Sink or swim?

Perhaps the most important investment-related debate in the world today is that on the dollar. If the American currency falls substantially – which many influential voices argue it is set to do – it could redraw the financial map of the world. Some asset classes would probably lose considerably while others would gain. Financial crises and substantially higher interest rates are also possibilities. If, on the other hand, the dollar remains stable then global markets can continue with business as usual.

To be precise, the key debate is not about the exact value of the dollar against other currencies. No doubt the exchange rate of the American currency will continue to fluctuate against its counterparts. The discussion of the dollar is largely a cipher for the sustainability of America’s position in the global economy. In its baldest terms, can the American economy maintain its position of global pre-eminence when it is so deeply in hock to the rest of the world? Naturally, if the world loses confidence in America’s ability to play its leadership role the dollar is likely to take a beating. But the discussion on the increasingly lopsided global economy is about more than finding a “correct” value for the dollar.

The debate on America’s relationship with the rest of the world also takes the form of a dispute over “global imbalances”. Although there are many imbalances in the world economy, the key one is between America and Asia. To put the argument at its starkest, the US is focused on consumption while Asia is centred on production. America is consuming more than is justified by its output alone. As a result it is having Pto borrow from Asian central banks to finance its purchase of Asian goods.

Obviously the real world is a more complex place than this model suggests. America is still a substantial producer and Asia is becoming increasingly important as a consumer. There are also other players involved in the process – for instance, Middle Eastern oil producers are currently large buyers of US treasury bonds. But the fact remains that the world economy is lopsided to an unprecedented extent. Whether the imbalance can be corrected peacefully, or whether some kind of traumatic correction is necessary, is at the centre of the debate.

Broadly speaking there are two sides to the discussion. On one hand there is what could loosely be called the “classical school”. Its leading advocates include Stephen Roach (chief economist of Morgan Stanley), Warren Buffett (arguably America’s most successful investor) and the Economist magazine. Their basic argument is that the lopsided economic relationship between America and the rest of the world is unsustainable. The longer it is maintained, the more likely it is that a painful adjustment will follow.

On the other hand there are those who could be called, perhaps unkindly, the revisionists. These include most notably the Federal Reserve as well as fund managers such as Bill Miller of Legg Mason and Komal Sri Kumar of TCW, a sister company of SG Asset Management (see Fund Strategy, April 4, 2005). The revisionist school does not deny the existence of America’s record-breaking current account deficit or its fiscal deficit. Instead it focuses on what its sees as the dynamism of the American economy. In its advocates’ views, America’s economic strength means that an adjustment is possible without significant pain for the global economy. Indeed, the reason that the imbalances have grown so large is because of the attractiveness of American assets to foreign buyers. If there is a culprit in relation to contemporary imbalances it is, in this view, the excess savings of foreigners rather than the excessive consumption of Americans.

This article will examine the main arguments of each school in turn. It will argue that both embody an element of truth but both are also one-sided. It is true that imbalances are at record levels but that does not necessarily mean there will be a painful adjustment in the short or medium term. It is also correct that, as the world’s leading power, America has certain advantages, but its claims to economic vibrancy tend to be overdone.

There are also two key factors missing from the mainstream discussion. First, global imbalances are themselves the latest symptoms of America’s relative economic decline. At present there is comparatively little discussion of this trend but it is likely to become an increasingly important factor in international economic relations. Second, the end of the cold war has helped promote political stability worldwide. This trend in turn has allowed more harmonious international relations. To an extent this factor assists in counteracting the effects of America’s relative decline. But in the longer term its impact is likely to be less significant.

To a point the arguments of the classical school are indisputable. No-one would question the extent of America’s current account deficit or of its fiscal deficit. The scale of global economic imbalances is truly immense and, at least so far, shows no sign of being corrected.

Whether this will necessarily lead to a traumatic rebalancing in the medium term is another matter. For one thing it is wrong to compare America’s imbalances with those of any other country. As the world’s largest economic and political power the US can get away with things that other countries cannot. The Asian countries, for instance, have a strong incentive to prop up the American economy, as it is a key market for their goods.

It is also true that the dollar is unlike any other currency. It is the closest the world comes, in an age of nation states, to a global currency. For instance, natural resources tend to be priced in dollars when they are involved in international trade. And a high proportion of the official reserves of many countries are held in dollars. There are therefore many players with an active interest in maintaining the value of the dollar, or at least protecting it from a precipitous fall.

On the other hand, the revisionists tend to go too far in their praise of American dynamism. It is true that American growth looks healthy compared with the eurozone and Japan. But this is more a sign of the weakness of the others than the strength of America. In relation to the rising countries of East Asia, particularly China, the US is clearly falling behind. It is also the case that a portion of America’s growth can be seen as being “bought” from abroad. A huge fiscal and monetary stimulus has boosted US growth in recent years. But America is essentially paying for this growth by getting into debt with the rest of the world – cheap money has made it easier for US consumers to buy foreign goods. As America repays its debt in the future it is likely, in effect, to have to pay back some of its growth to the rest of the world.

The arguments of the revisionists are also often self-serving. For instance, Ben Bernanke, a Federal Reserve governor, argues that the current account deficit is more a result of a savings glut in the rest of the world than of America’s low savings rate (see box on page 23). This is contrary to conventional economic theory, which sees such deficits as the result of too low a savings rate. The argument is basically that low savings mean investment is low (since the two are related), which in turn helps explain the economy’s lack of competitiveness. But Bernanke turns the argument on its head by claiming that the rest of the world is saving too much. America is doing the rest of the world a favour by having such a high rate of consumption. In other words he is rewriting the conventional economics textbooks to blame the outside world for America’s weaknesses.

Several authorities, including Jim O’Neill, head of global economics at Goldman Sachs, have disputed Bernanke’s argument. In a letter to the Financial Times (April 22, 2005) O’Neill pointed out that the large emerging markets – notably Brazil, Russia, India and China – attract substantial amounts of private sector savings from abroad. The problem, in his view, is the accumulation of large and unnecessary foreign exchange reserves by their governments. This process in turn leads to flows of money back to America.

However, from a historical perspective both schools are flawed in similar ways. The classical school and the revisionists both miss key trends that help explain the shape of contemporary imbalances: America’s relative economic decline and the impact of the end of the cold war. Since the financial markets are so fixated with the comparatively short-term they tend to miss the significance of key long-term trends.

There is no single indicator that definitively proves America’s relative decline. But there are several that help to provide a picture of what is happening. Angus Maddison’s figures on America’s share of global output are striking (see chart above). The US share of global output fell from 27.3% in 1950 to 22.1% in 1973 and 21.4% in 2001. Another sign is America’s net international investment position with the rest of the world (see graph above). The steady increase of its net liabilities is a measure of America’s more pronounced weakness relative to other countries. For a power to be in the ascendant it would normally be a net creditor rather than a net debtor.

It should be emphasised that America’s decline is relative. In absolute terms the US economy is bigger than ever. America is wealthier and it produces more than at any time in history. The decline is in the size of the American economy compared with the rest of the world. As a consequence it is less able to shape the global economy around its interests.

It is also important to recognise that this is an economic debate. It is not about the supposed moral failings of Americans or anyone else. In military terms the US is still easily the world’s strongest power. The weakness is in America’s productive capacity rather than in other areas.

If this is such a key trend, it begs the question of why it is not more widely recognised. Those with long memories may remember that back in the late 1980s there was much talk of Japan superseding America as the world’s pre-eