the debate about whether central banks should raise interest rates to cool down asset inflation. The Federal Reserve’s Alan Greenspan has declared himself fully vindicated in his decision not to prick the stockmarket bubble in the late 1990s, but instead to wait for it to burst and then cut rates sharply to cushion the economic consequences. A central bank, he argued, cannot be sure that it is really dealing with a bubble until it has burst, and raising rates by enough to prick a suspected bubble could itself set off a deep recession. Claudio Borio, an economist at the BIS, and Philip Lowe, at the Reserve Bank of Australia, have tried to shift the emphasis of this debate away from the question of whether central banks should prick a bubble. Instead, they look more broadly at financial imbalances, particularly excessive growth in credit, which tends to signal problems ahead . . . If it is possible for central banks to identify the build-up of financial imbalances in good time, then they can restrain those imbalances, rather than just waiting to offset the economic consequences of their uuwinding . . . An increasing number of central banks such as the Bank of England, the European Central Bank and the Reserve Banks of Australia and New Zealand, now support the view that monetary policy should sometimes act to restrain a rapid increase in credit and asset prices . . . . . . the ECB has pointed to the ‘second pillar’ of its monetary-policy strategy, which monitors growth in money supply and credit, to explain why it did not ease policy more. Otmar Issing, the bank’s chief economist, argues that central banks cannot afford to ignore asset prices and credit. Among the main central banks, only the Fed still seems to reject this advice. (2004, pp. 23–4) These issues were revisited in the 2006 article which discussed a conference in March in which Mr Donald Kohn, of the Board of Governors, defended the Fed view that: because of huge uncertainties, it is too risky to respond to bubbles and therefore it is safer to ‘mop up’ by easing policy after a bubble bursts. He tried to present the Fed’s approach as a neutral one, i.e. less activist than the ECB’s [position] that policy should be tightened by more than inflation alone would require. (2006c, p. 79)


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To what The Economist called ‘the usual Fed line’ it commented: that is misleading. There is no such thing as ‘doing nothing’. Under the Fed’s approach, unfettered liquidity sustains a bubble. (2006c, p. 79). Notably, the ‘Bernanke Fed’ has seen considerable change of personnel on the FOMC but the Committee’s thinking on the relationship between monetary policy and asset prices seems little changed. In a speech on the role of house prices in shaping monetary policy, Federal Reserve Governor Frederic Mishkin concluded that ‘central banks should not give a special role to house prices in the conduct of monetary policy but should respond to them only to the extent that they have foreseeable effects on inflation and employment.’ (Mishkin, 2007) 8. The life-cycle theory developed by Ando and Modigliani (1963), at its simplest suggests that consumers smooth their consumption flow, despite the fact that their income varies over their lifetime. They will save when their income is high and dissave when their income is low, especially in retirement. The proportion of a country’s population in each category will depend on the age distribution of the population. 9. The permanent income hypothesis of Milton Friedman (1957) suggests that, in the face of fluctuations in income, consumers will base their consumption of services on the average or ‘permanent’ level of income and, other things equal, save transitory changes in income.

4.

The international perspective

THE AGENDA The title of this chapter may seem to be misplaced, for any discussion about the US external deficit necessarily must have an international dimension. It is not possible for the United States to have a current account deficit unless some other countries, and all other countries in combination, have a current account surplus. Rather, what we mean by the distinction between domestic and international is whether the increase in the US current account deficit primarily reflects economic policies and other economic developments within the United States (the domestic explanation) or whether the deficit is primarily responding to economic policies and economic developments that originate outside of the United States (the international or Nth currency perspective). For example, from a domestic viewpoint the trade imbalance might be seen to be a consequence of trade-related factors such as variations in the quality or composition of US and foreign-made products (and there have been large changes in the latter), to changes in trade policy, or to unfair foreign competition (lack of intellectual property rights protection, currency manipulation), factors widely discussed in business circles, labour unions and in Congress. Most economists, however, have tended to offer explanations based on macroeconomic variables which, from a US domestic perspective, revolve around excess absorption (spending running in excess of output), fuelled by the fiscal deficit, or a savings– investment imbalance due to the collapse of national savings. Finally, the attractions of the domestic productivity boom and the housing ‘bubble’ may have led to some diversion of US capital exports to home, widening the capital account surplus that is the counterpart of the current account deficit. These explanations were examined in the two previous chapters. In this chapter we focus on the international explanations. These were outlined in broad terms in the preceding chapter as (1) the pursuit by many of the United States’ trade partners (especially in East Asia) of mercantilist trade policies involving undervalued exchange rates, (2) under-absorption in Japan and the eurozone due to slow growth, (3) the global savings glut, and (4) portfolio balance changes that have seen dollar assets expand in 86


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international portfolios. Our discussion here concentrates on a number of specific hypotheses in more detail. These are: ● ● ● ● ●

The Bernanke thesis New Bretton Woods The exorbitant privilege The empire of debt Globalization and home bias.

THE BERNANKE THESIS REVISITED The Bernanke position has engendered considerable interest not only because of its progenitor (then on the Board of Governors of the Federal Reserve System, now its Chairman), but because it runs directly counter to what might seem the most obvious explanation, namely that the US current account deficit is the result of US policies and the economic decisions of US households and corporations. Instead of relating the deficit to excessive borrowing and spending and insufficient savings by US households and the US government, the United States was cast in an accommodating role, rather than an initiating one. Instead of being ‘made in the USA’, the deficit is perceived chiefly to be the result of decisions made abroad that have produced a glut of savings on world financial markets. As explained in the previous chapter, a significant increase in the global supply of saving is said to have pushed down long-term real interest rates to low levels and flooded the United States with inflows of capital. As a result, US savings fell and investment rose generating the US current account deficit that is the statistical counterpart of the capital account surplus. Macfarlane’s Five Questions Ian Macfarlane, Governor of the Reserve Bank of Australia, considers the Bernanke argument to be the best explanation of global payment imbalances because it starts with surplus countries (i.e. those with current account surpluses) and puts the focus on why their national saving is so much higher than their national investment, which is evident from Table 4.1. (However, he considered the ‘glut of savings’ could more appropriately be called the ‘dearth of investment’ since there has not really been an increase in world saving, only a redistribution. Alternatively, a more accurate description might be ‘glut of savings in surplus countries’). Governor Macfarlane argues that this shift of emphasis from the US deficit to the position of the surplus countries is important because it

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Table 4.1

Saving and investment ratios, 2000–2004 (% of GDP) USA

Other Anglo

Euro area

Asia Japan

China

Other East Asia

Saving Investment

15.1 19.3

17.7 18.9

21.0 20.5

27.6 24.8

43.7 40.9

29.8 24.4

Deficient ()/ Surplus ()

– 4.2

–1.2

0.5

2.8

2.8

5.4

Source: Macfarlane (2005).

better can explain the five main questions that are in need of explanation. These are: 1.

2. 3.

4. 5.

Why did the US current account deficit start to widen sharply after 1997, reach such a higher percentage of GDP, and yet has been relatively easily financed? Why has Asia run such large current account surpluses and built up such a high level of international reserves? Why did the world’s central banks push short-term interest rates to their lowest level for a century, and why has this apparently easy monetary policy not led to an appreciable pick-up in inflation? Why have bond yields been so low, and why have they stayed low even when short-term interest rates have been raised? Against this background of wide payments imbalances, why have the margins for risk in corporate and emerging market debt been so exceptionally low?

Consider, first, the ease of financing. This is accounted for under the Bernanke/Macfarlane view by the plentiful supply of footloose, internationally-mobile capital generated by the ‘glut’, which has not had to be attracted by higher interest rates. Second, it is argued that in the wake of the Asian financial crisis, ‘governments of the region reached the conclusion that they had to make their economies more resilient to international capital flows. The simplest way of doing this was to cut expenditure (particularly investment expenditure), keep savings high, run current account surpluses and build up international reserves’ (Macfarlane, 2005, p. 5). As noted previously, this leaves the case of China, which did not suffer in the crisis. Macfarlane argues that China still absorbed the same lesson, reacted accordingly and built up its international reserves. The third question, as to


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why central bank interest rates were held down so long, is argued to have been caused by the low ruling inflation rates that gave the central bankers no reason to raise interest rates. Low inflation in its turn is explained by disabsorption in the surplus countries whereby spending failed to keep pace with production. Fourth, the global savings glut readily accounts for the low real long-term interest rates, with the greater supply of loanable funds (or demand for bonds) holding down bond yields. Finally (and one would have to add, less persuasively) the low risk margins are attributed also to the global savings glut. With a world excess supply of funds looking for a home, and bond yields so low, the supply spilled over to other securities as investors sought out alternative investment avenues that offered higher returns, compressing risk margins. Having answered the five questions posed, Governor Macfarlane goes on to note that some observers may think that ‘US profligacy and excessive reliance on debt’ have been let off rather too lightly (and we would put up our hands in agreement). If these were the causes, Macfarlane continues, then a very different set of outcomes would have ensued. In his words: What . . . would have happened if increased US spending and reduced savings had not been accommodated by Asian saving and lending? The answer is that the increased US spending and lower US saving would not have occurred, or would only have occurred on a greatly reduced scale. If the excess world saving had not been available, the global economy would have been in the opposite position, namely excess demand in goods and capital markets. US demand for funds would have pushed up bond rates, inflationary pressures would mean US monetary policy would be tighter, and the US Government would have difficulty funding its budget deficit. (2005, p. 7)

However, in our view there are some missing elements in his story. Before looking again at the five questions, we note two things. First, in the quotation above there is a subtle change in emphasis. In the Bernanke view, the savings glut induced US spending, whereas in the account above, it accommodated it. This suggests the possibility of multiple causes, which brings us to the second point. While many economists seem attracted to the idea of single explanations, we see it as much more reasonable (and likely) that a number of explanations are intertwined. The Five Questions Re-assessed Let us now return to Macfarlane’s five questions. First, it is apparent from Figure 1.1 (p. 1 above) that the current path of the US current account deficit began in 1992 well before the glut of savings began. True, the deficit widened after 1997, although there were rather extensive depreciations of the Asian

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24

(as a % of gross national income)

22 20 18 16 14 Post-WWII averages

12 1950

1955

1960

Gross investment

Sources:

1965

1970

1975

1980

1985

1990

1995

2000

2005

Gross national saving

Federal Reserve Flow of Funds; authors’ calculations; Reuters Ecowin Pro.

Figure 4.1

US national savings and investment, 1948–2006

currencies against the dollar to be brought into the story (just as the 1992 devaluation of the renminbi against the dollar cannot be entirely overlooked either). From a US domestic viewpoint, there is no shortage of factors that can be identified as driving domestic absorption (or an excess of investment over domestic savings). These are: the productivity-driven investment boom of the late 1990s; the Federal Reserve’s willingness under Alan Greenspan’s stewardship to test the economy’s ‘speed limit’ in these years and then insure aggressively against the risk of Japanese-style debt deflation; the fiscal deficit; and, of course, the surge in asset prices which has boosted household net worth to unprecedented levels relative to income over the last decade. Indeed, if we accept the 1997 dating favoured by Macfarlane then the expansion of the current account deficit from its level of around 3 per cent of GDP to its 2005 level of about 6 per cent of GDP is, arithmetically speaking, almost exclusively a function of lower national savings. In 1997, investment was around 20 per cent of gross national income, while saving was around 18 per cent. Investment in 2005 was again around 20 per cent – in line with its post-Second World War average – but national saving had fallen to a record low of 12.8 per cent. This pattern is shown in Figure 4.1. In fact, although admittedly distorted by the destruction of the housing stock wrought by Hurricanes Katrina and Rita, net national saving fell so low at the end of 2005 that it was negative, meaning that for the first time the United States was not saving enough even to maintain its existing capital stock (see Figure 4.2). However, this pattern does not establish causation. The increased consumption, or reduced saving, may be ‘made in the USA’ or responding to the availability of finance due to the ‘global savings glut’. If the deficit is

The international perspective 25

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(as a % of national income)

20 15 10 5 0 –5 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Net national saving Gross national saving


Figure 4.2 Gross and net US national savings, 1948–2006 (as a % of national income) home-grown how has it been so easily financed and why has Asia run such large current account surpluses and built up such high levels of international reserves? This is the second question posed by Macfarlane. Of course, arithmetically, the US external deficit must be matched by surpluses elsewhere, and the United States can only invest beyond its savings if others do the reverse. Some of the reasons why external finance might be readily forthcoming are bundled up in what has become known as the ‘new Bretton Woods’ (Dooley, Folkerts-Landau and Garber), ‘co-dependency’ (Catherine Mann, 2004), and ‘international vendor finance’ and the ‘balance of financial terror’ (both due to Lawrence Summers, 2004). These ideas are explored in more detail in the next section, but they can be effectively distilled to the notion that, for one reason or another, the surplus countries, particularly the Asian surplus countries, have been willing to buy US bonds and supply the United States with finance so that US residents will continue to buy their goods. Such action enables the United States to postpone corrective action and the Asian countries to put off structural reforms that would reduce their dependency (again for different reasons) on export-led growth. Brian Reading (1992, Chapter 6) described Japan and the United States in the 1980s as two drunks propping each other up,1 which is an image that may be invoked today of the United States and China. Macfarlane’s third question was always a strange one because the monetary policies that produced the ‘0–1–2’ pattern (0 in Japan, 1 per cent in the United States, and 2 per cent in the eurozone) – and brought policy rates down to below their 1930s levels – had nothing to do with the global savings

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glut and everything to do with the collapse of the dotcom boom and economic conditions in the three regions concerned. Equally, those monetary policies would be reversed when those conditions changed, and only when they changed, rather than as a result of events elsewhere. Admittedly, low inflation generally and the absence of the emergence of inflationary pressures in those three regions was undoubtedly an important contributor. Nevertheless, we would question whether this low inflation was primarily the result of ‘disabsorption’ in the surplus countries, as Macfarlane contends. The emphasis here is on the word ‘primarily’. Unquestionably, the disinflationary shock that the Asian crisis engendered flowed through to US and global inflation, and saw a diminution of exchange rate pass through. Undoubtedly, also, the deflationary impulses emanating from Asia encouraged the Fed to test the ‘speed limits’ of the US economy. What we would add to this story is that the low inflation had more to do with the impact of ‘the China price’ than to Asian deflation. The connections between the China price phenomenon and the ‘savings glut’ are tenuous, at best. We would also suggest that the China price, and its lowering of US inflation, when combined with a Federal Reserve Bank reaction function that gave a high weight to ‘deflation insurance’ and a zero weight to either preventing or ‘popping’ any asset price bubble, had more of an influence on monetary ease than the existence of the global savings glut. Macfarlane’s fourth point concerns the low long-term interest rates or bond market conundrum, which is indeed an unusual event. The global savings glut argument does provide a ready explanation for the low real long-term interest rates (although the current account surpluses from Asia have been joined by those of oil exporting nations and countries like Switzerland). Again, we consider that the extraordinarily expansive monetary policy, along with the variety of motives underpinning ‘new Bretton Woods’, played a signal role and together they offer what can be seen as an alternative, or complementary, interpretation of events. In general terms, the role of monetary policy as a factor behind the low saving in the United States (and we would add Australia, although to a much lesser extent) is an element that both Bernanke and Macfarlane seem keen to downplay. In the case of the United States, as discussed in Chapter 3, the decision to hold the ex-ante real Federal funds rate so low for almost three years (and for much of this time negative) was intentionally designed to encourage people to bring forward consumption. It seems almost perverse to deny the all too obvious success of the policy. Moreover, as also previously noted, the Federal Reserve’s ‘open mouth operations’ and policy statements were designed to elongate the impact of super-easy monetary policy and, in this way, keep long-term rates low even as the central bank began the long process of ‘normalizing’ policy rates.


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Whether this intertemporal shift in the consumption pattern is ‘rational’ (due to rising productivity) or illusory (due to unsustainable housing price rises and negative real interest rates), does not alter the fact that the lowering of US saving was to some considerable degree policy-induced. We would also add that the view that sees the United States as having attraction to foreign investors because of the ‘productivity miracle’ is belied by net equity flows into the United States being negative for some years. The reality is that foreigners have been buying bonds, not equities, the yields of which are not productivity-related, and with official central bank demand playing a stepped up role. While not necessarily inconsistent with the global savings glut argument, it also accords with the new Bretton Woods view. Finally, we come to the fifth question of why margins for risk are so low, against the backdrop of payments imbalances. Indeed, it would seem that owning risky assets such as stocks or real estate has suddenly become much less uncertain than it has been over the last century. Consider, for example, stocks. The risk premium is the extra return (over a very safe investment like Treasury bills) that investors have traditionally received for putting their money at risk. For stocks, the risk premium equals the expected real (inflation adjusted) return on a broad portfolio of shares, minus the real interest rate. Consider the following rough estimates of the risk premium that stock investors are getting. For expected return, the earnings yield on the S&P500 – earnings per share divided by price – adjusted for cyclical swings in profits can be used. At the end of 2005, the earnings yield was 4.3 per cent. To calculate the real interest rate, one can use the ten-year Treasury yield of 4.6 per cent and subtract the average inflation rate over the past five years, 2.7 per cent, to get a real rate of 1.9 per cent. So the estimated risk premium is the 4.3 per cent expected return minus the 1.9 per cent real interest rate, or 2.4 per cent. That figure is about half the 5 per cent margin that stocks have delivered for the past 80 years (Tully, 2005). Under the global savings glut hypothesis this compression of the risk premium (for all types of risky assets, not just stocks) is attributed to the sheer volume of savings sloshing around the system. With interest rates on safe investment avenues so low, investors have been willing to overlook traditional risk margins in order to eke out an extra return on money invested – the so-called ‘grab for yield’. The alternative interpretation would put the cause for the shrinking risk margin squarely on the shoulders of monetary policy. Greenspan’s asymmetric approach to the framing of monetary policy – namely, riding the booms and cushioning the busts – may have fostered entrepreneurial risk-taking across the board. On this assessment, Greenspan monetary policy might well have been destabilizing as a number of commentators have suggested (The Economist, 2006a; White, 2006) if only on the grounds that ‘success breeds excess’.

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Those investing in risky assets, and especially housing, may have perhaps come to believe that if the market turns down and prices start to collapse, the Fed would always ride to the rescue. This also leads us back to the debate (with the Fed on one side and many other central banks on the other) as to whether asset prices and the financial imbalances they occasion ought to condition policy settings. Putting this to one side, in the ‘glut of savings’ story the risk premium is overlooked by investors. Under the ‘asymmetric monetary policy’ argument, one of the factors contributing to the external deficit also contributed to the narrowing of risk margins. Thus we would seem to have two alternative lenses through which to view the same set of facts. From one perspective, the impulse for the US deficit originated overseas in a global savings glut. Asian and other countries wanted to increase their savings. In the process they flooded the world with loanable funds and drove down world long-term interest rates to such levels that they were willing to overlook long-standing risk margins in their eagerness to secure a reasonable return. For their part, American consumers obligingly accommodated the other countries’ desire to increase savings by reducing their own, and the US spending that resulted generated the US current account deficit that allowed the rest of the world in aggregate to run a current account surplus. In the alternative story, the US external deficit was made at home, resulting from excessive borrowing and spending and too little saving by US households and the government. Those countries supplying Americans with goods were only too happy to lend back the funds so that the spending spree would continue, and thus accommodated insufficient savings in the United States with more savings of their own. Greenspan’s particular brand of monetary policy saw the Federal funds rate pushed down from 6.5 per cent at the end of 2001 to an unprecedently low rate of 1 per cent in early 2003 and held at that level for over a year, fuelling a real estate boom and massive mortgage equity withdrawal, while the asymmetric ‘cushion the busts, ride the booms’ philosophy encouraged downside risks to be downplayed and risk premiums to be compressed. The Economist’s Litmus Test This account has deliberately put the two interpretations in direct conflict, and there are a number of points at which elements of the two could be integrated. Nevertheless, for the moment let us continue with the contrast between the two, for The Economist has sought to provide a simple test to differentiate between them and see which one best fits the facts (The Economist, 13 August 2005, p. 63). The article notes that there are two competing explanations for why around the globe real long-term bond yields

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Interest rate

LM

r1 r2

IS1 IS2 Y2 Source:

Y1

Output

The Economist (2005).

Figure 4.3

Depiction of an increase in savings

are unusually low. Interestingly, although it was less than four months after Bernanke’s address, the global glut of savings view was by then regarded as the ‘most popular explanation’ for why bond yields had been driven down. The alternative view is that bond prices have been pushed up (and yields pushed down) by excess liquidity due to the 0–1–2 policy.2 In The Economist article, the workhorse IS/LM model is employed to attempt to differentiate between the two. Figures 4.3 and 4.4 summarize the analysis, as applied to the global economy. Consider, first, the global savings glut. Figure 4.3 shows the economy initially in equilibrium at interest rate r1, and output Y1. If desired saving increases relative to investment (i.e. there is excess saving), the IS curve shifts to the left to IS2. Interest rates fall (to r2), and so also will output (to Y2). According to The Economist this scenario does not fit the facts of 2004/05. The world economy grew at its fastest pace for almost three decades, and in 2006 remains well above its long-term average growth rate. By contrast, Figure 4.4 illustrates the alternative view. A loose global monetary policy shifts the LM curve to the right, to LM2. Bond yields again fall, to r3, but this time output increases. In contrast to a shift in the

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Interest rate

LM1 LM2

r1 r3

IS Y1 Source:

Y3

Output

The Economist (2005).

Figure 4.4

Depiction of a monetary expansion

IS curve, the economy has instead moved along the IS curve since lower interest rates stimulate global output and hence investment. According to The Economist, this scenario seems to fit the facts more comfortably. Bond yields have been low largely because central banks have created so much liquidity. Monetary policy has been unusually expansionary. Average short-term rates in Japan, America and Europe under the ‘0–1–2’ regime remained below nominal GDP growth for the longest period since the 1970s. Figure 4.5 shows the growth rate of nominal GDP in the United States and the gap that emerged as the Federal funds rate was pushed down from 2001. In addition, America’s expansionary policy was amplified by the build-up in foreign exchange reserves and domestic liquidity in countries that tied their currencies to the dollar, notably China and the rest of Asia, since they import American monetary policy under the relatively fixed exchange rate link. As a result, for a few years after 2001 global liquidity expanded at its fastest pace for three decades. Figure 4.6 shows that the standard measure of global US dollar liquidity, which adds growth in the US monetary base to increases in US dollar reserves held in custody at the Federal Reserve Bank of New York peaked

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The international perspective 20.0 17.5 15.0 12.5 10.0 7.5 5.0 2.5

Bars mark recession 0.0 1970 1974 1978

1982

Nominal GDP (% y/y)

1986

1990

1994

1998

2002

2006

Federal funds rate (%)

Sources: BEA; Federal Reserve; authors’ calculations, Reuters Economic Pro.

Figure 4.5

US nominal GDP and Federal funds rate, 1970–2006

25 20 15 10 5 0 –5 –10

Bars mark recession

‘LTCM crisis’

1980 1985 1990 1995 2000 US monetary base plus reserves held in custody at NY Fed (% y/y)

2005

Sources: Federal Reserve; Federal Reserve Bank of New York; authors’ calculations, Reuters Economic Pro.

Figure 4.6

Global US dollar ‘liquidity’ growth, 1978–2006

at an annual growth rate of almost 21 per cent in August 2004, its most rapid rate of increase since the 1970s. If the world is awash with liquidity, it has to go somewhere, and presumably some of it went into bonds, resulting in lower yields. Or, in more strictly textbook terms, bond prices have been bid up until yields are so low that people are willing to hold the increased supply of money. In its 2005 Annual Report, the Bank for

98


International Settlements suggested that the fact that the prices of all non-monetary assets (including bonds) have risen could indeed reflect an effort by investors to get rid of excess liquidity. The Economist sensibly goes on to point out that the two theories are not mutually exclusive. An excess of saving relative to investment in the nonAnglo countries may well have gone hand in hand with excess liquidity, so that both the IS and LM curves shifted downwards. Central banks’ monetary easing was, after all, partly in response to a fall in investment after share prices slumped. Nevertheless, The Economist concludes that, if one must choose between the two explanations, the rapid pace of global growth suggests that excess liquidity is the prime cause of low bond yields. A question mark concerns the behaviour of prices. The Economist used the fixed price version of the IS/LM model for their analysis. If prices are flexible, the story does not end with their account. With Figure 4.3, the deflationary pressures that ensue subsequent to the downward shift of the IS curve will cause prices to fall (or grow more slowly). Falling prices will increase wealth and the money supply in real terms, which will see the LM curve shift down and the IS curve to shift up from IS2, pushing the system back towards Y1. By contrast, in Figure 4.4 the excess liquidity will tend to generate rising prices which will reduce the real value of the money supply and reduce real wealth, shifting the IS curve down and the LM curve to the left, pushing the system back to Y1. Critics of The Economist’s analysis (e.g. Wood, 2005) point out that the inflationary effects of excess liquidity have not arrived, and this fact casts doubt on the excess liquidity story. However, this criticism ignores that the starting position, Y1, may not be a position of relatively full employment. Indeed, as discussed earlier, the emergency level of the Federal funds rate in 2003–2004 was explicitly a response to the small, but worrisome, risk of price deflation that the Federal Reserve judged to be facing the economy in these years. Moreover, the backdrop against which these factors were playing out was one in which cheap labour costs in China and other emerging economies, and ever more efficient manufacturing techniques, were working to hold down prices. In summary, Bernanke’s (and Macfarlane’s) focus on the reserve accumulation by emerging market economies was essentially correct. When they were writing, the statistical counterpart to the dramatic widening of the US external deficit was the surge in the surpluses of emerging economies. Japan’s current account surplus has been largely unchanged. That of the eurozone has actually fallen, with Germany’s surplus rising while that of France, and especially Spain, falling. The big change has come from China, emerging Asia, oil producers (OPEC, Russia), Switzerland and to some extent commodity exporters in Latin America (e.g. Brazil).


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Precisely why this has occurred and why they have been willing to accumulate dollar reserves is examined further below. Where we part company from the Bernanke view is, first, his ingenious suggestion that US fiscal policy has essentially had no impact on the US current account deficit. Indeed, Bernanke more subtly argues that the large US budget deficits (government dissavings) prevented even lower global real interest rates from resulting from the global savings glut and, by implication, that the private sector deficit would have been even larger as a result. Second, his failure and that of his then Federal Reserve colleague Roger Ferguson (2005) to mention the ‘0–1–2 pattern’, under which central bank policy rates were driven below levels in the Great Depression of the 1930s, does seem a glaring – and all too convenient – omission from any story about the factors behind low US saving and low world interest rates.

THE NEW BRETTON WOODS In a series of papers, Dooley et al. (2003, 2004, 2005) have argued that the exchange rate arrangements of East Asian countries, along with other developing countries, constitute a new Bretton Woods system. Like the original Bretton Woods system, they see current relationships between governments of Asia and the United States as marked by the maintenance by the Asian countries of fixed or closely managed exchange rates, with the accumulation of dollar reserves on an historically large scale, based on an effort to keep trade flows open (Dooley et al. 2005, p. 2). Parallels with Bretton Woods While there are some valid comparisons between then and now, the old Bretton Woods did not begin as a fixed rate system nor was it one based entirely on dollar reserves.3 In fact, it began as a continuation of the gold standard. Under the rules of the Bretton Woods (or IMF) system established in 1944, member countries of the IMF were required to define the parity of their currencies in terms of gold and to maintain what amounted to indirect convertibility into gold, which came about via the stabilization of exchange values and gold prices. A parity for a country’s currency in terms of gold implied, as under the gold standard, an official exchange rate between it and other currencies, in particular the US dollar. The dollar was the primary intervention and vehicle currency and was the key currency in that it was the only country which allowed its currency to be convertible (for external purposes) into gold – moreover at the 1934 parity of $35 per ounce. Exchange rates were to be maintained within 1 per cent of parity,

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creating indirect convertibility into gold much as under a gold exchange standard. In addition, intervention took place in the London gold market to ensure that the private market price of gold did not differ from $35 per ounce by much more than the cost of shipping gold from New York to London. Both features of a commodity currency standard – parity and convertibility – were present. To all appearances a gold standard of sorts was still in operation. In some other respects the role of gold was downplayed. No country undertook to redeem money domestically into gold, and in many countries private hoarding of gold in specie form was not allowed. While IMF member countries maintained convertibility of their currencies into other currencies through the foreign exchange market (and thus indirectly into gold) that conversion was no longer at a parity meant to be immutable. Par values could be altered for any (non-dollar) currency adjudged to be in fundamental disequilibrium (although it was implicit that the dollar would not, being in effect ‘as good as gold’). This fixed-but-adjustable exchange rate mechanism grew out of the interwar experiences, as an alternative to either a gold standard or a fiat money standard, taking what was seen as the best features from both. The gold standard provided exchange rate stability along with rules and cooperation in promoting free trade and capital movements, but was regarded as contributing to depression when countries deflated to defend fixed parities. Fiat money, it seemed, led to inflation and unstable exchanges, but did enable countries to recover from unemployment by avoiding having to force down prices to bring them into line with gold parities. What emerged was the system of rigid, but adjustable, parities. Exchange rates would normally be kept fixed, with the widened parities allowing some margin for market clearing of fluctuations in trading positions. In terms of the ‘inconsistent quartet’4 of ‘desirables’ of international monetary arrangements, namely fixed exchange rates, free trade, monetary autonomy and free capital movements (Wallich, 1972), the architects of Bretton Woods were prepared to compromise on freedom of capital flows. Countries agreed to a ‘code of conduct’ dealing with cooperation, trade, convertibility and orderly exchange arrangements, yet continued restrictions on capital markets were envisaged and tolerated, at least initially. There are parallels in this respect with China today, in that it has not moved as yet to a fully convertible capital account. While the original Bretton Woods envisaged orderly changes in parity to correct a ‘fundamental disequilibrium’, it was soon transformed into a fixed exchange rate system, with maintenance of the existing parity central to policy formulation. This was not due to any unwillingness of the IMF to approve changes for it was never difficult for member countries to alter


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parity. Instead, countries became increasingly reluctant to change parities for a mixture of reasons. Revaluations were domestically unpopular because they jeopardized the competitiveness of domestic export- and importcompeting industries – a parallel again with today. Devaluation called into question the competence of economic policy-makers, and was compounded by the problem of speculation and of ‘unhelpful’ capital movements. The method of changing rates discontinuously in large discrete jumps – the adjustable peg – made obvious the direction of change, allowing speculators the luxury of anticipating change with facility and at virtually no risk. A government contemplating an adjustment to parity had to take cognizance of the likelihood that a change would merely encourage speculators to expect that it would be altered again in response to future payments difficulties, so making matters worse ‘next time round’. Once the system was transformed into a fixed rate system, the ‘liquidity’ and ‘confidence’ problems of the Bretton Woods system identified by Robert Triffin (l960) emerged. The liquidity issue arose because attempts to hold exchange rates fixed in the face of massive and destabilizing speculative capital flows created a need for large international reserves – certainly much larger than those likely under floating rates or those needed when commitment to the gold standard lent credibility to fixed parities. Yet accumulation of US dollars provided the major source of monetary reserves (which consisted of gold, dollars, sterling and other foreign exchange, and net claims in the form of the gold tranche at the IMF). Expansion of gold reserves came from newly mined gold and from gold sales of the Soviet Union. Augmenting this growth required either an increase in the price of gold – politically unacceptable because of the windfall gains which would accrue to South Africa and the Soviet Union – or a deflation of commodity prices relative to gold. Price deflation satisfied liquidity preferences for gold in the 1930s but was unwelcome in the post-war growth environment. Reliance upon a continued growth in foreign exchange reserves relative to gold to augment liquidity gave rise to the confidence problem. To expand liquidity, the United States had to run a balance of payments deficit, but the deficit eroded confidence in the system. As external dollar liabilities grew, the world was exposed to the danger of a financial crisis if confidence in the dollar’s convertibility faltered and should there be a flight from dollars into gold. In consequence: The United States became more and more reluctant to sell gold to other countries, and let this reluctance be known. Technically the United States was still under an obligation to sell gold in exchange for foreign-held dollars, an obligation which we had accepted when the Bretton Woods agreement went into force shortly after World War II. We were supposed to make our gold available without limit to other countries for monetary purposes, but in fact we increasingly

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4.0

(US $ trillion)

3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

Developing countries foreign exchange reserves

Sources:

IMF; authors’ calculations; Reuters Ecowin Pro.

Figure 4.7 Foreign exchange reserves of developing countries, 1958–2006 (US$ trillion) discouraged other countries from asking for gold. I don’t believe we ever actually told any country they couldn’t have it, but it was made clear to them that such requests were not welcome, to say the least, and most of them took the hint. They did not ask for gold when they had accumulated dollars as they had done previously; instead they held these dollars as an investment – perhaps an involuntary investment. And this of course was the essence of ‘benign neglect’. (Houthakker, 1977, p. 18)

It is with respect to the liquidity problem, the confidence problem, involuntary holdings of dollars and ‘benign neglect’ on the part of the United States that parallels arise with present-day conditions. Quite clearly, there is a liquidity issue today as evidenced by the accumulation of international (mainly dollar) reserves by developing countries shown in Figure 4.7, although there is the question of whether these holdings are voluntary, involuntary, or some mixture of both. This accumulation has the potential to give rise to a confidence issue (nowadays referred to as ‘sustainability’) because Asian current account surpluses are mirrored by current account deficits in other regions, particularly the United States. So far, the US policy response seems, once again, to be one of benign neglect. Reasons for Accumulating Reserves Whether this response is appropriate, and the US current account deficit sustainable, depends to some considerable extent on the reasons for the build-up of dollar reserves, for which there are a number of reasons


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advanced. One that has already been mentioned is what Summers (2004) called ‘international vendor finance’. In his words, ‘a substantial number of countries are maintaining a fixed or quasi-fixed exchange rate through very substantial exchange rate intervention and enjoying strong export performance to the United States as a result’ (p. 7). This description leaves open the question of whether the finance is encouraging the expenditure or whether it is accommodating it, or whether it is a case of ‘co-dependency’ (Mann, 2004). A more colourful description of international vendor finance is that ‘the US is like a shopper on a credit card binge, living beyond his or her means. In this case the cards are issued by the foreign central banks, mostly in Asia, which use the dollars generated by their huge bilateral trade surpluses to buy US government securities. In effect, they are lending the money to keep the binge going’ (Cornwell, 2004). China has even been described as America’s own ‘company store’ to which it is going deeper into debt in order to sustain its standard of living (Bonner and Wiggin, 2006, p. 37). As we have said, the difficulty with this explanation is establishing motive from the observed facts. Another reason, also mentioned before, is the ‘insurance’ or ‘precautionary’ demand for reserves, advanced by Feldstein (1999, 2005). In the aftermath of the Asian financial crisis, developing countries concluded that they cannot rely on the IMF or reforms in the international financial architecture to protect themselves from crises. Nor is it sufficient to follow sound macroeconomic policies, since even well-managed countries can be hit by contagion spilling over from elsewhere. The key was self-protection through increased liquidity. Consequently, several of the Asian governments seemingly resolved to accumulate foreign exchange reserves sufficient to eliminate or virtually eliminate the risk of unwarranted speculative attacks. They recognized that reserves could not protect a currency that is truly overvalued but wanted to prevent the destabilizing effects of speculators trying to undermine a currency that was essentially sound. In order to do so, the old guideline that foreign exchange reserves should equal three months of imports was abandoned in favour of a much larger target of reserves that would be enough to deter speculators. The results are evident in Figure 4.8. Foreign reserves, in terms of months of imports, are now over eight months of imports for non-industrial countries. There are a number of problems with this particular argument. First, it would seem from Figures 4.7 and 4.8 that the build up in international reserves began well before the aftermath of the Asian financial crisis. Second, Feldstein (2005) calls the self-insurance demand for international reserves ‘a kind of portfolio transition rather than a new sustained level of capital flows’ (p. 8), but how large is enough? Obviously, the cost of a

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Untangling the US deficit (in months of imports)

17.5 Middle East 15.0 12.5

Non-oil ‘developing’

China

10.0 7.5 5.0 2.5 Industrial economies 0.0 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006

Source: IMF IFS; authors’ calculations; Reuters Ecowin Pro.

Figure 4.8 Foreign exchange reserves relative to import demand, 1958–2006 (in months of imports) financial crisis is very large. On the other hand, having ‘excess’ reserves is also not costless. One rule of thumb is the so-called Guidotti–Greenspan rule5 that countries should hold liquid reserves equal to their foreign liabilities due within one year. On this basis, most emerging market economies already have adequate reserves, most with plenty of room to spare (Rodrik, 2006). Larry Summers (2004, p. 7) considers that ‘we are well past the point in many countries where reserve accumulation can sensibly be attributed to a prudent insurance motive with respect to the prospect of future financial crisis’. Third, as noted earlier, the ‘scarred by the crisis’ demand for international reserves does not so obviously apply to China, the country that has built up its reserves to the highest level (indeed, rivalling that of Middle Eastern countries after the first oil price shock). A third explanation for the reserve build-up, advanced by Dooley et al. (2004), which more directly addresses the case of China but is applicable to other developing countries as well, is that the international reserves held by the ‘periphery’ countries can be viewed as a compensating balance6 or form of collateral. Countries at the periphery of the world trading system are less creditworthy than centre countries. In order to engage in reciprocal trade with the centre, the less creditworthy countries must post collateral. The development strategy of these countries is one in which they attract direct investment from the centre, which exposes centre country investors to a variety of economic risks. A continued rise in exposure for the direct investors will eventually strangle the supply of funds and limit growth in


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the periphery unless collateral is posted. This circumstance is achieved by the net export of goods and services from less creditworthy countries, the proceeds of which are invested in Treasury bonds and other securities in the ‘centre country’ – the country that is the best depository and manager of the collateral. Dooley et al. liken the implicit economic contractual arrangement between a peripheral country and the centre country to a swap agreement. The periphery country promises to pay the United States (as the leading centre country) the return on US direct equity investments in its country. The United States, in turn, promises to pay a fixed interest rate on reserve assets. In a market context, such a swap arrangement would require the less creditworthy party to lodge collateral for actual and potential market-tomarket losses. Conceptually, the centre country would demand collateral to cover the entire expected present value of the swap, along with additional coverage for future valuation risk. The amount of the collateral would be governed by the potential volatility of the underlying assets and the credit risk of the counterparty.7 It is difficult to know what to make of this argument. It is certainly a different one that shifts the story to the geo-politics of international trade. In effect, the Dooley et al. hypothesis says that in order to continue being a recipient of foreign investment, China must run current account surpluses and build up dollar reserves to provide collateral to the world, held against the risk that China may expropriate FDI or otherwise default on foreign investments. Further, this requirement is ongoing. China must not only deposit the capital inflows from FDI as reserves to reassure foreign investors, but in addition run current account surpluses to add to the collateral as FDI in China increases. The faster China grows, and the more its FDI increases, so must its international reserves expand. It is indeed the case that China’s international reserves have grown rapidly, and the ‘collateral view’ is consistent with an accumulation of international reserves by developing countries that started before the Asian financial crisis unfolded. Against these observations, it must be questioned whether foreign investors in China would regard the international reserves held by US government agencies (deposits at the Federal Reserve, Treasury bills and bonds) as meaningful protection against the losses on their own investments. The ‘collateral’ is not an asset that foreign equity investors can seize in the event of default or a financial crisis, as Roubini and Setser (2005) note. Also, the collateral argument has little traction for the substantial build-up of reserves by oil exporting countries in recent years since the price of oil rose. To explain these, we must look to the international role of the dollar.

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THE ‘EXORBITANT PRIVILEGE’ Allied to the new Bretton Woods debate is the argument that the United States has become the ‘world venture capitalist’ or the ‘world’s biggest hedge fund’ by virtue of the ‘exorbitant privilege’ that accrues to US markets and institutions because the United States issues the world’s money. In exploring this explanation we return to the view of William Poole (2004) to the effect that US financial markets serve as the world financial intermediary or as world banker. US currency, bank deposits and other short-term or highly liquid claims act as the medium of exchange, unit of account and temporary store of purchasing power in many, if not most, international transactions. The US dollar is the major currency of invoice, the vehicle currency in most foreign exchange transactions, and the currency used for pricing in commodities and other international markets. These characteristics make US dollar-denominated claims attractive to hold, and a big part of international bank loans, bonds, notes and derivatives are denominated in US dollars irrespective of where the transactions occur (Lewis and Davis, 1987; Lewis, 1999). The term ‘exorbitant privilege’ is widely attributed to General (then President) de Gaulle in 1965 but it would seem was only committed to print by Valèry Giscard d’Estaing, then Finance Minister in France (Gourinchas and Rey, 2005, n. 2), and was used to describe the quite different financing constraint enjoyed by US nationals compared to those in other countries. If French citizens, it was argued, wish to buy a US factory they must first sell French goods or French assets (or borrow against them) for the US dollars needed for the purchase. By contrast, if Americans want to buy a French factory they need only supply US dollar claims. Thus the term ‘exorbitant privilege’ referred to the ability of the United States to run large direct investment surpluses, financed ultimately by the issue of dollars held by foreign central banks (Gourinchas and Rey, 2005, p. 3). Rueff and Hirsh (1965) as cited in Dooley, Folkerts-Landau and Garber (2004), made the point more evocatively: Let me be more positive: if I had an agreement with my tailor that whatever money I pay him returns to me the very same day as a loan, I would have no objection at all to ordering more suits from him. (p. 307)

Applied to present-day circumstances, the exorbitant privilege would relate to the different external constraint facing the United States as compared with other countries because of the special role of the US dollar in the world order, and is manifested in terms of (1) the ‘valuation’ effect, (2) the ‘composition’ effect and the ‘return’ effect, and (3) the ‘hot potato’ effect.


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The ‘valuation’ effect is a consequence of the structure of US foreign liabilities and assets (Tille, 2003; Gourinchas and Rey, 2005). At December 2005, the US net foreign asset position was a deficit of $2.7 trillion (or 22 per cent of GDP), with assets representing $10.0 trillion (80 per cent of GDP) and liabilities $12.7 trillion (102 per cent of GDP). Almost all US foreign liabilities are in dollars, whereas approximately 70 per cent of US foreign assets are in foreign currencies. As a consequence, a 10 per cent depreciation of the dollar constitutes a transfer of around 5 per cent of GDP from the rest of the world to the United States, nearly as large as the trade deficit itself. Capital gains on the investment account thus play a major role in the US external position and we shall explore in Chapter 6 the rising importance of this phenomenon in determining the sustainability of the US’s external position. The ‘composition’ and ‘return’ effects result from the role of the US securities market in acting as the world financial intermediary or bank. Banks typically take in short-term deposits that are regarded as being safe and liquid and invest them in longer-term, riskier assets. So, too, the United States borrows short (as foreigners acquire US currency, bank deposits, Treasury bills and short-term liquid dollar securities) and invests long (as US banks, securities markets and corporations make long-term loans and investment funds available to foreign enterprises, and take direct equity positions in the form of FDI). The ‘composition’ effect is the argument that the US external balance sheet increasingly resembles that of a venture capitalist or leveraged hedge fund, with liabilities dominated by low-yield safe assets and high-return, risky investments on the asset side. Flowing from this asymmetric composition of the external balance sheet is the ‘return’ effect. Because US liabilities supply foreigners with liquidity services, that provide a non-pecuniary return, the holders are willing to accept a relatively low pecuniary return.8 Income earned by US-owned assets abroad is larger than the income paid on foreign-owned assets in the United States, despite the fact that the assets are smaller in value than the liabilities. This is the return effect, or intermediation margin, enjoyed by the United States, just like a bank can earn profits, even though the bank’s income earning assets are usually smaller than its (non-equity) liabilities. Finally, we come to the ‘hot potato’ analogy. Because of the role of the US dollar as world money, it serves as a temporary store of purchasing power or buffer stock in international portfolios. Windfall gains such as those arising from oil price shocks seem likely to be held in the form of US dollar claims, valued for their liquidity and safety, until more permanent investment avenues are chosen. However, the position is more fundamental than the temporary abode of purchasing power role of international money. Because US dollar claims are readily transferable and have high

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international acceptability, dollars may be willingly accepted even if not demanded. There are obvious parallels here with studies of the demand for money which emphasize the buffer stock role and the potential for disequilibrium money holdings to emerge (Artis and Lewis, 1976; Mizen, 1994; Lewis and Mizen, 2000, Ch. 11). James Tobin (1963) used the ‘hot potato’ analogy when describing (and criticizing) traditional models of money creation where the monetary asset is passed from hand-to-hand like a hot potato, unable to be extinguished but accepted because it can be passed on to others when used for expenditure or investment. Such behaviour gives rise to the possibility of there being involuntary holdings of dollars in a world of fiat currencies, under a predominantly dollar standard. A fiat money system is one in which the currencies are not convertible into gold or some other asset, and cannot be extinguished by conversion into gold or another currency (itself convertible into gold) as under the gold standard. Such a situation arose in the latter years of Bretton Woods when conversion of the US dollar into gold was discountenanced by the US authorities. For most of the Bretton Woods era, there was every appearance that the US deficit was responding passively to surpluses in the rest of the system, supplying the liquidity in the form of dollar balances that was demanded. Hence the policy of ‘benign neglect’. Towards the end of Bretton Woods, with the US budget under pressure to finance the Vietnam War and Lyndon Johnson’s Great Society there was the possibility (and in many European minds the strong likelihood) that the supply of dollars might be outstripping demand. However, with the gold window effectively closed, any excess dollars could not be extinguished. Surplus countries tried to sterilize the money supply from the consequences of the accretion of international reserves, while applying, among a number of instruments, ceilings and taxes on the interest rates paid to foreigners and special reserve requirements on foreign deposits, which served to ameliorate the effects but did not correct the underlying payments position. As the market found ways around these restrictions, policy-makers were faced with the choice of tightening existing controls and introducing ever more Draconian measures – which to them were increasingly tedious to operate – or somehow escaping from the straitjacket of fixed parities. Floating exchange rates emerged as the only escape route, even though this was tantamount to a dollar devaluation vis-à-vis the major surplus countries and the recognition of a new era of fiat currencies. Are there parallels between this situation and the present system? If we accept the foregoing, then the possibility has to be conceded that some part of the international reserve accumulation may be involuntary. Suppose, for example, that China were to shift some of its dollar holdings of reserves to


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the euro. The immediate consequence would be that dollar claims held by the PBOC would be transferred to the ECB. If the ECB then decided to hold the reserves acquired in yen, the claims would be shifted to the Bank of Japan. Ownership of the dollars would change, but the amount of dollars would not. Here, in a way, we have the distinction made by Sir Dennis Robertson (1922) between ‘money sitting’ and ‘money on the wing’ (p. 30). Can we necessarily assume that international reserves at any moment of time are ‘sitting’ or are they ‘on the wing’? And, if ‘sitting’, are they the result of rational economic calculation or the complex geo-politics of international finance? As an example of the latter we have the view of Bonner and Wiggin (2006).

THE EMPIRE OF DEBT The idea that the United States is now an empire is not new. It has been part of the fabric of American politics since the Spanish-American War of 1898, if not earlier, as brought to life so vividly in Gore Vidal’s series of historical novels Narratives of Empire exploring the US imperial experience.9 Empire of Debt (Bonner and Wiggin, 2006) links the empire theme to the present day external deficit. But is the United States in fact an empire as these authors assume? Having introduced this thought into the volume, it seems beholden on us to offer a few comments on the question. Needless to say, there is a case for, and a case against. Both have a point to make. Is America an Empire? An obvious starting point is the key criteria or hallmarks of ‘empire’. Formally an empire usually implies territorial annexation via military conquest (or purchase) with the corollary that political and economic control will be imposed on these states by the ‘imperium’. Clearly the United States fails on this score. While in the nineteenth century the United States did display an appetite to absorb or annex neighbouring territories, once the original 48 states came under its aegis, its territorial zeal has dissipated (with the purchase of Alaska and Hawaiian statehood the exceptions that prove the ‘rule’). To our knowledge, Canadians do not lie awake fretting over the territorial ambitions of its southern neighbour. Overseas colonies acquired following war with Spain at the turn of the twentieth century – primarily the Philippines – were disposed of within 50 years. Nor did the United States exhibit territorial ambitions after the comprehensive victory over the Axis powers in 1945.

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However, other definitions have been offered, such as that of Charles Maier that he sees as more relevant to the present day United States: Empire does not just mean the accumulation of lands abroad by conquest. And it does not mean just the imposition of authoritarian regimes on overseas territories. Empire is a form of political organization in which the social elements that rule in the dominant state create a network of allied elites in regions abroad who accept subordination in international affairs in return for the security of their position in their own administrative unit (the ‘colony’ or the ‘periphery’). They intertwine their economic resources with the dominant power, and they accept and even celebrate a set of values and tastes that privilege or defer to the culture of the metropole. (Maier, 2006, p. 7)

In these terms, US global dominance and military power are such that it is the only country that can shape world events without having to seek other countries’ approval or form coalitions or partnerships. The fact that it does establish coalitions (however small the membership) does not alter the fact that it does not need to. In military terms, as of 2006, the US defence budget equals that of all of the other countries of the world together. The country that is often seen to be on the way to becoming eventually the world’s major manufacturing and industrial power – China – is encircled by a string of American bases around Asia, whereas China has no bases abroad (The Economist, 19 November 2005, p. 21). American economic strength is equally dominant. The US economy in 2005 was larger in size than the next four largest (Japan, Germany, France and Britain) combined (in market value). Stated in somewhat different terms, the US economy was larger than all of the combined economies of the other permanent members of the UN Security Council. China, its supposed rival for economic power, is less than 20 per cent the size of the US economy (again in market terms). GDP comparisons in terms of purchasing power are a little different as we shall see in Chapter 8. Nevertheless, if overwhelming military and economic power amounts to an empire then the United States clearly qualifies. In addition, on Maier’s definition, a key element is the ability to dominate the civil (and cultural) life of others.10 Those who indict the United States on this score would look no further than the Bush Doctrine as enunciated in ‘The National Security Strategy of the United States of America,’ presented to Congress in 2002 by President George W. Bush. The new global strategy, analysed in Foreign Affairs under the title ‘America’s imperial ambitions’ (Ikenberry, 2002), has three basic tenets. First the US has declared itself free to take preemptive action against terrorists and states that support them and have weapons of mass destruction. Second, no country or combination of countries will ever be allowed to challenge US military superiority. Third, unilateral measures are considered to be better


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than international treaties and organizations in preventing the spread of nuclear weapons. In short, the Bush Doctrine declares that America will no longer be constrained by the traditional norms and rules of the international community, and underlines that the exercise of US power has evolved to become increasingly ‘imperial’ in the post 9/11 world. What seems significant is that countries that are not technically in violation of any existing international laws could nevertheless be targets of American force – if Washington determines that they have a prospective capacity to do harm. Their sovereignty has been made conditional, and governments that fail to act appropriately could lose it. Richard Haass, director of the State Department from 2001 to 2003, writing in the summer/fall 2003 issue of the Georgetown Journal of International Affairs, argued that states should lose their sovereignty when they harbour terrorists, commit acts of terrorism themselves, or threaten global security (Nussbaum, 2003). As Ikenberry notes, great powers have always acted this way within their traditional sphere of influence, as the United States long has under the Monroe Doctrine. What is different today is the application of the intervention principle on a global basis, hence the current vogue for describing the US as an empire. The case against regarding America as an empire is that, first, US history, from the birth of the nation in revolution against Britain to battles against and opposition to the Spanish, German and Soviet empires, has been to oppose the concept of imperialism. Nussbaum (2002) contends that imperialism is not part of the country’s DNA and that many Americans, just like many people overseas, ‘are uncomfortable with the image of an America acting unilaterally around the world, breaking treaties at will, giving lip service to allies and international institutions while claiming for itself the sole legitimate use of force anywhere, anytime it feels threatened’ (p. 40). Indeed, US scepticism of foreign involvement runs far deeper in the American psyche than the relatively new concepts of pre-emption and unilateralism. George Washington’s farewell address of 1797, warning to steer clear of ‘entangling alliances’ can be cited by Americans as evidence enough to avoid global engagement in favour of addressing domestic needs first (Lundy, 2006). Second, the charge that the United States has become an empire is based on two notions: that its unchallenged military and economic power is tantamount to an empire, and that its control over world events robs other countries of any real sovereignty. However, as Lloyd (2004) observes: ‘Empires control . . . America does not control’ (p. 5). Philip Bobbit (2004) in his lead article ‘Better than empire’ in the same issue points out that ‘empire is not simply a matter of the power to coerce and the desire to see one’s ideals and values shared; rather, it is the use of coercion to enforce one

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society’s values and ideals upon another’ (p. 20). He argues that the United States is a ‘market state’, relying on incentives and security guarantees for its allies, rather than coercion. In the aftermath of the Second World War, when the United States had even greater relative economic strength than today, it used its economic and military power to create a network of international institutions and laws. It led in creating the UN Charter, the Universal Declaration of Human Rights, the International Monetary Fund and World Bank and, later, the various arms control treaties of the cold war. Nowadays, it continues this tradition by providing collective goods, such as ‘building coalitions and acting globally through regional co-operation, implementing anti-missile, anti-proliferation and pro-environmental regimes, organising humanitarian intervention and sharing information about terrorism’ (p. 25). Returning once again to Charles Maier’s definition, the benefits of Pax Americana have therefore led to a willingness on the part of many others to ‘accept, even celebrate’ American (or broadly Western) values and institutions. If the United States is an empire, it is largely an ‘empire by invitation’ (Maier, 2006). Power and Money11 Running an empire, whether by coercion, invitation or default, or overseeing an hegemony does not come cheaply. There is a standing army and a naval fleet to maintain. Airports, roads and other infrastructure may need to be built or upgraded and administered. Public servants need to be recruited and a common trading, legal and judicial system devised or agreed upon by treaty. How is this superstructure to be paid for? Bonner and Wiggin (2006), who obviously consider the United States of today to be an empire, address this question and begin their assessment by noting that the lesson of history is that ‘running an empire is a disastrously expensive business’. In the past, Britain did it by insisting that trade preferences (‘imperial preferences’) be granted to British industries. It also levied duties and other charges on shipping using Empire ports. Many of the costs were shifted onto largely self-governing colonies and dominions which could also be relied on for military support when the Empire came under threat, much like the lords and barons in feudal times.12 However, the traditional method of financing an empire is to make the subordinated nations pay tribute. As Bonner and Wiggin (2006) observe: ‘Imperial finance is simple. The imperial power, the imperium, provides a public good; it extends security and order. In return, the groups that benefit pay tribute’ (p. 39). In some cases, the tribute was paid so that the conqueror would keep their distance (e.g. the Danegeld).13 More usually, it took the form of resources transferred from the vassal states to the imperial centre of power.


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Rome, for example, was resourced by the provinces in three ways: taxes, booty and slaves (Temin, 2006). The agrarian tax was about 10 per cent of output and was mostly paid in money, but in the case of Egypt and Africa was also paid in kind with grain. Some grain was redistributed to feed the one million people living in Rome. Nevertheless, the great bulk of the tax revenue found its way out of Rome to sustain the standing army of about a quarter of a million, made up of a mixture of paid and conscripted men. Booty largely took the form of land holdings outside Italy, although slaves were probably more important. Slavery made up the basis of life in the classical world, and the purpose of war was to capture bodies as well as land.14 All of this historical perspective poses a dilemma for the United States. It has provided three types of collective goods that the world wants. It has underwritten the security of its traditional allies and potential rivals – Japan–Korea, Germany and her neighbours – when they faced the Soviet challenge. It has helped create the legal framework for the society of nation states to universalize international law and human rights. Finally, it managed the superpower confrontation to keep the cold war cold by containing the Soviet Union (the policy devised by George F. Kennan)15 and now orchestrates the ‘war’ on terror. Many states have benefited by diverting resources to other uses that would otherwise have gone into defence. The United States might reasonably expect that the beneficiaries contribute to the cost, as indeed Japan, Korea, Taiwan and Saudi Arabia did in the first Gulf War. However, the application of ‘user pay’ principles runs into the traditional ‘free-rider’ and ‘non-excludability’ problems that bedevil suppliers of public goods. Here the United States is to some extent hoist by its own ideological petard. A country committed to export democratic pluralism and rightsbased systems can hardly force others to pay by demanding money in exchange for protection. Nor can it use the framework of law to obtain payment since it has bypassed the United Nations and, under the Bush Doctrine, generally downplayed international rules, treaties and security partnerships, hence, Bonner and Wiggin’s (2006) book title, Empire of Debt. Rather than requiring other countries to pay, those authors argue that the United States has borrowed from them. Instead of collecting tribute to support a military budget greater than the military spending of the rest of the world combined, the United States finances these costs by borrowing. Many of the countries extending the finance may perceive that they probably have little choice, in the sense that they greatly benefit from the global trading system that the United States has helped to create and they need the Americans to continue buying their products. More subtly, perhaps the other countries understand, and accept, the implicit ‘rules of the game’. There are thus parallels with both ‘international vendor finance’ and the ‘balance of financial terror.’ There are also parallels with the British

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Empire and the Dutch Republic, which relied extensively on government borrowing.16 The relevant issue is whether the borrowing can be sustained, and at what level, which brings us to the Greenspan argument.

HOME BIAS AND GLOBALIZATION Alan Greenspan (2005b) argues, on the basis of recent evidence, that the US current account deficit is ‘essentially a byproduct of long-term secular forces, and thus is largely benign’ (p. 5). The secular forces relate to greater financing and financial integration and interdependence, both within and across national borders. In particular, ‘anecdotal, circumstantial, and some statistical evidence is suggestive that the historically large current account deficit of the United States may be part of a broader set of rising unconsolidated deficits and accumulated debt that is arguably more secular than cyclical’ (p. 5). We have left his suggestion to last because it overlaps with the next chapter. More evidence exists on the cross-border financial activity than the domestic flows, and at a superficial level the evidence of financial integration is compelling. Average daily turnover in foreign exchange markets was 100 times greater at the beginning of the twenty-first century than it was 30 years earlier and total world exports increased nearly 18-fold during the same period. As late as 1982, worldwide foreign direct investment amounted to less than $60 billion. Two decades later it stood at more than $735 billion. Figure 4.9 shows gross cross-border transactions in bonds and stocks in the United States between foreign investors and US residents from 1977 and 2006. Relative to GDP, transactions increased from 5.5 per cent of GDP in 1977 to 390 per cent of GDP in 2006 or over 70-fold. However, there are two behavioural measures that have traditionally indicated that the extent of cross-border financial integration is not as high as the preceding figures would suggest. One is home bias, the finding that investors do not buy the world market portfolio, but overweight i.e. bias their portfolios toward domestic securities. In Figure 4.10, drawn from Ahearne et al. (2004), home bias is measured as one minus the ratio of the portfolio share of foreign equity in US portfolios divided by the portfolio share of foreign equity in the world market portfolio. If investors held the world market portfolio and there is no home bias, the measure is zero. Quite obviously, it is not. In the 1970s, it was close to unity, but it has been declining since. Nevertheless, in 2001 the portfolio share of foreign equities of US investors was 23 per cent of what it would have been had these investors held the world market portfolio, so that the home bias measure was 77 per cent.

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The international perspective 400

(as a % of GDP)

350 300 250 200 150 100 50 0 1978

1982

1986

1990

1994

1998

2002

2006

Total sales and purchases of domestic and foreign stocks and bonds

Sources: Treasury Department; authors’ calculations; Reuters Ecowin Pro.

Figure 4.9 US gross cross-border capital transactions, 1977–2006 (as a % of GDP) 1.2 1.0

‘home-bias’ measure for US investors

ratio

0.8 0.6 0.4 0.2

share of foreign equities in US investors’ equity portfolio

0.0 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Sources: Adapted from Ahearne, Grieves and Warnock (2004).

Figure 4.10

Measures of home bias for US investors

This figure for the United States is somewhat higher (indicating more home bias) than for all developed countries which averaged 63 per cent in 2001 (Stulz, 2005). Another study (Aurélio, 2006), using mean-variance analysis (the return-volatility trade-off curve) found that, in 2004, ‘home bias remained a feature of US stock investment, a behaviour that cannot be

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explained by more attractive domestic returns or volatility’ (p. 14). In general, home bias implies that lower risk compensation is required for geographically closer investment opportunities, which seems to remain a stronger force for the US investor than some other countries. Fortunately, for the United States, it is the home bias of foreign investors that is of importance insofar as financing the deficit is concerned. The other behavioural measure is the Feldstein–Horioka puzzle. In an integrated world capital market, one might expect savers to put their savings into those countries and those assets that promise the highest riskadjusted expected rate of return. Similarly, those undertaking fixed investment would obtain finance where it is most plentiful and inexpensive. In such an environment, the correlation between savings in one country and investment in that same country would be low. In fact, Feldstein and Horioka (1980), using data from 1960 to 1974, found almost the reverse to be the case. Savings tended to remain in the country in which they originated. Feldstein and Horioka estimate that a 1 per cent increase in a country’s savings-GDP ratio increased the investment-GDP ratio of that country by more than 0.8 per cent – the 80-plus per cent savings retention coefficient that they made famous. More recent evidence (Feldstein, 2005) suggests that the original conclusion is in need of some revision. Updating the original 16-country OECD sample it is found that the savings retention coefficient for the decade 1971 to 1980 is only 0.58, significantly less than the original estimate for the fifteen-year period from 1960 to 1974. The savings retention coefficient estimated for each subsequent decade (i.e. the decades ending in 1981, 1982, etc.) remained in the range between 0.55 and 0.69 until the decade ending in 1992. It then fell sharply in the 1990s until it reached only 0.19 for the decade ending in 2002, the last year for which there are complete data. These estimates imply a sharp decline in the segmentation of the capital market among the industrial countries of the OECD. However, the result seems to be dominated by the behaviour of the smaller economies in the sample. When each observation is weighted by the GDP of the country, there is found to be a more modest decline (from 0.93 ending 1980 to 0.70 ending in 2000) and a much higher recent value of the savings retention coefficient (0.57 for the decade ending in 2002). Feldstein concludes that the original segmentation of the global capital market appears to have persisted among the major industrial countries of the OECD while the smaller economies are now more integrated into a global capital market’ (p. 4). On this basis, it may be too early to conclude, as Greenspan (2005b) does, that starting in the 1990s, home bias began to decline discernibly, the consequence of a dismantling of restrictions on capital flows and the advance of information


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and communication technologies that has effectively shrunk the time and distance that separate markets around the world. The vast improvements in these technologies have broadened investors’ vision to the point that foreign investment appears less risky than it did in earlier times. (p. 2)

Nevertheless, the direction of the movement seems clear and, to that extent, the results have important implications for the extent and sustainability of current account imbalances. If domestic saving is directed mainly toward domestic investment, one would expect external imbalances to be small, as indeed they were for most of the early post-Second World War era. In the extreme, if domestic saving exactly equalled domestic investment for every country, all current accounts would be in balance, and the dispersion of current account balances would be zero. Obviously, current account imbalances require the correlation between domestic saving and investment to be less than unity. Feldstein’s declining savings retention coefficients are reflected in the increasing dispersion of current account balances, with larger US current account deficits matched by widening current account surpluses of China and OPEC countries. How far can this process go? What are the implications of further reductions in home bias and shrinking savings retention coefficients for the size and sustainability of US current account deficits? How do adjustment mechanisms alter? These are the issues taken up in the next chapter.

NOTES 1. 2.

3. 4. 5. 6.

7.

This followed from his observation that one-quarter of the extra spending by Americans between 1981 and 1985 (following the Reagan tax cuts) went on additional imports, many from Japan. Here we follow The Economist which couches the exercise in terms of long-term bond yields. However, these may not be a good proxy for ‘the rate of interest’ of macroeconomics which is some mixture of the rate relevant for the supply of money (short-term rates?), demand for money (long-term rates?), savings decisions (time preference?), and investment behaviour (return on capital?). The account here draws on Artis and Lewis (1991) and Lewis and Mizen (2000), and the references contained within. They are so-called because policy-makers who simultaneously seek to attain these four objectives will be unsuccessful, for at best only three of the four can be achieved. See Artis and Lewis (1991, p. 271). This principle was enunciated by Pablo Guidotti (then deputy finance minister of Argentina) and endorsed by Alan Greenspan (see Rodrik, 2006). Compensating balances are an old practice in US banking whereby a company is asked by the bank to keep a certain amount in a deposit account with the bank when it borrows from that bank. Common until about the mid-1970s, the amount on deposit was seen as a form of collateral or as a way of the bank receiving a higher return on money lent out or invested in the company. Both explanations have some relevance in this context. The authors give some examples of what this might entail. A more creditworthy counterparty might pay 15 per cent collateral on an asset-based swap the underlying ten-day

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8. 9. 10. 11. 12. 13.

14. 15. 16.

Untangling the US deficit volatility of which is 10 per cent, while a lesser credit might have to deliver 30 per cent. An additional factor might be added to cover foreign exchange risk and country risk for foreign or emerging market underlying assets. Some examples of the range of collateral actually required are: for a total return swap on a highly liquid US equity, a hedge fund (less creditworthy) would be asked for 15 per cent, for the S&P index 10 per cent collateral would be required, for Gazprom in Russia 50 per cent initial margin would be required. Swaps in listed China equities draw a similar large margin requirement. The various dimensions of liquidity and the nature of the non-pecuniary returns are outlined in Lewis (1990). The series of novels comprise Burr, Lincoln, 1876, Empire, Hollywood, Washington DC and The Golden Age. In the words of another historian, Paul Schroeder, ‘imperialism means simply and centrally the exercise of final authority and decision-making power by one government over another government (Financial Times Magazine, 13 March 2005, p. 19). With apologies to Charles Kindleberger (1970) for borrowing the title. For example, in Norman England, landholders were required to supply men and weapons for the King’s army, together with necessary materials and labour to maintain bridges and fortifications in their locality (McDonald and Snooks, 1986). The Danegeld (later a medieval land tax) originated in the payments, effectively protection money, paid by King Ethelred to raiding Danes to make them go away. For example, following the Battle of Maldon in 991 , he agreed to pay the Vikings 20 000 pounds in gold and silver, upon which payment the raiders duly departed (Lacey and Danziger, 1999). The use of slaves continued after Pax Romana in medieval Europe and the enthusiasm of Germanic and Arab slavers for raiding the Slavic tribes explains the origins of the word ‘slave’. Kennan organized and headed the Policy Planning Staff in the Office of Secretary of State from 1947. The classic account of this period is by Louis Halle (1967). Consols are an example of the British government’s borrowing power. An abbreviation of consolidated stock, consols were first issued in the eighteenth century as a consolidation of the national debt, as unredeemable (perpetual) government bonds bearing an interest rate of 2.5 per cent.

5. Nature of the adjustment mechanisms THE NEW POLICY ENVIRONMENT With the onset of floating exchange rates in 1973, the current account position replaced the overall balance of payments as an indicator of the need for adjustment in a country’s macroeconomic policies. One point we make in this chapter is that in the new environment of financially integrated markets the distinction between internal balance and external balance made in the theory of economic policy may no longer be relevant: the latter balance, however defined, can no longer usefully or indeed reliably be targeted by traditional instruments such as monetary and fiscal policy. Policy-makers may also find themselves in the unfamiliar position of having the capital account drive the current account, rather than the reverse causation implied in old Keynesian models, and this can lead to policy confusion as we have seen with the debates about the causes of the US current account deficit and who bears the onus for its correction. A lack of utility in current account targeting is implicit in the intertemporal theory of the balance of payments, as expressed for example by Sachs (1981) and by Frenkel and Razin (1987). The process of global financial integration makes the essential assumptions of that theory more nearly realistic. From a policy viewpoint, the basic trouble is that the current account imbalances are being measured, and concerns about them assessed, at the wrong level. This conclusion is the message that emerges from Alan Greenspan’s analysis of the implications of the decline of home bias. What is special about the past decade is that the decline in home bias along with the rise in US productivity growth and the rise in the dollar, has engendered a large increase by US residents in purchases of goods and services from foreign producers. The increased purchases have been willingly financed by foreign investors with implications that are not as yet clear. Typically, current account balances, saving, and investment are measured for a specific geographic area bounded by sovereign borders. Were we to measure current account balances of much smaller geographic divisions, such as American states or Canadian provinces, or of much larger groupings of nations, such as South America or Asia, the trends in these measures and the seeming 119

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implications could be quite different than those extracted from the conventional national measures of the current account balance. The choice of appropriate geographical units for measurement depends on what we are trying to ascertain. I presume that in most instances, we seek to judge the degree of economic stress that could augur significantly adverse economic outcomes. To make the best judgment in this case would require current account measures obtained at the level of detail at which economic decisions are made: individual households, businesses, and governments. That level is where stress is experienced and hence where actions that may destabilize economies could originate. Debts usually represent individual obligations that are not guaranteed by other parties. Consolidated national balance sheets by aggregating together net debtors and net creditors, accordingly can mask individual stress as well as individual strength. Indeed, measures of stress of the most narrowly defined economic units would be unambiguously the most informative if we lived in a world where sovereign or other borders did not affect transactions in goods, services, and assets. . . . If economic decisions were made without regard to currency or cross-border risks, then one could argue that current account imbalances were of no particular economic significance, and the accumulation of debt would have few implications beyond the solvency of the debtors themselves. Whether the debt was owed to domestic or foreign lenders would be of little significance. (2005b, pp. 3–5)

The imbalances would be of ‘little significance,’ in Greenspan’s words, because the outcomes would be resolved by market forces, and would not obviously call forth policy action. Max Corden (1983) was one of the first to argue that continued concern about the balance of payments reflects a failure to understand the nature of the current international system.1 Much of conventional macroeconomic policy analysis remains rooted in the conditions that applied under Bretton Woods. For example, policy analysis following Tinbergen’s (1956) approach to economic policy, specifies targets derived from the community’s and policy-makers’ preferences, and instruments such as monetary and fiscal policy that can be adjusted to achieve policy aims. This framework reflects the presumption that the authorities are not exclusively concerned with the inflation rate but have aims relating to unemployment and the balance of payments position. Concerns about the balance of payments arose in the Bretton Woods context (which itself, we recall, had origins in, and should be seen as an extension of, the gold standard). Exchange controls lingered for decades after the Second World War, and an integrated capital market emerged only later. So for a long time the private market was limited. When a balance of payments gap opened up, countries had to borrow from other governments or the IMF, even if they were financially sound. After Bretton Woods collapsed, and fixed rates were replaced by floating rates, many economists and commentators struggled to come to grips with

Nature of the adjustment mechanisms

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the nature of the new system, and the implications for policy-making. The present international monetary system differs from earlier ones because, being a fiat money system, it is one in which national central banks and monetary authorities monopolize the supply and the management of inconvertible paper moneys. It is thus based on claims such as paper money, coinage, and deposits at the central bank of a country which are not convertible by law or custom into anything other than themselves, and which have no fixed value in terms of any objective standard or monetary substance. In the past, the value of the internal currency was intrinsic or was maintained in a fixed or nearly fixed relationship to a monetary substance or some other external standard of value. For example, in 1816 and again in 1925, the value of the pound sterling was laid down as a specific weight of fine gold (113 grains) to which the value of sterling was to be kept equal. In 1834 the gold dollar contained 23.22 fine grains of pure gold, giving a mint par to exchange of $4.8665 1 pound prior to the First World War. After the Second World War, national currencies were maintained at a fixed rate of exchange relative to the US dollar, itself backed by a gold commitment. That all changed in 1971. The significance of that change has been characterized by Milton Friedman: The world’s current monetary system is, I believe, unprecedented. No major currency has any link to a commodity. What economists call outside money consists entirely of government fiat in the form of paper currency, minor coin, and book keeping entries such as deposits at US Federal Reserve Banks. The major earlier episodes in which governments departed from a specie standard and issued irredeemable paper money were expected to be temporary, and most of them were. The others ended in disaster, as in the hyperinflations after World Wars I and II. They were followed by monetary reforms that restored some relation between the currency and a commodity. Only since President Nixon ended Bretton Woods by closing the gold window on August 15, 1971, have the United States and all other major countries explicitly adopted monetary systems in which there is no link to a commodity and no commitment to restoring such a link. (1986, 643)

The period since 1971 is not the first time that the link between major national currencies and a commodity base has been severed. During the 1930s much of the world employed paper money, yet in many cases its value was maintained as successfully as it had been when based on a commodity. Moreover, it can be argued that the closing of the US ‘gold window’ in 1971 was simply part of the same evolution that was already giving rise to the gathering inflationary momentum of the late 1960s and early 1970s, and that the departure from gold was symptomatic of these inflationary tendencies rather than the reverse. But there can be little doubt of the symbolic

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significance of the break as the culmination of a long evolutionary process. When money either is a commodity or has a value tied to a commodity, inflation is ultimately a story of fluctuations in the prices of goods in general relative to that other commodity. In that sense, inflation under a commodity standard might be said to be a real matter, not a monetary one. With the universal adoption of independent paper money since 1971, the value of fiat money cannot be explained by such factors. Many leading experts, notably Williamson (1976), seized upon the absence of constraints to characterize present arrangements as a ‘nonsystem’, by which they mean the absence of an explicit set of rules. This follows a long tradition in monetary economics of defining a fiat money system in negative terms – for example as a ‘monetary system in which the value or purchasing power of a monetary unit is not kept equal to the value of a specific quantity of a particular commodity or of a group of commodities’ (Kent, quoted in Mason, 1963, p. 183). Viewed in these terms, the present system has no agreed rules upon international behaviour. Issuers of money do not promise to exchange it for gold or any other commodity. Many countries do not make their money convertible at a fixed rate into another currency. No limits are placed upon money creation. Countries can choose inflation, deflation, any fiscal–monetary policy mix, fast or slow growth. Notably, they can lend or borrow as much as they choose. However, absence of a ‘system’ in the sense meant by Williamson need not imply disorder. Order in monetary arrangements can be induced spontaneously as well as by design; coordination can arise voluntarily without coercion; actions can be constrained without there being any central direction. These are the distinctions which underlie Corden’s (1983) insightful observation that present monetary arrangements have similarities with one of the oldest of systems, namely laissez-faire – in Corden’s words, the present system is one of ‘international financial laissez-faire’. Old-fashioned (and nowadays politically incorrect) textbooks on economic principles used to begin with parables about housewives going off to market each day for shopping. Their actions are not managed or centrally directed, but neither are they uncoordinated or unconstrained. Coordination comes through the marketplace. Household purchase plans are drawn up on the basis of preferences and expected prices. When confronted by posted selling prices, these plans are revised along with marketclearing prices. So it is internationally. Economic entities formulate plans about exports and imports, consumption and savings, holdings of money and assets. These decisions are integrated, revised, constrained, and coordinated through the international marketplaces for goods, services, and assets, by exchange rates and interest rates and overall demands and supplies.


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Corden argues that in the new environment of international financial laissez-faire, saving and investment decisions are made by ‘consenting adults’ who, we must suppose, know what they are doing. The current account surplus or deficit simply reflects, in the aggregate, these individual saving and investment decisions. Consequently, if a case for assigning policy priority to the current account is to be made, it must rest on ‘the identification and rectification of externalities in the borrowing process’ (Pitchford, 1989, p. 6). In their absence, private-sector (and public-sector) decision-makers should be left to get on with their own activities. This is a useful way of thinking about the international accounts: the balance of payments is indeed quite a general concept of economics. Any individual, or group of people and firms, has a balance of payments and can have a current account ‘problem’. A household, business enterprise or geographical region makes current payments and has current receipts and, when the two are not equal, will have a current account ‘imbalance’ which is matched by reduced asset holding or increased net debt. Sometimes a current account deficit is compared with a company’s profit and loss account. If a corporate analogy is to be used at all, it is that of the cash flow. This can be negative for a corporation with profitable prospects that is borrowing from the financial markets. A current-payments deficit is the difference between exports and other overseas earnings, and imports. But it is also the difference between a country’s investment and its domestic savings. Some countries have a surplus of savings over investment opportunities; others have more investment opportunities than they can finance. As Samuel Brittain once pointed out, those who do not like red ink in the balance of payments are saying that there should never be any net international lending or investment. Our major point, however, is that we look to people and firms to marshal their own resources and to undertake corrective actions should their current account imbalances within the domestic economy become excessive. Why, then, should we not do likewise for international transactions? This is the central issue posed by Corden and Greenspan. Before turning to this question we need to consider the balance of payments issue in the light of the new international financial laissez-faire that has gradually evolved over recent decades, for it is the advent of this era, rather than new theoretical developments that is at the bottom of the controversy as to the sustainability of the US deficit.

PAYMENTS IMBALANCES In earlier chapters we established current account imbalance as being the sum of the private-sector imbalance (the difference between private saving

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and investment) and the public-sector imbalance (the difference between tax revenues and government spending). In practical measurement, this result can be shown to hold only approximately because of certain statistical difficulties in deriving consistent national income and production estimates from the available data (as reflected in the national accounts by the statistical adjustment in Tables 1.2 and 3.2). In 2005, the US government budget deficit contributed, arithmetically, $457 billion to the current account deficit, while the private sector deficiency of saving relative to investment was $385 billion. While these figures might suggest that it is the government imbalance on which attention should be focused, in fact the government budget deficit actually declined in size from 2003. Most of the widening of the deficit has been reflected in the changed position of the private sector. From being roughly in balance in 2003, the private sector is now substantially in deficit ($493 billion in 2006). Figure 5.1 illustrates rather dramatically that the deficits which the United States incurs on the current account of the balance of payments must of course be matched by surpluses on the part of countries with which the United States has trading and financial relationships. In the new international financial laissez-faire framework envisaged by Corden and others these individual national relationships are seen as part of an overall pattern of global saving and investment. Central to this analysis is that for any open economy operating in a milieu of floating exchange rates, financial deregulation and high capital mobility, the current account balance is really understandable only within the framework of a general United States Japan Russian Federation China Rest of Asia Euro Area $ billions –1000

Middle East –800

2005

–600

–400

–200

0

200

2006

Sources: IMF IFS; authors’ calculations.

Figure 5.1

Current account balances for selected countries, 2005–2006

400


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equilibrium involving the spending and saving decisions of citizens of many countries.2 If we accept this as a reasonable approximation of reality (and there are exceptions, for example, countries that continue to run forms of exchange or capital controls) then the long-accepted dichotomy between internal balance and external balance as the appropriate policy framework is no longer relevant, and is likely harmful. Suppose, for example, that it is the capital account of one such country that ‘overshoots’; in the sense that more capital is brought in than is required to finance a given current account deficit. If the authorities, fearing that the resulting currency appreciation would widen the deficit, apply the monetary brakes and push up interest rates in an attempt to ‘control’ the deficit by dampening domestic demand, they only make things worse by encouraging capital inflows. By contrast, the new policy paradigm, which anticipates that such a capital-account effect will occur, argues that the authorities should confine themselves to the task of monitoring the internal balance, leaving the deficit and the level of private debt to adjust to their policy settings. It is in this strict policy sense that the deficit ‘does not matter’. Under international financial laissez-faire, policy-makers should look at market data, such as interest rate differentials or exchange rate movements, rather than potentially misleading balance of payments figures, for signs that overseas borrowing is excessive. If governments concentrate on keeping inflation down and their own books in order, the balance of payments will take care of itself – or at least that is how the argument goes. A second prong of the analysis concerns the benefits of international lending and borrowing in a highly integrated world economy. In a model of intertemporal equilibrium, the price of present consumption in terms of future consumption is the real rate of interest, which will be the higher the stronger the community’s preference for present goods. But countries have very different sets of preferences for present and future goods, and by means of exchange of financial assets they may ‘trade’ present current account deficits/surpluses for future surpluses/deficits in much the same way as they trade goods and services. This will give rise to ‘gains from trade’, the residents of surplus countries being able to make their saving available in international markets at a higher interest rate than would be possible under a regime of restricted capital movements, and the residents of deficit countries being able to borrow more cheaply. Capital-market deregulation, in other words, is akin to removing protection of local savers from foreign ‘competition’. If, at the same time, there are national differences in the marginal efficiency of capital, those areas which are endowed with superior natural and/or human resources will export financial assets and attract an inflow of

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capital carried, in effect, by an inflow of goods. Interaction of investors in search of the highest rate of return with the behaviour of savers seeking to maximize intertemporal utility determines the efficient worldwide distribution of saving and investment with its counterpart national current account imbalances. It then follows that if the ‘comparative advantages’ in present and future goods differ widely across countries (as they certainly do between Japan and Germany vis-à-vis the United States and Australia) then even large current payments imbalances among countries can persist, contrary to the conventional view that focuses only on the current transactions section of the balance of payments. What further follows is that if such imbalances are to be reduced, it is not sufficient to correct the imbalances resulting from merchandise and service trade flows, but also to narrow the disparities between national preferences for present and future goods. Neither the ‘prodigality’ of nations like the United States, Australia or Spain, nor the ‘thriftiness’ of countries like Japan, Switzerland or China, should serve as the norm of internationally responsible behaviour, since presumably citizens of those countries can be adjudged to be making decisions which accord with their own best interests. Viewed in this global setting the use of economic policies, whether at the macro or micro level, purely to reduce the size of the current account deficit to some ‘tolerable’ level is neither practicable over extended periods of time, nor necessarily desirable. Given the level of world saving, investment expenditures for any one country will be governed by the marginal productivity of capital domestically relative to that of other countries, the current account imbalance always matching ex post the gap between domestic investment and saving. Reduction of the current account deficit below that level would reduce economic welfare both in that country and the world. In a world of integrated financial markets, therefore, the policy-makers of individual countries, such as many of the emerging market nations, are caught on the horns of a dilemma. They may deregulate the exchange markets and the financial system, but only at the risk of losing essential control (by the traditional means) over the current account. Alternatively, they may attempt to retain some degree of control over the current account, if only they are prepared to forgo some, if not all, of the benefits of free international capital movements. Should they attempt to do both, they court the danger of succeeding in neither, as may have been the case during the Asian financial crisis. ‘Welfare’ in this abstract debt/borrowing model must be understood to refer to the aggregate level of welfare, and not to the distribution of welfare among various economic groups. Not all members of the American community need benefit equally from freeing the balance of payments from all


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policy constraints; indeed, some might be net losers. To illustrate, suppose that the real rates of return on capital in the United States attract capital on a scale exceeding substantially the pre-existing current account deficit. For the current account to ‘accommodate’ itself to the capital inflows, a rise in the US deficit (and a corresponding rise in the current account surpluses of the lending countries) would be necessary, a process that may require some change in relative prices. In particular, any real appreciation of the US dollar would inevitably (so long as the inflows continued) erode the competitive position of exporters and of manufacturers competing with imports. For such groups the direct losses due to lower competitiveness would be likely to outweigh the more indirect benefits of open capital markets and greater trade.3 The processes outlined above envisage that any increase in spending and decrease in saving by the deficit countries has, as its direct counterpart, increased saving by the surplus countries and their lower spending. To the extent that such changes simultaneously alter both the capital account and the current account balances, the international economy is spared the shocks of exchange rates adjusting too sharply to bring about short-term adjustments to trade flows. For an economy which maintains a broad equilibrium in its trade and services account, short-term private capital movements would prima facie also suffice to safeguard stable exchange rate outcomes without undue official interference. In the case of the United States, faced with the need to finance current-period deficits as well as the necessity to re-finance past deficits by rolling over existing short-term debt, this presupposes that the export of financial assets and import of goods by Americans continue to match closely the export of goods and import of financial assets by foreigners. The fact that the US deficit has been financed ‘without measurable disruption to international financial markets’ (Greenspan, 2005b, p. 1), might indicate that this situation is in fact the case. Nevertheless, the clearest illustration of such a smooth payments mechanism (where adjustment costs are either absent or minimal) is an association of regional economies in a monetary regime with a single currency.

A REGIONAL PAYMENTS SYSTEM? Milton Friedman once observed that California has probably had a current account deficit with the rest of the United States since 1945, yet no-one knows and no-one cares. Why is this so? In a regional payments system, a member economy may indeed sustain current account deficits with other regions more or less indefinitely, since the deficits are always automatically financed by capital inflows from the other partners. It would be regarded as

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the height of absurdity, if Friedman’s conjecture is true, for California to worry about its state of payments with the other American states. This situation is in part because the free movement of goods across state borders keeps regional prices in line with those of other states. Indirectly this interstate trade in goods and services acts to narrow regional differences in wage and other costs. Wage costs are also kept in line by the interstate mobility of labour. In these ways, differences in competitiveness which give rise to trade imbalances are less likely to occur within an integrated country than they are across countries. To some degree also, regional trade imbalances arising from slower growth or regional downturns may be offset by government transfer payments if lower tax revenues and higher social security payments result in net transfers from surplus to deficit regions via the central government. However, the main reason why regional payments imbalances are ignored – to the extent that countries do not even attempt to keep statistics on them – comes from the high substitutability between financial claims issued in the different regions. In response to a payments deficit, members of a region within a country must borrow through the issue of liabilities, or draw down assets, or do both, in order to finance the imbalance. Liabilities could be issued to banks by means of bank borrowing or be sold in local or national capital markets. Alternatively, members of the region can run down bank balances. In a branch banking system, or one like the United States with a well developed inter-bank system, local loans will grow relative to local deposits, funnelling funds from the surplus regions to the deficit region. Entities in the deficit region could also sell off other assets. If the assets sold, or liabilities issued, were exactly those which members of the surplus regions wanted to buy, prices of the financial claims would remain unchanged, and the current account disequilibrium would be exactly matched by offsetting transactions on the asset account which left the local economies unaffected. In practice, not all assets are readily transferable nationally (for example, many real assets). Nevertheless, in order to effect the transfer, relatively minor changes are likely to occur in the prices of those assets which are free to move between regions. This process can continue until national banks and lenders in other regions are unwilling to lend further, or members of the region run out of assets which can be sold off or borrowed against. Most likely, well before these limits are reached, and in response to the growing repayment burden and decline in net assets and wealth, members of the region will revise their economic plans, cut costs and prices, so adjusting expenditures and correcting the imbalance of payments. Notably, this correction is brought about without government intervention. It is prompted by no more than the self-orientated behaviour of individuals and firms looking to their


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financial positions in response to changes in the physical quantities of the assets in their portfolios. And it may involve little in the way of changes in asset prices so long as members of the deficit regions and financial intermediaries hold large stocks of nationally transferable assets, and portfolio preferences are regionally unbiased. Something akin to these results obtains for a currency union of sovereign states the currencies of which are pegged unalterably against each other, or replaced by a common currency, for example, the eurozone. An historical example comes from the gold standard. Fixity of exchange rates promoted a high degree of integration of goods markets so that prices for tradable goods moved broadly in step with purchasing power parity relationships. At the same time the gold standard was an era of unimpeded international capital movements with capital naturally flowing to regions with high economic returns. It is important to observe that the above conclusions do not apply to free trade areas such as NAFTA. So long as each member nation retains sovereignty over its money supply, differential rates of inflation will make more or less continuous exchange rate adjustments among members inevitable, thus introducing a powerful new factor: exchange risk. The distribution of saving and investment over the whole region will then also depend upon what view the different transactors take of exchange risk. In order to overcome the currency risk and all other factors making for a lack of substitutability between claims on the different countries, interest rates in the deficit country may need to rise, forcing some of the adjustment onto the prices of domestic assets, credit conditions, and incomes and expenditures. To the extent that this occurs, the ultimate adjustment costs imposed upon the deficit country need by no means be negligible. More generally, it is the presence of exchange rate uncertainty that introduces a new element into the debt/borrowing processes sketched out earlier, for it gives rise to costs and externalities that are not explicitly considered in the abstract model.

EXCHANGE RATE RISK The growth of international banking, together with the liberalization and globalization of securities markets, can be seen as taking the existing modes of international adjustment some way towards the situations typified by the gold standard or the type of monetary arrangement that has developed in the eurozone. However, the present world economy differs radically from those two systems in the sheer magnitude of the currency risks faced by international investors in the ordinary course of business. Judging from the

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analyses of Feldstein and Horioka (1980), Feldstein and Bacchetta (1989) and Bayoumi (1989), the existence of exchange rate uncertainty has militated against the operation of an efficient international capital market along the lines of the pre-1914 gold standard when legally fixed mint parities between countries enabled saving and investment decisions to be made largely free of exchange rate risks. More recent evidence along the same lines, discussed in the previous chapter, suggests that this position may be changing rapidly and that the sorts of contributing factors (home bias, exchange rate uncertainty) may be exerting less of an influence upon the segmentation of national capital markets than was the case previously.4 To the extent that exchange risk does impede the coalescing of national capital markets into a truly integrated world capital market, the conclusions of the international financial laissez-faire school are also in need of some qualification. At this point a distinction needs to be made between net and gross flows of international capital. For net capital movements to occur there must of necessity be exchange rate risk, since a capital transaction hedged on the ‘principle of offsetting risk’ generates an equivalent capital transfer in the opposite direction. Thus a British or Australian firm which borrows overseas in foreign currency could shelter its liabilities against a depreciating pound or Australian dollar respectively by buying an equivalent amount of foreign currency on the spot market to cover its risk pending delivery; it would pay for this with domestic currency, thus generating a capital outflow which offsets the inflow from the foreign loan. Such gross (each-way) capital movements motivated by desires to spread exchange risk are not costless. To the extent that resources must be expended in diversifying the exchange risk, there is an offset to the gains arising from the globalization of capital transactions, and this offset will be the greater the greater the volatility of exchange rates and the greater the volume of transactions across the exchanges. Who bears the risk, and what the response to it is, depends upon the form of the borrowing. The United States is unique amongst nations in that its foreign liabilities are almost entirely in US dollars, shifting the foreign currency risk onto others. US borrowers may have little exchange rate risk (assuming the assets acquired are also mainly in US dollars), but the same is not true of those acquiring US debt and equity claims. Potential foreign holders of US dollar bonds and other claims must weigh a number of considerations – political stability, marketability, default possibilities, the tax regime, institutions and laws, the possibility of expropriation – but cannot overlook exchange rate risk. The expected exchange rate change needs to be taken into account, along with the risk premium. This premium is the excess return, for a given expectation of the return that a foreign holder requires because of the volatility of the nominal


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returns on US assets measured in terms of other currencies. Both may be low for US dollar securities and other assets, but not zero. Here, then, we have the possibility of important factors being generated, which simply do not arise in the regional adjustment model underpinning much of the reasoning behind the new approach to the balance of payments. Because of near to perfect substitutability of, say, Californian debt for that of the other states, New Yorkers need not worry about the aggregate amount of California debt. But foreigners do react to the accumulation of US debt because they regard country exposure as a factor in their decisions, and because it can be fairly presumed that individual borrowers looking to their own interests take little or no account of the effects of their borrowings upon the total. In the discussions of country risk it is the rising supply price of capital due to increasing risk premium imposed upon all external borrowers that is often regarded as the source of negative externalities visited upon the borrowing economy. But this in itself is not an externality; we should expect such an effect to arise in every competitive market, and irrespective of whether the loans are raised domestically or internationally. To illustrate how externalities may be generated under the conditions envisaged here, consider the simplified case of two ventures, one involving the external financing of a project in the sector of the economy exposed to foreign trade (for example, creation of export-generating or importreplacing capacity) and the other involving domestic takeover activity. On competitive considerations alone it seems likely that a rising risk premium would render the first project unprofitable (with the private cost of financing the project exceeding the private benefit) well before the second project, even though by all accepted criteria the social benefit of the former would be deemed to exceed the social benefit of the latter. To the extent that disparities between private and social gains from large-scale external borrowings may give rise to externalities hitherto unexperienced, they also generate mistrust in the mind of the public about the efficacy of the market process when the United States emerges as the world’s largest borrower. Nor do the possible externalities end there. If we regard the current account balance as residually determined by the amount of public and private investment relative to the pool of available domestic saving, the resulting deficit can be seen as optimal only if there are no distortions5 to private saving and investment (for example, the tax treatment of interest income and gearing) and if the public sector and the economy as a whole are in reasonable balance, which has obviously not been the case with the US government budget. An individual US borrower may appear to be freely choosing overseas over domestic borrowings, but the borrowings made by borrowers as a whole are not voluntary if it is domestic policies

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and other demands on capital markets that both drive them to seek funds offshore, and shape their overall exposures. In marked contrast with a regional payments system (used here as a benchmark for the new global financing environment) international transactors need to respond continually to the perceived exchange risks facing them. It is the assessment of these risks which is critical to the borrowing/investment process, for the outcome of such assessment influences the enterprises’ perceptions of the marginal efficiency of the capital. The analyses of the new laissez-faire approach to the balance of payments surveyed earlier are all predicated on the assumption that it is the private-sector decision-makers who are on average more capable of making sensible, well-informed choices about investment and borrowings than with risk-averse policy-makers and politicians whose planning horizons are necessarily restricted by the political cycle. While no one can seriously quarrel with that proposition, the difficulty is that in projects involving foreign financing it is not just the particular commercial risk but also the overall exposure risk that is relevant. The theory of ‘efficient markets’ discounts the possibility of sustained biases in the estimation of this risk on the grounds that private economic agents would rapidly assimilate any new developments into their decisions and constantly reassess their exchange exposures. This contrasts with the ‘price dynamics view’ (Dooley and Shafer, 1984) which holds that exchange rate behaviour and exchange risk assessment are primarily shaped by perceived trends in traders’ expectations, as reflected in price runs, selffulfilling prophecies, bandwagons, and ‘technical corrections’, only loosely related to fundamental factors like the balance of payments, terms of trade, and rates of inflation. Given some empirical support for the price dynamics hypothesis (Fourcans and Franck, 2003) it is by no means a foregone conclusion that superior economic outcomes will always follow from foreign private-sector borrowings for which foreign exchange risk is a major component. This perhaps is why Asian countries, seared by the experiences of the financial crisis of 1997/1998, have gone to such lengths to build up a ‘war chest’ of reserves to self-insure against the perceived capriciousness of foreign investors.

THE POTENTIAL TRANSFER PROBLEM These comments bring us to the issue of the extent to which privately-based overseas borrowings may be expected to be ‘self-correcting’. Ultimately, the sustainability of America’s foreign debt turns on what is done with it, for no country can continue to borrow indefinitely or to sell off its assets to


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consume more than it produces, although it can do both for some time. In the final analysis, the question always remains: can the private sector be relied on to assess fully the implications of providing the goods and services necessary for servicing, and ultimately repaying, its short-term foreign debt? A foreigner acquiring a financial claim against a US entity gives up current purchasing power in favour of the American borrower. When payment of interest and/or repayment of capital are made, the reverse of this process occurs: the purchasing power is retransferred to the original transferor, together with the interest, which is his/her reward for waiting. As far as the financial part of the retransfer is concerned, there generally is no difficulty, so long, of course, as the borrower is solvent. He/she simply writes a cheque for the amount of interest (or capital repayment) which the original lender then negotiates, and there the matter ends – for the individual borrower and lender. But in order to bring about the real retransfer of past loans, a debtor economy must generate a trade and current account surplus equal to the amount of the real transfer. It is in this sense that the debtor country has traded present current account deficits for future surpluses. In the traditional framework such surpluses can be generated in one or more of three ways. The first is that in the course of the deficit/borrowing process sufficient new export or import-replacing capacity is created to facilitate the future flow of real transfers. On this basis the rapid growth of America’s short-term foreign debt during the ‘productivity boom’ of the 1990s hardly caused any public concern: in due course, the United States would repay its borrowings by increasing its supply of information technology-based services to the rest of the world. Investment to expand industrial capacity might be seen in a similar light. The second way is to ‘squeeze’ the required surplus out of the economy by ‘disabsorption’; that is, by restricting domestic consumption of resources until a trade surplus of sufficient size is generated. This scenario is more likely to arise in the case of ‘unproductive’ government borrowing, but the recent experience of equity withdrawal and highly leveraged borrowings against real estate collateral that may prove to be illusory in a major down turn would suggest that the problem of generating goods and services to the value of the transfers needed is not necessarily confined to the ‘unproductive’ government sector alone. The dichotomy between ‘good’ privately-driven foreign debt and ‘bad’ government-contracted debt, on which much of the laissez-faire analysis of foreign debt rests, may be in need of some modification. Nor is the contention that the private borrowing process is self-correcting (that is, projects financed by borrowings are either profitable and repay debt,

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or go bankrupt) of much comfort to those who are uneasy about the future transfer process. The issue here is not the optimality of free markets but the quality of intermediation and risk management (particularly where there are many layers separating an individual home mortgage from a mortgagebacked bond), and these are not one and the same thing. For example, there could be a period of painful adjustment to unwind the high debt servicing ratios. The third way in which transfer may be brought about is through adjustment in the exchange rate and the terms of trade. If, as a result of a depreciation the prices of imports rise with the domestic supply prices of exports remaining unchanged, the terms of trade deteriorate, and the debtor country is said to suffer from a secondary burden; that is, in addition to the primary burden of the transfer itself the debtor country pays a penalty in the form of a higher real cost of imports. The question then arises: how large would the secondary burden have to be if America were to effect the real retransfer of at least some portion of its foreign debt? Those who consider that there is little concern about the growth of American foreign liabilities presumably take comfort on these matters from the stance that in the laissez-faire environment, adjustment would occur not only through flows of tradables on the current account, but also importantly through asset stock demands and supplies, all of which would combine to determine the equilibrium exchange rate. Everything would go well if asset preferences continue to favour the debtor country without rising marginal costs in terms of loss of international competitiveness and upward adjustments to the interest costs of re-financing. Eventually, the original asset switches are simply reversed, the proceeds from maturing securities providing the creditor with the funds needed for the import of the debtor’s goods, again possibly with no great disruption to relative prices. The whole process can be envisaged taking place as if brought about through perfect forward markets, with foreigners buying forward American goods when saving and Americans selling forward exports when borrowing. How does this picture of almost perfectly dynamically matched preferences for goods and assets differ from a world in which transfers occur through adjustments in the trade accounts of the debtor and creditor countries? The conventional analysis does admit the possibility that both the primary burden and the secondary burden of the transfer process may turn out to be too much for the transferring economy to bear. In that case the real transfer is said to be undereffected (that is, the trade surplus needed is less than the amount of the financial transfer) with two possible results: (1) the debtor economy has to go on borrowing, facing possibly worsening terms in the world capital markets, until the evil day cannot be postponed


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any further; or (2) it needs to bridge the gap by transferring to foreigners the ownership of its assets. In this latter case, the debtor country is conducting the equivalent of ‘debt–equity’ swaps, with foreign holders of debt exchanging debt instruments for the acquisition of equity in local companies, property, and real estate. Any concerns on this account transcend simple xenophobia, although that was real enough when the Japanese started buying commercial property in the United States in the 1980s and China (in the form of the Chinese National Offshore Oil Corporation (CNOOC)) sought to acquire equity in the US energy sector in 2005.6 Suppose that such transfer pressures spill over into residential real estate. Then the ‘transfer problem’ would not necessarily manifest itself in an external variable like the exchange rate, but in an internal variable, in this case land and housing prices. In a general equilibrium setting the asset price adjustments implied by large and rapidly rising foreign debt may have implications in areas seemingly removed from their initial source. Again, these adjustments may be little different from those taking place in the regional payments system, except that they are more visible and attract more attention.

CONCLUDING REMARKS Throughout the book we have argued that a current account deficit in itself is neither ‘bad’ nor ‘good’. For that reason we have sought to avoid using terms such as ‘deterioration’ or ‘worsening’ of the current account instead of ‘increase’. The current account deficit is simply an accounting statement which tells us that investment spending exceeds what domestic residents see fit to finance from their immediate income. Nor does the deficit tell us anything about the facility with which the excess spending is financed, or what steps have been taken by US borrowers to ensure repayment. Similarly, if we are to consider the questions of whether US citizens should rejoice at the willingness of foreigners to lend to Americans their savings, or whether they should worry about how the debt should be repaid, we need to look elsewhere for an answer. Specifically, we need to look to the overall balance of the economy and the stance of domestic policies, which, over the years, may have led to distortions in the patterns of saving and investment that have manifested themselves in sectoral imbalances and a seemingly intractable current account deficit and foreign debt ‘problem’. The adjustments to this ‘problem’ could be quite painful. For example, Quiggin (2004, p. 4) considers that any significant reduction in the imbalances

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on goods and services appears likely to require very large changes in market prices or US income levels such as: ● ● ● ●

A (further) larger devaluation of the US dollar; Large reductions in US wages relative to those overseas; Large increases in US productivity relative to foreign productivity; and Large reductions in US consumption relative to foreign consumption.

As to the first of these, Feldstein (2006) estimated that the real tradeweighted value of the dollar must fall by at least 30 per cent to shrink the trade deficit to a sustainable level of 3 per cent of GDP. In this chapter we have taken a somewhat different tack and explored the economic environment in which these issues must be worked out. In particular, we have examined the similarities and differences between the balance of international payments under the new system of international financial laissez-faire and the balance of trade and finance between economic units. We have argued that while the similarities between the two have undoubtedly become much stronger as a result of inexorable forces in the world economy, there are still some elements likely present in the international case which have no parallels in inter-regional adjustment. How close the international system has, and can ever, come to the regional system of payments that we have used as a kind of conceptual scaffolding for our discussion remains an open question. Nevertheless, to the extent that they coalesce, very different implications follow for the ‘resolution’ of the deficit as compared with the required adjustments outlined above. To begin with, in a regional payments context, we would probably not even know that a current account deficit exists. If it did, then the deficit could be financed with little disturbance to overall global interest rates. In particular, a government budget deficit, for example, would be financed not by drawing upon US domestic saving but on savings from the entire world. There would be no necessity for US interest rates to rise (as indeed would appear to be the case in the last few years). Even if the international system only approached such a payments system, relatively small adjustments to interest rates and/or exchange rates might suffice so long as asset preferences favour the debtor country and there are reasonably intertemporally-matched preferences for goods and assets. Finally, in response to greater economic and financial integration it seems likely that borrowing countries will want to borrow more, and countries that save and lend will want to lend more, so that the distribution of current account balances will widen (Blanchard and Giavazzi, 2002). This conclusion is consistent with the greater dispersion of current account imbalances in recent years to which Greenspan (2005b) drew attention.


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In short, the major message of this framework is that the analysis of the current account deficit, and its resolution, shifts to asset markets and the capital account, and to the nature of asset preferences and wealth positions, irrespective of whether or not the deficit is ‘made in the USA’. Accordingly, we begin the next chapter by looking at the foreign asset and liabilities structure of the US balance of payments and the US national balance sheet.

NOTES 1. We have already noted the earlier comments by Richard Cooper in Chapter 2, p. 17 (1981). 2. This analysis draws extensively upon Lewis and Polasek (1990), which was written with the Australian context in mind. For a recent analysis of the Australian current account deficit, see Gruen (2005). 3. In principle, compensating payments could be made by the gainers (importers and consumers of imports) to the losers, but who is to estimate these and by what means might the levies be collected and paid, especially within a political process? 4. We recall that the null hypothesis tested by Feldstein and Horioka was that in a truly integrated world market for capital we should expect no significant correlation between a country’s investment and savings rate, since investors in any single country could draw upon the world pool of savings with little regard for national boundaries. The Feldstein–Horioka null hypothesis was rejected and the negative result confirmed for a more recent data set by Feldstein and Bacchetta. The authors conclude that national capital markets continue to be segregated, and attribute this significantly to the influence of exchange rate uncertainty. Bayoumi demonstrates that the Feldstein–Horioka– Bachetta expectation of no correlation between country saving and investment rates was realised in the years 1880 to 1913. Recent work by Feldstein (2005) indicates that the ‘savings retention coefficient’ has declined markedly amongst OECD countries for the decade 1993–2003 (0.19) compared with the original sample, 1960–1974 (0.80) using unweighted data. Finally Blanchard and Giavazzi (2002) find, as might be expected, that amongst the group of eurozone countries, the savings retention coefficient has declined substantially over time and for 1991–2001 is only 0.14. For this group of countries, the Feldstein–Horioka phenomenon seems to have largely disappeared. 5. In his 2006 Mundell-Fleming lecture, Olivier Blanchard analysed the US current account through just such a ‘Cordenite’ prism and weighed the case for policy interventions to curb current account balances in the teeth of large swings in private sector savings and investment decisions. He too concluded that the case for intervention rests on the presence of distortions. And despite exploring a number of distortions in labour, product and financial markets, optimal policy is not typically found to involve current account reduction. See Blanchard (2006) for more details. 6. In June 2005, CNOOC, a Chinese state-owned corporation, tried to buy Unocal, a middling-sized American oil firm. The House of Representatives voted 398 to 15 to urge a presidential ‘review’ of the bid. CNOOC withdrew its bid.

6.

The sustainability of the deficit

HOW MUCH OF A THREAT? In the previous chapter we said that the sustainability of a current account deficit for any country depends ultimately on what is done with the borrowings or realization of assets. No nation (or grouping of citizens) can borrow indefinitely or sell off assets without limit to consume more than it produces, although it can do so for some, perhaps considerable, time. In the words of Joan Robinson (1973): The deficit country is absorbing more, taking consumption and investment together, than its own production; in this sense, its economy is drawing on savings made for it abroad. In return, it has a permanent obligation to pay interest or profits to the lender. Whether this is a good bargain or not depends on the nature of the use to which the funds are put. If they merely permit an excess of consumption over production, the economy is on the road to ruin.

The United States is not exempt from such admonitions, but the role of the US dollar as international money does mean that the constraints that it faces are very different from those of other countries. Nowhere is this more evident than in the investment income flows and the external balance sheet. Indeed, for all countries the major implication of growing financial integration and the international financial laissez-faire framework is that the examination of a current account deficit, and its ramifications and sustainability, shifts firmly to asset markets and the structure of foreign assets and liabilities. The valuation of those claims becomes a crucial matter and none more so than in the case of the United States. This issue has an important bearing on the answer to the question: ‘How threatening is the deficit in reality?’ Our conclusion is that this alternative perspective does indeed make a considerable difference to the story. Contrary to many other commentators who regard the present US current account deficit as clearly unsustainable, and warn of the dangers of delaying adjustment, we consider that the question of sustainability is more complex than it first appears and that a more relaxed assessment emerges when the special position that the United States occupies in the world economy and financial system is taken into account. Nevertheless, the Jeremiah-like warnings of the ‘deficit pessimists’ certainly cannot be ignored, and it is with this ‘orthodox case’ that we begin. 138

The sustainability of the deficit

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THE ORTHODOX CASE Almost all observers, including both the past and present Chairman of the Board of Governors of the US Federal Reserve System (Alan Greenspan and Ben Bernanke), accept that the US current account deficit is unsustainable in the sense that it (1) cannot continue to widen indefinitely and (2) must also begin to shrink at some point. But at what point does this occur and how much must it decline from its current level of 6.1 per cent of GDP to become sustainable? And what will be the dynamics of reversal? Is the deficit currently so large that a ‘disorderly correction’ or ‘abrupt’ reduction in the deficit is now almost inevitable or can the United States (or, more correctly, its citizens) move towards a smaller and ultimately more sustainable current account deficit in a smooth and relatively benign fashion? Certainly, there is an increasingly widespread view in the literature that the later adjustment begins the more difficult it will ultimately prove for the US economy (Roubini and Setser, 2004; Obstfeld and Rogoff, 2005; Truman, 2005). The Historical Perspective Implicit in this latter view is that the US deficit is already unsustainable. But exactly when does a large current deficit become ‘excessive’ or more pertinently ‘unsustainable’? One approach has been to examine the history of current account adjustments and reversals in an attempt to see whether the empirical evidence suggests that there is some kind of ‘threshold’ level beyond which adjustment must quickly take place, even if signs of adjustment or stress are limited or scarce until the threshold is reached. In short, is there a ‘tipping point’ for current account deficits? On this basis, America’s widening current account deficit has prompted a number of articles focusing on the history of current account reversals (Freund, 2000; Freund and Warnock, 2005; Clarida et al., 2005). This historical analysis suggests that, while there have been instances of developed countries since 1980 running deficits as high as double-digit percentages of GDP before markets enforced a reversal, a deficit of around 5 per cent of GDP has typically proved to be the threshold or tipping point at which reversals frequently follow (Freund, 2000). For some years, this remained the conventional wisdom as summarized by Bergsten who in 2002 argued that: research at both the Federal Reserve Board and the Institute for International Economics reveals that industrial countries, including the United States, enter a ‘danger zone’ of current account unsustainability when their deficits reach 4–5

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per cent of GDP. . . . At these levels, corrective forces tend to arise either spontaneously from market forces or by policy action. (Bergsten, 2002)

Echoing this, Sebastian Edwards (2005, p. 222) finds that the prevailing (over 6 per cent of GDP) US current account deficit is in the top decile of ‘all’ the deficits recorded by industrial countries since 1971, that is since the unravelling of the Bretton Woods system. Moreover, since 1971, the United States has been the only large industrial country with a deficit in excess of 5 per cent of GDP, underlining the apparently ‘unchartered waters’ towards which the United States is now moving. So far, however, these warnings have proven to be, at best, premature. Not only has the deficit been in the 4–5 per cent of GDP ‘danger zone’ for over four years, it is now over 6 per cent of GDP. Although the chorus of current account pessimists has not been muted, evidence of pressure for adjustment remains at time of writing noticeable only by its absence. With the United States giving every appearance that it may be able to sustain much larger current account deficits than was thought possible even a few years ago, clearly a much more detailed and comprehensive toolkit is required to grapple with the question of sustainability. Given the divergence of views over the underlying causes of the US current account deficit, it is perhaps unsurprising that there is correspondingly a wide spectrum of opinion over what would be a sustainable current account position. Measures of Sustainability Addressing the question in more systematic fashion revolves around the question of solvency (Milesi-Ferretti and Razin, 1996, 1998; Edwards, 2002; Roubini and Setser, 2004; Truman, 2005). In effect, this moves the focus from analysis of the ‘flow’ of debt to the ‘stock’ of debt – away from the size of the current account deficit per se to what it implies for the United States’ external balance sheet, usually referred to as the net international investment position (NIIP). A ‘sustainable’ level of the current account is the level consistent with solvency. By definition, solvency, in turn, implies that the present discounted value of future trade surpluses is equal to current external indebtedness. The practical relevance of this definition is constrained by the fact that virtually any deficit path can be consistent with inter-temporal solvency if future surpluses are sufficiently large. Given the mild nature of the theoretical demands for long-run solvency and sustainability, a rather more practical criterion for debt sustainability has emerged. A current account position that leads to ever increasing foreign indebtedness is considered unsustainable. Lenders will eventually question the borrowers’ ability, not


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to mention interest, in repaying the debts and a financial crisis will ensue. As a result, stabilization of the ratio of external debt (that is, the NIIP deficit) has emerged as standard proxy for external sustainability.1 For ease of description, we define a negative NIIP as the net international investment deficit (NIID). Any country is regarded as likely to remain solvent as long as its NIID to GDP ratio is not growing. The logic seems inescapable. Any country whose NIID ratio is continually increasing ‘without bounds’ (in the description of Roubini and Setser, 2004) will become insolvent over time if adjustments are not made. Underlining this, Obstfeld and Rogoff (2004) have shown that, if the US deficit continues to run at current levels, then in 25 years the NIID of the United States as a share of GDP will exceed that of any other country in modern times. The algebra below, based on Hervey and Merkel (2000), illustrates that, depending upon the relationship between the economy’s growth rate and the net effective interest rate paid on the NIIP, a current account deficit can be sustained over the long run. By definition, the current account is the sum of the trade balance (X – Z), net investment income and unilateral transfers, which are typically foreign aid. Net investment income is simply the effective interest rate (r) on US foreign assets or debt times NIIP. Theoretically, the capital account is equal to the change in the NIIP and also the current account. Abstracting from unilateral transfers, which should be a relatively small and constant share of the economy, we have: (Xt Zt ) (1 r) NIIPt NIIPt1

(6.1)

Remembering that the current account is equal to the capital account and dividing through by GDP (Y ) yields: (Xt Zt )Yt [(1 r)NIIPt]Yt ) [(Yt1 Yt )] · [NIIPt1 Yt1]

(6.2)

With the prefix s indicating share of GDP and g the growth rate of GDP, then: (sXt sZt ) (1 r) · sNIIPt (1 g) · sNIIPt1

(6.3)

The long-run, steady state for this equation is therefore: (sX sZ) (g r) · sNIIP

(6.4)

(sZ sX) (g r) · sNIID

(6.4a)

or, rearranging

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Provided that the rate of growth of income is greater than the effective interest rate, a negative trade balance can be sustained over the long run. It is in this context that the use made of the overseas resources matters, in that the growth rate of the economy needs to exceed this threshold rate for sustainability. The Resources Gap Using a stable NIID ratio to GDP as the benchmark for external sustainability allows the prevailing current account position to be assessed against the concept of the ‘resource gap’ (Roubini and Setser, 2004). The resource gap can be defined as the difference between the asterisked ‘primary’ external balance (or non-interest current account) required to stabilize the NIID ratio and the prevailing primary external balance. The primary external balance is the sum of the trade balance plus unilateral net transfers (which were excluded from the above analysis). Equation 6.4 can therefore be re-arranged once again to give: (r g) · sNIID (sX sZ)*

(6.5)

meaning that the current ‘resource gap’ is simply: (sXt sZt ) (sX sZ)*

(6.6)

Equation 6.5 shows that the bigger the gap between interest rates and the economy’s growth rate, the smaller is the primary external deficit required to keep the NIID ratio steady. Note also that equation 6.5 implies that the bigger the starting point for net foreign debt, the larger is the deficit consistent with external sustainability. Using the latest data for 2005, we are able to update Roubini and Sester’s estimate of the current resource gap. At the end of 2005, the United States’ NIID (at current cost) was 21 per cent of GDP,2 the trade deficit for the year as a whole was 5.73 per cent of GDP and net current transfers were 0.71 per cent of GDP. The ‘primary’ external balance was therefore in deficit by 6.44 per cent of GDP. Despite the large stock of net foreign debt, net investment income remained in surplus of 0.38 per cent of GDP. By definition, the current account as a whole was in deficit to the tune of 6.06 per cent of GDP in 2005. Analysis of why the United States has been able to maintain a small, albeit dwindling, surplus on net investment income despite being a large net debtor and whether this significantly affects the sustainability calculus will be explored in detail later. However, with returns on the United States’ smaller stock of foreign assets continuing to outstrip payments on


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the much larger stock of foreign holdings of US assets, the effective interest rate on US net debt in 2005 was in fact negative, (–)0.4 per cent. Finally, nominal GDP growth was 6.4 per cent in 2005, somewhat above its 20-year average of 5.7 per cent per annum. On these figures, the benchmark value for calculating the resources gap in 2005 was: (r g) · sNIID ( 0.004 0.064) · 21% 1.43%

(6.7)

With the United States’ effective interest rate well below the economy’s growth rate in 2005, the calculation implies the United States can run forever a primary external deficit of 1.43 per cent of GDP and stabilize net foreign debt relative to GDP. But given that the actual non-interest current account was in deficit by 6.44 per cent of GDP in 2005, the current ‘resource gap’ is a not inconsiderable 5.01 per cent of GDP. This is an indication, on this calculation, of how big the ultimate adjustment in the US external balance might need to be to restore long-run sustainability. With the current transfers balance broadly steady at around 0.5 per cent of GDP over the last 45 years, the ‘required’ trade deficit would be around 0.75 of one per cent of GDP, almost 5 per cent of GDP lower than its 2005 average. Alternatively, were the 2005 primary external deficit to be maintained at its current rate, the United States’ net debt position would increase, ceteris paribus, by around 5 per cent of GDP per annum. The above calculation has only indicated the size of adjustment relative to the current deficit that is required to stabilize the NIID at its current GDP ratio, and not what level of net foreign debt may be realistic or the United States might be willing to service over the long run. The more US borrowers are prepared to become indebted over the medium term, the higher is the primary external deficit required to stabilize the NIID ratio. As the algebra shows, the higher is the initial starting point of net foreign debt, the larger is the primary deficit that is able to stabilize the deficit. Were net foreign debt 50 per cent of GDP, rather than 21 per cent, the US’s current ‘resource gap’ would (other things equal) be 2 per cent of GDP lower. In this respect, the Roubini–Setser measure indicates the adjustment needed to prevent the debt ratio from growing, and the level that is unsustainable in this particular sense. A variety of unacceptable scenarios can be visualized. Given the present trajectory of the current account deficit, net foreign debt as a share of GDP would already appear to be on course to exceed all records. Commentators have warned that too high a level of external debt implies infeasible levels of foreign ownership of the US capital stock and equally an unrealistic concentration of US assets in foreign portfolios. For an economy like the United States with a capital/output ratio of about 3, these trends would

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mean foreigners would eventually own assets equivalent to one half of the country’s capital stock (Eichengreen, 2006). Recent backlashes against foreign ownership of supposed strategic assets, such as China’s CNOOC’s attempt to buy the oil company Unocal or concerns over the possibility that a Dubai-based company might acquire control over a number of US ports, underlines that, for certain buyers, broad swathes of the US economy are not for sale. Equally, even if the United States were prepared to sanction these levels of foreign ownership, an indefinite continuation of US borrowing would imply that foreigners would finish up holding US assets almost entirely in their portfolios which is equally unlikely. Debt Trade-offs According to the Roubini–Setser analysis, the longer the resource gap persists, the more net foreign indebtedness will rise and, in turn, the net investment income position can be expected to deteriorate. Such a change will worsen the arithmetic set out above by raising the effective interest on foreign debt. Expressed a little differently, sustainability requires that, the larger the stock of net foreign debt, the more the trade balance must ultimately change to make ‘space’ and cover for the higher net interest payments abroad. Without such a change, the United States will have to borrow more to finance an unchanged trade deficit. In the framework outlined above, this is captured by a rising interest rate which gradually worsens the sustainability calculus of the US external position. Within the context of this analysis Table 6.1 details how the trade balance consistent with a stable NIID position evolves as the net effective interest rate on foreign debt rises against a large and increasing NIID position. The economy’s nominal GDP growth rate is held constant at 6 per cent in the simulations. As the matrix makes clear, for a given NIID, a rising net effective interest rate quickly reduces the trade deficit required to stabilize the NIID. The highlighted area details those ‘trade-offs’ that would allow the United States permanently to run a 3 per cent of GDP (or higher) non-interest trade deficit and so effectively halving the prevailing noninterest trade deficit relative to GDP. Note, as will be discussed in fuller detail, it is reasonable to expect the effective net interest rate paid on foreign debt to be positively correlated with foreign indebtedness. As the NIID increases, lenders can reasonably be expected to demand a higher risk premium for continuing to lend funds. Nevertheless, as the next section will demonstrate, the outlook for the net investment income balance is far more complex than is often made out. The United States has so far been able largely to escape the ‘permanent obligation to pay interest or profits to the lender’, as the quotation that began this

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Table 6.1

US external sustainability trade offs1 Net effective interest rate on NIID 2

1

0

1

2

3

4

less nominal GDP growth of 6%

US NIID as a % of GDP

20 25 30 35 40 50 60 75 100 125 150

8

7

6

5

4

3

2

1.6 2.0 2.4 2.8 3.2 4.0 4.8 6.0 8.0 10.0 12.0

1.4 1.8 2.1 2.5 2.8 3.5 4.2 5.3 7.0 8.8 10.5

1.2 1.5 1.8 2.1 2.4 3.0 3.6 4.5 6.0 7.5 9.0

1.0 1.3 1.5 1.8 2.0 2.5 3.0 3.8 5.0 6.3 7.5

0.8 1.0 1.2 1.4 1.6 2.0 2.4 3.0 4.0 5.0 6.0

0.6 0.8 0.9 1.1 1.2 1.5 1.8 2.3 3.0 3.8 4.5

0.4 0.5 0.6 0.7 0.8 1.0 1.2 1.5 2.0 2.5 3.0

Note: 1. This table shows the primary external balance for a range of net effective interest rates required to stabilize NIID at a given level as indicated in the left-hand column. Source: Authors’ calculations.

chapter warned, and so avoid the deleterious cash-flow consequences of steadily rising net foreign indebtedness. A detailed examination of this ‘riddle’ suggests that this happy state of affairs may well continue for some time, meaning that the United States’ effective net rate of interest on foreign debt may remain depressed and that a larger stock of foreign debt would be more sustainable. As the matrix shows, were the United States’ effective net interest to remain around zero, the benchmark figure consistent with an NIID of 50 per cent (more than double the current position) would be around 3 per cent of GDP. While this situation admittedly constitutes an uncomfortable position for a relatively closed economy such as the United States, the export base of which is currently less than 11 per cent of GDP, it is far from disastrous.

THE INVESTMENT INCOME RIDDLE An Investment Income Imbalance? The conventional wisdom is that, even with a prompt current account improvement, foreign indebtedness will continue to grow (the assumption

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being that the NIIP should equal the sum of past current account balances). In turn, the balance on investment income must not only swing into the red but become increasingly negative. This position has been put most succinctly by Federal Reserve Bank of New York Governor, Timothy Geithner: The US trade deficit is now roughly the size of the current account deficit, and US net interest earnings have fallen to quite low levels. The continuing build-up in liabilities should soon push US net investment income balances into deficit, with progressively larger net transfers of income to the rest of the world. In that event, net income flows will begin to boost the nation’s current account deficit instead of reducing it, reinforcing the deterioration in the net liability position of the United States. (Geithner, 2006, p. 4)

In its most provocative form, this argument has been applied by Warren Buffet to argue that the United States is on track to become a ‘sharecropper society’ as the rest of the world enjoys a mounting ‘royalty’ on US output. In his annual letter in 2005 to Berkshire Hathaway shareholders, Warren Buffet cautioned that the United States’ excessive consumption and low savings risks turning the country into a nation of ‘sharecroppers’ beholden to foreign landowners whose insatiable appetite for US assets increasingly is garnering influence over the country’s economic destiny. Specifically, Buffet estimated that if the US trade deficit continued at its current rate for another decade, US citizens would end up paying 3 per cent of their annual income to foreigners as a ‘tribute for the over-indulgences of the past’ (Buffet, 2005, p. 19). While this is an extreme characterization, there is no doubt that a view has emerged in the literature that the United States must inevitably have a rising deficit on net investment income as foreign indebtedness rises (see, for example, Higgins et al., 2005 and Truman, 2005). Truman estimates that, if current account deficits consistently equal 6 per cent of GDP, net investment income outflows will eventually reach 4.5 per cent of GDP. But is this outcome bound to happen? Just as the US current account deficit has long been in the 4–5 per cent of GDP ‘danger zone’ at which adjustment was deemed inescapable, might not the United States’ net investment income balance defy the laws of economic gravity and continue to avoid significant deterioration despite mounting foreign indebtedness? Certainly current account ‘pessimists’ have been predicting an imminent deficit on the investment income balance for some time. Roubini and Setser (2004), among others, predicted over two years ago that ‘net interest payments on US external debt will soon start to exercise a drag on the US economy’ (p. 43). In fact, as Figure 6.1 demonstrates, the net investment income has remained consistently in the positive despite the significant widening of the

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The sustainability of the deficit 1 0 –1 –2 –3 –4

0 –50 –100

–5 –6 –7 1980

–150 –200 1985

1990

1995

2000

2005

Current account balance (as a % of GDP) Net investment income, $bn (RHS) Trade balance, $bn (RHS)


Figure 6.1

US net investment income, 1980–2006

current account deficit after 1992. This recalcitrant behaviour of the net investment income balance has encouraged some current account ‘optimists’ to argue with growing confidence that the ‘sharecropper society’ scenario is not inevitable nor even likely. A close examination of the factors that have enabled net investment incomes flows for the United States to remain positive when US foreign assets are less than US liabilities to foreigners suggests that such a benign outcome is possible, throwing open the whole question of current account sustainability (Kitchen, 2006). What lies behind the United States’ surprising ability to sustain positive net investment income flows for so long in the teeth of rising net foreign indebtedness – seemingly the modern equivalent of alchemy – are three asymmetries. The first asymmetry is the result of the risk (or conversely liquidity) characteristics of the US external balance sheet. The second asymmetry derives from the currency composition of the external account. The third asymmetry stems from the geographic make-up of the trade flows and foreign assets. Differential Risk Positions The first (and in our view, key) asymmetry arises from US investors’ seemingly greater appetite for risk in comparison with that of foreigners. Table 6.2 gives the structure of US external assets at the end of 2005. US assets abroad are highly concentrated in equity. At the end of 2005, over 55 per cent of the United States’ stock of $10 trillion overseas assets were held

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Table 6.2

Composition of US foreign assets, end 2005

Official reserves of which gold Other US government assets Private assets FDI at current cost Equity Bonds Claims reported by US banks Claims repored by non-bank concerns Total assets Sources:

$bn

% of total

188 134 78 9 743 2 454 3 086 988 2 431 785 10 009

1.9 1.3 0.8 97.3 24.5 30.8 9.9 24.3 7.8 100

BEA; authors’ calculations.

in corporate shares or foreign direct investment. By contrast, foreign claims on the USA, which amounted to some $12.7 trillion by end 2005, are heavily tilted towards debt instruments. The composition of US foreign liabilities is shown in Table 6.3. Only around 31 per cent of foreign claims on the US are held in corporate shares or foreign direct investment whereas bonds account for over 36 per cent of claims with bank loans totalling a further 23 per cent. As a consequence, the United States’ substantial net foreign debt position marks a more heterogeneous and complex net asset structure. The United States is actually a net creditor in terms of FDI and equity to the tune of some $1.6 trillion (12 per cent of GDP) while this position is, of course, more than offset by a net liability position worth around 33 per cent of GDP in other asset types, mostly comprising interest-sensitive debt and banking positions. This dichotomy in terms of risk assets underlies descriptions of the United States being the ‘world venture capitalist’ (Gourinchas and Rey, 2005; Tille, 2005). Richard Cooper (2006) argues that this situation largely mirrors the domestic attitudes to risk of the major economies. At the end of 2004, direct holdings of equities made up only 21 per cent of German household financial assets (62 per cent of disposable income), 16 per cent in Britain (64 per cent of disposable income) and 8 per cent in Japan (39 per cent of disposable income) compared with 28 per cent (116 per cent of disposable income) in the United States.3 The greater share of debt and fixed interest assets in the United States’ liabilities also reflects the role of US financial markets as a world financial intermediary or banker (Poole, 2004). As the world’s predominant reserve


Table 6.3

149

Composition of US foreign liabilities, end 2005

Foreign official assets of which US govt. securities of which liabilities reported by US banks of which other Private liabilities FDI at current cost Bonds Equity US currency Liabilities reported by US banks Liabilities reported by non-bank concerns Total liabilities

$bn

% of total

2 216 1 649 295 272 10 486 1 874 2 980 2 115 352 2 601 564 12 702

17.4 13.0 2.3 2.1 82.6 14.8 23.5 16.7 2.8 20.5 4.4 100

Sources: BEA; authors’ calculations.

currency, the US dollar serves the threefold functions of a medium of exchange, a unit of account and a temporary store of purchasing power in many international transactions. These attributes, alongside highly liquid and efficient markets, ensure a high degree of ‘structural’ demand for US financial assets, particularly foreign currency and short-term debt. The competitive advantages of US debt in facilitating international transactions and storing liquid wealth securely bestow several lucrative privileges and seigniorage benefits upon the US economy, allowing it the luxury of borrowing in its own currency and investing in riskier assets. The rest of the world’s willingness to hold US assets in liquid forms is underlined by the fact that some 3 per cent or around $350 billion of US liabilities are simply held in non-interest bearing cash by foreigners. Assuming an average interest rate of 5 per cent, this constitutes an implicit gross subsidy to the United States of some $17.5 billion per year.4 Moreover, the United States’ ability to benefit from its greater risk appetite and the entrenched privileges flowing from the US dollar’s status as the world’s reserve currency has increased significantly thanks to the enormous increase in global financial integration in recent years. As the United States’ NIIP measured at current cost has swung from a positive balance before 1986 to a $2.7 trillion deficit by the end of 2005, this turnaround has masked an even more pronounced growth in its gross asset and liabilities position. Both sides of the international balance sheet have grown rapidly with gross foreign claims touching 100 per cent of GDP by end 2005 while US holdings of foreign assets have jumped to over 78 per cent of

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Untangling the US deficit (as a % of end-year GDP, at current cost)

90

Foreign-owned US assets

70 50

US holdings abroad

30 10 –10

NIIP

–30 1980

1985

1990

1995

2000

2005

Sources: BEA; authors’ calculations, Reuters Ecowin Pro.

Figure 6.2 US gross external assets and liabilities, 1976–2005 (as a % of end-year GDP, at current cost measured at current cost)

GDP (Figure 6.2). Over the last ten years, the value of US foreign assets has almost doubled relative to GDP while foreign claims on the US have obviously increased even faster. The United States’ ‘portfolio’ is therefore highly leveraged, with foreign liabilities over four times the size of net foreign debt and assets held abroad worth over three times net foreign debt (Obstfeld, 2005). Because of the United States’ greater appetite for risk, these pools of assets and liabilities differ fundamentally in nature, meaning that these gross positions are not offsetting and will produce different payouts under different scenarios. With a portfolio long on equity and short on debt, relatively small differences in rates of return on assets and liabilities can have, and have had, large differential movements in payments and receipts. In 2005, the United States earned an average rate of return of 4.7 per cent on its foreign asset holdings, while foreign investors received an average return of 3.6 per cent on their holdings of US assets. This slightly more than 1 per cent differential in rates of return left the United States receiving small, but nonetheless positive, net investment income of $11 billion despite having a net foreign debt position of around $2.7 trillion. This mismatch between a large pool of ‘real economy’ assets and an even larger pool of largely interest-bearing debt liabilities means that falling interest rates on bonds and short-term securities will tend to boost net investment income. Notably, the average rate of return received by foreigners on foreign claims on the United States hit a record low of just 2.7

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Table 6.4 Foreign and US cross-border direct1 and portfolio investments, and average returns since 1976 Amount at the end of 2005 ($bn)

Average annual return 1976–2005 (%)

US-owned assets abroad Direct investment Portfolio investment Total

2 454 7 555 10 009

9.5 5.1 6.3

Foreign-owned assets in the USA Direct investment Portfolio investment Total

1 874 10 828 12 702

3.6 5.4 5.0

580 3 273 2 694

5.9 0.4 1.3

Difference (USA less foreign) Direct investment Portfolio investment Total Note: 1. FDI valued at current cost. Sources: CBO; authors’ calculations.

per cent in 2003 at the bottom of the US rate cycle. Higgins et al. (2005) estimate that a uniform rise of 1 percentage point across the yield curve in both US and foreign interest rates would have subtracted $32 billion from net investment income in 2004. Differential FDI Earnings In general terms, however, it has been the superior performance on American foreign direct investment relative to foreign real economy investments in the United States that has generated the income required to offset the rising interest burden. Indeed, as Table 6.4 shows, on portfolio investments, rates of return on average since 1976 have actually been in the rest of the world’s favour. But on FDI investments, US holdings of FDI have outperformed foreign direct investments in the United States by an average of nearly 6 percentage points. As a result, on a net stock of foreign direct investment worth some $580 billion at the end of 2005, the United States generated net FDI earnings of $134 billion in 2005; a net rate of return of over 23 per cent!

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11 10 9 8

Average since 1976 = 5.9%

7 6 5 4 3 2 1976

1980

1984

1988

1992

1996

2000

2004

Sources: BEA; authors’ calculations; Reuters Ecowin Pro (FDI stocks measured at current cost).

Figure 6.3 US foreign direct investment out-performance, 1976–2005 (rate of return on US FDI abroad less foreign FDI in the US (%)) Valued at current cost, US FDI assets abroad returned over 10 per cent in 2005 while foreign FDI in America returned only a little over 6 per cent. Kitchen (2006) calculates that, abstracting from recession and near recession years, the long-run differential averages more than 5 per cent in America’s favour (Kitchen, 2006). This figure seems consistent with the long-run average differential that we find from 1976 to 2005 of 5.9 per cent. But the latest BEA data given in this figure find little evidence of the differential rising in recent years as claimed by some researchers (Higgins et al., 2005). As Figure 6.3 illustrates, the opposite appears to be the case. From a peak of 10 per cent in 1990, the differential had fallen to 4 per cent in 2005 and may be in secular decline. This differential performance of FDI investments has generated some controversy. With some justification, the BEA argues that US companies’ rates of return on their overseas investments are not abnormally high, only averaging around 1 percentage point more than the rate of return for all non-financial companies which it considers to be a fair premium for the greater risk of investing overseas (BEA, 2006). Abnormally low returns on foreigners’ direct investments into the United States therefore seem more responsible. One of the more compelling arguments adduced to explain this phenomenon is the relative immaturity of foreigner’s stock of FDI in the United States. Hung and Mascaro (2004), for example, find that differential rates of return are associated


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with the longer presence of US investments abroad. As the foreign stock of FDI in the United States matures, the rate of return differential, which is already arguably in secular decline, may narrow further. As a later Central Budget Office study noted: As foreign-controlled companies become older, the pattern of returns on direct investment that has so far favoured US companies abroad could diminish. (CBO, 2005, p. 3)

In effect, these direct investments in the United States by foreigners can sensibly be regarded as ‘growth stocks’ that will, over the longer run, yield a rising stream of profits and dividends that will flow abroad as these investments reach maturity. On this interpretation, only a mismatch between US companies’ mature stock of foreign direct investments and the much younger vintage of foreigners’ stock of FDI in the United States is preserving the rate of return differential. Can the Differences Persist? From a sustainability perspective, the key question is: can the United States’ highly leveraged portfolio continue to generate this exceptional performance, with a smaller pool of assets consistently producing returns that are consistently higher than its much larger pool of liabilities? Will the United States continue to be rewarded for taking extra risk or has it been exceedingly lucky in recent years? Are temporary factors that are likely to fade the key driver or is the United States simply a ‘savvy investor’, a ‘cunning capitalist’ whose investment expertise will allow it to continue to escape the typical consequences of mounting external indebtedness for many more years to come? Or is the United States still exploiting and reaping the benefits of the ‘exorbitant privilege’ that attaches to being the issuer of the world’s principal reserve currency? To the extent that the future resembles the past, Kitchen (2006) sets out a benign scenario in which the current status quo is maintained (i.e. rates of return differentials continue to hold as does the United States’ ability to earn capital gains on its foreign investments). He finds, under such circumstances, that it will cost the United States less than 1 per cent of GDP to finance a net external debt position of 50 per cent of GDP. Nevertheless, as Obstfeld (2005) observes, the different liquidity characteristics of the two sides of the US external balance sheet mean that very different payouts can ensue from different future states of the world. The United States has benefited from a particularly propitious combination of accelerating global growth and falling inflation between 2002–2004 that

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produced a bull market in both equities and bonds. These conditions constituted the ideal global macroeconomic backdrop to sustain the US net investment income flows despite the sharply rising indebtedness. The jury therefore remains out on the degree to which the current Panglossian state of affairs for the world’s ‘venture capitalist’ or ‘development bank’ can persist. There is some evidence that the United States’ competitive advantage in FDI may be waning. Also, to the extent that US indebtedness continues to mount, borrowing costs are likely to be pushed up to reflect a rising supply price of capital due to increasing risk (Roubini and Setser, 2004; Eichengreen, 2006). A scenario of slowing, even sluggish growth, weakening equity markets and rising interest rates could therefore see the benign performance of recent years transformed into something much less favourable. Leverage can, and often does, cut both ways. For the time being, there can be little doubt that the scaling-up of the United States’ international balance sheet is progressively bolstering the gains it receives from the financial transformation (from short to long, from safe to risky) that US financial markets effect due to the role of the United States as the world’s banker and venture capitalist. In fact, as Meissner and Taylor (2006) note, had yield differentials remained constant, the increase in leverage in recent years would have produced a much larger surplus on investment income than that seen. The fact that it did not reflects that yield differentials are narrowing, which dovetails with the erosion of relative FDI returns highlighted above. If this narrowing continues, ‘astronomical and implausible explosions’ in leverage would be needed to maintain the ‘out-performance’ of the investment income balance. The implication is that present conditions may not last. This viewpoint is buttressed by their examination of the British experience from the 1870s to the 1910s, which suggests that financial hegemons operating in an increasingly globalized world are fated to see superior investment returns steadily eroded. Emerging markets mature and offer less outlandish risk-reward combinations. . . . the world becomes less risky as a whole; at the same time other rival financial centres emerge which can compete for lucrative business with the financial pioneer. (Meissner and Taylor, 2006, p. 3)

The historical record therefore offers grounds for pessimism. Efficient markets eventually catch up with the canniest of capitalists. The Currency Mismatch However, it must be remembered that two other asymmetries beyond the United States’ greater risk appetite and investment acumen underpin the


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ability of the United States to sustain positive net investment income flows in the face of rising external indebtedness. Both relate to the US dollar. The second asymmetry is currency mismatch. While foreign claims on the United States are overwhelming denominated in US dollars, US foreign assets are a mix of US denominated-assets and foreign currency denominated assets. Estimates suggest that some two-thirds of the United States’ foreign holdings are denominated in foreign currencies (Tille, 2005). Accordingly, both the United States’ net investment income and the valuation of the stock of net foreign debt (NIID) reflects swings in the value of the US dollar vis-à-vis and other currencies. This result flows from the United States’ ability to borrow in its own currency (the ‘exorbitant privilege’). A lower dollar will tend to boost the United States’ net investment income by increasing the US dollar value of its overseas earnings while lowering the US dollar value of its stock of net foreign debt. According to some calculations, this valuation effect is substantial. The IMF has estimated that a 25 per cent depreciation of the US dollar reduces the NIID ratio by 7 per cent of GDP (IMF, 2004). Just as the net debt position of the United States is highly leveraged, so too the ‘exorbitant privilege’ allows it to run a highly leveraged foreign currency position, one that is effectively ‘long’ on foreign currencies. Perhaps, it would be more accurate to say that the United States’ ability to borrow in its own currency has left its creditors ‘long’ in dollars. Financial integration and the increasingly leveraged nature of the US external ‘portfolio’ means that the impact of this ‘valuation channel’ has grown significantly in recent years. There is correspondingly a greater potential role for US dollar depreciation in the adjustment process, with a falling dollar working both through a ‘trade channel’ and a ‘valuation channel’. However, the more leveraged is the United States’ portfolio, and hence the bigger the valuation channel, the greater is the moral hazard. Because of the exorbitant privilege of issuing its own currency debt, the United States can always allow the real value of its indebtedness to be eroded by currency depreciation. Over time, this potential ought to be one factor that would raise the risk premium on US assets demanded by foreign lenders and steadily lift the discount rate embedded in the Roubini and Setser sustainability arithmetic outlined above, although there is so far scant evidence of this effect. Mismatched Trade and Financial Flows Finally, there is a geographical asymmetry between the United States’ trade flows and its foreign assets. This third asymmetry is essentially a legacy of the sizeable current account surpluses that the United States

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once ran. Its trade deficit is concentrated with emerging Asia, particularly China, and, increasingly the oil producers (see Table 2.1 on p. 28 above). But the overseas assets are centred in the Anglo-sphere (UK, Canada, Australia, New Zealand) and continental Europe. With Asian and oil producing currencies fixed against the US dollar (the Chinese RMB and the Saudi riyal the most obvious examples), downward pressure on the dollar has taken the path of least resistance since 2002. From a trade flows perspective, the US dollar has rather illogically depreciated significantly against the currencies of countries with which the United States does not run large trade deficits (Japan being the main exception). This pattern can be seen in the movements of the Federal Reserve’s various dollar exchange rate indices shown earlier in Figure 2.5 (p. 26 above). The best guide to the US dollar’s external value is the Federal Reserve broad index which is computed via trade weights of the United States’ 26 main trading partners. The Federal Reserve System also calculates two important sub-indices of the broad dollar index – a major currencies index and the ‘other important trading partners’ (OITP) index. Seven of the 26 currencies in the Fed’s broad dollar index – the euro, Canadian dollar, Japanese yen, pound sterling, Swiss franc, Australian dollar and the Swedish krona – trade widely outside their respective home areas and crucially are free to fluctuate against the US dollar. These currencies are referred to as ‘major currencies’ and are used to construct a major currencies index. The remaining 19 currencies are used to compile the OITP index. Both the geographical composition of the United States’ trade deficit and the tendency of emerging economies to experience secular real exchange rate appreciation (for factors already discussed in the context of China), should suggest greater downward pressure on the OITP index. In fact, the converse has been the case. Since the start of 2002, the Federal Reserve’s broad index has depreciated some 16 per cent. But this decrease has been exclusively the result of a drop in the major trading partners’ index which has fallen by some 27 per cent between the start of 2002 and June 2006. By contrast, the OITP index is broadly unchanged, dropping by a mere 1 per cent in this four-and-a-half-year period. When thinking about the need for and nature of likely US dollar changes, the simple reality is that consideration of the external value of the US dollar purely in the traditional trade-weighted context is no longer sufficient for sustainability issues when portfolio movements are so important. Tille (2005) usefully calculates an ‘asset weighted’ US dollar index and finds that it has been more volatile and depreciated more than its tradeweighted equivalent over the same reference period. By definition, a depreciation in the US dollar against a given currency operates through both a


Table 6.5

157

US dollar asset and trade weights compared

Europe ex-UK1 Canada Japan Mexico China United Kingdom Other Asia2 Others

Tille’s asset weight

Federal Reserve’s 2005 Broad US$ trade weights

Ratio

34.2 9.5 7.6 2.4 0.7 16.5 8.0 21.1

20.7 16.3 10.0 9.8 13.4 4.8 17.3 7.7

1.7 0.6 0.8 0.2 0.1 3.4 0.5 2.7

Notes: 1. Europe ex-UK defined as Euro area, Switzerland, Sweden. 2. Other Asia includes Taiwan, Rep. of Korea, Singapore, Hong Kong, Malaysia, Thailand, Philippines, Indonesia, India. Sources:

Tille (2005, Table 3); Federal Reserve; authors’ own calculations.

‘trade’ and ‘valuation’ channel. While the former affects the flow of goods and services between countries by altering ‘competitiveness’, the latter produces capital gains or losses by rebalancing ‘wealth’. It seems likely that US dollar movements against the Asian currencies will operate predominately via the trade channel, whereas swings against, say, the pound sterling will generate a bigger impact through the ‘valuation channel’. One rough and ready metric to assess the relative importance of these two channels for differing currencies is to look at the ratio of asset to trade weights, set out in Table 6.5. If greater than unity, the valuation channel will predominate, if less than unity, the orthodox trade channel will prove paramount. For Europe and particularly the UK, the valuation channel dominates. The increased financial integration between the United States and Japan over the last 20 years means Japan’s ratio is pushing up towards unity. With a ratio of just 0.1, the trade channel dominates in the case of China as it does with the rest of Asia, Mexico and surprisingly, Canada. When thinking about the US dollar’s behaviour since 2002, the standard view that it has fallen against the ‘wrong’ currencies simply does not hold when assessed from the broader, more relevant asset-based approach. In effect, the US dollar has been weaker than typically assumed and hence its movements have made a greater contribution to enhancing sustainability than is apparent from the traditional perspective.

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THE NIIP ENIGMA As the above discussion has sought to emphasize, it is the evolution of the US external balance sheet – the NIIP – that ultimately controls long-run sustainability. In principle, the NIIP should equal the sum of past US current account balances. In turn, this presumption forms the basis of the orthodox sustainability argument most heavily identified with Roubini and Sester but also others including Obstfeld, Rogoff and Truman. For example, Roubini and Setser argued back in 2004: The US is simply not on a sustainable path so long as the trade deficit remains at close to current levels. Ongoing trade and current account deficits imply a growing external debt stock, and payments on the stock of debt start to lead the current account to widen significantly. (p. 32)

But in much the same way as the positive net investment income balance has defied predictions of its demise for several years, the NIIP is stubbornly refusing to decrease further as the cumulative path of current account deficits should imply. The official BEA data on the NIIP show that this expected development is far from the case even when the balancing item of ‘errors and omissions’ is factored in. Consequently, the US economy has therefore been able to escape not only the expected investment flow consequences for a given stock of net foreign debt but the stock of net debt itself is significantly smaller than implied by the increasingly large negative ‘flow’ of the current account deficit, posing perhaps the biggest challenge to the orthodox assessment of deficit sustainability. Big deficits matter because they ought to imply big debts, which if not repaid, at least have to be serviced. If they don’t, who cares? The Path of NIIP Considering the evolution of the United States’ NIIP over the last 30 years underlines how remarkable this development has been. This evolution is shown in Figure 6.4. From a net creditor to the tune of 8.75 per cent of GDP back in 1976, the NIIP first slipped into the red in 1986. The pace of debt accumulation was relatively modest until 2000 and the net international investment deficit (NIID) never increased beyond 10 per cent of GDP during the years 1986 to 1999. Between 1999 and 2002, the NIID widened by over ten percentage points of GDP, reaching nearly 20 per cent of GDP by end-2002. But despite the accelerating current account deficit in the last three years, the NIID has barely changed as a share of GDP subsequently, with the latest BEA data reporting an NIID of ‘only’ 21 per cent

159

The sustainability of the deficit 15

(as a % of end-year GDP)

10 5 0 –5 –10 –15 –20 –25 1980

1985

US NIIP at current cost

1990

1995

2000

2005

US NIIP at market value


Figure 6.4 US net international investment position, 1976–2005 (as a % of end-year GDP) of GDP. Given that the standard definition of sustainability hinges on the requirement to stabilize net debt relative to income, the United States’ ability basically to achieve this requirement in recent years despite an everwidening current account deficit seriously undermines the orthodox case. Equally fortuitous is the picture painted by an alternative sustainability metric favoured by many. Sustainability is often assessed by looking at net foreign debt relative to total net export earnings, which, rather than GDP, constitutes a truer measure of the earning power of a country to service its net liabilities with the rest of the world. This ratio given in Figure 6.5 has not only levelled off but fractionally declined in recent years. From a peak of around 205 per cent of export revenues, net debt had eased to just below 200 per cent by end-2005 according to the latest vintage of BEA data. Despite an accelerating current account deficit, this measure suggests that the United States’ external position is becoming more, not less, sustainable. Comparing the evolution of the NIID to the cumulative current account in dollar terms is also instructive (see Table 6.6). The latest available BEA data used for Table 6.6 reveal that, since 1989, the United States has racked up a cumulative current account deficit of just over $4.5 trillion. By contrast, its NIID has increased by ‘only’ some $2.5 trillion, meaning that almost $2 trillion (some 45 per cent of the total) has ‘vanished’ from the NIID since 1989. Furthermore, the United States’ magician-like ability to make liabilities vanish appears to be growing as the flow of its borrowing expands. Since 2002, the current account deficit has been a cumulative $2.4

160


250

(Net foreign debt as a % of total export revenues)

200 150 100 50 0 –50 –100 –150 1980

1985

1990

1995

2000

2005

Sources: BEA; authors’ calculations; Reuters Ecowin Pro (NIPP measured at current cost).

Figure 6.5 US net foreign debt relative to export earnings, 1976–2005 (net foreign debt as a % of total export revenues) trillion while the NIID expanded by only $775 billion, meaning that a remarkable $1.6 trillion (68 per cent of the total) of debt has vanished in just the last four years. Accounting for the Vanishing Debt As shown in Table 6.6, the BEA provides a particularly useful tabulation which disentangles the key factors driving the evolution of the NIIP since 1989 and which is subsequently, the preferred point of departure to attempt to account for the United States’ vanishing debt. The first column shows the NIIP position at the beginning of each year. The second column, labelled (‘a’), shows for each year the US’s capital account position, in other words, the financial flows that underlie the current account deficit. While in flow terms a current account deficit implies a capital account surplus, the transaction is recorded as negative since rising foreign claims on the United States are a liability. Other things equal, the stock of NIIP at end of that period would simply be the initial starting point plus the financial flows. In other words, there would be no ‘vanishing’ deficit. However, the end stock of NIIP is not the accumulated flows. Columns (‘b’), (‘c’) and (‘d’) therefore account for the disappearing $2 trillion of US liabilities since 1989. Column (‘b’) details the change in the US external balance sheet due to changes in asset prices. A positive number implies that capital gains on the US holdings of foreign assets have outweighed the capital gains recorded on foreigners’ holdings of US assets. Column (‘c’) details


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swings in the US external balance induced by exchange rate changes – in other words, the ‘valuation channel’ highlighted above. In effect, columns (‘b’) and (‘c’) together capture the effect of what we termed the three key asymmetries (differential risk positions, the ‘privilege’ of borrowing in one’s own currency and the mismatch between trade and financial flows) on the US external balance sheet. Finally, column (‘d’) details the changes in the NIIP that cannot be explained by differential investment performance or by exchange rate changes and is simply labelled ‘other’ by the BEA. The BEA argue that these effects arise from revisions in the data coverage and methodology. Once again, the results are counterintuitive, bordering on the remarkable. The BEA’s data find that the three asymmetries that have boosted US net investment income (columns (‘b’) and (‘c’)) account for only a fraction of the United States’ $2 trillion vanishing deficit since 1989. Given that the trade-weighted or more appropriately the asset-weighted dollar is broadly unchanged over the period, the cumulative impact of the exchange rate ‘valuation channel’ is close to zero over the full period. Indeed, the net effect of changes in exchange rates since 1989 has actually been to increase the NIIP by $73 billion. Consistent with its greater risk portfolio, the United States’ overseas investments have earned a net capital gain of some $525 million, accounting for about 25 per cent of the ‘vanishing’ deficit. It is column (‘d’), the so-called ‘other’ changes that have produced the bulk of the disappearance – more than $1.5 trillion appears to have vanished. Cline (2005a, p. 46, 2005b, p. 262) labels these unidentified ‘other’ valuation changes as ‘statistical manna from heaven’ (see also Kitchen, 2006, p. 29), confirming in this one crucial respect that the United States does indeed appear to be ‘God’s own country’! Certainly, this ‘ingredient X’ or ‘celestial bounty’ further complicates and undermines any ‘orthodox’ assessment of the sustainability outlook. Arguably, the experience of the last four years, with a remarkable 68 per cent ($1.6 trillion) of the cumulative current account deficit disappearing since 2002, offers even stronger grounds for an optimistic view on the US deficit. Growing financial integration and the increasingly leveraged position of the United States is easing the potential burden of the US current account position by magnifying the palliative effect of the three key asymmetries. The United States’ ability to operate as a canny capitalist has yielded net capital gains of over $660 billion since 2002, worth over 40 per cent of the $1.6 trillion ‘vanished’ deficit. With the exchange rate lower, the valuation channel has been worth a net $390 billion or nearly 25 per cent of the total reduction. Moreover, there is evidence suggesting that increased leverage has actually magnified the impact of this equilibrating channel. Between 1989 and 2000, the absolute average swing in the NIIP accounted

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1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

178 470 259 506 245 347 309 259 431 198 306 956 323 397 458 462 495 055 820 682 895 358 766 237 1 381 196 1 919 430 2 088 008 2 131 170 2 360 785

Position beginning

38 017 26 636 63 179 39 673 109 707 39 636 93 308 47 359 44 200 148 130 220 818 12 299 116 115 56 477 20 200 74 565 625 441

(b)

(a) 49 545 60 337 46 420 96 253 81 490 127 052 86 298 137 687 221 334 69 740 236 148 486 373 400 243 503 167 538 345 582 419 785 449

Price changes

Financial flows

5 747 43 845 4 272 54 691 14 462 45 741 17 221 42 287 140 151 31 100 36 392 199 581 111 724 148 321 276 332 191 655 226 283

Exchangerate changes1 (c) 12 273 57 287 41 415 68 678 110 487 25 234 27 320 96 022 80 058 112 094 180 843 58 696 89 848 242 745 198 651 86 584 53 277

(d)

Other changes2

Changes in position attributable to valuation adjustments

81 036 14 159 63 912 121 939 124 242 16 441 135 065 36 593 325 627 74 676 129 121 614 959 538 234 168 578 43 162 229 615 333 014

(abcd)

Total

259 506 245 347 309 259 431 198 306 956 323 397 458 462 495 055 820 682 895 358 766 237 1 381 196 1 919 430 2 088 008 2 131 170 2 360 785 2 693 799

Position ending

Table 6.6 Components of changes in the net international investment position, 1989–2005 (millions of dollars, with direct investment at current cost)

163

663 729

2 409 380

From 2002

390 025

72 831

(c)

581 257

1 541 512

(d)

774 369

2 515 329

(abcd)

1 635 011

‘Vanished deficit’3 1 992 971

Sources:

BEA; authors’ calculations.

Notes: 1. Represents gains or losses on foreign-currency-denominated assets and liabilities due to their revaluation at current exchange rates. 2. Includes changes in coverage, capital gains, and losses of direct investment affiliates, and other adjustments to the value of assets and liabilities. 3. ‘Vanished deficit’ equals cumulative ‘financial flows’ less cumulative ‘valuation adjustments’.

524 290

4 508 300

(b)

Sum total

(a)

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2.5 2.0 1.5 1.0 0.5 0.0 –0.5 –1.0 –1.5 –2.0 –2.5

(as a % of GDP)

1989

1991

1993

1995

1997

1999

2001

2003

2005

Swing in NIIP produced by FX channel

Sources:

BEA; authors’ calculations (NIIP measured at current cost); Reuters Ecowin Pro.

Figure 6.6 Movements in NIIP due to foreign exchange channel, 1989–2005 (as a % of GDP) for by the exchange rate or valuation channel was 0.65 per cent of GDP. Between 2000 and 2005, this factor had almost trebled to an average annual swing of 1.72 per cent of GDP in the NIIP effected by the valuation channel, as shown in Figure 6.6. Partly, this outcome reflects greater volatility in the US dollar itself. The average annual swing in the Federal Reserve’s broad dollar index has risen from 4.4 per cent between 1989–2000 to 8.3 per cent over the last years. Yet, even when adjusted for volatility, the valuation channel appears to be rising in significance as the rest of the world’s long US dollar position builds and US foreign assets also increase. It is also noteworthy that in 2005, for example, the capital gain and valuation channels (i.e. columns (‘b’) and (‘c’)) moved in opposite directions therefore offsetting rather than is often the case, reinforcing one another. The stronger US dollar in 2005 brought to an end three years of balance sheet windfalls from the valuation channel but the currency appreciation was a factor dampening the performance of the US equity market relative to the rest of the world. The Morgan Stanley Capital International Index of world stock markets excluding the US rose by 12 per cent in dollar terms compared with a 4 per cent gain in the S&P500. As a result, capital gains from differential stock market performance ($664 million) helpfully outweighed the balance sheet impact from the stronger dollar ($226 billion), underlining Lane and Milesi-Feretti’s (2006) analysis. That said, ‘other changes’ continued to play a sizeable (albeit reduced) role in the foreign liability erosion, contributing around $580 billion (over 35 per cent) of the total ‘vanished’ deficit since 2002.


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The combination of the net investment income ‘riddle’ and the NIIP ‘enigma’ that together significantly undermine the orthodox approach to assessing the sustainability of the US’s external position has seen some exotic explanations advanced to account for these oddities. Of course, the simplest way to account for the discrepancy is to argue that the data – either the current account or the NIIP – are simply wrong. But, in what direction? Dark Matter In a widely cited paper, Hausmann and Sturzenegger (2005) invoked the image of ‘dark matter’. With the United States still receiving net interest income from abroad despite having large net external liabilities, they suggest the existence of significant un- or under-recorded US net exports of goods and services. This ‘dark matter’ explains the apparent financial alchemy of the US external position. Specifically, Hausmann and Sturzenegger believe that the persistence of positive net investment income, despite years of accumulated deficits, can be attributed to offsetting exports of ‘dark matter’. This matter corresponds to assets, which must exist since they generate revenue, but cannot be seen or properly measured. They suggest three types of dark matter: the embedded knowledge in US assets overseas, the benefits from providing the world’s reserve currency and the leverage from acting as a venture capitalist – issuing debt and purchasing riskier assets abroad. Of the three, they lean strongly to the former and not to what they call the ‘financial distortions’. Thus the bulk of dark matter is seen as arising from unrecorded knowledge flows. The upshot of the argument is that US foreign investments properly measured to reflect their income-generating value must exceed the rest of the world’s claims on the United States when similarly valued. In turn, therefore, ‘dark matter’ is the difference between the ‘correct’ NIIP, arrived at by capitalizing the United States’ positive net investment income stream, and the BEA’s official NIIP data. The 2004 data, which were the latest available when Hausmann and Sturzenegger wrote their paper, showed a surplus on net investment income of around $30 billion. Capitalizing this net income stream with an arbitrary 5 per cent rate (which as the authors point out implies a price–earnings ratio of 20) produces a net asset position of $600 billion rather than $2.5 trillion or so of net foreign debt then reported by the BEA. On this reasoning, the United States must have been the owner of some $3.1 trillion of ‘dark matter’ or unaccounted net foreign assets in 2004. Using the latest 2005 data does not fundamentally alter the calculation. BEA data released in 2006 reported the surplus on net investment income had eased to around $11 billion in 2005, which capitalized at the same 5 per cent rate, implies a

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net foreign asset position of $220 billion. Compared to the latest BEA estimate of net foreign debt of around $2.7 trillion at end-2005, the authors’ methodology applied to the latest data therefore still implies ‘dark matter’ of around $3 trillion. Any argument that provokes the flurry of counter-arguments that the Hausmann and Sturzenegger’s ‘dark matter’ thesis has provoked, deserves attention, particularly when it prompts a question and answer primer from the Bureau of Economic Analysis (BEA, 2006), an Economics focus ‘America’s dark materials’ in The Economist (2006b), and a detailed assessment from Federal Reserve Bank of New York staff (Higgins, Klitgaard and Tille, 2006). Most economists examining the US deficit have been puzzled by the higher returns earned by the United States on its overseas assets than foreigners earn on their American investments, and have asked themselves why this might be so. Rather than turning their microscope on the asymmetries that have left the United States able to work the financial alchemy of producing positive returns from a stock of net debt, Hausmann and Sturzenegger look through the other end of the microscope and effectively reverse the question. To them, the mystery lies not in the flow of income earned but in the value placed on the overseas wealth that generates it. In physics, dark matter is the name given to material in the universe that can be identified only by its gravitational pull.5 In the context of the US deficit, dark matter refers to foreign wealth the existence of which can only be inferred because of the income it provides. Interestingly, as The Economist article points out, the idea of ‘dark matter’ in fact originated not with Hausmann and Sturzenegger but with William Cline (2005a), although he did not call it that. Like the dark materialists, he also calculated the value of the United States’ net foreign assets in terms of the income they generated, but instead labelled it ‘capitalized net capital income’ (CNCI), defined as an economically meaningful measure of net foreign assets based on the capitalized value of annual net capital income (p. 4). On this basis, Cline argued that the United States ‘is not a net international debtor in terms of economic burden’ (p. 54) on the grounds that ‘a country with positive net capital services earnings does not have a net external debt burden in a meaningful economic sense’ (pp. 63–4). Rather, ‘the United States has remained a persistent “economic” net creditor throughout the past three decades despite its transit into net debtor status in accounting values 15 years ago’ (p. 61). In short, ‘the United States has indeed remained an “economic” creditor despite becoming an “accounting” net debtor’. To a considerable degree, the United States has enjoyed ‘debt without pain’ or even ‘free debt’ (p. 33). ‘Dark matter’ or CNCI is a valuable counter-orthodoxy in that it challenges us to reconsider which set of numbers are to be trusted (Eichengreen,


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2006). Hausmann and Sturzenegger, for example, explicitly assume that the net investment income statistics are reliable while the NIIP data from the same source are not. As argued above, one key reason underlying the United States’ ability to generate a positive return on its net foreign debt (and, by definition, for the existence of ‘dark matter’) is the strong outperformance of US investments abroad relative to foreign-owned FDI in the United States (see also CBO, 2005). This may reflect a mismatch between the mature stock of US FDI abroad and the more immature stock of foreign FDI in the United States. Additionally, it may also reflect the scope for multinationals to shift profits between national subsidiaries to minimize tax liabilities (Huang and Mascaro, 2004). Transactions between foreign direct investors and their US affiliates may occur at transfer prices that result in the US affiliates recording low returns. In this way tax arbitrage may account for some of the differences in reported profitability between outward and inward FDI that risk alone cannot explain. Either way, the latest BEA data suggest that the rates of return differential on FDI is beginning to decline although the mounting leverage of recent years is masking this trend. One summation of the dark matter controversy comes from Meissner and Taylor (2006) who note that Hausmann and Sturzenegger essentially make two claims. First, their concept of ‘dark matter’ adjusted NIIP provides a fresh way of looking at rates of return differentials in the US external accounts. That is, they ask what the United States’ NIIP would need to be in order to generate the existing surplus on net investment income in a world without asymmetries. Second, they claim that this differential results from unmeasured exports such liquidity services, insurance services or managerial ‘know how’ that American firms transfer to subsidiaries abroad. The response of much of the economics profession can be summarized as acknowledging the first point as correct but not wholly original while accepting the second as original but not necessarily correct. The Black Hole A diametrically opposing explanation but one that also employs an astronomical metaphor is that, far from benefiting from ‘dark matter’, the US economy’s ability to make debt ‘vanish’ off its balance sheet, an attribute not enjoyed by other major economies, means that it operates as a ‘black hole’ in the global financial system (Gros, 2006). The essence of the ‘black hole’ argument is a familiar stock-flow discrepancy. While a large amount of investment can be observed flowing into the United States, a substantial portion of it then disappears from the statistics. This characteristic, Gros argues, is the product of the fact that the flow data are based on actual

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statistics of payments transactions recorded in the balance of payments6 while the stock data (i.e. the NIIP data) are identified through US surveys, which tend to miss out on US assets held by foreigners, particularly real estate holdings. His conclusion is therefore the exact opposite of that of Hausmann and Sturzenegger. In other words, the United States’ net debtor position is significantly larger than officially reported. With this stock-flow discrepancy likely to persist, Gros expects that the future will continue to look a lot like the past. That is, the officially reported NIIP will always decline much less than the combined effect of current account deficits and identifiable ‘windfalls’ from exchange rate changes and capital gains. Ironically, the ultimate conclusion that is reached from the ‘black hole’ argument is the same as that arising from the ‘dark matter’ thesis in that both agree (for different reasons) that the NIIP data are unreliable. Consequently, any analysis of the sustainability of the United States’ balance of payments position based on the size of the net foreign debt data is hugely compromised by uncertainties over the numbers.

CONCLUDING REMARKS Certainly, there is something very unusual about the apparent fact that world’s largest debtor country has been actually making money on its indebted financial position. If we accept the existence of ‘dark matter’, the paradox is quickly resolved. On this interpretation, and with assets valued ‘appropriately’, the United States emerges not as a debtor, but as a creditor. If we accept the alternative idea of a ‘black hole’ in the financial system, then the dissonance between the stock position and the flows is increased. Measured at current cost, the latest data show that the United States’ NIID at the end of 2005 was 21.2 per cent of GDP. Add back in the $1.5 trillion that ‘other changes’ have eradicated from the US balance sheet since 1989 and the NIID rises to 33.3 per cent of GDP. Yet, the investment income flows in 2005 remained in the United States’ favour. One must then appeal more strongly to the distinctive role that the United States occupies in the global system. As the world banker, it borrows short and lends long. As the world venture capitalist or development bank, it issues debt securities and acquires equity positions. Both characteristics endow the United States with an ‘exorbitant privilege’. But, at the same time, they also impose upon it a substantial obligation to maintain a stable currency and reserve asset. Given the huge question marks over the efficacy of using the enigmatic NIIP data to assess the issue of sustainability, another approach may be expedient. Sustainability can be defined more prosaically as the rest of the world’s willingness to finance the prevailing deficit at the prevailing level of


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the rate of interest. In effect, this approach is to view the question of sustainability through the lens of the portfolio balance model, which views the current account position as reflecting the balance of net external demand for and supply of a country’s financial assets. Provided the rest of the world’s demand for US dollar assets continues to keep pace with increased supply, almost any size of deficit can be financed. This perspective leads us to the next chapter on the demand for US assets which examines sustainability in this sense through the standpoint of the situation in different groupings of countries.

NOTES 1. Two important points of clarification. The US foreign debt of course includes equity and debt claims so the term foreign liabilities rather than foreign debt is more appropriate. It is the net foreign liabilities rather than gross external debt, that matters for external sustainability. 2. The BEA report the NIIP data at both market value and current cost. The current cost numbers are compatible with the NIPAs for analysing net income flows relative to GDP. See Nguyen (2005) and also Kitchen (2006). 3. These are, of course, substantial indirect holdings of equities in these countries via mutual funds and insurance and pension funds. 4. The net seigniorage benefits would need to take account of the costs of maintaining the note circulation and the costs of policing the money laundering and other criminal uses of the currency. 5. However, it was reported in 2007 that a group of astronomers using the Hubble Space Telescope detected dark matter in the form of a rippling halo around a galaxy cluster 5 billion light years from earth (The Australian, 17 May, 2007, p. 3). 6. This is not strictly correct. Alexandra Heath of the BIS in a 2007 paper ‘What explains the US net income balance’ (www.bis.org) points out that income flows for portfolio debt and portfolio equity in the United States are ‘derived from information about these stocks and independently measured yields’. The corollary is that ‘measurement problems for the stocks translate directly into measurement problems for income’ (p. 6).

7.

The demand for US assets

INTRODUCTION After exploring the metrics of the current account deficit and the US external balance sheet in the last chapter, we came to the conclusion that the most practical indicator of sustainability revolves around the demand for US assets. Issues such as the investment income riddle, the net international investment position enigma, and the dark matter debate are reflective of data that are either seriously flawed, or at least questionable, in one way or another, rendering unhelpful the use of the standard sustainability measures. The more reliable test is foreigners’ willingness to go on holding US dollar claims. This chapter analyses a number of issues relevant to the US external deficit and its sustainability from this particular perspective. The first is the implications of a continued reduction in home bias. The second is the substantial build-up of international reserves and official holdings of dollars by foreign government agencies. The third concerns the financial innovations that have linked capital inflows into the United States with household sector financing and the housing market. The fourth issue is to what extent the euro may offer competition to the US dollar as an international currency and repository for international reserve holdings.

HOME BIAS Alan Greenspan noted in late 2005 that signs of stress in the funding of the current account deficit such as the inflation premiums embedded in longerterm interest rates seemed noticeably absent despite the continued increase in the size of the current account deficit (Greenspan, 2005b). At the time of writing, almost another year on, the same benign financing conditions continue to hold. The United States seems to attract the required financing of the deficit almost effortlessly, despite the fact that both the nature of the financing and who is providing it have changed appreciably in recent years. Global demand for US assets is not only proving unexpectedly durable but continues to grow. Given the sizeable net outflows of capital from the 170


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Table 7.1 US gross capital account flows by decade, 1960–2006 (per cent of GDP)

1960s 1970s 1980s 1990s 2000s to date1

Outflows

Inflows

1.0 1.9 2.4 3.4 4.9

0.6 1.8 3.6 5.0 9.9

Note: 1. Up to and including 2006. Sources: BEA; authors’ calculations.

United States in recent years, the United States has been able to attract financing well beyond that simply required for the current account deficit. In 2005, for example, the United States attracted $1.3 trillion of capital inflows whilst itself investing almost $500 billion overseas. Table 7.1 shows gross capital flows as a percentage of GDP since the 1960s. Outflows were larger than inflows in the 1960s, but had come roughly into balance in the 1970s. Since the 1980s gross outflows relative to GDP have more than doubled to 4.9 per cent, while gross inflows are double that again at close to 10 per cent of GDP. As discussed in Chapters 5 and 6, the expansion of the US current account deficit has occurred along with an acceleration in globalization that has been prompted and spurred by a decline in ‘home bias’. This phenomenon has been defined by Alan Greenspan in the following terms: home bias is the parochial tendency of persons, though faced with comparable or superior foreign opportunities, to invest domestic savings in the home country. The decline in home bias is reflected in savers increasingly reaching across national borders to invest in foreign assets. (Greenspan, 2005b, p. 2)

Stated alternatively, lower home bias implies that the rest of the world will be willing to hold more US assets without demanding any additional risk premium compensation. As the world’s biggest economy, it is inevitable that a decline in home bias would significantly ease financing constraints on the United States. The following ‘back of an envelope’ calculation by Richard Cooper (2006) illustrates how the United States would benefit from the removal of home bias. In a fully globalized world economy, with no home bias, one would expect roughly 30 percent of world saving outside the United States to be invested in

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the United States – and 70 percent of US saving to be invested abroad. Saving outside the US was around $7 trillion, 30 percent of which would be $2.1 trillion. US private saving was about $1.8 trillion, 70 percent of which would be $1.2 trillion. The difference is $900 billion, larger than the US current account deficit in 2004 or even 2005. (Cooper, 2006, p. 12)

Maurice Obstfeld (2004) uses a similar ‘back of envelope’ approach to emphasize how large US foreign liabilities would be in a world without home bias. Obstfeld assumes a homogenous world economy in which the United States accounts for a quarter of the world’s GDP while also containing a quarter of the world’s capital stock. Then, taking (as a lower bound) a global capital–output ratio of 2, the United States, assuming no home bias, would hold only a quarter of its own capital – equivalent to 50 per cent of GDP – and hold an amount of foreign capital equal to 150 per cent of GDP! Needless to say, the NIIP would be in deficit to the tune of 100 per cent of GDP. Therefore, despite the ‘veritable explosion in international asset trade’ in recent years, the world is considerably closer to full global financial integration than it was but still remains some way from the ‘holy grail’ (Obstfeld, 2004). Of course, although declining, home bias remains important, but these types of thought experiments illustrate that if the United States is able to continue to attract a rising share of world saving, the current account deficit should continue to be financed with relative ease for some time to come. Viewed from this perspective, sustainability will ultimately be determined by the evolution of foreigners’ portfolio preferences (and by definition the relative attractiveness of investment opportunities in America and the rest of the world). This is the key conclusion of a more formal model of current account sustainability outlined by Sebastian Edwards (2002). Just as solvency requires that the sum of all future current accounts must be equal to the initial foreign debt of the country then solvency can also be defined when the ratio of net international demand for the country’s liabilities stabilizes at a level compatible with foreigners’ net demand for these claims on future income flows. The net international demand for countryj assets, Aj, can be written as Aj aj (W Wj ) (1 ajj )Wj

(7.1)

where aj is the percentage of world’s wealth (W) that international investors are willing to hold in the form of countryj’s assets; Wj is countryj’s wealth (broadly defined), and ajj is countryj’s asset allocation on its own assets. The asset allocation shares aj and ajj, depend, as in standard portfolio analyses, on expected returns and perceived risk. Assuming that countryj’s wealth is


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a multiple bjj of its (potential or full employment) GDP, and that countryj’s wealth is a fraction nj of world’s wealth W, it is possible to rewrite Aj as: Aj [ajcj (1 ajj )] bjjYj

(7.2)

where Yj is (potential) GDP, and cj (1nj)/nj. Denoting [{ajcj (1 ajj)} bjj] f j*, then: Aj f* j Yj

(7.3)

This equation states that, in long-run equilibrium, the net international demand for countryj assets can be expressed as a proportion f *j of the country’s (potential or sustainable) GDP. Under the simplifying assumption that international reserves do not change, the ‘sustainable’ current account ratio to GDP is given by: Tj (gj p*j ) [{aj cj (1 ajj )} bjj ]

(7.4)

where T is the ratio of the trade or current account balance to GDP, gj is the country’s sustainable rate of growth and p*j is a valuation factor (approximately) equal to international inflation. The main message of this relationship is that ‘sustainable’ current account balances vary across countries and depend on whatever variables affect portfolio decisions, and economic growth. The notion that no country can run a sustainable deficit in excess of 4 or 5 per cent of GDP, or any other arbitrary number, is in Edwards’ view, nonsense. While this framework offers a very different perspective than the orthodox sustainability model outlined in Chapter 6, Edwards himself notes that this approach still has important limitations. Equilibrium portfolio shares remain unknown, while the speed at which a country is able to absorb the increased demand for its assets can effect the path of the sustainable current account. Nevertheless, the main point that can be drawn from this analytical framework is that sustained swings in portfolio preferences can generate current account positions that, at least relative to the historical experience post-1971, look uncomfortably, if not dangerously, large. As Edwards concludes: The key point is that even small changes in foreigners’ net demand for the country’s liabilities may generate complex equilibrium adjustment paths for the current account. These current account movements will be necessary for the new portfolio allocation to materialize, and will not generate a disequilibrium – or unsustainable – balance. However when this equilibrium path

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of the current account is contrasted with threshold levels . . . analysts could (incorrectly) conclude that the country is facing a serious disequilibrium. (Edwards, 2002, pp. 17–18)

In short, as home bias declines, movements in current account positions that had previously been regarded as infeasible may be the norm and basic sustainability analysis as set out in the ‘orthodox case’ will prove progressively futile. A related and important point is that as home bias declines, the historical record since the collapse of the Bretton Woods system may be of limited value as a guide to the current situation. Edwards (2005) correctly identifies that there is no doubt that in a post-1971 world of floating exchange rates the size of US deficits in recent years has been unprecedented. But compared to other eras this is less true. In the world of relatively free capital mobility under the operation of the classical gold standard before the First World War, current account imbalances, some larger than those that have usually prevailed in the modern era, were not unusual. Admittedly, deficits the size of the United States’ today (relative to GDP) could not be said to be typical, but what has not changed is that the United States (along with Australia) was a large borrower then, as it is now. Moreover, there is increasing evidence that the dispersion of current account positions has been steadily increasing over the last 15 years or so (Backus et al., 2006). If the US deficit is abnormally large, then Germany, Japan, Norway, Switzerland and, of course, China are running historically large surpluses. Dispersion of current account positions has also expanded within the eurozone with Greece, Portugal and Spain running very large deficits in recent years.1 Heightened capital mobility and a reduction in home bias as exchange rate risk is removed are obvious candidates to explain these developments and the decoupling of investment and saving within each country (Blanchard and Giavazzi, 2002). The nature of inflows into the United States in recent years is also frequently cited as a major cause of concern. There is a significant asymmetry between the stock of US overseas assets, which are heavily weighted towards equity and direct investments, and foreign investments into the United States, which are weighted more towards less risky bond and bank finance. During the dotcom boom of 1997–2001, foreign acquisition of equities and FDI were significant. Since 2002, net inflows into the United States have been dominated by foreign purchases of US debt. A further change is that in the past, inflows were primarily private in nature, whereas a sizeable portion of the bond purchases of recent years have been ‘official’ i.e. foreign central bank purchases.


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OFFICIAL HOLDINGS One statistic encapsulates the significance of central bank (i.e. ‘official’) holdings of reserve assets. Between the end of 1999 and May 2006, the world as a whole has accumulated US$2.78 trillion in additional foreign currency reserves alone. The importance of this figure is revealed by Martin Wolf’s (2006d) observation that three-fifths of the international reserves accumulated since the beginning of time have been accumulated in this six and one-half year period. Table 7.2 details the composition of net capital flows into the United States since 2003 including the figures for flows in 2006. Note that 2005 did see a renaissance of net FDI inflows into the USA although this impression is misleading. This inflow was actually the by-product of the Home Land Investment Act that encouraged US firms to repatriate profits and dividends for domestic investment purposes. The pickup in net flows was therefore the result of US firms repatriating capital rather than any growth in foreign demand for US real economy assets. Net FDI flows during 2006 once again slipped back into negative territory. Viewed from a gross, rather than a net, flow perspective, however, it can be at least questioned whether net reserve accumulation has financed the US current account deficit in any meaningful way. Rather it might be said that these flows have financed the United States’ substantial outward investments, particularly FDI and portfolio equity, which as Table 7.1 illustrated have accelerated to almost 5 per cent of GDP on average so far this decade. As shown in Figure 7.1, gross FDI inflows into the United States, while well below the 3 per cent of GDP or so pace of the late 1990s, averaged in excess of 1 per cent of GDP between the years 2004 to 2006. It is also worth noting that apart from a brief hiatus during the equity ‘bubble’ years of the late 1990s, the BEA data show that ‘official’ purchases have constituted a relatively stable share of gross liability flows – including or excluding bank lending flows – since the early 1990s period (Gourinchas and Rey, 2005). IMF Chief Economist Raghuram Rajan (2005) seeks to clarify the role of ‘official’ central bank financing when he notes that: It is therefore entirely correct to say the US current account deficit is more than fully financed by foreign private investors while US private investment abroad is partly financed by foreign central bank investment in the US. (p. 9)

He also makes the point that, with considerations of profit and return less important than for private investors, central banks are unlikely to effect violent shifts in the composition of their portfolios. Such an act would both

176

86 133 117 55

84 25 54 4

Net portfolio equity

474 616 653 643

Net portfolio bond flows

232 94 42 233

Net banking and other flows1

Source:

BEA

Note: 1. For 2006 includes net financial derivatives flows of $28.7 billion

$bn 2003 2004 2005 2006

Net FDI

Table 7.2 US capital account flows, 2003–2006 ($ billion)

3 2 4 4

Net capital transfers

2 3 14 2

Official reserve assets

1 2 6 5

Net govt assets other than official reserves

13 86 18 18

Statistical discrepancy

522 640 755 811

Total net inflows

177

The demand for US assets 4.0

(as a % of GDP, four-quarter moving average)

3.5 3.0

Inward FDI

2.5 2.0 Outward FDI

1.5 1.0 0.5 0.0 –0.5 1980

1985

1990

1995

2000

2005


Figure 7.1 US gross FDI flows, 1980–2006 (as a % of GDP, four-quarter moving average) crystallize significant capital losses on central bank’s existing holdings and also increase upward pressure on their currencies, the avoidance of which was a key motivation in acquiring the US dollars in the first instance. It is therefore probable that private investors, whose prime motivation in buying US assets are expected returns and who remain essential to financing the deficit, will exit the US dollar market first. Central bank selling may therefore exacerbate, but is unlikely to trigger, the kind of US dollar ‘crisis’ prophesized by the current account ‘pessimists’. While the one-dimensional characterization of private equates to equity, and central bank equals bonds, for financing the US deficit must be jettisoned, the changing composition of net inflows can sensibly be viewed as the counterpart to the shifting sands of the forces driving the increase in the US current account deficit. Between 1997 and 2001, a pick up in investment was associated with the widening of the deficit. Since 2001, the association has been with a collapse of national saving. The former was inevitably reflected in ‘real economy’ capital inflows while the latter has seen a sharp rise in bond finance. Feldstein (2005) has argued that the scale of central bank financing of the deficit in recent years means that the contribution, and standard estimates, of the decline in home bias as cited by Alan Greenspan, for example, are an overstatement. A counterweight to this view is that central bank finance should not necessarily be seen as ‘special’ since central banks are serving as financial intermediaries, compensating for excessively cautious private sector

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behaviour in the case of Japan and the immaturity of the financial sector in the case of China (Cooper, 2006). The ranks of those central banks providing finance to the United States have changed dramatically over the last few years. The Bank of Japan, the biggest provider of ‘official’ finance to the United States in 2003 and 2004 is no longer providing net finance. The PBOC has continued to purchase US debt at a steady rate. Other Asian central banks have pared back their purchases, with Malaysia’s decision to float its exchange rate in 2005 being a prime example. To an increasing extent, it is the central banks of the key oil-exporting economies, particularly Saudi Arabia and Russia, that are the major ‘official’ buyers of US assets. Nevertheless, in general, the precise scale of the contribution of central banks to financing the US deficit remains unclear and is hampered by data limitations. A fair summary is that it is not as important as it was but still plays a significant role. There are in essence three key sources of data used to estimate the role of ‘official’ purchases in financing the US data. These are the ‘official’ quarterly balance of payments BEA data on capital inflows, the monthly data from the Treasury International Capital Reporting System (the so-called ‘TIC’ data) and, finally, the weekly custodial data released by the Federal Reserve Bank of New York (FRBNY) on their holdings of US Treasury and other securities on behalf of foreign official institutions. Of the three sources, the BEA data, while the least timely, have the considerable merit of being consistent with the rest of the balance of payments statistics. They also offer the broadest coverage including short-term ‘official’ capital flows (bank deposits, etc.) and also flows of direct investment (although even the PBOC has not yet resorted to foreign direct investments). Both the FRBNY and TIC data exclude short-term capital flows and, assuming these flows are positive, will therefore tend to underestimate ‘official’ demand for US assets. The FRBNY custodial data have the advantage of being extremely timely (they are published weekly), are of high quality (mistakes in the FRBNY data would be similar to a bank making mistakes over account balances) and, although the FRBNY is only one of many custodians, it nevertheless holds the bulk of the world’s official holdings of US Treasury securities (Warnock and Warnock, 2005). For example, the Treasury department estimate that, at the end of 2005, foreign official holdings of Treasury notes and bonds ($1.0786 trillion) and Treasury bills ($201.9 billion) totalled $1.2804 trillion.2 At the end of 2005, the FRBNY held some $1.0997 trillion, around 85 per cent of the stock. Given that they also include ‘official’ purchases of Government Agency bonds as well, it is unsurprising that the FRBNY custodial data have been labelled the ‘best source of foreign official flows into the US securities’ (Warnock and Warnock, 2005).

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The demand for US assets 3.5

(as a % of GDP, four-quarter moving average)

3.0 2.5 2.0 1.5 1.0 0.5 0.0 –0.5 –1.0 1980

1985 BEA data

1990

1995

FRBNY data

TIC data

2000

2005

Sources: BEA; Federal Reserve Bank of New York; Treasury Department; authors’ calculations; Reuters Ecowin Pro.

Figure 7.2 US ‘official’ inflow measures compared, 1980–2006 (as a % of GDP, four-quarter moving average) Unlike the FRBNY custodial data, the TIC data include central bank purchases of corporate bonds, which have been rising in importance. However, the flow data excludes bonds of maturity of less than one year, i.e. Treasury bills. In addition, the usefulness of the TIC data in gauging the scale of central bank purchases, is further circumscribed by the fact that they allocate capital inflows by the agent effecting the transaction rather than the true owner of the funds (Feldstein, 2005, 2006). A London bank purchasing US Treasuries on behalf of the PBOC would therefore be recorded as a private British buyer rather than an ‘official’ Chinese purchaser. The TIC data nevertheless provide a timely, monthly gauge of overall foreign demand for all US portfolio assets, covering both debt and equity. Figure 7.2 compares and contrasts the three data of ‘official’ purchases of US assets. We would identify two key stylized facts. First, all three measures confirm that central bank buying of US assets has clearly stepped up to a historically unprecedented level this decade. But, while the absolute importance of ‘official’ inflows has climbed, their relative importance has increased only slightly. As shown in Figure 7.3, in 2005, and the first half of 2006, the ‘official’ share of gross inflows remained below 20 per cent and not greatly different to the average share of 13.5 per cent between 1985 and 2000. Second, all three measures record that the importance of central bank holdings in financing the United States’ accelerating capital requirements

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150 125 100

Mean 1985–2000 = 13.5% of gross inflows

75 50 +1 St.Dev

25 0

–1 St.Dev

–25 –50 1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

Sources: BEA; authors’ calculations, Reuters Ecowin Pro.

Figure 7.3

‘Official’ inflows as a per cent of total gross inflows, 1970–2006

peaked in the first half of 2004 and has declined substantially since despite the continued strong pace of global reserve allocation. The ending of Japan’s large purchases of Treasury securities seems to be the main cause. Moreover, just as the one-dimensional characterization of the record current account deficit being largely financed by record central bank buying does not stand up to scrutiny, nor does the stereotype of enormous buying of Treasury securities. The reality is that both the composition of overall and ‘official’ inflows, while skewed heavily towards debt instruments, has become increasingly heterodox in recent years. There has been a move to higher yielding and implicit government guaranteed Agency bonds. ‘Official’ appetite for corporate bonds has also grown. The Bank for International Settlements (BIS) finds that Agency bonds (including mortgage backed securities) accounted for some 22.5 per cent of all foreign official institutions holdings of long-term US securities by mid-2005, up from around 15.5 per cent in early 2000 and a mere 3.5 per cent at the end of 1989. (BIS Quarterly Review, September, 2006). As will be argued later in the chapter, the growth in demand for Agency debt – both official and private – in recent years exemplifies why the demand for US assets, even when skewed towards fixedinterest instruments, may be more permanent and less footloose than the current account ‘pessimists’ would have us believe. Measuring, or making informed estimates of, official capital flows is one thing. Explaining the reasons for them, and determining how long they may persist, is another. For this purpose we examine three different sources of capital flows to the United States: capital flows from Asia, oil revenues and ‘demographic flows’.

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THREE SOURCES OF CAPITAL FLOWS Capital Flows from Asia A major contributing factor has been the capital flows from Asia. Recent data compiled by the BIS (Wooldridge, 2006) enable us to put some magnitudes upon the flows. From the end of 1998 to the end of 2005 total cumulated foreign invested funds across the major non-Japan Asian countries3 are estimated as $2.8 trillion. These funds consist of total foreign reserves plus gross financial flows (i.e. foreign direct investment abroad and gross portfolio investments and other invested funds). As shown in Figure 7.4, reserve accumulation has accounted for 44 per cent of cumulative invested funds, followed by portfolio investment and FDI flows, in that order. It is estimated that almost 40 per cent of Asia’s invested funds have been placed in US dollar assets. 3000

2500

2000

Reserves Other investment

1500

Portfolio investment FDI

1000

Invested funds2

500

0 1999

2000

2001

2002

2003

2004

2005

Notes: 1. China, Hong Kong SAR, India, Indonesia, Korea, Malaysia, the Phillipines, Singapore, Taiwan (China) and Thailand. 2. Invested funds comprise the sum of the change in reserves, FDI abroad, and gross portfolio and other investments. Source: BIS Quarterly Review, June 2006, p. 21.

Figure 7.4 Asia’s1 invested funds, cumulative flows 1998–2005 (balance of payments data)

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Some explanations for these capital flows were offered in earlier chapters. One is that the accumulation of funds abroad is a response to the financial crises (Mexico, Asia, Latin America, Russia) of the 1990s. Unwilling to trust the IMF, or accept its conditionality requirements, countries both in Asia and elsewhere have sought to self-insure against future crises by building up a war-chest of precautionary reserves (Feldstein, 2005). Yet, it is nearly ten years since the Asian crisis, and, as the reserves and investments mount, the benefit–cost calculation in terms of forgone income must begin to change (Rodrik, 2006). In any case, the precautionary motive for reserve holding seems more of a once-for-all portfolio transition to a new level, rather than a sustained flow. A second reason is the ‘balance of financial terror’ (Summers, 2006). The world’s largest economy is running a big current account deficit, and issuing financial claims such as bonds and equities in exchange for buying goods and services. Countries such as China and Japan see little choice but to loan the money to the United States, and so provide ‘international vendor finance’ (Summers, 2004), because they need Americans to continue buying their goods. Allied to this explanation is the idea that the present system constitutes Bretton Woods Mark II in which countries accept the hegemony of the United States in the world trading system. They are willing to acquire dollars to maintain the regime, and many choose to maintain relatively fixed parities with the US dollar in order to promote international trade. As the capital flows and the accumulation of reserves have continued, two other hypotheses have gained popularity. One, advanced by Prasad et al. (2006) at the annual symposium of the Federal Reserve Bank of Kansas City at Jackson Hole, Wyoming, is that developing countries have limited their capacity to absorb foreign capital because of their underdeveloped financial systems, which makes it difficult for firms and households to borrow. For example, Eichengreen (2005) considers that some of the inefficiencies of the Chinese banking system may be being circumvented when China acquires liquid claims (e.g. Treasury securities) on the United States and the latter in turn uses the proceeds to fund less liquid FDI in China. Huang (2003), in particular, argues that private firms in China find it difficult to raise funds in the state-dominated Chinese banking system and are sometimes forced to resort to FDI for funds for expansion (see also Chiu and Lewis, 2006). The other, and perhaps more compelling, reason is that the countries may not need, or want, to borrow. Some of them have large domestic savings and do not require the additional capital that foreigners wish to provide. Others may have made a deliberate choice to restrict overseas funding. According to Rajan: one reason global imbalances have emerged is because emerging markets have recognized the risks posed by volatile cross-border flows, especially given the


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fragility of their own financial and corporate systems. They have learnt to fit their investment coat within the domestic savings cloth they have available, even leaving a bit over to finance rich countries. (2006, p. 4)

The upshot is described by Martin Wolf in the following terms: according to the March 2006 report from the Washington-based Institute for International Finance (IIF), the foreign private sector poured $US400 billion into the group of emerging market countries on which the IIF focuses attention. ‘We do not need this money, thank you,’ said the recipients. ‘After all, we are running an aggregate current account surplus of $US232 billion, which we are determined to keep.’ So, they pushed the money right back out again, predominantly into the liabilities of an insufficiently grateful US Treasury. In aggregate, the reserve accumulations in 2005 were $US416 billion. . . . By accident, the world has found a way to make the crisis-prone world of financial globalisation work. Investors consider emerging market economies appealing destinations, but the governments of many of the most courted countries hate the idea of absorbing the capital. So they resist pressure for currency appreciation and recycle the inflow predominantly into US liabilities. The US then complains about the deficits, while enjoying the inflow of resources. (2006d, p. 28)

If we combine this interpretation with the assessment of Rajan (2005), quoted in the previous section, then a curious anomaly emerges. According to Rajan, official central bank investment in the United States is financing, at least in part, US private investment abroad. According to Wolf, this private investment is promptly returned to the United States in the form of purchases of US Treasury bonds. These purchases in turn presumably ‘finance’ more US private investment abroad, which then finds its way back to the United States, and so on. This raises the spectre of a giant global game of pass-the-parcel. In a world of fiat currencies, US dollars can no longer be extinguished by conversion into gold. They can be converted into other currencies, but the balances would finish up being held by another central bank. The imagery we invoked in Chapter 4 was of US dollars being a ‘hot potato’ that could only be passed from one holder to another. Another apparent anomaly relates to the pattern of global capital flows. One might expect capital to flow from rich countries to poor countries, which have less capital and may offer higher returns. This was the pattern in the nineteenth century when British capital (net foreign investment) financed railroads and other infrastructure in the less developed Americas. Currently, however, much of the flow of global capital is ‘uphill’, and the

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US deficit is being financed significantly by purchases of US Treasury bonds and other securities by some of the world’s poorer countries.4 What the Bank for International Settlements described as ‘a weakening of investors’ appetite for risk . . . [and] a reallocation of portfolios in favour of highly-rated instruments such as government bonds’ (2006, p. 1) might be seen as a continuation of this trend and we have suggested some reasons why, in the words of Balakrishnan and Tulin: the Asia crisis created a pool of savings looking for relatively risk less opportunities, which were provided by deep, liquid, and innovative U.S. financial markets with robust investor protection. (2006, p. 24)

Oil Revenues In the case of the oil-exporting countries, the story is different. What is remarkable is how quickly the oil exporters have, once again, become major suppliers of funds on the world markets. Between 2002 and 2005, net oil exports of the fuel-exporting countries rose by US$437 billion. By comparison, between 1973 and 1981, net oil exports increased by almost exactly the same amount, US$436 billion (although relative to world GDP the first episode was larger, 1.9 per cent against 1.2 per cent). In 2005, current account surpluses of the oil exporting countries at US$350 billion were about the same level as the East Asian countries. In 2006, the oil exporters’ surpluses amounted to US$396 billion. However, these figures conceal a considerable size imbalance. The three largest non-US oil producers are Saudi Arabia, Russia and Iran, and they produce around one-quarter of the world’s oil. Other large holders of proven oil reserves are, in descending order, Iraq, Kuwait, United Arab Emirates, Venezuela, Kazakhstan, Libya and Nigeria. In the first oil shock, the oil exporters held mainly short-term dollar balances which were ‘recycled’ to developing countries through the Eurodollar banking system. This time the major global borrower is the United States itself, and the funds have come to US financial markets in a variety of ways, very different from in the earlier episode. For example, oil money from the Middle East tends to flow to the United States through European banks (sometimes via the repayment of debts incurred when oil prices were low) or by means of the international bond market (Eurobonds). Other oil revenues are thought to have found their way into hedge funds (Gottliebsen, 2006). Even Gulf oil producers’ investments such as those in oil refineries in China or telecoms in Egypt are US dollar-based. Thus the pattern is very different from the first oil shock. In the 1970s, the oil exporting countries held their petrodollars in short-term, liquid deposits with international

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banks, but the funds were intermediated via the international banking markets to what turned out to be risky borrowers. Now the oil revenues are being invested in long-term bonds and other more risky assets, but many of the funds are finding their way through many channels to the world’s safest borrowing nation (Wolf, 2006c). ‘Demographic’ Flows However, it would be a serious oversight to regard the current constellation of global capital flows as simply the economic perversion of the ‘poor’ periphery financing the ‘rich’ United States with the more recent overlay of flows from oil exporters to oil importers. The picture is more complex, more heterodox than simply ‘mercantilist’ Asia and cash-flush oil exporters financing the United States. As important, arguably more so, is the fact that so many other ‘rich’ economies are running unusually high current account surpluses (see Cooper, 2006 and also Backus et al., 2006). As Table 7.3 reveals, the increases in the current account surpluses of Japan, Germany, the Netherlands and Switzerland can arithmatically account for over 70 per cent of the widening in the US current account deficit from 2000 to 2006. Table 7.3 Global current account balances, selected years 1997–2006 (US$ billion)

US Japan Germany, Netherlands, Switzerland Other ‘rich’ countries China Other developing Asia Central and East Europe CIS Middle East Latin America Africa Discrepancy Memo: fuel exporters

1997

2000

2006

2006–2000

% of US change 2000–2006

141 97 41

416 120 5

811 170 263

395 50 258

n/a 12.7 65.3

68 34 27 21 9 11 67 6 14 16

23 21 26 32 48 70 48 7 176 149

139 239 12 89 99 212 49 20 1 396

162 218 38 57 51 142 97 13 177 247

41.0 55.2 9.6 14.4 12.9 35.9 24.6 3.3 44.8 62.5

Sources: IMF World Economic Outlook; Richard Cooper (2006); authors’ own calculations

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40.0

Gross capital formation as a % of GDP

37.5 35.0

Japan

32.5 30.0 27.5 Switzerland

25.0 22.5 20.0

Germany

17.5 15.0 1970

1975

1980

1985

1990

1995

2000

2005

Sources: World Bank; authors’ calculations; Reuters Ecowin Pro (measured at current prices).

Figure 7.5 Investment in Japan, Germany and Switzerland, 1970–2005 (Gross capital formation as a % of GDP) (China’s surplus, by contrast, accounts for about a half of the post-2000 change.) These increased surpluses in developed countries seem to reflect low investment rather than sharp increases in saving – an investment ‘dearth’ more than savings ‘glut’. Partly, the phenomenon is a cyclical one reflecting the low growth performance of recent years but it is also likely to be in part structural due to the demographic outlook of these economies. All of these economies have seen the share of investment in GDP slump (as shown in Figure 7.5 in the case of Germany, Switzerland and Japan to the lowest levels since 1970) without a correspondingly offsetting fall in national savings rates. The fall in investment in these economies may partially reflect their policy frameworks and the structure of their financial systems (the investment share has fallen significantly in the UK over the same period but savings have fallen even further) but also demographics. These are economies with rapidly ageing populations, the working age populations of which are set to shrink significantly in the next few decades. There is simply less need to invest in physical capital. In a prescient point, Richard Cooper notes that, of the four major economies – the United States, Japan, Germany and China – only the United States, due to higher birth rates and immigration, is projected to see its working age population grow over the next 20 years or so (Cooper, 2006). By 2050, today’s figure of 300 million Americans is projected to exceed 400 million, according to UN World Population Prospects and the US Census Bureau (The Economist, 14 October 2006, p. 37). It accordingly


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seems fair to attribute a significant portion of the unusually high demand for US assets as constituting finance from ‘old’ to ‘young’.5 As a result, there therefore seem to be at least three cross-cutting axes of capital flows into the US: ‘uphill’ flows, ‘oil’ surplus recycling flows and ‘demographic’ flows. The cumulative effect of these three factors has been to boost significantly the demand for US assets, providing one explanation for the interest rate ‘conundrum’ of recent years in the form of the decline in mortgage and other long-term interest rates despite the upward steps in the Federal funds rate starting in mid-2004 – a phenomenon ‘without precedent in recent US experience’ (Greenspan, 2005c).6

FINANCING INNOVATIONS Mortgage-Backed Securities The bond-based nature of US financing is often taken as worrisome, indicative of demand for US assets that may be relatively ephemeral or footloose. But it now seems that the demand may be more structural, less cyclical, than the current account ‘pessimists’ have typically assumed. The growth in foreign purchases of US mortgage-securitized bonds is a case in point. A potent combination of the United States’ role as world banker, given its deep and liquid financial markets, allied with the role of the US dollar as international money and the American proclivity for financial innovation have created a new asset class with ‘worldwide appeal’ (IMF, 2006b). Unsurprisingly, given the backdrop of historically low interest rates and booming house prices between 2001–2005, much of the innovation in structured financing in the United States has centred on housing finance. Mortgage debt has been ‘commoditized’ by the large banks as it is securitized (and frequently re-securitized), bundled into different risk categories and then sold to both domestic and foreign investors. Mortgage-backed securities (MBS), by widening the demand for mortgage debt and narrowing spreads, have allowed US citizens to borrow against the housing wealth that the long house price boom of 1997–2006 has produced and tapped the world’s expanding pool of savings. Simultaneously, the rest of the world’s willingness to finance US borrowing and the attractiveness of mortgage-backed bonds in terms of providing higher returns on safe and liquid US dollar assets has underpinned and extended the housing market. In a symbiotic relationship, the United States’ financial infrastructure and capacity for innovation has enabled it skilfully to exploit favourable financing conditions preserving and extending foreign demand for its debt while enabling its citizens to acquire and borrow against increasing housing

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Table 7.4 Holdings of US securities1 by foreign official institutions, selected years 1989–2005 (US$ billion, % of total)

US Treasury debt US Agency debt Corporate and other debt

December 1989

March 2000

June 2005

188 (95.4) 7 (3.6) 2 (1.0)

465 (82.3) 88 (15.6) 12 (2.1)

1054 (73.2) 261 (18.1) 44 (3.1) 80 (5.6)

Asset-backed securities2

Notes: 1. Market value of debt securities with original maturity of one year or more. 2. Mainly mortgage backed securities. Source:

BIS Quarterly Review, September 2006.

wealth. The IMF (2006b) estimates that foreign holdings of MBS were worth close to $1 trillion by March 2006, representing about one-third of the increase in net foreign indebtedness since the mid-1980s. Even foreign official institutions have increased their holdings of MBS in recent years, and assetbacked securities (mainly MBS), along with corporate bonds, accounted for nearly 9 per cent of official holdings of US debt securities in 2005 (Table 7.4). Surprisingly, these statistics are rarely mentioned in the discussion of the US current account deficit. The phenomenon means that, along with holdings of equities and other investment instruments, ‘a major part of the rising indebtedness of the United States reflects foreign investment inflows into the US housing sector’ (IMF, 2006b, p. 8). The significance of this link can be appreciated by considering the following line of reasoning. One explanation of the US current account deficit that we explored earlier runs in terms of (what seems in retrospect at least) excessively expansionary monetary policy, not only in the United States but at a global level. A way of articulating this argument is in terms of the relationship between the market or actual rate of interest (i.e. the price of loans) and Wicksell’s (1898) ‘natural’ rate of interest. Following an injection of money from monetary policy, the market rate would fall below the rate of return required to clear the loans market, which Wicksell called the ‘natural rate’ (approximately equal to the rate of return on newly created capital). As a result there would be the opportunity for entrepreneurs to borrow at the market rate to invest in newly formed capital and earn a return at the natural rate of interest. In these circumstances the demand for


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loans would rise as entrepreneurs seek to make profits from investment in capital goods and the demand would continue to rise until the rates were again equal. In the process of stimulating the loans market by lowering the rate of interest the monetary expansion would also boost the demand for goods, raising prices indirectly as households save less and spend more. Wicksell went on to show, in a mechanism known as the cumulative process, that so long as the market rate was below the natural rate the effect would create continuously changing prices, i.e. inflation (Lewis and Mizen, 2000, p. 67). Of course, we do not know what has happened to the natural rate in the United States. It may have increased with the spurt in productivity associated with the dotcom boom, and may have fallen subsequently. But, unless it has declined drastically in recent years, then it seems likely that something like the scenario outlined in the previous paragraph took place in the United States in the 2001–2003 period, when the Federal funds rate was lowered 550 basis points to 1 per cent in 2003 and then held at that historically low level for one year. As noted previously, the subsequent asset price inflation has undoubtedly made households feel wealthier and encouraged them to borrow and spend. Median household debt rose by 34 per cent between 2001 and 2004, and nearly one-half of all US families did not save any portion of their income (Kliesen, 2006). From this perspective, such behaviour is entirely rational. The expansion of debt and consumption has been matched by considerable increases in the value of household assets, especially housing, obviating the need to save out of income. Equity has been extracted from housing mainly by the refinancing of home mortgages. At the end of 2005 and early 2006, equity withdrawal was running at an annual rate of over $800 billion. Moreover, unlike the real estate related financial crises in other countries that marked the 1990s (Bentick and Lewis, 2004), US borrowers incur liabilities in US dollars due to the ‘privilege’ of the United States issuing international money. The currency risk that featured in those financial disasters is absent. The fact that foreigners are all too willing to purchase the re-packaged borrowings and facilitate the housing equity transactions would seem to close the circle. Have Housing Prices Increased Wealth? Others are not so sure. There are those who would question whether there really has been an increase in wealth that can be consumed with impunity. Wealth in the form of a rise in equity prices, at least in theory, reflects expectations of enhanced corporate earnings and greater productivity. The same is not obviously true of rising housing prices, unless there has been an

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improvement in the quality of the housing stock. In fact, it is argued that the increased wealth is illusory and the consequence of inconsistent accounting treatments of the assets and liabilities. When household net housing assets increase in value the cost of using that housing stock (the flow of future housing services) increases by precisely the same amount. This is because the present value of any asset is the sum of the discounted future cash or service flows that the asset is expected to provide. A comprehensive accounting treatment or balance sheet will record, as an asset, the current value of the housing stock and, as a liability, the future flow of housing services that this stock will provide. The net value will be zero (Emmons, 2006). In effect, the argument is that rising real estate prices do not increase real wealth for society as a whole. The capital gains accruing to home-owners are offset by the increased future living costs borne by those who do not own homes. Wealth is redistributed between these groups, but is not created overall. In this respect, society as a whole is not better off (The Economist, 2004). An important countervailing argument, in turn, is that not only has net worth of US households expanded over the last decade as house prices have risen but the net worth of the elderly has also continued to grow (Table 7.5). Even allowing for the baby-boomers’ reputation as the SKI (Spend the Kids’ Inheritance) generation, there may be larger bequests from the wealthy older generation to their children (if only because of an unexpectedly early demise), eventually redistributing wealth from the property ‘rich’ to one class of the property ‘poor’. Indeed, to the degree that these bequests are being anticipated by the younger generation, this will produce additional downward pressure on household saving and, in turn, the current account deficit (Cooper, 2006). The real losers then become those without an inheritance or a house, and whose prospects of ever becoming a homeowner recede further. Although innovations like subprime loans have reduced down-payment constraints and increased access to mortgage finance, home ownership remains low amongst young, minority and low-income households (Garriga et al., 2006). A study of household savings behaviour in the United States, the United Kingdom, Australia and Canada over the last three decades confirms these points (Hiebert, 2006). From 1997 to 2005 all four countries have experienced housing booms, although the increase in household spending and residential investment over these years has been far the strongest in the United States (see Figure 7.6). In round terms, house prices have risen 160 per cent in the UK, 120 per cent in Australia, 80 per cent in the United States and 60 per cent in Canada. In all cases, declines in household or personal savings have been correlated with these capital gains, and this process has been facilitated by financial innovations that have made it easier for

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Table 7.5 US median net family worth, selected years 1995–2004 (thousands of 2004 US$)

All families Age of head (years) – less than 35 – 35–44 – 45–54 – 55–64 – 65–74 – 75 or more

1995

1998

2001

2004

70.8

83.1

91.7

93.1

14.8 64.2 116.8 141.9 136.6 114.5

10.6 73.5 122.3 148.2 169.8 145.6

12.3 82.6 141.6 193.3 187.8 161.2

14.2 69.4 144.7 248.7 190.1 163.1

Sources: Federal Reserve 2004 Survey of Consumer Finances; see also Richard Cooper (2006).

77.5

(measured at current prices, as a % of GDP)

75.0 72.5

USA

70.0 67.5

UK Australia

65.0 62.5

Canada

60.0 57.5 1965

1970

1975

1980

1985

1990

1995

2000

2005

Sources: BEA; ONS; Australian Statistician; Statistics Canada; authors’ calculations (Measured at current prices); Reuters Ecowin Pro.

Figure 7.6 ‘Anglo-sphere’ consumption and residential investment, 1965–2006. Household spending and residential investment (as a % of GDP) households to borrow. Wealth effects due to housing may result through realized capital gains (such as equity withdrawal for housing) that enhance households’ ability to spend, although these effects seem likely to be complemented or even eclipsed by the influence of unrealized capital gains. Nevertheless, Hiebert concedes that the underlying premise is flawed. The

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wealth effect from this channel is debatable since housing is both a household asset and a consumption item: while an increase in the price of housing benefits existing homeowners, it is accompanied by an offsetting increase in the implicit rental cost of housing and therefore simply represents a transfer of wealth within the household sector between current homeowners and renters or future homeowners. (Hiebert, 2006, p. 7)

Individual Consumption-Saving Preferences This is not to say that individual Americans are wrong to sell off, or borrow against, their houses (or land, or golf courses or factories) to finance consumption, especially if there are vast differences in consumption-savings preferences as between individuals in different countries, as we stressed in Chapter 5, that create the potential for trade. Individual US citizens, by generating in aggregate a large current account deficit are selling mortgage and other debt in exchange for buying goods and services. Transactors in other countries buying the MBS are doing the reverse, and by saving acquiring command over future goods and services. The question of the propriety of such decisions is one best left to the individuals concerned (whether buying the bonds or raising the debt) under international financial laissez-faire. Nevertheless, as Emmons (2006) argues, it may be a mistake to conclude that US households’ low saving does not impact in some way upon future prosperity. In the long run, wealth is created when there is investment in real income-generating assets, rather than from paper wealth generated perhaps from inappropriate monetary policies. On the other hand, if the natural rate has fallen and if global real interest rates stay low, the bulk of these vast gains in individual US net worth may prove permanent. If this is the case, then US citizens cannot be said to have egregiously over-consumed or to have been ‘living beyond their means’. Individuals’ consumption has been unusually high and saving unusually low in recent years because their net wealth has been unusually high.7 Assessing sustainability from the perspective of the household balance sheet suggests little problem (Backus et al., 2006). The net international investment position remains small at around 5 per cent of household net worth in 2005 and has been broadly stable since 2000 despite the sharp drop in equity prices between 2000–2002. Provided asset prices stay at their current historically elevated levels, then it is far from axiomatic that US households have ‘over-consumed’. Assuming that there is no dramatic fall in US house prices, household saving can reasonably be expected to adjust slowly with the household financial balance gradually creeping back


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towards the black. The corollary of this scenario would be a slow and gradual rise in the household saving rate (and so reduction in the household sector’s financial deficit) as the ‘wealth effect’ from rising house prices slowly abates or even mildly reverses. Indeed, such a process may have already begun in the second half of 2006 and this is how it should be. If individual Americans have over-stretched themselves in their exposure to the housing market, it is they, and they alone, who will have to work things out. The current account deficit is the aggregation of these individual decisions (made by consenting adults in public) through market forces, and these same market forces will bring about a correction under the conditions of international financial laissezfaire as we argued in Chapter 5. Whether the ‘natural rate’ has, in reality, fallen seems more problematical. Wicksell’s conception can be approximated by the intersection of the IS curve (investment and savings) at full employment, and concerns the marginal productivity of capital (governing investment) and the rate of time preference (governing consumption-saving choices). The long-term real bond yield used in most calculations of the real long-term interest rate may be a measure of the social rate of time preference (or of the market rate as influenced by official policy), but it is not so obviously a measure of private time preference. Nor is it necessarily a measure of the marginal productivity of capital (Wicksell’s rate of return on newly created capital). The decline in real long-term bond yields is indeed a phenomenon that requires explanation, but while this has been happening profits have been at close to record levels. Corporate profits, as measured by the ratio of before-tax profits of domestic non-financial corporations to that sector’s gross value added, rose to more than 12 per cent in 2005, near to its peak level of 1997. At the end of 2005, operating earnings per share for the S&P500 firms were nearly 14 per cent above their level a year before. In conclusion, viewed from these various perspectives, the keys to the sustainability of the US current account would seem to be the extent and speed with which investment opportunities re-establish themselves in the other economies, the United States’ ability to sustain the pace of financial innovation adding even more layers to its financial superstructure, and finally the permanence of the spectacular jump in US net worth over the last decade, particularly household net worth that has underpinned the expansion of structured finance. With financial markets in many emerging economies not sufficiently developed to meet either the volume or risk characteristics demanded by investors, the United States, which accounts for around 30 per cent of world output and nearly half of the world’s marketable securities, was always likely to be the beneficiary of any rise in savings driven by restricted investment opportunities elsewhere. Although

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other financial markets are being developed, the pace of continuing financial innovation in the United States as witnessed in the rapid development of the MBS market and other types of structured finance means that the comparative advantage enjoyed by US financial markets is likely to remain an important ‘structural feature in the allocation of global savings’ (IMF 2006b, p. 33). Less developed countries, with immature or inefficient financial systems and/or insecure property rights and ‘excess’ saving may very well continue to experience large outflows of financial capital while simultaneously receiving substantial amounts of inward FDI. Nevertheless, while the continued ease of financing of the US deficit has begun to temper the alarmist predictions of the current account ‘pessimists’, apprehension over the rest of the world’s willingness to go on holding ever increasing amounts of US dollar denominated assets will not go away. Even a current account ‘optimist’ like Alan Greenspan (2005b) has noted that the ‘piling up of dollar claims against US residents is already leading to concerns about concentration risk’ (p. 6). After all, the rest of the world is purchasing close to $900 billion of US debt in 2006. A related concern is that the moral hazard inherent in owning the world’s reserve currency, while piling up huge debts, might see lenders demand rising risk premiums that will ultimately circumscribe the valuation channel’s effectiveness in ensuring sustainability. As Lane and Milesi-Ferretti argue: At some point, the vision of the US as a safe haven and natural home for liquid holdings would be undercut by persistent portfolio losses induced by a depreciating currency and/or investors will begin to require more significant risk premia on US-issued liabilities. (2005, p. 18)

It is in this context that we now consider the competition for the US dollar as international currency.

RESERVE CURRENCY COMPETITION Japan is the second largest economy, accounting for about 15 per cent of world GDP (relative to the United States with 31 per cent). However, the European Union (EU) is the second largest economic grouping with 26 per cent of world GDP, while the eurozone countries (those EU countries that use the euro as currency) constitute about 21 per cent of world GDP (Britain being the major omission). If we are to believe recent accounts (for example, The Economist, 2006e), the EU was born in 1957 as the six-country European common market, now transfigured into the 25-country union, as the French desire to take revenge on the United States, and counterbalance

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Table 7.6 Currency composition of foreign exchange reserves, selected years 1965–2003 (% of total reserves)

US dollar Japanese yen Pound sterling Swiss franc Euro Deutschmark French franc Netherlands guilder ECUs Unspecified currencies

1965

1973

1987

1997

2003

56.1 0.0 20.0 – – 0.1 0.9 – – 22.9

64.5 0.1 4.2 1.1 – 5.5 0.7 0.5 – 23.6

53.9 6.8 1.9 1.7 – 13.8 0.9 1.2 13.6 6.4

59.1 5.1 3.3 0.5 – 13.7 1.5 0.5 5.0 11.3

63.8 4.8 4.4 0.4 19.7 – – – – 6.8

Source: IMF data – updated version of statistics contained in the IMF Annual Report.

US power, after France’s humiliation at American hands in Suez in 1956. Already, 50 years on, the euro has become the second largest reserve currency (Table 7.6). Will it come to assume a much larger role, and erode the special privileges that the United States now enjoys? At present, the position of the US dollar looks secure. Official reserves8 totalled $4.9 trillion at March 2006 (equivalent to 11 per cent of world GDP), and nearly two-thirds of reserves are held in dollars (Wooldridge, 2006). Moreover, the dollar share has actually been rising over the last two decades. The dollar is the main vehicle currency used for non-bilateral foreign exchange deals. Oil and other commodities are bought and sold and priced in US dollars, and many international services (e.g. hotel rooms) are denominated in dollars. The US dollar is the leading currency of substitution, as evidenced by the ‘dollarization’ in Latin America and elsewhere. Finally, as documented in Table 7.7, the dollar is the main international currency for the invoicing of exports and imports, with the major (and obviously important) exception of the eurozone and EU-accession countries for which the euro dominates for both internal and external trade. This global role for the dollar brings a number of benefits9 to the United States (Chinn and Frankel, 2005). First, there is the convenience factor for US exporters, importers, borrowers and lenders in being able to transact in the home currency. Second, there is the ‘exorbitant privilege’ of being able to borrow from abroad in domestic currency. Third, there is the seignorage accruing to the issuer of non-interest bearing money. Fourth, there is the spillover for associated intermediation services. Because of the demand for dollars, holders want to access US financial markets such as that for

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Table 7.7 Use of the US dollar and euro for export and import invoicing, 2003–2004 (per cent of total) Export invoicing

United States Japan Korea Malaysia1 Thailand Australia United Kingdom Euro-area2,3 EU-accession countries3

Import invoicing

dollar

euro

dollar

euro

99.8 48.0 83.2 90.0 84.4 69.6 26.0 29.5

– 9.6 7.4 – 2.7 1.3 21.0 57.6

92.8 68.7 79.6 90.0 76.0 50.5 37.0 37.4

– 4.5 5.4 – 4.3 9.0 27.0 53.7

27.7

58.6

23.9

62.3

Notes: 1. Estimates for 2000. 2. For trade with countries outside euro-area. 3. Unweighted averages. Source: Adapted from Goldberg and Tille (2006).

Treasury bonds. This process becomes self-reinforcing. Because the market for US Treasury securities is the most liquid financial market in the world, it is attractive for central banks to continue to hold their reserves as dollars. As these last comments indicate, there are some conditions that must be met for a currency to qualify as a reserve currency. Its issuer must be important in terms of production and trade. Its financial markets must be deep and well-developed. There must be confidence in the value of its currency. On these grounds it is obvious why the US dollar clearly dominates. The US economy is the largest in the world, and the United States is the world’s largest trader. US financial markets are the most developed in the world. The only question mark has arisen recently and concerns the future value of the dollar in view of the moral hazard created by the United States’ new status as the world’s largest debtor. Equally, on these grounds, it is understandable why the euro is the second largest reserve currency. GDP of the eurozone at US$9 trillion in 2004 is roughly 80 per cent of that of the United States’ US$11.5 trillion. The GDP of the extended 25-country European Union at $12.1 trillion actually exceeds that of the United States. Population of the extended EU at 460 million is 50 per cent larger than the United States. Germany, the largest


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eurozone country, is the world’s second biggest trading nation, and the trade of the eurozone as a whole is roughly the same as America’s. Bond market capitalization in the Euro area, at 123 per cent of GDP, and equity market capitalization at 53 per cent of GDP, are less than in the United States (149 and 147 per cent respectively), but banking assets at 208 per cent of GDP are very much larger than the 92 per cent of GDP in the United States (Fonteyne, 2006). However, the position is changing very quickly. Wooldridge, writing for the Bank for International Settlements, considers that ‘the liquidity and sophistication of euro financial markets are fast approaching those of US dollar markets [and] this helps to strengthen the position of the euro as a possible alternative to the US dollar in official reserves’ (2006, p. 38).10 Since the euro was introduced in 1999, as the ‘newest kid on the block’ amongst the central banking fraternity, the European Central Bank has had to establish credibility in its policies. Like Avis, it has had to try harder. Robert Mundell (Wallace, 2006) considers that the euro has ‘performed spectacularly’ (p. 7). In his view, every citizen in the euro area has a better currency than before, one that vies with the dollar in its prestige and stability. Every firm now has access to a capital market that is continental in scope. With the removal of exchange rate uncertainty between members of the eurozone, speculative capital movements within the euro area have been eliminated and interest rates have become equalized. Every country in the euro area has a better monetary and fiscal policy mix than before. Information and transaction costs have plummeted, stimulating intra-area trade and payments. In addition to these points, as reported in The Australian (29 December, 2006, p. 20), another measure of success is that the value of euro notes in circulation now exceeds the value of circulating dollar notes. Economic theory suggests that there is a great deal of inertia in people’s money-using behaviour. Yet the institution of money in fact rests on a fragile basis. We accept money because others accept it in turn from us. Any doubts lead to a rapid unravelling. Money is thus a case of a commodity with strong network externalities and it derives its value in exchange because others are also using it. Much the same is true at the international level (Bacchetta and van Wincoop, 2005; Goldberg and Tille, 2005). There is a tendency for each monetary authority to favour the dominant currency because all other monetary authorities are doing so. This is true, up to a point. But the problem with this argument is that the functions of money are, to some degree, separable. During the German hyperinflation of 1919–1923, the mark continued in use domestically as the medium of exchange, but the dollar was used as a medium of account, while commodities served as a store of value. Admittedly, these were extreme circumstances, and it is more efficient to have something that serves all monetary functions. For this reason, there may be a strong inertia (‘path-dependence’)

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in favour of using whatever currency has been international money in the past. Yet it is at least possible that the dollar could continue to act as the invoice currency and vehicle currency, while losing popularity as the store of value in terms of reserve holdings if its exchange value is called into question. Historically, the dollar did appear to lose popularity vis-à-vis European currencies (the Deutschmark and the ECU)11 during the 1980s, and the same could happen again. Another historical precedent has been suggested in terms of the decline of sterling (Eichengreen, 2006). The pound sterling was once as dominant as the dollar is today and held sway under the gold standard that operated from 1879–1914, although the system was not nearly as universal as is widely assumed to be the case (only Britain, Germany and the United States permitted full and automatic gold convertibility, and France, Belgium and Switzerland were on ‘limping standards’ with convertibility at the authorities’ discretion). In the years after the First World War, Britain gradually swung from being a large net creditor nation to net debtor; the balance available for foreign investment in the years 1907–1913 averaged 157 million pounds, by the years 1930–1938, it averaged (–) 25 million pounds (Deane and Cole, 1962, p. 37). In the early 1920s, the US dollar was the only major currency to retain gold convertibility, and it emerged as the major international currency thereafter. However, this transition from sterling to the dollar was not just the consequence of the changed balance of payments and Britain’s international debt. It was symptomatic of a much broader shift of power, military and economic as well as financial. While the euro is currently the only realistic competitor to the international role of the dollar, the broader power shift that contributed to the demise of the pound is not evident. Nevertheless, the potential for a diversification of reserve holdings from the dollar to the euro remains. A study of the factors determining the shares of different currencies in global reserve holdings (Chinn and Frankel, 2005) found that the answer to the question of whether the euro might rival the dollar as a reserve currency turns on two things. The first is the success of the enlarged eurozone (and especially whether the UK joins). The other is whether US macroeconomic policies eventually undermine confidence in the value of the dollar. The significance of the first condition is that, as euro markets continue to expand and trust in the euro (and EU institutions) grows, the dollar may be forced to share its position with the euro, although mainly as a store of value (The Economist, 2005; Galati and Woodbridge, 2006). The importance of the second condition is that the status of the dollar probably depends more on US policies than on what is happening in the eurozone, although there will always be the desire to diversify reserve holdings.


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Obviously, given the magnitude of international reserve holdings, a loss of confidence in the value of the dollar could have major international consequences. Any sell-off of US Treasury bonds and other dollar securities would merely re-arrange their ownership but in the process would likely raise US interest rates and could see a decline in the dollar’s value. Foreign central banks are surely aware that a sell-off would merely precipitate the event that a sale would be seeking to avoid, namely capital losses on their dollar holdings, as they in effect turn the market against themselves. So far the evidence suggests that this fact is not lost on them. China, for example, has diversified its reserve holdings away from dollars over the 2000 to 2004 period. However it appears to have done so by purchasing larger amounts of securities dominated in other currencies rather than switching out of current holdings of dollar assets (Valderrama, 2005). Whether this gradualistic approach continues, or at some point foreign central banks decide to ‘cut and run’ from the dollar, depends on a complex interplay of international politics and economic forces. To a considerable degree, the future of the dollar lies with America itself and its economic policies. Equally to a considerable degree it does not, and rests on tradeoffs with other countries involving military power, trade and stability of the world order. China quite clearly plays a major part in all of this, and it is to China’s relationship with the United States that we now turn.

NOTES 1. 2. 3. 4.

For example, in 2005 the respective current account deficits relative to GDP were Greece (7.75 per cent), Portugal (9 per cent) and Spain (7.5 per cent). See the Major Foreign Holders Table, published by the Treasury Department and available at http://www.treas.gov/tic/mfhhis 01.txt. China, Hong Kong SAR, India, Indonesia, Republic of Korea, Malaysia, the Philippines, Singapore, Taiwan POC and Thailand. Hence the ‘man from Mars’ observation of Summers: If you were on Mars, and you had not seen planet Earth, but you had studied economics, and someone said there are these countries, there are these substantial number of countries that are growing at 4, 5, 6, 8, 10 percent a year that are relatively poor, where several billion people live that have rapidly growing populations, and there are these other countries that are rich, aging, growing at 2 percent a year, 3 percent a year, 4 percent a year perhaps, with slowly growing populations, and you had been asked to predict which way the flow of capital would be taking place, it would not be very difficult to figure out that the flow of capital would vary substantially from the rich, labor-short countries to the poor, labor-long, capital-short, rapidly growing countries. . . . it is the central, global financial irony of our times . . . that the flow of capital is actually very substantially from poor countries to rich countries, and in particular it is from poor countries to the world’s richest and most powerful nation. On a scale never before contemplated or seen. (2006, p. 4)

200 5.

6. 7.

8.

9.

10.

11.

Untangling the US deficit McMorrow and Roeger (2003) predict that the EU and Japan will run surpluses for some time, but expect the US to run ongoing deficits, reflecting growth differentials. Their projection implies that, as a consequence of ageing, the bulk of cross-border claims will remain within the OECD region. As discussed in Chapter 3, the other explanation for the low level of long-term rates runs in terms of the lowering of the inflation risk premium, see Mehra (2006). Income disparities may reinforce this point. It has been calculated that the top 20 per cent of income earners in the United States account for nearly 60 per cent of consumption, while the bottom 20 per cent spend just 3 per cent (The Economist, 18 November 2006, p. 77). The IMF defines official reserves as ‘external assets that are readily available to and controlled by monetary authorities for direct financing of payments imbalances, for indirectly regulating the magnitudes of such imbalances through intervention in exchange markets to affect the currency exchange rate, and/or for other purposes.’ Total reserves comprise gold, foreign currency assets, reserve positions in the IMF and Special Drawing Rights (SDRs) (IMF, 1993, p. 97). There are also some possible disadvantages of having the dollar serve as international money. One drawback is the potential for fluctuations in demand, although it is not altogether clear that an enhanced demand will produce greater variability. A second is the criminality associated with the use of the dollar for drug operations, money and tax laundering, and international terrorism. The third is what Chinn and Frankel (2005) call the ‘burden of responsibility’ in that the Federal Reserve may need to take greater account of its actions on world markets than would otherwise be the case. Interest rate policy in the wake of the 1981 LDC debt crisis may be an example, similarly the Long Term Capital Management fallout. However, the domestic charter of the Fed militates against this being a major factor, except insofar as world events impact upon the US economy. Significant changes have already occurred in the international banking and bond markets. At the end of June 2006, 39 per cent of international bank loans were denominated in euros, compared with 41 per cent in dollars. In the international bond market, the euro has in fact since 2003 supplanted the dollar as the major currency of issue. As at September 2006, using BIS data, nearly 50 per cent of the outstanding global stock of international bonds and notes (i.e. foreign currency issues and domestic issues targeted at non-residents) comprised euro issues vis-à-vis about 35 per cent of dollar issues (as reported in Finance and Development, March 2007, pp. 47–8). The European Currency Unit (ECU) was a constructed composite currency unit, in effect a ‘virtual’ currency, that comprised so many French francs, so many Deutschmarks, so many pounds sterling, etc., which had both an official value and a market value. See Artis and Lewis (1991, Chapter 8) for an example of its calculation, and its role in the old European Monetary System.

8.

China and the United States

CHINA: FRIEND OR FOE? An article ‘Made in China’ in Fortune (Taylor, 2006, p. 65) posed two alternatives. Will China be a beneficial driver of global economic prosperity? Or should Americans be scared of it, as a threat to jobs and living standards?1 US Treasury Secretary Hank Paulson in September 2006 would seem to have opted for the first, telling his hosts in Beijing that ‘We want you to succeed.’ He continued: ‘The United States has a huge stake in a prosperous, stable China – a China able and willing to play its part as a global economic leader’ (The Australian, 15 September 2006, p. 24). However, the second question never seems never to be far from the surface, as reflected in a Fortune 2005 cover story called ‘China rising – will the US be flattened?’ (4 July 2005). In the 2006 article referred to above, the author notes: ‘In an echo of the demonization of Japan in the late 1980s, China is accused of gaming the world economic system to steal American jobs’ (p. 65). Such fears are fanned by predictions such as that by Jeffrey Sachs to the effect that by 2050, China’s economy could be 75 per cent larger than that of the United States.2 Clyde Prestowitz, president of the Economic Strategy Institute in Washington in his book Three Billion New Capitalists: The Great Shift of Wealth and Power to the East (2006) chronicling the rise of China and India, provides much detail to illustrate his point that China is well and truly on its way to becoming the world’s premier manufacturing and industrial power. He argues that the dwindling role of the US dollar in international finance will mean a decline in living standards for the United States for the simple reason that America will no longer be able to run chronic trade deficits if other nations do not have to accept dollars as payment. According to him, no industry will be safe from competition. Services, research and development, and basic research, in which the West now leads the world, could all follow manufacturing to Asia. As we saw in the previous chapter, the ‘dwindling role’ of the dollar is far from evident, nor does it even look to be imminent. What of the rest of the story? Wal-Mart is at one extreme. It has been estimated that between 10 and 13 per cent of everything that China sends to the United States finishes up on a shelf in one of Wal-Mart’s stores. In fact, if Wal-Mart were a 201

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nation, it would be China’s fifth largest export market, ahead of both Germany and the United Kingdom (Fishman, 2005). At the other extreme, in terms of automobiles it is said that China accounts for less than 1 per cent of the value of components in US-made cars and trucks, according to estimates made in 2005 in The McKinsey Quarterly (Taylor, 2006). Which better reflects the reality of China’s position in the global system?

THE CHINA CENTURY?3 There is no shortage of those pronouncing the demise of America and the elevation of China to superpower status. No so long ago, discussion of the problems of the twenty-first century started from the presumption that it would be the American Century, with the problems being those arising by virtue of the United States’ overwhelming economic, military, scientific and technological strengths and its unchallenged position as the sole ‘hyperpower’. Now with its military forces in Afghanistan and Iraq stretched, the problems of financing pax Americana, along with the decline in the value of the dollar and the trend of increasing US external debt are seen by some to signal ‘the beginning of the end of US world hegemony’ (Csapo, 2003), and ‘the last of the American empire’ (Lundy, 2006). Indeed, opinion has shifted so far that the ‘weakness’ of the United States is thought to make the world a ‘scary place’. Baker (2006c) says that we now have a situation in which ‘the world’s only superpower, with the largest economic and military advantage that any country has ever enjoyed on earth, is pinned down like Gulliver, tormented by an army of fundamentalist Lilliputians’. It is not in our remit to evaluate these views, except to the extent that the current account deficit is a symptom of, or cause of, US so-called ‘weakness’ which we have argued appears not to be the case. The US budget deficit in general, and the Iraq war in particular, is at most a contributor, to the widening of the US current account deficit in recent years. There is no sign of a financial retreat from US markets on account of concerns about US solvency or the sustainability of the US external deficit. Moreover, in our view, it would be a serious mistake to under-estimate American resilience and the ability of the United States to recover from testing times (for example, the Civil War, the Great Depression, Pearl Harbor, the Cold War and Vietnam). There is no reason to suppose that Iraq will spell the end of US pre-eminence in world affairs, even if it does succeed in hastening the ending of the Bush-doctrine version of American empire (Lundy, 2006). Nevertheless, there are those who perceive that a more profound re-ordering of world affairs is underway in which the current uni-polar


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system – a world dominated by one ‘hyper-power’ – is evolving into a multi-polar world with competing power concentrations (Csapo, 2003). Economically, culturally and historically, Europe is a leading contender as a power concentration. Yet the European Union continues to lack the cohesion that the institutions of a nation state provide. Japan seems likely to remain an economic giant, but a military-geopolitical midget. Its ageing and declining population size render it an unlikely contender in the world power stakes. Consistent with the Monroe Doctrine and economic ties, Latin America is unlikely to depart far from the US position. The economic fortunes of the Middle East, as always, rest on the price of oil, but the region is riven by political differences and the Sunni–Shia divide, and united only in its opposition to Israel. Africa has little strategic significance in the post-Cold War environment. This assessment would seem to leave China, and especially Greater China (the PRC, Hong Kong SAR and, at some later date, Taiwan POC) as the most serious challenger to the United States. ‘If any country is going to supplant the United States in the world market place, China is it’ (Fishman, 2005). Many would appear to agree. Eswar Prasad (2005) in the IMF’s Finance and Development sees China’s emergence as an economic power, and its sheer size, as putting it ‘firmly at the center of the global economic stage’ (p. 44). The Economist (3 September 2005) described China as ‘the next superpower’ (p. 26). If we put together the facts that China has the fastest growing economy in the world, the fastest growing military budget, and possesses its own nuclear weapons, then it is hard to disagree with the Foreign Affairs judgement of Nicholas Kristof that ‘When historians one hundred years hence write about our time, they may well conclude that the most significant development was the emergence of a vigorous market economy – and army – in the most populous country of the world’ (1993, p. 59). An impressive array of statistics can be cited in support of Prestowitz’s view of China’s rise as a major manufacturing and industrial economy. As of 2006, ● ● ● ● ●

China produces two-thirds of the world’s photocopiers, shoes, toys and microwave ovens. It produces one-half of the world’s DVD players, digital cameras, textile products, shoes and cement. One-third of the world’s desktop computers and DVD-ROM drives are produced in China. One-quarter of all mobile phones, television sets and car stereos are produced in China. China is the world’s largest producer and consumer of coal.

204 ● ●

●

●

● ●

● ● ●


Official Chinese steel production is three times larger than that of Japan, the second largest steel producer. Even illegal (mainly private) steel production in China at 50 million tonnes is equivalent to more than one-half of steel production in the United States, the third biggest steel producer. China’s production of motor cars at 5.2 million exceeded that of the United States at 4.4 million. (In 1997 China’s motor vehicle production was only 5.4 per cent of that of the United States.) China consumes 37 per cent of the world’s cotton, 32 per cent of rice, 22 per cent of copper, 21 per cent of aluminium, and 16 per cent of wheat. Over 40 per cent of all the iron ore that is loaded into a ship anywhere in the world ends up in a Chinese steel mill. China has overtaken the United States as the world’s leading consumer of four of the five ‘basic’ commodities – grain, meat, oil, coal and steel. It lags the United States only in oil consumption. In oil, China is second to the United States in world oil consumption, and is third in imports of oil, following the US and Japan. China is the world’s largest buyer of factory machinery. China is the world’s second largest exporter, the third largest importer and the third largest trading nation overall.

In some respects these developments can be seen as a return to the past. For most of its history, China was the dominant economic power in the world, and it probably remained the largest economy in the world until the late nineteenth century by virtue of its population size (Maddison, 1995, 2001). In 1820, China still accounted for 30 per cent of world GDP. By 1950, this share had fallen to less than 5 per cent (Chiu and Lewis, 2006). Since 1978, when Deng Xiaoping instituted the reform process, Chinese real GDP has grown at 9.5 per cent per annum, faster than any other country, and on average three times faster than the United States. This growth has transformed China’s relative position. China ranked as the fourth largest economy in the world in 1950, behind the United States, the Soviet Union and the United Kingdom. By 2003 it had moved to second position behind the United States in Maddison’s calculations (based on purchasing power parity, PPP). China, with 7.4 per cent of the world’s land mass and 21 per cent of the population, produced 15.4 per cent of world GDP in 2005. By contrast the United States, with 6.5 per cent of land mass and 4.7 per cent of world population, produced 20 per cent of GDP in 2005 (in PPP terms). For a variety of reasons these measures can be misleading, at least insofar as China is concerned. China is undoubtedly the size of a continent,


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stretching 4400 km (2725 miles) east to west, and 4100 km (2500 miles) from north to south. At 9 572 900 square km (3.7 million square miles) it is roughly the same area as Europe. Among countries, only Russia and Canada are larger than China. The United States, Brazil and Australia then follow in that order. Such is the extent of China that Mao Zedong’s Long March from the Jianqxi region in the south to Yan’an in Shaanxi province in the north (admittedly by a semi-circular route), covered 6000 miles, roughly the same distance as marching from New York to Los Angeles and back again (Lynch, 1996).4 Yet the land mass of China is deceptive. Only 7 per cent of China’s land is arable, much of it being either mountain or desert. Obviously, China’s sheer weight of numbers, and its population’s literacy and industriousness, is at the core of its economic and political power (as well as being the source of future problems). According to the census, the population of China is 1.3 billion. On some estimates China’s population is thought to be much larger than that, perhaps 1.5 billion. This higher figure is based on an analysis by intelligence agencies of China’s grain consumption, which is far in excess of the likely consumption of 1.3 billion people (Fishman, 2005). Even on the basis of census data, the urban population has trebled between 1978 and 2003, and China now has over 100 cities, and perhaps as many as 160 cities, with a population in excess of one million, whereas the United States has nine and Europe 36. This drift to the cities seems likely to sustain the labour-intensive manufacturing base, despite a rapidly ageing population that will see the (official) working population peak around 2010–2015. GDP figures are also open to question because of the different methods of comparison. The exchange rate approach simply converts an economy’s GDP into foreign currency (usually US dollars) at the official exchange rate. On this basis, China accounted for 5 per cent of world GDP in 2005, and was one-sixth the economic size of the United States, which represented 28 per cent of world GDP. By contrast, the PPP approach adjusts money incomes to reflect the ability of a unit of local currency to purchase goods and services in its country of issue using international prices for a standard basket of goods and services. In low-income countries, PPP measures of income per capita usually are higher than the exchange rate measures, as they adjust for the undervaluation – essentially because wages are so low – of non-tradable goods and services in these countries. On a PPP basis, China’s economy can be thought of as closer to two-thirds that of the US economy than it is to one-seventh. Paralleling the population statistics, there is also the question of the reliability of the GDP figures. In the past, official statistics are thought to have overestimated the growth of the Chinese economy because officials had an

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incentive to inflate the economic figures to show that they were doing a good job. Nowadays, the opposite presumption holds. With concerns currently being raised about regional disparities in growth, relatively wealthy east coast provinces may mask their economic growth so that resources are not redistributed elsewhere, while depressed regions understate performance so that they remain beneficiaries of central government transfers. Indeed, in December 2005, the National Bureau of Statistics raised the estimate for GDP in 2004 to 15.9 trillion yuan, 16.8 per cent higher than the previous calculation of 13.7 trillion yuan (Chiu and Lewis, 2006). Despite all of these adjustments, it is important to keep things in perspective. On a straight dollar basis, the US economy remains seven times larger than the Chinese economy. Again, in dollar terms, the US manufacturing sector alone is as large as the entire Chinese economy. Even on PPP figures the contrast remains considerable. In terms of per capita GDP (i.e. GDP per head of population), China with GDP per person at PPP of $7198 in 2005 is well behind the United States ($41 399). China may be much wealthier, and the Chinese may live much better than the official statistics would suggest, but the gap between it and the United States remains considerable.

CHINA’S AMBITIONS So far we have concentrated on China’s geographic mass, its population density and its economic strength, ignoring its military and political ambitions. Writing in 1993, Nicholas Kristof considered that ‘What China is doing is in most cases perfectly natural, and even its territorial and military aspirations are reasonable’ (pp. 68–9). There seems little reason today to alter that judgement. China’s foreign policy priorities would appear to be in order of precedence: status, development, security, Taiwan (Story, 2003). Status is paramount when considering a civilization as old as China, for it has always, and continues to be, shaped by what C.P. Fitzgerald called The Chinese View of their Place in the World (Fitzgerald, 1964). The desire for continuity free of foreign domination and the dislike of disorder and fragmentation are enduring themes. After all, China is the only large area which has never, at any period, been brought under the rule of the West, and the only region where an alternative ancient tradition has flourished and been maintained down to modern times. The reform agenda initiated in 1978 sought to restore China to its rightful place in the world order. As the ‘chief engineer of China’s reform’, Deng Xiaoping defined the basis of the post-Mao regime’s reform objectives in practical terms as the


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transformation of China into a ‘rich and powerful’ (fu-qiang) country. Reformers in China had pursued such aims for over 100 years, but had been thwarted by a succession of foreign invasions, rebellions, revolutions, civil war, and 27 years of Mao Zedong’s Communism. Since Deng came to power, China has transformed itself into a much richer and more powerful country. Indeed, Deepak Lal (1999, Chapter 7) wonders whether Deng Xiaoping, a keen student of Chinese history, might have sought inspiration for his reforms from the history of the Sung dynasty (960–1279 CE) and the vision of a strong China ruled by mandarins that nonetheless tolerated a market economy and overseas trade and the prosperity they brought. Restoration of status and economic development are thus inexorably intertwined. With economic development as the proximate objective, China needed a secure and peaceful domestic and global environment. It also needed to become an integral part of the international community, abiding by its rules and implementing its obligations as a full member of the World Trade Organization (WTO). The United States was the nation best placed to offer both. China accepted that it had more to gain by coming to terms with, rather than challenging, the leadership role of the United States in the world order. For its part, China’s offer to cooperate with the United States in the war on terrorism saw any remaining obstacles to bring China into the WTO quickly wrapped up after September 11. Security and Taiwan are more difficult issues. US dominance in the AsiaPacific region has provided the platform of Asia’s security structure, and thus has underpinned trade. As the world’s third largest oil importer, China relies on the United States to keep the straits of Malacca open. For the moment, China has no alternative but to accept its virtual encirclement by US bases in Japan, South Korea, Guam, Thailand, Pakistan, Afghanistan, Tajikistan and Uzbekistan. US officials argue that many of these bases will be given up when they are no longer needed for operations in Afghanistan. Yet, other interpretations are possible. John Mearsheimer of Chicago University argues that the United States ‘will seek to contain China and ultimately weaken it to the point where it is no longer capable of dominating Asia. In essence, the US is likely to behave towards China much the same way it behaved towards the Soviet Union in the Cold War’ (quoted in Wolf, 2005, p. 30). In this scenario, the ‘mutually assured destruction’ of the Cold War is replaced by a ‘cold peace’. In many respects, Europe and China may be more natural partners than the United States and China. Chinese enterprises do not obviously need American goods, but they do need German machinery, French nuclear power technology and European automobile technology (the Chinesemade Volkswagen is the largest selling car in China). From the European perspective, China in many ways looks to be more committed to global

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stability than the United States of President George Bush. France, in particular, sees the world in multi-polar terms, and recognizes China as ‘the only country that can counterbalance the economic and political weight of the United States’ (Fishman, 2005, p. 288). Whether a Europe–China axis would have similar appeal to the Chinese is more problematical. China’s desire to lift itself up and become ‘rich and powerful’ leaves no room for power games. It must keep on good terms with Europe, Russia (as its chief arms supplier), Iran and the oil exporters of the Middle East (who feed its demand for energy) and the United States too. In particular, America still remains the key to the Taiwan problem. One of the issues that has confronted China since its resurgence is what to do about the vast tracks of its territory that it lost over the last century and a half, when China was weak. So far its response has been measured. It has not demanded the return of half of the old Manchuria taken by Russia or the return of (Outer) Mongolia. Return of Hong Kong was a necessity because of China’s humiliation during the Opium Wars. So too was Macao. But none is more important to China than Taiwan. It has been said that China has only one foreign policy and that is Taiwan. The Shanghai Communique of February 1972, signed by both President Nixon and Chairman Mao Zedung, acknowledged that ‘the Chinese on either side of the Taiwan Strait maintain that there is but one China and that Taiwan is a part of China.’5 The question is how this is going to be achieved in a political sense even though, economically speaking, Greater China (the mainland, Hong Kong, Macao and Taiwan) is already a reality. In Shanghai alone there are more than 5000 Taiwanese businesses in operation. There is always the possibility that China may invade Taiwan to realize its political goal, but the probability recedes daily as China integrates into the world economy. Even if we ignore the potential for US intervention, the People’s Liberation Army (PLA) would be hard pressed to conduct – let alone win – an integrated operation against Taiwan. The reality, as Table 8.1 suggests, is that China is not, as yet, a great power. By all of the conventional power indicators, it is still a second-rung power. China’s leadership sees a US military presence in central Asia and the AsiaPacific, and may suspect that one intention is the encirclement and containment of China to prevent it from raising its status to that of a world power. But China has little in the way of countervailing power to employ to prevent this from happening, except perhaps to build up such a holding of US government securities so as to create a co-dependency, the financial counterpart of the doctrine of mutual self-destruction, to compensate for its military weakness. The lesson of Russia’s folly in taking on the United States in a head-tohead competition for technological and military leadership is one that is

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Exports of goods and services (% world) 50.8 4.8

2.1

2.6

11041

763

17075

143 2.3

Russia

39.5 1.0

5.3

6.4

30615

4567

378

128 2.0

Japan

51.0 4.1

6.6

15.4

7198

2234

9573

1304 20.7

China

13.8 2.7

1.2

6.0

3320

772

3166

1095 17.3

India

10.2 2.3

1.1

2.6

8561

796

8512

186 2.9

Brazil

33.3 1.5

8.9

4.1

30579

2792

357

82 1.3

Germany

World Bank, IMF World Economic Outlook, International Institute of Strategic Studies and US State Department.

1. GDP shares calculated on a PPP rather than market value basis.

Sources:

Note:

348.5 3.3

20.1 10.1

GDP in PPP terms, 2005 (% world)1

Military expenditure, 2002 ($bn) Military expenditure, 2002 (% GDP)

41399

12456

9529

Territory (1000 km2)

GDP at market value, 2005 (US billion) GDP per capita in PPP terms 2005

296 4.7

Population, 2005 (mn) Population, 2005 (% world)

USA

Table 8.1 Indicators of geo-political power

37.3 2.4

4.6

3.0

30436

2229

244

60 0.9

U.K.

40.2 2.5

4.4

3.0

29187

2127

544

61 1.0

France

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surely not lost on Chinese leaders. Taiwan offers the greatest potential for conflict with the United States, and must remain on the back burner. China’s ‘special’ relationship with, and role of ‘go-between’ with, North Korea6 is a wild card and potential bargaining tool, but one that is also fraught with danger.7 Better in these circumstances to continue to ‘dance with the wolf’, in the words of ex-President Jiang Zemin, and cooperate with the United States in multiple ways (Story, 2003, p. 36). Modernization and development, and the status that brings, are far more important for China than global political manoeuvres and military adventurism. Reinforcing the primacy of pursuing the development route are a host of internal problems, its ‘governance crisis’ (Pei, 2002), that must be juggled, or risk losing the momentum that holds the disparate forces within China together. All have the potential to derail China’s growth, but for their resolution or amelioration need development to continue.

CHINA’S GOVERNANCE PROBLEMS When a former Indian defence minister (Georges Fernandes) on a visit to China in 2003 asked China’s premier, Wen Jiabao,8 to list his economic priorities, the answers were unemployment, regional disparities and the enduring poverty of farmers. Mr Fernandes realized that these applied equally to India and concluded that both countries were ‘sailing in the same boat’.9 There are other similarities between India and China. Both have huge populations and correspondingly massive needs for water and energy. Both must solve issues of environmental degradation. Interestingly, also, they share another characteristic, English. This is well known in the case of India. Less well known is that only 53 per cent of China’s population can communicate with each other in Mandarin (common speech). There are now as many Chinese learning English as a second language as there are people who speak English as a first language in the combined total of the United States, Canada and Great Britain. Thereafter the similarities between India and China end. India is a stable democracy which has all of the institutional trappings (checks and balances, independent judiciary and sound legal and business protections) expected of a parliamentary democracy with respect for the law and legal institutions China, contrastingly, is seen as a large, highly nationalistic, dictatorial, Communist–capitalist hybrid, lacking in human rights and avenues for political expression (Fishman, 2005, p. 283). Most analyses of China’s governance crisis revolve around the fact that political reform has lagged well behind economic reforms. According to Qian (2000), mainstream economists hold strong prior beliefs about the


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formula that a transition should follow which translate into a powerful ‘conventional wisdom’ about the set of necessary and sufficient conditions for transformation, namely, stabilization, liberalization, privatization, and democratization. Although China has adopted many of the policies advocated by economists, such as being more open to trade and foreign investment and achieving macroeconomic stability, its violations of the standard policy prescriptions are also striking. For most of the past two decades, China’s reform succeeded without complete market liberalization, without privatization, without secure private property rights and without democracy. Yet, the actual performance of the Chinese reforms would seem to confound these expectations. More controversially, Qian (2000) argues that nothing may have been more responsible for China’s relative success than the controversial Chinese developmental model of ‘economic reforms without parallel reforms in the political system’. The chief architect of this strategy was Deng Xiaoping, who wanted to clear away the havoc wreaked by the Mao Zedong era as quickly as possible, but was averse to wild experimentation and great risk-taking in the style of Mao. There was a clear desire to increase productivity and raise living standards by reforming the economic system and structure, but China’s leaders did not have a clear vision of what the new system would be like – the end point was undefined. Hence they proceeded with the reform as though ‘crossing the river by stepping on each of the stones’. There were many initiatives at the local government level which were initially tolerated, then encouraged, and later promoted nationally. In his review of the merits of a ‘gradualist’ approach to transition in comparison with the ‘shock therapy’ of much of Eastern Europe, Kornai (2000) argued that ‘speed, while important, is not the primary measure of success. The transformation of society is not a horse race’ (p. 13). With the benefit of hindsight, it is apparent that the transition from socialism to capitalism has to be an organic process. It is a strange mixture of revolution and evolution, a step-by-step trial and error process in which some old enterprises survive while others disappear, and new ideas have to be tested before being accepted or rejected. McMillan (2004) regards the success of such a piecemeal approach to be its flexibility. Transition is marked by the unforeseen and the unforeseeable. One can no more plan for these events, than one can plan the economy. All of this sounds very much like economic reform, China-style (Chiu and Lewis, 2006), which can seem confusing and frustrating to outsiders such as those Americans who look for rapid reforms to human rights, a reorientation from investment to consumption, early liberalization of the capital account, and a quick solution to the exchange rate ‘problem’. As Chinese

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leaders are fond of pointing out, in the short-term it will happen, but in a civilization as old as 8000 years, the short-term can be a long time.10 Obviously, the one-dimensional model of gradual reforms has served China well but can it carry China forward? The society that has emerged is very different from that which began, and is increasingly urbanized, educated and open to the world. Martin Wolf (2006d) considers that the combination of a market-led economy with a bureaucratic autocracy does not look a good bet for the long run. He envisages four possibilities for China. First, reforms continue, the economy grows and political reform restarts. A democratic, law-governed society then emerges smoothly over the next few decades. Second, China becomes a prosperous market economy under a reforming communist regime. An autocratic superpower then transforms the political balance of the world. Third, China proves unable to pursue the necessary reforms, which ultimately stifles the economy’s progress. The regime becomes ever more repressive and China becomes a sad case of failed development. Fourth, slowing growth generates political crisis. Turmoil ensues. But a democratic regime finally emerges. Of these, Wolf finds it difficult to accept the smooth transition to nirvana implicit in the first possibility. In his view it is also hard to believe in an advanced, internationally integrated economy governed by a communist autocracy. The third also looks implausible: it seems unlikely that the Chinese will allow anything to stop them from gaining greater prosperity. Thus the last possibility as forecast by Gordon Chang in his The Coming Collapse of China (2002) is far easier to imagine, although Wolf does not envisage a political crisis or sharp slowdown in growth in the near future. In similar vein, the World Economic Forum has been using Delphi techniques to peer into China’s future, using 150 experts to flesh out its prospects over the next two decades (Smith, 2006). Its most optimistic scenario, which it calls the ‘New Silk Road’, has China continuing to grow at a rapid rate (averaging 9 per cent a year until 2025), pushing through economic and banking reforms and containing internal political dissent. China comes to be seen as a positive partner by the rest of the world both politically – contributing to peacekeeping operations – and economically, as the world’s motor. At the other end of the scale is what is called the ‘Unfulfilled Promise’. Growth is still strong by normal standards, averaging 6 per cent, but it falls short of what China has achieved over the past 25 years. The reform process slows down to a walk because of fear of dissent. Export growth weakens as competitiveness declines. As a consequence, China fails to become a major global player. Another scenario considered was that of ‘Regional Ties’, which sees China continuing to grow strongly, averaging perhaps 7.5 per cent per


213

annum, but with the emphasis on trade with Asia. Trade with the rest of the world is hit, initially by a sharp United States slowdown and, later by protectionism as the world breaks up into a series of regional trading blocs. What is of interest about this alternative scenario is that it parallels some recent trends in China. Global trade appears to have lost some of its lustre under the leadership team led by President Hu Jintao (Callick, 2006c). The WTO accession obligations negotiated in November 2001 are seen by the current administration as onerous. Constant US and EU complaints about China’s ‘unfair competition’ continue to rankle, particularly since nearly 60 per cent of Chinese exports emanate from foreign or partly-foreign owned companies operating in China (although by no means all of these companies are owned by US or EU entities). Instead of relying on the WTO trade round, China has sought to engineer trade openings on a bilateral basis, and it has signed trade agreements with a number of nations. Also of interest is that this Western crystal-balling has coincided with what appears to be a reassessment within the Chinese Party leadership of the economic development strategy (Callick, 2006a; de Jonquieres, 2006a, b; Chandler, 2006). For the first time since Deng Xiaping declared that ‘to get rich is glorious’, there are signs that headlong export-led growth may no longer be the main priority. Hu Jintao and Wen Jiabao appear to be more cautious and inward-looking than their predecessors and (like emperors in the past) their primary concern is to cement social stability, not to accelerate reforms and generate structural upheavals that could endanger it. China’s economic future is thus bound up with how it manages ‘the incompatibilities between China’s current political system . . . and the essential requirements of the rule of law, a market economy, and an open society’ (Pei, 2002, p. 99). The central issue is the role of the Chinese Communist Party (CCP). Historically, Communist (Marxist-Leninist) parties have flourished in economies dominated by collective farms and state-owned enterprises (SOEs). The former have been dissolved and Chinese SOEs have declined in economic importance since the reform era began, although they still account for a sizeable proportion of industry output (Chiu and Lewis, 2006). Private and foreign-funded enterprises are growing faster and they constitute an inhospitable environment for the Party apparatus to take root. For this reason, the CCP launched a major recruitment drive in 2002 directed at private businessmen and private companies, which has borne some fruit. Over the past five years, Party membership has expanded by six million to 70.8 million.11 Despite its swelling numbers, for all intent and purposes, the CCP is akin to a church without a religion. Yet the party-state nevertheless has had some success in putting some alternative belief systems in place. One is the

214


language of patriotism. China shares with the United States the belief in its own destiny and place in the world – the Middle Kingdom and God’s own country, respectively – and the regime plays on the need for stability to avoid the upheavals and humiliations of the past. A second is optimism. The CCP has discovered how to instil China with optimism, and uses its control over media outlets to suppress stories of civil unrest. Then, third, there is ‘the daily plebiscite of consumers in the shops’ offered as a substitute for real elections (Story, 2003, p. 7).12 In all of this, the party-state is able to draw upon an underlying well of support. It is given credit for its national role: ‘it is guiding China to great-power status’ (The Economist, 2005, p. 18). How deep this well of support runs depends in large part upon how well the regime does in addressing China’s other governance issues. These are outlined below. Rural imbalance Most agriculture is run by individual farmers who work tiny plots of land, often with little mechanical aid. But they are subject to state predation by local officials and carry an onerous tax burden. Such is the imbalance between China’s prosperous areas and the rural parts, and the government’s fear that it could threaten stability, that the Party unveiled measures in 2004 aimed at redressing farmers’ complaints and providing tax relief, while offering subsidies and encouragement for industries to locate in the poorer regions. Alienation Farmers are not the only ones who are disenchanted. Much resentment is fuelled by the seizure of houses and land, with little compensation, by local officials in cahoots with property developers. The urban poor and dispossessed, like the farmers who migrate from the countryside to join them in increasing numbers, seem alienated from their country’s economic transformation. In 2005, there were 87 000 demonstrations and other protests around the country, a tenfold increase since 1993 (Callick, 2006d). Paradoxically for an authoritarian state, central authorities find it difficult to rein in headstrong local and provincial governments. Ironically, this impotence is a legacy of Mao Zedong’s omnipotence. ‘His violent swings in policy left the legacy of a weakened central bureaucracy and a country organized along territorial lines with well-entrenched provincial governments’ (Chiu and Lewis, 2006, p. 29). Environmental degradation This problem poses a severe threat to China’s continued economic growth. One third of China suffers from severe soil erosion, 80 per cent of the


215

country’s lakes and about one half of its rivers have been polluted, five of the ten most polluted cities worldwide are in China, acid rain falls on one-third of the country and 80 per cent of the rubbish in cities is treated in an environmentally unsustainable way (Pei, 2002; McCarthy, 2005). It has been estimated that environmental damage cost China the equivalent of 3 per cent of national output in 2004 (The Australian, 9-10 September 2006, p. 36). Unfinished enterprise reforms After nearly 30 years of reforms and vast institutional changes, the financial system remains largely as it began, dominated by banks, dominated by state banks, dominated by lending to SOEs and saddled with non-performing loans. A programme of recapitalization, strategic foreign investments and corporatization is well under way, but this remains work in progress. Much the same is true of the SOEs themselves. They have been merged, combined into enterprise groups, corporatized, and partially privatized. But many of them continue to lose money. SOEs’ sizeable demand on the banks (they absorb about three-quarters of bank credit) undermines an already weakened state banking system, and crowds out access to credit by private sector firms. By spilling over to the financial and fiscal sectors in terms of bank loans and fiscal outlays, China’s SOE problem jeopardizes other important elements of the government’s economic reform programme. Macroeconomic structures On the macro front there is also unfinished business. The PBOC, the central bank, has been drastically re-organized geographically and administratively to enable it to concentrate on monetary policy. By Chinese standards it has a high degree of independence, but it is still answerable to the State Council. PBOC officials call this ‘relative’ or ‘partial’ independence. China’s exchange rate system, administered by the PBOC, has been detached from its de facto peg to the US dollar, but remains tightly managed. Capital controls remain tight, limiting speculation and enabling the large trade surpluses, combined with capital inflows, to boost international reserves while at least limiting monetary growth. Savings and investment is unbalanced. Investment at 40–45 per cent of GDP is very high by any standards, but saving at one half of GDP is even higher, with the difference representing the macroeconomic counterpart to the large trade surpluses (see Figure 8.1). Much of the investment is undertaken by the SOEs using cheap bank credit, indicating the close interconnection between enterprise reforms and the macroeconomy. How long can this macroeconomic position be sustained? How long can the managed exchange rate and tight capital account controls be sustained?

216


10.0

55.0

(as a % of GDP)

50.0

Saving* (RHS) 7.5

45.0 40.0

5.0

Investment (RHS)

35.0 30.0

2.5

25.0 20.0

0.0

Current account balance (LHS)

15.0 10.0

–2.5

5.0 –5.0 1985

0.0 1990

1995

2000

2005

Sources: People’s Bank of China; authors’ calculations *National saving rate calculated by residual; Reuters Ecowin Pro.

Figure 8.1 Chinese gross savings, investment and current account balance, 1985–2006 (as a % of GDP) Will China sign on to the American-inspired agenda of faster financial liberalization and market-led reforms to the financial system? There are those such as Prasad and Rajan (2006) who argue that the cautious, incremental and experimental reforms that have marked the past decades are no longer enough, and that a bolder approach is needed.13 Are they right? These are some issues taken up in the next section.

CHINA’S EXCHANGE RATE In Chapter 2 we discussed the yuan–US dollar link at some length. Introduced in the context of the Asian financial crisis, the de facto peg to the US dollar served China’s neighbours well by enabling the countries of East Asia (Taiwan POC, Republic of Korea, Singapore, Thailand, Philippines and Indonesia) to increase their competitiveness vis-à-vis Chinese exporters and Hong Kong SAR. Since then the fixed or relatively fixed link has served the United States and the rest of the world well by allowing ‘the China price’ to be reflected in low inflation on a global basis, rather than having the high rate of labour productivity put sustained upward pressure on the yuan. Few worried when the yuan was over-valued. Now that there is general agreement that the renminbi is undervalued, there is concern. The precise extent of the misalignment remains difficult to quantify. The basic problem

217


is that the pace of Chinese reserve accumulation by itself does not constitute clear evidence of a substantial undervaluation of the renminbi. As Prasad (2005) notes: ‘speculative inflows tend to feed on themselves and may sometimes bear little relation to macroeconomic fundamentals’ (p. 45). In order to make some sense of the numbers we need to disaggregate the foreign reserves build-up. By definition: current accountcapital account current account(private capital inflow private capital outflow) change in FX reserves

(8.1)

(8.2)

Rearranging and disaggregating further we obtain: change in FX reserves current account net FDI net portfolio inflows ‘errors and omissions’

(8.3)

Table 8.2 shows the resulting disaggregation. In 2003–2004, the Prasad qualification seems apposite. The ‘errors and omissions’ term is the residual balancing item in the external accounts that, by definition, captures unrecorded flows. The sum of this category combined with net portfolio Table 8.2 Decomposition of Chinese foreign exchange reserve buildup, 2002–2006 (US$ billion, per cent of GDP)

Change in FX reserves ($bn) Current account balance ($bn) Capital account balance ($bn) of which net FDI ($bn) Errors and omissions net ($bn) Non-FDI capital account inc. ‘errors and omissions’ ($bn)

2002

2003

2004

2005

74.2 (5.1) 35.4 (2.4) 32.3 (2.2) 46.8 (3.2) 7.8 (0.5) 6.7 (0.5)

116.8 (7.1) 45.9 (2.8) 52.8 (3.2) 47.2 (2.9) 18.4 (1.1) 24.0 (1.5)

206.7 (10.7) 68.7 (3.6) 110.7 (5.7) 53.1 (2.8) 27.0 (1.4) 84.6 (4.4)

208.9 (9.2) 160.8 (7.1) 58.9 (2.6) 67.8 (3.0) 16.8 (0.7) 25.7 (1.1)

Source: State Administration of Foreign Exchange; authors’ calculations.

2006 247.5 (9.2) 249.9 (9.3) 6.0 (0.2) 60.3 (2.2) 12.9 (0.5) 67.1 (2.5)

218


250

(US$ billion)

200

Reserve accumulation

Current account balance

150 100 Net FDI

50 0 –50

Non-FDI capital inflows plus errors and omissions

–100 1996

1998

2000

2002

2004

2006

Sources: People’s Bank of China; authors’ calculations; Reuters Ecowin Pro.

Figure 8.2 Composition of Chinese foreign exchange reserve accumulation, 1995–2006 (US$ billion) inflows can therefore usefully be thought of as capturing so-called ‘hot money’ flows. There was a sharp swing in the sum of errors and omissions and the non-FDI capital account, suggesting ‘hot money’ probably speculating on a sizeable RMB appreciation. In 2005 this pattern changed and the current account surplus in 2006 reached $250 billion (see Figure 8.2). This change-around from 2001 is even more remarkable given that China, like the United States, is a large oil importer and its oil bill has obviously risen in recent years. As a share of GDP, the non-oil current account surplus of 5.2 per cent of GDP in 2004 expanded to 9.1 per cent of GDP in 2005 (Figure 8.3). These developments gathered pace in 2006, and the non-oil current account surplus approached 12 per cent of GDP. The IMF in its assessment of the Chinese economy that was made in May 2006 noted that: it is especially difficult to . . . explain the doubling of the surplus in relation to GDP in 2005 and that would suggest that the surplus at its present level could be considered to be a new ‘normal’ level of the saving-investment balance for China. (IMF 2006c, p. 17)

On these grounds, the case for the renminbi being undervalued in real terms is compelling, although precise quantification is complicated by the need to take into account the removal of export rebates. The rebates were introduced in 1985 to encourage export growth and were increased in the late 1990s to compensate for the impact that the depreciating values of the cur-

219

China and the United States 12 (as a % of GDP) 10 8 6 4 2 0 1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Sources: People’s Bank of China; authors’ calculations; Reuters Ecowin Pro.

Figure 8.3 Chinese ex-oil current account balance, 1995–2006 (as a % of GDP) rencies of China’s regional competitors were having on the Chinese economy. Since 2003 the rebates have been trimmed several times and abolished for some products. According to local ‘experts’ quoted by Xinhua, the official news agency, the reduction of the rebates amounted to an effective revaluation of the yuan to 7.7 to the dollar at the end of 2005 (or 4.6 per cent). Export rebates were further cut by about 2 per cent in July 2006 in industries that were ‘energy-consuming and resource intensive’. This reduction was aimed at rebalancing the economic structure, restraining economic growth, and reducing over-investment in heavy industry (The Australian, 25 July 2006, p. 24). Xinhua saw this latest move as easing pressures to revalue the yuan, but the agency was mistaken if it thought that the change would diminish foreign pressure for revaluation. Earlier we doubted whether a larger revaluation of the yuan would do much to correct the US external deficit. It may reduce China’s exports to the United States, but not do much for the overall US current account deficit unless the deficit could be seen as a bilateral trade imbalance peculiar to China or as a specific consequence of China’s reserve accumulation and acquisition of US Treasury bonds. Otherwise, in a multilateral trading world, US purchases of Chinese computers and electronics ($50 billion), phones and audio ($29 billion), toys, tools and luggage ($28 billion), clothes and textiles ($26 billion), shoes and leather goods ($18 billion), appliances and electric goods ($17 billion) and furniture ($13 billion)14 would likely be replaced by purchases of much the same goods (or even different goods)

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from India, Mexico, South East Asia or elsewhere, and some country other than China would end up holding the dollar securities. Put somewhat differently, from a macroeconomic perspective, the key issue is that the United States relies on foreign saving to finance investments that cannot be met from the domestic savings pool, not that the saving comes from China. We should be concerned with the overall trade deficit rather than bilateral trade balances. If the United States did not obtain capital from China as a result of the exchange rate peg, it would have to get the funds from other countries (or otherwise alter spending propensities). A Chinese revaluation would do little to alter this position. As one example, ex-China Asia Pacific countries have reduced their external imbalances since 2004, that these have been replaced by another set of imbalances with the oil exporting countries. In any case, it is not within the province of the United States to determine the nature of China’s exchange rate regime and the level of its currency. The last time the United States intervened in such a way was in the mid-1980s when it talked Japan into lowering interest rates in order to provide a soft landing for the dollar, which had risen to high levels under Reaganomics. The result was the crippling of the Japanese economy. Japan dutifully lowered interest rates, but the lower rates sparked an asset price boom in equities and real estate that burst in the early 1990s, resulting in a lost decade of no growth and deflation. Presumably this particular lesson from history has not been lost on the Chinese. Consequently, we concur with Jeffrey Frankel that the urgings of American politicians are often a political response to ill-informed (if perhaps understandable) domestic concerns about the causes of US trade deficits. More fundamentally, there is an important principle involved. Any country is free to choose to peg its currency if it wishes. Thus, allegations of ‘illegal exchange rate manipulation’ are inappropriate. It is not even true that an appreciation of the renminbi against the dollar would have an immediately noticeable effect on the overall US trade deficit, and still less on employment . . . . . . But, in any case, the first order of business for China should be to determine what policy is in its own interest. (2006, p. 248)

Frankel goes on to argue that, although an exchange rate that is de facto fixed has served China well over the last decade, the time has probably come to allow the yuan to appreciate. His recommendation is based on four major reasons. First, most calculations suggest that the real value of the renminbi is (and has been for some time) low, not just in comparison to the US dollar or the currencies of other developed countries, but substantially below the equi-


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librium value for a country at China’s stage of development. Goldstein and Lardy (2006) put estimates of the extent of under-valuation of the yuan in the 20–40 per cent range. Note that this is not because of currency ‘manipulation’. China has maintained (until 2005) the same currency link in nominal terms. The real value has changed because Chinese productivity has increased much faster than that of its major trading partners. Second, China’s large trade surplus, combined with capital inflows, has led to a rapid accumulation of foreign reserves. Although foreign exchange reserves are a useful protection against currency crises, China’s balance of payments surpluses have been so large that its level of reserve holdings in 2006 passed those of Japan and at end March 2007 were a massive $1.2 trillion. While the benefits of repelling a speculative currency attack and avoiding a currency crisis are substantial, China is currently forgoing a lot of income when it buys low-return US Treasury securities with the proceeds it raises from high-return inward investments. Third, China has had to engage in substantial sterilization policies in order to prevent the balance of payments surpluses from spilling over to domestic markets. These policies are outlined by Yu (2006). In the early reform years, sterilization involved the discount window. From the middle of the 1990s large-scale open market operations were conducted, with the PBOC absorbing increases in reserves by selling government bonds from its portfolio. Since 2003, the task has got so large that the PBOC found it necessary to create a new financial instrument – central bank bills – to mop upon liquidity in the banking system. The idea is that any accretion to bankers’ excess reserves at the PBOC, resulting from the PBOC’s acquisition of foreign exchange, be replaced by central bank bills. In reality, the difficulty of rolling over bill issues has meant that the sterilization has been partial, and the monetary base at times has expanded much faster than the PBOC has wanted. In 2006, the PBOC supplemented the issue of central bank bills when it raised interest rates slightly and made two calls to banks’ required reserves by increasing the required reserve ratio. In theory, so long as the interest rates paid by the central bank on its bills are lower than corresponding interest rates on US assets, say, the yields of Treasury bills, the PBOC should be able to carry out full sterilization indefinitely, and hence maintain effective control of the monetary base. However, there are several obstacles to full sterilization. One is that the sale of central bank bills tends to push up interest rates in markets, which in turn will invite more capital inflows and place more pressures on the RMB and hence the need for more sterilization. A second is that, when there are better options, commercial banks may refuse to buy the low yielding central bank bills. As a result, the yields of the central bank bills will be bid up and the PBOC may suffer operational losses, if the changes in US interest rates

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are unfavourable. Finally, if commercial banks buy the bills (perhaps preferring that to an increase in required reserves), there will be a negative impact on the banking system as a result of lower earnings or on the return that depositors receive on their bank accounts (Yu, 2006). Fourth, Frankel argues that the time is right for a change. A strategy that continues to exclude currency appreciation from the policy response mix will become increasingly difficult to sustain. The experience of other emerging markets suggest that it is better to exit from an exchange rate peg when times are good and the currency is strong, than to wait until times are bad and be forced to do so when the currency is under attack. Also, most fixed rate systems or currency board-type arrangements are for small countries. A country as large as China probably needs an exchange rate system with some flexibility, and now is a good time to begin moving in that direction. Nicholas Lardy (2006) of the Institute of International Economics has also argued that China’s investment and export-led development strategy has reached the point of diminishing returns, identifying five key factors. First, at over 40 per cent of GDP, the rapid pace of investment is producing excess capacity in a number of key industries, such as steel, where China’s excess capacity of 120 million tonnes dwarfs the 122.5 million tonnes produced by the world’s second largest supplier, Japan. Second, declining corporate profitability in such key sectors threatens to unravel the progress made in repairing the balance sheets of many state-owned banks and creating a more commercially orientated banking system.15 Third, the focus on investment and net exports has impeded growth in personal consumption, which dropped to below 40 per cent of GDP in 2005, a fall of over 10 percentage points of GDP since 1980 when China’s reform process got under way (IMF, 2006c). Fourth, an unwelcome by-product of the investment-driven growth is the disproportionate expansion in China’s energy demands, greatly adding to the pressure on the environment mentioned earlier in this chapter. Fifth, China’s increasing reliance on net exports intensifies the risk of a protectionist backlash from the United States. As discussed in Chapter 2, China narrowly avoided being branded a ‘currency manipulator’ and having punitive import tariffs imposed on its goods by the United States Treasury in May 2006, which may prove simply a temporary reprieve. Lardy’s prescription for the Chinese economy is straightforward: fiscal stimulus, preferably by increasing government consumption expenditure on health, education and welfare but also greater exchange flexibility allowing the yuan to appreciate and in turn freeing domestic interest rates to curb investment spending. Frankel arrives at a similar conclusion, using a variant of the famous Swan-diagram (but with most un-Swanlike axes) to underline the importance of exchange rate flexibility to rebalancing the

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ZONE I IN

EX

TE

R

ZONE IV

ZONE II

COST RATIO (R)

AL

RN

TE

C

BALANCE

B

BA

D NC E

LA

L NA ZONE III

A

REAL EXPENDITURE (E)

Notes: Zone I: Over-full employment and balance of payments surplus. Zone II: Under-full employment and balance of payments surplus. Zone III: Under-full employment and balance of payments deficit. Zone IV: Over-full employment and balance of payments deficit. Source: Based on Swan (1955 [1963]).

Figure 8.4

Representation of internal and external balance

Chinese economy. Swan’s original axes are shown in Figure 8.4, with the cost ratio (eP*/p), or real exchange rate (R) on the vertical axis, and real expenditures (E) on the horizontal axis. Any combination of E and R along A gives internal balance, while any combination of E and R along B represents external balance. Only at the point of intersection do we have both internal and external balance. For any other combinations there are four zones of ‘economic unhappiness’ (Swan, 1955). The main message of the framework, in the words of Harry Johnson (1958 [1962]), is that ‘in order to achieve the two objectives of policy, internal and external balance, it is necessary to use two policy instruments, control of aggregate demand and some sort of switch instrument’ (p. 21). Expenditure-changing policies involve monetary policy (interest rates) and fiscal policy. Expenditure-switching policies (involving the real exchange rate) aim to switch expenditures between home-produced goods and foreign-produced goods. Note that because the nominal exchange rate, e, in the cost ratio is defined as the number of domestic currency units per unit

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of foreign currency, an increase in e represents depreciation and a lower e appreciation. China as of 2006 might be seen as occupying zone I with a combination of balance of payments (and trade) surplus and excess demand or overheating in the economy, say point C. The mere facts of the employment position and balance of payments can identify the zone, but not the quadrant. Without more precise information, it is not possible to know what direction of movement in the interest rate and fiscal expenditures is entailed by the optimal combination of adjustment in the two instruments. It depends in what quadrant China lies. However, there is no ambiguity about the cost ratio. The direction of movement called for in the real exchange rate is clearly downward, i.e. real appreciation if it wishes to attain internal and external balance. Thus, for China, the currency question is not a case of buckling under American pressure. China’s own economic policy interests would seemingly be served by allowing the value of the yuan to rise. By the same token there is also a message for the United States. If Chairman Bernanke remains concerned about inflation (as reported in The Australian, 6 October 2006, p. 20), then the United States would seem to be in zone IV, overheating and with a trade deficit. Again, without further information we do not know what quadrant the US economy occupies, and thus what direction of movement is required for the US dollar. If it is a depreciation, then the US economy might be represented by a position such as D. In these circumstances, the movement of the other instrument would seem to be unambiguous. Correction calls for a reduction in absorption, that is, an expenditure-reducing programme. If a revaluation of the yuan is good medicine for China, an expenditurereducing policy might be good for America. Indeed, there are those such as The Economist who consider that a US recession would be ‘cathartic’. Their argument is quoted at some length. The internationalists have long feared that a recession might lie ahead should foreigners abruptly abandon the dollar. The prospect of a more conventional downturn – engineered not by foreign central banks, but by America’s own – suggests the cart and horse belong in a different order. A recession might bring about a reversal of the current account deficit, rather than the other way around. In principle, current account deficits can be closed without a slowdown in production. America’s gross domestic purchases of its own and foreign goods are currently running at about 106 per cent of gross domestic product. In other words, there is enough domestic demand to buy all of America’s output and more. In principle, these purchases could fall by six percentage points of GDP, eliminating the deficit, without anyone in America needing to fall out of work. America would not suffer a recession. But it would feel like one: every man, woman and child would have to curtail their spending by $2,600 a year.


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Without import tariffs, however, it is not possible to curb consumers’ purchases of foreign goods without slowing their purchases of everything else too. When domestic demand falls, it tends to decline across the board. In some models, such as the one offered by Maurice Obstfeld, at Berkeley, and Kenneth Rogoff, of Harvard University, the price of non-tradable goods falls by however much is necessary to clear the market and keep everyone at work, producing an undiminished amount of traded and non-traded goods In reality, however, America’s deficit is unlikely to close without its industrial structure changing substantially. Only about a quarter of what it now produces can be sold across borders. Andrew Tilton of Goldman Sachs has calculated that to boost exports and narrow its deficit to 2.5 per cent of GDP by 2010, America would need to increase its manufacturing capacity by about 17 per cent. But until this year, it was housing, a non-traded good par excellence, which has attracted extra labour and capital. Might a recession do for housing what it did for late-l9th-century railways? . . . [Then] recessions, however unpleasant, were cathartic, and therefore necessary. They released capital and labour from profitless activities (such as laying the year’s 6,000th mile of track) as an essential prelude to redeploying them elsewhere. . . . Recession is not inevitable. But if a 2007 slowdown curbs inflation, narrows the trade deficit and clears space for an American manufacturing revival it will prove a surprisingly fruitful period of dearth. (2006d, p. 64)

However valuable such a shake-out may be for the US economy, it is not recommended. In Chapter 3 we noted Martin Wolf’s (2006a) estimate that a reduction in the US trade deficit from 7 to 4 per cent of GDP represents around 10 per cent of demand for tradables. With no alteration to relative prices, overall demand in the economy would need to fall by about 10 per cent to generate the desired reduction in the trade deficit. This would create a fall of about 7 per cent in GDP, all of which would fall upon industries producing non-tradables. It would be much better for the world economy for the United States to combine ‘expenditure-switching’ and ‘expenditure changing’ adjustments. Given the unprecedented mismatch between savings and investment in both the US and China, exchange rate swings would appear an essential part of the policy ‘tool kit’ and a key lubricant to the eventual rebalancing that must ultimately take place in both economies. This is the message of the Swan diagram.

THE DIRECTION OF CHINA’S REFORMS Based on analyses such as that in the preceding section, a conventional wisdom or orthodoxy about the direction of Chinese economic policy has emerged. As evidence on both the renminbi’s likely overvaluation and the diminishing returns from the current development strategy has mounted,

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there is a general expectation that China will loosen its ties upon the renminbi, further relax capital controls thus gaining the greater monetary policy independence required to rebalance the economy. As Prasad and Rajan argue: by how much, the renminbi is undervalued may not be the right way to frame the main issue about China’s exchange rate regime. What is essential is that China introduce greater flexibility in its exchange rate, which would give it a more independent monetary policy and also allow the exchange rate to play a role in correcting external imbalances. It would also remove one of the hindrances to banking reform, since a fixed exchange rate reduces the central bank’s ability to use market instruments such as interest rates to guide credit growth, and instead perpetuates a reliance on administrative measures, vitiating efforts to make the banking system more commercially oriented. (2006, p. 333)

However, China has surprised before, and it may do so again. It defied conventional wisdom when it adopted a gradualist, piecemeal approach to reform, rather than ‘big bang’, and it may yet defy conventional wisdom on the exchange rate issue. Ronald McKinnon and Robert Mundell have, in fact, argued the case for greater, not less, fixity. McKinnon (2006) sees the danger of China, like Japan, being stuck in a liquidity trap under floating rates. With the yuan/dollar rate flexible, the interest rate risk premium on yuan vis-à-vis dollar securities would cease to be non-zero (or close to it). If portfolio equilibrium requires the interest rate on renminbi assets to be less than dollar assets, China may be stuck in a zero-interest liquidity trap, unable to lower nominal interest rates sufficiently. McKinnon concludes that for countries like China, on the periphery of the dollar standard, pressure to appreciate their currencies is ‘misplaced’. The solution is ‘to credibly fix the central yuan/dollar rate into the indefinite future’ (2006, p. 431). Robert Mundell strongly disagrees with global pressure to force China to appreciate its currency, insisting that a large yuan appreciation would not help resolve global current account imbalances, but would devastate China, causing drastic deflation, impoverishing the rural sector, and cutting its growth rate by as much as half. Instead, he hopes China will keep its exchange rate fixed to the dollar while continuing to move toward currency convertibility (Wallace, 2006). China’s huge buildup of foreign exchange reserves was seen as a more legitimate concern, but Mundell considers that this problem is one best solved by more Chinese investments abroad and more Chinese consumption of imports (as reported in Callick, 2006a). Mundell’s advice in particular coincided with a rethinking of China’s development strategy, as reflected in a number of policy outlets. For example, an article by State Council economist Guo Yanying in China


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Economist, produced by the Chinese Academy of Social Sciences, urges the country to abandon its export-oriented model of growth. Instead of indiscriminately embracing all foreign investors, foreign investment that brings low efficiency or even negative results should be discouraged. He considers that it is time to change China’s role in the sweatshop of the international division of work. Instead, China should nurture a contingent of large transnational enterprise groups that can make strategic investments overseas. Similarly, Lu Daodao, an economist with the Chinese Academy of Sciences, argued that a high proportion of foreign investment is in the export sector, and most exports earn more profits for foreign than for Chinese firms. Consequently, the view increasingly is expressed that reining in new investment may not really harm China (Fortune, 23 October 2006, pp. 15–7). An alternative economic development strategy is thus being talked about in which the emphasis is squarely upon raising national self-sufficiency. The main elements are: first, to use the vast holdings of foreign reserves to buy strategic stakes overseas in energy and minerals to secure future access to these resources; second, to tighten up the rules on foreign investment to prevent over-investment in property and other such investments; third, reduce savings to allow the ‘weak donkey’ of consumption to catch up with the ‘strong horses’ of trade and investment; and fourth, to retain a relatively fixed, and heavily managed exchange rate to facilitate trade and provide a nominal anchor for inflation. Capital controls may actually be tightened to prevent speculative attacks. Such a path incorporates key elements of the emerging ‘Occidental’ conventional wisdom (the need to boost consumption) but is clearly very different. Any intensification of protectionist pressure from the United States may ironically make this path more attractive. One merit of this scenario is that it builds on Chinese unwillingness to increase the value of the renminbi sharply, on a number of scores. First, such an exchange rate alteration would result in large capital losses on China’s considerable holdings of dollar assets. Second, it would present those who speculated on a yuan appreciation with large gains, and China is politically, culturally and economically opposed to rewarding those who speculated against Chinese policy. Third, this last point is reinforced by the observation of Fan Gang, director of the National Economic Research Institute, that: a rapid revaluation [of the yuan], pricing China’s exporters out of the market, would hit Chinese farmers and immigrant workers hard as many low-wage jobs would disappear. (cited in Callick, 2006f)

A policy change that simultaneously impoverished villagers and rewarded wealthy speculators would be harmful to social stability.

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Admittedly, any retention of a relatively fixed exchange rate might see China’s foreign reserves continue to rise. However, this build-up cannot be viewed solely in economic terms. True, the world’s largest reserve holding is an indisputable indicator of China’s economic resurgence, but the reserves are also a bargaining chip in any showdown with the United States over trade. It is in this context that the now $1.2 trillion reserves (75 per cent in dollars) might be thought by China’s leaders to provide a hold over the United States that Washington cannot ignore. As one journalist puts it: China lends the US the money it needs to buy Chinese products. This enables the US to manage its massive current account and budget deficits, and holds down its interest rate. China gets the jobs, the US gets the goods – and the wars it might not otherwise be able to afford. (Callick, 2006f, p. 35)

We do not know which of these alternative approaches to the exchange rate and development strategy will win the day. There is now much support within China for greater exchange rate flexibility, along with pressure for change not only from the United States administration (and Congress) but also from Europe. But then China’s managed exchange rate system has some powerful friends in North American academia. Will there be an opening up or a ‘great leap inwards’? The answer can only be that time will tell.16

NOTES 1. 2. 3.

4. 5. 6.

7. 8.

Their answer was yes and yes. As reported in Fishman (2005, p. 17). The title is borrowed from Chapter 11 of Fishman (2005) entitled ‘The China century’, although it also follows an earlier special issue of Foreign Affairs, November/December 1993 called ‘The Pacific century?’, the centrepiece of which was an article on ‘China’s rise’ (Kristof, 1993). Although, according to the (strongly anti-Mao) account of Chang and Halliday (2005), Mao Zedong and a few other leaders were carried most of the way. Hence the sobriquet Taiwan POC (Province of China). China has become North Korea’s lifeline for oil and food and provides $1.3 billion annually in aid (Callick, 2006b). It accounted for 53 per cent of North Korea’s $2.1 billion of imports (including oil, pork, electronics and farming machinery) and purchased $500 billion of North Korean exports (fish and minerals). Most of the goods are trucked across Friendship Bridge at Dandong, the main link across the Yalu River that forms part of the 1400-km border between the two countries. While America and China may agree that North Korea is a threat, there are different perspectives. Disarming North Korea is the United States’ major goal. China does not want North Korea to collapse and unleash a rash of refugees into China. China’s administrative apparatus is complex because of the duality of Party and government. The central organs of the Chinese Communist Party (CCP) make the most important economic policy decisions. These decisions are then translated into the objectives to be pursued by the State Council and are implemented by the various


9. 10.

11. 12.

13.

14. 15.

16.

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commissions and ministries of the central government and through them by the provincial and lower levels of government. The Economic and Finance Leading Group is usually chaired by the holder of the position of General Secretary of the CCP and President. This Group, which determines China’s economic and financial policies, includes members from several government commissions and ministries, but stands above the State Council and any commission or ministry. President Hu Jintao, as Party chief, is the undisputed No. 1, and his power is reinforced by chairing the Military Commission that cements the Party’s enmeshment with the PLA. The National People’s Congress is the highest law-making body (China’s version of a parliament), which usually meets annually in March. Its chairman, Wu Banzzuo, is technically No. 2 in the hierarchy, but Premier Wen Jiabao in practice holds more sway. As Premier, he chairs the State Council. The State Council, established under the National People’s Congress, serves as the executive branch of the State, and undertakes the regular work of government, coordinating the various commissions and ministries of the State and overseeing the work of all agencies in the state bureaucracy. See Chiu and Lewis (2006, pp. 27–9). As reported in The Economist (2005). ‘I have listened to both sides of this debate. Here is what I think. I think those who call for a fixed exchange rate are right in the short run. And those who call for a floating exchange rate are right in the long run. How long is the short run, you ask? You must understand. China is 8000 years old. So when I say, short run, it could be 100 years.’ – Li Ruogu, Deputy Governor, People’s Bank of China, Dalian, May 2004, as paraphrased by Frankel (2006). Of the Rupert Hoogework 2006 list of China’s Rich 100, 38 are members of either the National People’s Congress or the Chinese People’s Political Consultative Congress (Callick, 2006e). One television commentator put it this way. After Tiananmen Square in 1989, the Chinese people metaphorically were put in a room with two exits, one door marked Politics and the other Economics. If they took the Political route, they could expect the full might of the regime in opposition. If they took the Economic one, they were offered riches and relative economic freedom. Most have taken the latter, with the promise fulfilled for the urban middle class. One consideration prompting their prescription is that between one-half and two-thirds of China’s economy is accounted for by the private sector. Chiu and Lewis (2006) suggest the lower end of this range is probably correct. Huang (2008), on a somewhat different basis, consider that only 14 per cent of fixed assets are in private hands. Figures in brackets are the value of US purchases from China of the various categories of goods in 2005. These goods add to $181 billion. Total US imports from China in that year were $243 billion (Business Week, 25 September 2006, p. 52). Brad Setser agrees, noting that ‘Chinese banks have financed too much capacity, chasing too little demand – excess capacity that will eventually give rise to a new generation of bad loans’ (Setser, 2006, p. 365). See also Chiu and Lewis (2006, Chapter 7) for a detailed analysis of the resolution of Chinese banks’ bad debt problems. As of May 2007, the message remains mixed. In order to placate American trade pressure, the Chinese authorities agreed on a package of concessions that included introducing export tariffs on 142 items, lowering import tariffs on 209 items, spending $5.3 billion on goods from US firms, lifting interest rates and reserve requirements, and allowing the yuan to fluctuate against the US dollar by 0.5 per cent rather than 0.3 per cent (The Australian, May 21, 2007, p. 31). However, China has also changed its overseas investment strategy, establishing the China Investment Corporation to manage $300 billion of its reserves in a more profitable way, while buying a 10 per cent non-voting equity stake in Blackstone group, the world’s largest private equity firm (ibid, p. 24).

9.

Conclusion

A REVIEW OF OUR APPROACH There is no single cause of the US current account deficit and no single solution. More so than for any other country, the US external deficit is the result of the economic (and even political) decisions of a vast multitude of transactors, both government and private, engaged in buying and selling goods, earning and spending, saving and investing, and building and rearranging their wealth. It will change, if at all, when those decisions are revised in response to different economic signals, rising wealth and indebtedness, and ever more concentrated and unbalanced portfolios. Alternatively, governments individually or in unison may agree to take corrective actions. From the outset we made clear that this book was not designed to be a polemic, directed to expounding one particular viewpoint. We had no particular barrow to push, nor did we start with a strong set of priors (although we did have some preconceptions not all of which turned out on closer examination to be vindicated). Rather, our aim has been to canvass, and evaluate, a wide range of hypotheses as to, first, the origins and sources of the deficit, second, its sustainability, and third, the urgency of corrective action and the consequences of doing nothing. We have come to some conclusions in the process of this investigation, but begin with a brief review of what has been done in earlier chapters. In the first chapter we provided some bullet points detailing the extent of the US current account deficit and highlighting some of its unusual features, most notably that, despite absorbing so much of the world’s savings, there has been no apparent urgency on either the lending side (the surplus countries) or the borrowing side (e.g. the United States) for the situation to change. This chapter also set out the basic framework and themes that run through the volume, by which the various explanations of the deficit are grouped under four approaches (trade, absorption, savings–investment, portfolio balance) and two dimensions (domestic and international). Table 9.1 provides a schematic of the various explanations covered under the 4 2 matrix. The trade approach, examined in Chapter 2, focuses on imports and exports of goods and services (since other current transfer and income flows roughly balance out) and the financing implications in terms of 230

Conclusion

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capital flows. From this perspective, the prognosis for the United States does not look promising. Imports are now over 80 per cent larger than exports, and the financing requirement expanded to $811 billion in 2006. Add to this position the econometric estimates of ‘elasticity pessimism’, the Houthhaker–Magee income asymmetry, the significant trade deficit in petroleum, and the slipping US share of world exports, and it would seem that the United States is indeed ‘doomed to deficits’ (Chinn, 2005), although we regard this assessment as much too gloomy. At the same time, from an international perspective, the favoured culprit in all of this, China, can on our assessment be largely excused of blame. Its relatively fixed exchange rate link to the US dollar has brought a reduction in inflation and other benefits for America (and the rest of the world), while we doubt that an appreciation of the yuan would do much to correct the US trade deficit. However, our major conclusion is that the trade approach offers much too narrow a prism through which to view the many influences upon the US current account deficit. For example, the implicit assumption that the current account of the balance of payments commands and the capital account obeys may have made some sense in the early post-Second World War era but is not descriptive of the world today. Chapter 3 thus broadened the analysis to include the portfolio balance approach to capital flows, while using the national income and production accounts to show how an imbalance between total domestic demand for goods and services and domestic production or, equivalently, between domestic investment and domestic savings, gives rise to net imports or net exports of goods and services to fill the gap. Arithmetically speaking, from a domestic perspective, one popular explanation, the government budget deficit, based on the ‘twin deficits’ argument (fiscal and current account deficits), may have been a factor from 1990 through to 2001, but would appear to have since declined in relative importance. Its place has been taken, again arithmetically speaking, by a rapid, and unprecedentedly large, increase in the household financial deficit, contributing to excess absorption and a savings–investment imbalance. The factors behind this development that we considered included easy money, the asymmetric policy responses of the Federal Reserve, revisions to risk premiums, the ‘conundrum’ of long-term interest rates, the housing ‘bubble’ and rising household net worth. From an international perspective, the US current account deficit may be responding to ‘disabsorption’ overseas, a dearth of investment and glut of world savings, and a strong portfolio shift to US financial markets and dollar assets under globalization. In one way or another, the remaining chapters fill out these themes. Chapter 4 looks at the international factors sketched out in Chapter 3. In the earlier chapter, the international forces were organized under the

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Table 9.1


Summary of explanatory factors for US current account deficit Domestic perspective

International perspective

Trade balance approach

Elasticity pessimism Houthhaker–Magee asymmetry Currency of invoicing (Goldberg and Tille) Reduced exchange rate pass through Terms of trade of capital goods Declining share of world exports ‘Hollowing out’ of US industry

Mercantilist trade policies in Asia Undervalued exchange rates (yen, renminbi) ‘Unfair competition’ from China Variation in range and quality of foreign products ‘International vendor finance’ (Summers) ‘Co-dependency’ of trade (Mann)

Absorption approach

‘Testing the economy’s speed limits’ Asymmetric monetary policy responses (‘ride the boom, cushion the slump’) ‘Deflation-insurance’ policy Long-term interest rate conundrum Fiscal deficit (‘twin deficits’) Consumption of housing wealth

Excess supply of tradable goods in East Asia Underabsorption in Japan and eurozone due to slow growth Low long-term interest rates due to central bank purchases of Treasury bonds (‘international financial balance of terror’)

Savingsinvestment approach

Productivity-driven investment boom (Ferguson) Decline of national savings Widening of household financial deficit

‘Global savings glut’ (Bernanke) ‘Dearth of investment’ (Macfarlane) Demographics of ageing populations in developed countries

Portfolio balance approach

US home bias stronger than other developed countries (Stulz) Home bias increased due to domestic real estate boom

Increased world preference for dollar assets (Obstfeld) Precautionary demand for reserve assets (Feldstein) ‘New Bretton Woods’ (Dooley et al.) The ‘exorbitant privilege’ (Gourinchas and Rey) The ‘world venture capitalist’ (Gourinchas and Rey), or ‘world’s largest hedge fund’

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Conclusion

Table 9.1

(continued) Domestic perspective

International perspective US as world banker (Poole) ‘Hot potato’ and fiat money ‘Empire of debt’ (Bonner and Wiggin) Globalization and reduced home bias (Greenspan) Recycling of oil revenues to dollar assets Financial innovations linking US housing markets to overseas

absorption, savings–investment, and portfolio balance headings. Rather than go over the same ground, we focused in Chapter 4 on five specific hypotheses: the Bernanke thesis, new Bretton Woods, the exorbitant privilege, the somewhat more esoteric and colourful empire of debt, and globalization and home bias. All are found to contain an important kernel of truth but are not, in themselves, able to bear the weight of explaining the US current account deficit. The issue is what weight they are to be accorded, something that became apparent when we reviewed the analysis of The Economist that sought to pit the Bernanke global savings glut argument against that of a global liquidity expansion, fuelled by unusually expansionary monetary policy in the United States and magnified by the build-up in foreign exchange reserves and domestic liquidity in those countries that have tied their currencies to the US dollar. The Economist opts for the excess liquidity explanation rather than excess savings, considering it to be more consistent with the facts, but the framework used is a very simple one and there are many missing ingredients to be accounted for such as subdued inflation and the long-term interest rate conundrum. The excess savings and excess liquidity hypotheses contrasted in Chapter 4 can be seen as essentially cyclical events, due to policy swings in response to a mixture of domestic and international developments (the stock market downturn and September 11 in the United States, real-estate related bank failures and currency crises in Asia). The new Bretton Woods and exorbitant privilege hypotheses are prompted by the observation that, with many countries limiting the movement of their currencies vis-à-vis the US dollar and showing a willingness to accumulate dollar reserve balances, there has been a paradigm shift in exchange rate relationships that has returned large

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parts of the international financial system to conditions resembling the original Bretton Woods system. The empire of debt view is something different again, but essentially takes the paradigm shift idea to another plane, likening US borrowing and surplus countries’ lending to the United States to a form of tribute to sustain (what we would prefer to call) the US hegemony in world affairs. The final hypothesis introduced in Chapter 4 relates to secular trends. Alan Greenspan argues that the US external deficit is the byproduct of long-term forces that are more secular than cyclical, resulting from greater financial integration, globalization and a reduction in home bias. On this account, he sees the US current account deficit as largely benign. Chapter 5 takes up the points raised by Greenspan, but in a different way. The world to which Greenspan alludes is exemplified most completely by an inter-regional payments system, such as that within the United States. California, for instance, may well have had a current account deficit with the rest of the country since 1945 due to its economic and population growth, yet it is of no concern to policy for two reasons. First, individual Californians have got into debt to invest or consume, and they must work things out. They do so by repaying debt out of earnings, by rolling over the loans or, by selling off other assets out of their wealth. Second, if the liabilities issued or assets sold are near perfect substitutes for those of other regions, the transactions might be effected with little change to asset prices. Something like this result might be approximated at a global level if Greenspan is right. If so, it suggests that the issue of the sustainability of a current account deficit needs to be approached from the viewpoint of asset markets and wealth positions. Following on from this conclusion, Chapter 6 dealing with the sustainability of the deficit concentrated on the external balance sheet of the United States. From this perspective, three major puzzles arise. The first is that the US current account deficit has long been in the 4–5 per cent of GDP ‘danger zone’ at which policy adjustment was deemed by some experts to be inevitable, yet the United States has escaped pressure for adjustment and does not bear any obvious cost. This situation is undoubtedly a consequence of the second puzzle which, put simply, is that the United States has for many years actually made money on being a net debtor. Although the position may well change, the investment income ‘riddle’ is why the United States has for so long been able to achieve positive net investment income flows in the face of rising net international indebtedness. On investigation, this ‘financial alchemy’ would seem to derive from asymmetries due to the risk characteristics of the US external balance (‘the world’s largest hedge fund’), the currency composition of the external account (the ‘exorbitant privilege’ again), and the geographic pattern of trade flows and financial assets.

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These findings have an important bearing on some issues raised earlier, particularly ‘elasticity pessimism’ about the role of the exchange rate. Due to the ‘exorbitant privilege’, a falling dollar works through both a ‘trade channel’ and a ‘valuation channel’ with a greater potential role for US dollar depreciation in the adjustment process and with the latter increasingly dominating the former. Importantly, the speed of globalization, and the growth of gross asset positions that has accompanied it, has helpfully magnified these effects in recent years. To some extent, the United States has been fortunate recently with its residents’ overseas investments paying off handsomely while foreigners’ US investments have fared less well. Unlike the current account ‘pessimists’, we make no judgements as to how long this position may hold in view of mounting evidence that a greater portion of demand for US assets is structural rather than cyclical. Finally, a third puzzle considered in Chapter 6 is the net international investment position ‘enigma’. Seemingly, the United States has a magicianlike ability to make debt disappear from its external balance sheet. An astonishing $1.6 trillion vanished from 2002 to 2005. Some of the ‘vanishing debt’ stems from the three asymmetries listed above, but much is apparently unexplained. In order to account for this category (‘statistical manna from heaven’) we were led to explore the existence of ‘dark matter’ and ‘black holes’ in the international financial system. There is clearly something very strange going on with the statistical data of the US balance of payments, and rather than accept some data while rejecting other data series, we moved away from the conventional metrics of current account sustainability to more practical considerations. Instead, sustainability is defined in more practical terms as foreigners’ willingness to hold US dollar claims, and for this reason the attention switched in Chapter 7 to the demand for US assets. Sebastian Edwards’ analysis formed the backdrop to the chapter giving lie to the fact that a sustainable deficit cannot exceed 4 or 5 or some other arbitrary percentage of GDP. Rather, the sustainable level of debt is governed by portfolio decisions and economic growth. On this score, a favourable conjunction of events has underpinned US capital inflows – Asian investments (of which reserve flows are only one component), direct and indirect dollar holdings of oil exporters, and the surpluses of many developed countries. Two factors are identified that are rarely discussed in the literature on the US current account deficit. One is the demographic profile of the United States relative to that of many of the surplus countries. The other relates to the financial innovations that have made US financial markets even more attractive to foreigners and have drawn world savings into the US housing market. Max Corden’s world in which the current account is to a considerable degree driven by the savings and investment decisions of private entities would

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seem to have come to pass. His prescription that these private decisions should not be a matter for public policy concern is now that much more relevant. Nevertheless, public sector behaviour (overseas government reserve accumulation on one side, the US government deficit on the other) remains an important element, and the final section of Chapter 7 considered the US dollar’s future as international money, a role which makes foreigners willing to hold dollar assets and allows US residents the ‘exorbitant privilege’ of borrowing from overseas in their own currency. In our view, the international role of the US dollar is intricately tied up with the position that the United States occupies in the international order, in maintaining secure routes for international trade and stability in the global system which allows countries like India and China to continue their headlong economic development. This conclusion provides the setting for Chapter 8, which examines the China–United States relationship. In the eyes of many Americans, the US current account deficit and its trading imbalance with China are one and the same (although in fact China accounts for only one-quarter of the US trade deficit), while the United States’ ever increasing reliance on capital flows from China to finance the deficit seems symbolic of a Chinese challenge to the United States’ supremacy as a world power. These perceptions are analysed in Chapter 8. At some future date, China might be the next superpower, but it is a long way off, for it is, at present, a second-level economic and military power. To be sure, China wants to restore itself to what it sees as its rightful place in the world order, but in other respects its ambitions do not match those attributed to it. Economic development remains China’s major priority and it appears willing to accede to the US hegemony in world affairs to keep its economy rolling. In any case, its own governance problems, outlined in the chapter, rule out adventurism in global politics if it is to remain on the growth path. Like Jeffrey Frankel we accept that China has the right to choose its own exchange rate system without US prompting. Like him, we also recognize that greater exchange rate flexibility may be in China’s own self-interest. This result is suggested both by the recent behaviour of the Chinese balance of payments and, in terms of the achievement of internal–external balance, by its macroeconomic condition. China is generally expected to acquiesce to US and EU pressures to loosen controls over its exchange rate and liberalize its capital account as first steps towards a floating renminbi. But China may yet surprise and prominent academics such as Robert Mundell and Ronald McKinnon have been urging it to stay the course on fixed rates, advice which if followed may herald a ‘great leap inwards’ away from headlong export-led growth to one of more strategic capital investments. China’s massive international reserves, so puzzling from a purely economic point of view, make more sense when seen in geopolitical terms.

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OUR CONCLUSIONS Having briefly summarized what was done in the book, we now try to pull the threads together and offer some conclusions. A number of issues present themselves for consideration. What are the causes of the US current account deficit? Should it be seen as ‘made in the USA’ or in the rest of the world, and does it matter? Is the US current account deficit sustainable or, more to the point, at what level is the deficit sustainable? Causes of the Deficit Someone once said that the trouble with economics is that ‘everything affects everything’, and that observation seems all too true of the US external deficit. We have endeavoured to give the most comprehensive account to date of the US current account deficit and global imbalances, with a large number of very different hypotheses canvassed. At the risk of being accused of fence sitting, all of the different explanations that we have considered contain a grain of truth and all can be seen to have played some part in the evolution of the US current account deficit. But in our view only some of the explanations can be regarded as providing major impulses. What are these factors and how are they connected? If we accept the rules of engagement laid down by what has probably become the most popular explanation of the US current account deficit, the ‘glut of savings’ or ‘Bernanke view’, we are confronted by the choice between two alternatives: ‘made in the USA’ or ‘made abroad’ (specifically ‘made in Asia’). In effect, is the US payments imbalance ‘made in the USA’ as the product of an increase in spending and decline in the US national saving rate (mainly the household saving rate), which the rest of the world has obligingly financed from its savings. Or, is there a lack of investment opportunities and a surplus of saving in other countries which the United States has been ready to accept and willingly put to work? As we noted before, put in these terms, many people might respond by saying a little of both, a position with which we would not disagree. However, there is another reason why we should not go along with the Bernanke rules of the game. The likely explanations are conditioned by the time period under consideration. Figure 1.1, we recall, shows the US current account balance from 1980–2006, both in billions of dollars and as a percentage of GDP. From being in broad balance in 1980, the deficit first increased to nearly 3.5 per cent of GDP in the mid-1980s before returning to balance in 1990. This was the era when the ‘twin deficits’ idea, of the government budget deficit twinning the current account deficit, was born. And there would seem to be a good reason, for the government

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budget deficit went from around 1 per cent of GDP in 1979 to over 5 per cent in the mid-1980s, a change relative to GDP almost the same as that by which the current account deficit increased. Notably, also, the widening of the US current account deficit that began after 1990 was again associated with a government budget deficit of around 5 per cent of GDP in the 1992–1993 period. This period was also the time when the US household sector financial balance started to fall below its more usual post-war level. It is only after 1997, some six or so years after the US current account deficit began its current trajectory that the ‘glut of savings’ argument enters the picture. July 1997 marks the onset of the Asian financial crisis, and the US external deficit did widen at around this time. Nevertheless, this crisis was not the only event of moment at the time and our assessment is that a mutual interaction (a ‘little of both’) provides a more convincing explanation. On one side of the Pacific we have the Asian countries, traumatized by the currency crisis, suffering from the effects of an over-investment in real estate and industrial capacity, and needing to rebuild international reserves. On the other side of the Pacific, the United States is in the middle of its ‘productivity miracle’, dotcom boom, and a surge in private investment. Did the glut of savings induce the dot.com boom? Probably not is the answer. Did the dotcom boom induce Asian excess savings? Perhaps, but probably not, seems the answer (unless we are to blame the dotcom boom for reducing the attractiveness of Asia as a place to invest). Rather, we suggest, a coincidence of two powerful and interacting developments combined to generate large global imbalances, marked in particular by Asian current account surpluses and the US current account deficit. This is the story up to 2001. The US current account deficit fell slightly in that year to about $400 billion and 4 per cent of GDP before widening further in subsequent years to $811 billion and 6.1 per cent of GDP in 2006. The global savings glut view would appear to have an advantage in that it provides a continuing explanation. In these years, investment in many (but certainly not all) Asian economies remains subdued, savings are high, and the accumulation of reserves continues as the Asian countries build up a war chest of funds to self-insure against future currency crises and the need to rely on IMF conditionality. The difference comes, on this account, from the impact on the United States. With the dotcom boom over, the excess savings flowed into Treasury bonds, corporate bonds and mortgage bonds driving down US long-term interest rates and presenting the US consumer with an opportunity too good to miss. On this view, the fall in savings, the surge in residential investment, house prices and household net worth, along with a record household financial deficit and mortgage equity

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extraction, are induced responses to the glut of global savings finding its way into US financial markets. The problem with this continuation of the global savings glut argument is that some of its simplicity has been lost. Before, the excess savings emanated from Asia. Now, for the extension through to 2006 (and beyond), Asian savings are supplemented, and even supplanted, by those of the Middle East and other oil exporters, along with savings of countries such as Germany and Switzerland. The cast of lenders keeps on changing, but the one constant fixed point in all of this is the borrowing by the United States. In this respect, the ‘problem’ might seem to be more on the American side, with US demands for funds rather than overseas supplies of funds providing the stimulus. Moreover, to reinforce this observation, there are some important elements missing in the global savings view. With these points in mind, we turn to the ‘made in the USA’ position. The missing ingredient in the account above is the asymmetric Greenspan monetary policy of ‘ride the boom, and cushion the bust’, and the reader is referred to Figure 3.10 (page 60 above) and Figure 4.6 (page 97). We start with the dotcom boom. Global factors, by dampening inflation and boosting the terms of trade, certainly played a part and helped spur the investment and stock market boom of the 1990s, consistent with the trade perspective and the excess savings position. Where we depart from this story is in recognizing that the Federal Reserve, both temperamentally and institutionally (with its mandate as it interprets it for maximum sustainable growth), was predisposed to ‘ride the boom’. Indeed, judging by the expansion of liquidity after the Long-Term Capital Management (LTCM) crisis, it would seem that it gave the boom more than a helping hand. Having ridden the boom, Fed officials perhaps then felt that they had little choice other than to ‘cushion the bust’ given the uncertainties of September 11 and their desire to put in place a ‘deflation-insurance policy’ against the perceived risk of a Japanese-style stagnation. Whether or not their perception of ‘looking down the abyss’ is tinged with some degree of selfjustification is probably unimportant now. The results are there to be seen in the form of the lowest real ex ante Federal funds rate since the 1970s and the fastest rate of growth of global dollar liquidity since 1980. On this reading, it was this expansionary monetary policy that drove down US interest rates, producing a Wicksellian cumulative process (but in terms of asset rather than commodity prices) as the ‘market’ rate fell below the ‘natural’ rate. The policy announcements that accompanied the lowering of rates to the effect that the 1 per cent Federal funds rate would not be quickly reversed, and then only slowly, helped push down long-term rates. Long-term rates were then seemingly held down by a reduction in inflation uncertainty, occasioned

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by the impact of the ‘China price’ on inflation which either misled the Fed as to the true expansionary impact of its policies or provided a rationale for it to continue with its deflation-insurance strategy much longer than required. Again, it was the case that US consumers were offered a bargain too good to pass up, but on this interpretation of events the gift came from the Fed and not from foreigners. There is then the question of why the foreign recipients of the spending by Americans were willing to absorb the dollars. A number of reasons suggest themselves. First, those countries such as China that maintained a fixed link to the dollar imported US monetary policy and experienced an increase in dollar reserve holdings much like Germany and Japan towards the end of the original Bretton Woods system. Second, exporting countries wanted US consumers to continue to buy their products and were willing to return the dollars to the United States to ensure that this happened. Third, countries may have felt obliged to hold the dollars to sustain the world trading system and global order under US leadership. Fourth, under fiat money conditions, US dollars once created are like a ‘hot potato’. They can be passed from Asian exporters to Middle Eastern oil producers or to ageing European countries, but they cannot be extinguished. As before, it might be possible to combine the two stories, in which case the unprecedented nature of the global imbalances can be seen to be the coincidence of two equal and opposite forces – American demand for funds and surplus supplies of funds from the rest of the world in aggregate, as revealed so starkly in Figure 5.1 (on page 124 above). Of course, this particular figure does exaggerate the United States’ isolation. A somewhat different grouping emerges from Table 4.1 (on page 88 above) in which the United States, UK, Australia, New Zealand and Canada are grouped on one side as the deficit countries vis-à-vis other major areas of the world, with the common denominator being that those particular deficit countries have experienced unusually rapid increases in housing prices and financial innovations that have enabled households to borrow against the increased wealth. Explaining the economic and psychological factors that produced this pattern is perhaps a topic best left for another study. But if we stay with our present brief, which is the US current account deficit, then while accepting mutual interaction it is also difficult to resist some measure of sympathy with the conclusion of Fan Gang, director of China’s National Economic Research Institute and, significantly, a member of China’s monetary policy committee: The real problem the world faces today is an overvalued dollar, not just against the renminbi but against all major currencies. The main responsibility for this imbalance lies with a US Treasury, which is printing too much money. (China Daily, 11 November, 2006)

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Does it Matter? If the real aim of answering this question is one of attributing blame, then coming down on the side of ‘made in the USA’ might be thought to erode the United States’ moral authority. If the US external imbalance were the result of other countries in aggregate having under-valued exchange rates, spending too little, growing too slowly, saving too much, or having an insatiable demand for US assets and the services of US capital markets, all of which the United States has passively accommodated, then it might be argued that the solution also lies outside America’s shores. Even if it could be argued that US consumers gave in rather too meekly to the temptations put before them in the form of ultra-low interest rates, then it might be thought that other countries ought to be enjoined to participate in the resolution of the global imbalances. But what if the impulses originated in America? However, we would argue that this is the wrong line of questioning. The real issue is whether the global imbalances originate in the private sector or the public sector. Can the US deficit be attributed mainly to an increase in the government budget deficit, as appeared to be the case in the 1980s? Or, was the deficit the consequence of a decrease in private savings and an increase in private (residential) investment? If the deficit is due to public sector behaviour – that is, fiscal imbalances within or outside of the United States – then the trade and current account imbalances that accompany them would seem to be a valid matter for public policy concern (although the government bodies might be acting much as a private transactor would do). On the other hand, it is not so apparent that the decisions of private sector transactors should be a policy issue. If individuals in different countries engage in inter-temporal trade (American households refinance their home mortgages which are packaged and securitized as mortgage-backed bonds purchased by Japanese savers), why would we not suppose these decisions to be optimal? The Japanese household has put money aside for future consumption, perhaps in retirement, the American household has decided to consume now, also perhaps in its retirement, the benefits and wealth locked up in their house that they may have struggled for years to acquire. On this basis, it can be argued that a current account deficit that arises from changes in private sector behaviour ought not to enter the realms of public policy. If the decisions turn out to be wrong then the individuals concerned must bear the consequences. The Japanese saver may die before the fruits of the future consumption can be enjoyed. The American household may over-borrow and be forced to cut back on consumption or sell the remaining equity in the house. These are the types of decisions taken every

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day by private citizens in many countries. That they now occur across borders does not alter the fact that individuals make them and take corrective action if they get the signals wrong. The difficulty comes when the signals are distorted by excessively lax monetary policies or by false expectations that monetary policy will ride to the rescue if asset prices start to fall. Again, these are issues that enter many other fields. Should governments provide agricultural support and how much should be given in the way of drought relief or flood assistance? Obviously, moral hazards abound. Is the Deficit Sustainable? On our reading of the situation, the basic cause of the widening of the US current account deficit since 2001 has been the exceptionally high asset prices produced by unsustainably low interest rates. National, especially household, saving in the United States has been pushed to record lows and an unprecedently high level of household borrowing has eventuated. The low long-term interest rates remain something of a conundrum, but we see little grounds for thinking that the natural rate of interest may have fallen sustainably. Ultimately, those individual American households that have taken out the debt will determine if and when there is an adjustment. Under conditions of international financial laissez-faire, and given the layers of financial innovation that separate a home mortgage from mortgage-backed bonds, the borrowing limits may have widened substantially. In that respect, the ‘sky is the limit’. Those private individuals incurring debt and those individual entities overseas acquiring the claims will determine at what level the deficit can be sustained. There are some who contend that this adjustment process is inadequate, and call for co-ordinated international action. Many of these views were paraded before the G20 meeting in Melbourne, Victoria in 2006. A ‘wishlist’ that regularly circulates such meetings includes raising savings in the United States, perhaps by cutting the budget deficit, increasing European growth through structural reforms, and shifting East Asia, particularly China, away from reliance on exports through exchange rate adjustment. Others see a role for the IMF to use its surveillance process more forcefully, perhaps as part of a new Plaza agreement, as advocated by William Cline, that would see a broad currency alignment of surplus countries against the dollar. Our own view, which appears to accord with that of the IMF’s managing director Rodrigo de Rato, is that the world has changed in the 20 years since the Plaza agreement, and markets are too strong to make exchange rate coordination a realistic option. That the Plaza Hotel itself has now been sold off into private luxury apartments symbolizes the

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dramatic changes in the global economy over the last 20 years and the increased impediments to a successful multilateral approach. Much better, it would seem, is to allow the resolving of the global payments imbalances to be left to market forces. The movements of capital will set in train their own adjustments through asset markets. If there is to be fiscal consolidation, which would undoubtedly lift the United States’ national saving rate, then this should be done largely for its own sake. Certainly, the fall in the federal budget deficit since 2005 has been impressive and, with the shortfall now below its thirty-year average as a share of the economy, the budget deficit can no longer realistically be singled out as a prime reason for the record current account deficit. Nevertheless, for an economy probably operating slightly above its long-run potential, the US structural budget deficit remains uncomfortably large and can prudently be reduced for fiscal rectitude. In the meantime, the combination of high debt and high asset prices that provides the backdrop to private sector decision-making presents some deflation risks to the US and world economy. Indeed, it was to insure against such deflation that the Fed cut interest rates aggressively in 2001–2003. Ironically, this action helped convert a spent equity boom into one involving house prices. If US households were left to themselves, household borrowing could well ‘simmer down’, in Greenspan’s words, as the housing boom fades, and mortgage equity extraction subsides. The current account deficit might then begin to level out as household spending’s share of the economy returns to more normal levels and the household financial deficit recedes. There is always a risk that the adjustment may not proceed in such an orderly way and lead to an asset price shake-out. In this case, it remains to be seen whether the ‘Bernanke Fed’ will respond to incipient signs of weakness in the housing market with the same alacrity that typically characterized the ‘Greenspan Fed’, and continue to ‘cushion the busts’. Such a policy relies upon, if not abuses, the privileges flowing from issuing international money, and could conceivably erode faith in the integrity of US policies and eventually undermine confidence in the dollar. For the present, a rejection of the US dollar seems an unlikely event. So long as the United States is able to work its financial alchemy of avoiding large net income outflows to abroad while being in deficit, and to boot make its debts disappear, large deficits are much less threatening than the deficit ‘pessimists’ would have us believe. Since this alchemy seems to be a corollary of the special place that the US dollar occupies in the world economy, the potential for it to be replaced as a reserve currency is the final arbiter of the demand for US assets and the sustainability of the current account deficit. As we said in earlier chapters, the likelihood of this happening is not greatly influenced by what happens in China or Europe or elsewhere. The

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future of the dollar turns on America itself and its economic policies. Continued abuse of the United States’ ‘privilege’ may hasten the dollar’s decline as international money, but given its entrenched position and the current rapid pace of financial innovation in US financial markets, the likely timetable is measured in decades rather than years.

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Index absorption 11–12, 17, 44–69, 90, 232 accommodating capital flows 18, 42, 89, 231 adjustment mechanisms 14, 41, 127, 133–5, 136, 242, 243 Afghanistan 47, 207 Agency debt 178, 180, 188 Ahearne, A. 114 alchemy 147, 243 Alexander, S.S. 45 American empire 109, 110, 111, 202 Ando, A. 85 Anglo-sphere countries 156, 190, 191, 240 Artis, M.J. 11, 108, 117, 200 Asia countries 15, 37, 40, 75, 76, 92, 126, 132, 181, 207 currencies 31, 32, 40, 90, 156, 157 invested funds 14, 181–2 reserve accumulation 8, 88, 91, 96, 102, 103–4, 178, 182 asset prices 61, 62, 63, 77, 84–5, 92, 189, 243 asset weighted US dollar index 156, 157 Aurélio, M.M. 115 Australia 30, 58, 77, 84, 126, 190 Bacchetta, Philippe 130, 137, 197 Backus, D. 174, 185, 192 Bailey, Martin 38 Baker, Gerard 37, 39, 202 Balakrishnan, Ravi 184 ‘balance of financial terror’ 4, 91, 113, 182 balance of payments 5–6, 16–17, 45, 119, 120, 123, 125 Balassa, B. 34 Baldwin, R.E. 22, 43 Bank for International Settlements (BIS) 61, 65, 98, 180, 184, 197

Bank of Japan 28, 109, 178 Bartoloni, Leonardo 73 Baxter, Marianne 72 Bayoumi, T. 130, 137 Benelux countries 33, 35 ‘benign neglect’ 17–18, 102, 108 Bentick, B.L. 189 Bergsten, C.F. 139–40 Bernanke, B.S. 4, 13, 14, 17, 42, 63, 76–8, 85, 87–99, 139, 224, 232, 233, 243 Bernanke thesis 13, 14, 17, 42, 76, 77, 87–94, 98–9, 237 ‘black hole’ in global system 167, 168 Blanchard, Olivier 136, 137, 174 Bobbit, Philip 111–2 bond market ‘conundrum’ 65, 66–8, 94–5, 187, 200 bond yields 80, 81, 88, 89, 95, 97, 239 Bonner, William 13, 103, 109, 112, 113, 233 Bordo, Michael D. 56–7 Borio, C. 65–6, 84 Bretton Woods 14, 31, 99, 100, 101, 120, 174 British empire 112, 114, 198 Brittain, Samuel 123 Broda, Christian 29 Buffett, W. 146 Bureau of Economic Analysis (BEA) 152, 158, 159, 160–63, 165–6, 167, 169, 178 Bush, George W. 48, 61, 110–11, 113, 208 Business Week 59, 61, 69, 229 California 127, 128, 131 Callick, Rowan 213, 214, 226, 227, 228 Canada 30, 109, 157, 190 capital account 6, 8, 17, 42, 78–9, 86, 119, 125 265

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capital flows 14, 81–2, 114, 171, 175, 179, 187 capital gains 83, 161 capitalized net capital income (CNCI) 166 ‘carry trade’ 80 Cavallo, Michele 72 central banks 78, 84, 99, 175, 177–8 Central Budget Office (CBO) 153, 167 Chandler, Clay 213 Chang, Gordon 212 Chang, Jung 228 Cheung, Y.W. 34 China banking system 33, 182, 215, 221, 222, 229 ‘currency manipulation’ 12, 28, 30, 32, 34, 35, 222 current account surplus 33, 124, 174, 217 economic performance 203–4, 205, 206, 211, 212, 213, 215 exchange rate system 12, 28, 30–33, 34–41, 216–25, 227, 229 exports 29, 35, 37, 201–2, 204, 209, 222, 227, 229 governance problems 210–16 reserves 31, 35, 103, 104, 105, 199, 217, 219, 221, 228 savings 126, 192, 215, 216 size and population 204–5, 209, 210 trade imbalance with US 3, 7, 28, 37, 103, 219, 220, 229, 236 under-valuation of currency 32–3, 34–5, 38, 39, 218, 219, 220–21, 225 China National Offshore Oil Corporation (CNOOC) 135, 137, 144 ‘China price’ 36, 60, 62, 67, 69, 92, 216 Chinese Communist Party (CCP) 213, 214, 228, 229 Chinn, M.D. 21, 22, 34, 195, 198, 200, 231 Chiu, B. 38, 182, 204, 206, 211, 213, 214, 229 Clarida, Richard H. 139 Cline, W.R. 1, 3, 4, 46, 163, 166 co-dependency 91, 103 Cole, W.A. 198

collateral view of reserve growth 13, 104–5, 117–8 Congress 32, 34 consumption spending 9, 48, 51, 53, 56, 64, 81, 92, 191 Cooper, R.N. 5, 17, 137, 148, 171–2, 178, 185, 186, 190 Corden, W. M. 14, 69, 120, 122, 123, 235 Cornwall, Rupert 103 corporate bonds 64, 188 corporate savings and investment 9, 71 Coughlin, C.C. 82 Csapo, Laszlo 202, 203 Cumby, Robert 5 currency valuation effects 154–5, 161 current account deficit approaches to 11–13, 16–18, 44 causes 3–5, 70–71, 76, 80–83, 86–7, 90, 94–5, 125–6, 237–40, 242 ‘danger zone’ 139, 140, 146, 173, 235 defined/measures 5–6, 7, 10–17, 45, 70, 71, 79, 141–2, 185 sustainability, see sustainability currency of invoicing 21, 195, 196 current account ‘pessimists’ 138, 140, 146, 177, 180, 187, 194, 235, 243 Daly, Deirdre 43 Danziger, D. 118 ‘dark matter’ 3, 165–7, 168, 169 Davis, K.T. 106 Deane, Phyllis 198 ‘dearth of investment’ 75, 76, 87, 186–7, 233 debt, see household sector debt defence, see military expenditure deficit, see current account deficit, trade deficit ‘deflation insurance policy’ 59, 62, 63–6, 68, 90, 92, 98, 239, 240, 243 De Gaulle, General 106 de Jonquieres, Guy 213 demographic factors 78, 80, 185–7 Deng, Xiaoping 204, 206–7, 211 depreciation 20, 21, 22, 25, 40, 41, 42, 43, 89, 101, 134, 224, 235 de Rato, Rodrigo 242 D’Estaing, Giscard 106 developing countries 1, 75, 102, 104

Index disabsorption 12, 69, 92, 133, 224 ‘dismal arithmetic’ of US trade balance 25, 26, 69 dollar 30, 107, 108 confidence problem 101–2, 197–8, 243 ‘hot potato’ 107–9, 183, 240 role in international system 15, 82, 107–8, 138, 148–9, 168, 195, 196, 243 trade-weighted value 25, 26, 156, 157 valuation effect 107, 154–5, 161, 164 domestic demand 45, 46, 60, 72 Dooley, M. P. 4, 5, 13, 56, 59, 91, 99, 104, 105, 106, 132, 232 Economic Report of the President 73 Edwards, Sebastian 140, 172–4, 235 Eichengreen, Barry 144, 154, 166, 182, 198 elasticities pessimism 19, 20–22, 42, 44, 45, 232 Emmons, W.R. 190, 192 ‘empire of debt’ 13, 109–14 equity investment 80, 93, 114, 115, 164, 169, 174, 176, 243 euro 30, 109, 156, 195, 197, 198 euro area (zone) 12, 14, 28, 69, 75, 91, 129, 174, 196 European central bank (ECB) 84, 109, 197 European union (EU) 194, 196, 200, 203, 207, 213 European currency unit (ECU) 195, 198, 200 exchange rate pass through 21, 39, 42, 43, 92 exchange rate risk 120, 129–32, 174, 194, 199 exchange rates 18–19, 25–41, 134, 136, 156–7, 234 expenditure switching and changing 46, 223, 225 ‘exorbitant privilege’ 13, 106–9, 130, 168, 244 exports 6, 18–19, 20–22, 24, 27, 28, 37, 40, 41, 44 external balance sheet of US 147–57, 234

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external imbalances 76, 81, 83, 86, 124, 136, 238, 240 Fan, Gang 227, 240 Faust, J. 39 Federal Advisory Council 62 Federal funds rate 60, 66, 84, 92, 96, 97, 239 Federal Open Market Committee (FOMC) 63, 64–5, 67–8, 83 Federal Reserve 25, 36, 37, 52, 55, 59, 61, 62, 64, 66, 67–8, 73, 83, 87, 90, 92, 98, 105, 139, 156–7, 239, 243 asymmetric policy 59, 61, 62, 63–6, 92–4, 239 easy money 60, 63, 66, 92, 94, 98, 239 Federal Reserve Bank of New York 96, 146, 166, 178, 179 Feldstein, Martin 8, 13, 103, 116, 117, 130, 136, 177, 179, 182, 232 Feldstein-Horioka effect 116–7, 130, 137 Ferguson, Roger W. Jr. x, 5, 13, 73, 80, 82, 99, 232 Fernandes, George 210 fiat money 100, 108, 121, 183 financial intermediation, role of US markets 13, 82, 106, 107, 148–9, 195–6 financial innovations 82, 187–94, 235, 242, 244 Financial Times 33, 35, 118 fiscal balance, see government budget balance fiscal policy 72–3, 98 Fisher, J.D.M. 58 Fishman, T.C. 202, 203, 205, 208, 210, 228 Fitzgerald, C.P. 206 fixed exchange rate 31, 35, 36, 37, 96, 100, 103, 121, 220, 222, 226, 228, 240 flow of funds 50, 53, 72 Folkerts-Landau, D. 5, 13, 91, 99, 104, 105, 106, 232 Fonteyne, Wim 197 foreign assets 78, 107, 142, 148 foreign debt ‘trade-offs’ 144–5

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foreign direct investment (FDI) FDI in China 33, 37, 105, 182, 217, 227 FDI in the US 135, 144, 151–4, 174, 175, 177 US FDI 38, 106, 107, 151–4, 175–7, 183 foreign liabilities 148, 149, 172 Fortune 38, 201, 227 Fourcans, Andre 132 France 77, 98 Franck, Raphael 132 Frankel, Jeffrey 56, 73, 195, 198, 200, 220, 222, 229, 236 Frenkel, J.A. 119 Freund, Caroline 139 Friedman, Milton 18, 59, 85, 121, 127 Fujii, E. 34 Gagnon, J. 39 Galati, Gabriele 198 Gapper, John 28, 43 Garber, P.M. 5, 13, 91, 99, 104, 105, 106, 232 Garriga, Carlos 190 Gavin, W.T. 190 Geithner, T.F. 146 general equilibrium framework 17, 124–5 geo-political power factors 105, 109, 208, 209, 227–8 Germany 33, 35, 75, 98, 126, 174, 185, 186 Giavazzi, Francesco 136, 137, 174 Giovannetti, Giorgia 42 global liquidity 65, 91, 95, 96–7, 239 global savings glut 4, 13, 14, 17, 76–7, 87, 94, 95–8, 238 globalization 14, 114–7, 171, 183 gold standard 31, 40, 99–100, 121, 198 Goldberg, Linda 21, 196, 197, 232 Goldstein, Morris 34, 35, 221 Goretti, Manuela 139 Gottliebsen, Robert 184 Gourinchas, P.O. 5, 13, 106, 107, 148, 175, 232 government budget balance 3, 9, 47–8, 71–4, 136, 243

Greenspan, Alan 2, 4, 12, 14, 55–6, 59–61, 63, 66, 83, 84, 90, 93, 94, 114, 116–7, 119–20, 123, 127, 136, 139, 170, 171, 177, 187, 194, 233, 234, 239, 243 Grieves, W. 114 Gros, Daniel 167–8 gross domestic product 9, 10, 15, 45, 46, 110, 206, 209 growth performance 68–9, 186–7 Gruen, David 137 Guidotti-Greenspan rule 104, 117 Guo, Yanying 226–7 Haass, Richard 111 Halle, Louis J. 118 Halliday, Jon 228 Hausmann, Ricardo 3, 165–8 Heath, Alexandra 169 Hellerstein, Rebecca 43 Henriksen, E. 174, 185, 192 Hervey, J.L. 141 Hiebert, Paul 190, 192 Higgins, Matthew 5, 70, 81, 146, 151, 152, 166 Himmelberg, Charles 59 Hirsch, Fred 106 home bias 4, 14, 81, 114–6, 130, 170–74 Hong Kong currency link 31, 32, 40, 216 Hoogework, Rupert 229 Hooper, Peter 22 Horioka, C. 116, 130 hot money, see speculation household sector debt 10, 51, 52, 53, 54, 189, 192, 241 financial balance 3, 48–51 savings 10, 51–2, 71, 83 wealth 52–5, 190, 192 housing prices 55–9, 80, 188, 189–92, 243 Houthakker-Magee asymmetry 22, 44, 231, 232 Howard, D.H. 5 Hu, Jintao 213 Huang, J. 152, 167 Huang, Yasheng 38, 182, 229 Hume, David 40

Index Ihrig, J. 39 Ikenberry, G.J. 110–11 imports 6, 18–19, 20–22, 27, 28, 29, 36, 37, 38, 41, 44, 219, 229 ‘inconsistent quartet’ 100, 117 inflation 35–6, 45, 68, 89, 92, 98, 122, 129 interest rate conundrum, see bond market conundrum interest rates 41, 55, 66, 67, 77, 95–8, 117, 241 the 0–1–2 structure 78, 91, 95–9 internal-external balance 45, 119, 125, 223 ‘international financial laissez-faire’ 14, 122, 123, 125, 130, 132, 136, 193, 242 International Monetary Fund (IMF) 31, 36, 58, 100, 103, 175, 188, 194, 200, 203, 218, 222, 238, 242 international vendor finance 3, 91, 103, 113, 182 inter-temporal trade 80–81, 125, 126, 192, 241, 242 investment, see savings-investment approach investment income 2, 14, 142, 145–7, 234 Iraq war 47, 202 Italy 77 J-curve effect 42–3 Japan 69, 113 current account surplus 14, 174, 185, 200 deflation 59, 220, 239 exports 12, 28, 30, 43, 91 interest rates 80, 81, 220, 226 investment 75, 186 savings 75, 80, 126, 241 trade tensions with US 38, 201 Japanese yen 30, 33, 35, 80, 195 Jiang, Zemin 210 Johnson, Harry 18, 223 Johnson, Karen 22 Jorgenson, D.W. 27 Kahn, G.A. 59 Kaletsky, Anatole 80 Kennan, George F. 113 Kindleberger, C.P. 42, 118

269

Kitchen, John 147, 152, 163, 169 Kliesen, K.L. 189 Klitgaard, Thomas 5, 70, 81, 146, 151, 152, 166 Kohn, D. 36, 63, 84 Korea 113 Kornai, J. 211 Kristof, Nicholas 203, 206, 228 Krugman, P.R. 22, 43 Lacey, R. 118 Lahiri, Amartya 73 Lal, D. 207 Lambert, F. 174, 185, 192 Lane, P.R. 164, 194 Lansing, Kevin J. 47, 83 Lardy, N.R. 35, 221, 222 Latin America 76, 98, 195, 203 Lawrence, Robert 38 Lerman, Robert 81 Lerner, A.P. 20–21, 42–3, 45 Levich, Richard 5 Lewis, M.K. 11, 27, 31, 38, 40, 106, 108, 117, 118, 137, 182, 189, 200, 204, 206, 211, 213, 214, 229 Li, Ruogu 229 Li, Yong 40 life-cycle hypothesis 74, 85 liquidity 65–6, 82, 107, 118 Lloyd, John 111 Long-Term Capital Management (LTCM) 200, 239 Lu, Daodao 227 Lundy, Derek 111, 202 Lutz, F.A. 42, 43 Lynch, Michael 205 McCarthy, Michael 215 McDonald, John 118 Macfarlane, I.J. 14, 87–99, 232 Machlup, Fritz 42 McKinnon, R. I. 40, 226, 236 McMillan, J. 211 McMorrow, K. 200 Maddison, A. 204 Magee, S.P. 22, 44, 231, 232 Maier, C. 110, 112 Malaysia 178 Mann, Catherine L. 1, 22, 30, 91, 103, 232

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manufacturing sector 23, 25, 27, 28, 38 Mao, Zedung 207, 208, 211, 214, 228 Marazzi, M. 39 Marquez, Jaime 22, 39 Marquis, M. 83 Mascaro, A. 152, 167 Marsh, Christina 43 Marshall, A. 20–21, 42–3, 44, 45 Marshall-Lerner condition 20, 21, 42, 44, 45 Martin, R. 39 Mason, W.E . 122 Mayer, Christopher 59 Meade, J.E. 18 Mearscheimer, John 207 Mehra, Y.P. 67, 200 Meissner, C.M. 154, 167 Merkel, L.S. 141 Metzler, L.A. 18 Mexico 28 Middle East 75, 104, 203 Milesi-Ferretti, G. M. 140, 164, 194 military expenditure 110, 112, 113 Mishkin, F. 60, 84, 85 Mizen, P.D. 11, 31, 40, 108, 117, 189 Modigliani, F. 85 Mokyr, J. 27 monetary policy 78, 88, 91, 96 mortgage debt 51, 54, 56, 62, 77, 187, 192 mortgage-backed securities 134, 180, 187–9, 194, 241 mortgage equity withdrawal (MEW) 51, 52, 56, 189 Mun, S.H. 27 Mundell, Robert 197, 226, 236 National income and accounting approach 10, 70, 124 natural rate of interest 188–9, 192–3, 242 Net Foreign Investment 10, 71 NIID 141, 142, 143, 144, 145, 155, 158, 159, 160, 168 NIIP 2, 140, 141, 146, 158–68 new Bretton Woods 14, 91, 92, 182 ‘new economy’ 27, 59 see also productivity ‘miracle’ New Zealand 77, 84 Nguyen E. 169

Nickell, S. 83 Nixon, Richard 208 Nussbaum, Bruce 111 Obstfeld, Maurice 1, 13, 139, 141, 150, 153, 158, 172, 225, 232 Office of Federal Housing Enterprise Oversight (OFHEO) 57 official reserves 174, 175–80, 181, 195, 198, 199 oil exporting countries 3, 75, 81, 98, 184–5, 208 oil prices 22, 107 OECD 67, 116 Pakka, M.R. 82 Palley, T. 61 Papaioannou, Stefan 69 paper money, see fiat money Paulson, Hank 201 PBOC 30, 33, 109, 178, 179, 215 Pei, Minxin 210, 213, 215 peripheral countries 104–5 personal savings 49, 83, 84 petrodollars 81, 107–8, 184–5 Pettersson, Bengt 25 Pitchford, J. D. 123 Plaza Agreement 4, 242 Pluck, Katharina 22, 30 Polasek, M. 137 Poole, William 13, 20, 64–5, 81, 82, 106, 148, 233 portfolio balance approach 12, 13, 17, 78–83, 169, 172–3, 232 portfolio investment 8, 151, 169, 176, 181–2 Prasad, Eswar 29, 37, 182, 203, 216, 226 precautionary reserves 13, 76, 88, 103–4, 182 Prestowitz, Clyde 201, 203 prices 19, 34, 37, 39, 41, 62, 84, 98 productivity ‘miracle’ 26–7, 60, 62, 77, 93, 133, 238 protectionism 37–9, 222 purchasing power parity (PPP) 19, 34, 129, 204, 206, 209 Qian, Y. 210, 211 Quayyum, S. 58 Quiggin, John 135

Index Rajan, Raghuram 175, 182, 183, 216, 226 Razin, A. 119, 140 Reading, Brian 91 real interest rates 60, 67, 84, 93, 99 Reeve, T. 39 regional payments imbalances 119–20, 127–9, 136 renmimbi (RMB) 30, 32, 33, 34–41, 90, 156, 216 reserve accumulation 76, 88, 102–5, 175, 177–80, 181–7 residential property investment 10, 56, 59, 80, 191 resources gap 142–4 Rey, H. 5, 13, 106, 107, 148, 175, 232 risk premiums 13, 61, 88, 89, 93, 130, 131, 155, 171, 194 Robertson, Dennis Sir 109 Robinson, Joan 18, 138 Rodrik, Dani 117, 182 Roeger, W. 200 Rogers, J. 39 Rogoff, Kenneth 1, 19, 139, 141, 158, 225 Rolnick, Art 38 Romer, C. 60, 84 Romer, D. 60, 84 Rothenberg, A. 39 Roubini, Nouriel 1, 105, 139, 140, 142–4, 146, 154, 158 Rueff, Jacques 106 Rumbaugh, Thomas 29 Russia 76, 98, 184 Sacchetti, U. 69 Sachs, J. 119, 201 Samuelson, Paul 34, 47, 48 Saudi Arabia 113, 156, 184 savings 10, 70, 73, 89, 90, 93, 116, 177 savings-investment approach 9, 12, 13, 17, 69–78, 90, 91, 186, 232 savings rates 74, 75, 90 Schiller, Robert 56–7 Schlagenhauf, Don 190 Schumer-Graham bill 34 seigniorage 82, 149, 169, 195 Setser, Brad 1, 105, 139, 140, 142–4, 146, 154, 158, 229 Shafer, J. R. 132

271

‘sharecropper society’ 146, 147 Sheets, N. 39 Sinai, Todd 59 Singapore 30 Smith, David 212 Snooks, G.D. 118 Spain 77, 98, 126, 174 speculation 31, 35, 101, 103, 217, 218, 227 ‘speed limit’ of the economy 61, 90, 92 Standard International Trade Classification (SITC) 29 Stiglitz , J.E. 58 Stiroh, K.J. 27 stock market, see equity investment Story, J. 206, 210, 214 Stulz, R.M. 114–5, 232 Sturzenegger, Federico 3, 165–8 Subramanian, Arvind 182 Summers, L.H. 3, 4, 91, 103, 104, 182, 199, 232 surplus countries 81, 87, 91, 98, 108, 124, 174 sustainability of deficit 14, 138, 139–45, 170, 173, 192, 193, 235, 242, 243 conventional measures 139–45, 170 investment income ‘riddle’ 14, 145–7, 165, 168, 234 NIIP ‘enigma’ 14, 158–68, 235 preferred approach 168–9, 170, 172–3, 235, 241, 242 Swan, T.W. 45, 222–3, 225 Swann, Christopher 56 Switzerland 33, 35, 98, 126, 174, 185, 186 Taiwan 113, 208, 210, 228 Tanigaki, Sadakazu 40 tax cuts 48, 61 Taylor III, Alex 201, 202 Taylor, A.M. 154, 167 Taylor, Mark P. 139 Telmer, C. 174, 185, 192 Temin, Peter 113 terms of trade 24–5, 39, 134 The Australian 32, 38, 80, 197, 201, 215, 219, 224

272


The Economist 3, 12, 15, 26, 30, 32, 34, 37, 58, 60, 61, 80, 81, 84–5, 93, 94, 95, 96, 98, 110, 117, 166, 186, 190, 194, 198, 200, 203, 214, 224–5, 229, 233 The Region 38 The Times 80 Tille, Cedric 21, 107, 146, 148, 151, 152, 155, 156–7, 166, 196, 197, 232 Tilton, Andrew 225 Tinbergen, J. 120 Tobin, James 108 total domestic demand, see domestic demand trade balance approach 11, 18–41, 232 trade deficit 7, 22, 23, 35, 37, 38, 42, 69, 86 trade weighted indices 26, 37, 156, 157 Treasury International Capital Reporting System (TIC) 178, 179 Treasury notes (bonds) 8, 66, 72, 76, 82, 91, 105, 178, 183, 188, 196, 221 Triffin, Robert 101 Truman, E.M. 1, 11, 139, 140, 146, 158 Tulin, Volodymyr 184 Tully, Shawn 93 twin deficits 3, 71–4, 237–8 Tyson, L. D’A. 38 United Kingdom 28, 58, 72, 190 United Nations 29 US dollar, see dollar US Treasury Department 32, 35, 222 Valderrama, Diego 199 valuation effects, see dollar, valuation effect van Wincoop, Eric 197 ‘vanishing debt’ 159–65, 235 vendor finance, see international vendor finance Venti, Steven 56

‘venture capitalist’ view of United States 106, 107, 148, 154, 165 Vigfusson, R. 39 Vines, David 45 Volcker, Paul 56 Wallace, Laura 197, 226 Wallich, H.C. 100 Warnock, F. 67–8, 114, 139, 178 wealth effects, see household sector, wealth Weinstein, David 29 Wen Jiabao 210, 213, 229 White, William 61 Wicksell, K. 188–9, 193 Wiggin, Addison 13, 103, 109, 112, 113, 233 Williamson, J. 122 Wise, David 56 Wolf, Martin 40, 46, 62, 175, 183, 185, 207, 212 Wood, Alan 82, 98 Woodbridge, Philip 198 Woodford, M. 68 Wooldridge, P.D. 181, 197 world banker, see financial intermediation, role of US markets World Economic Forum 212 World Economic Outlook 35 World Trade Organization (WTO) 207, 213 ‘world’s largest hedge fund’ 106, 107, 154 Wu, Banzzuo 229 Xinhua 219 yen, see Japanese yen Yi, Kei-Mu 69 Yu, Yongding 221, 222 yuan, see renmimbi

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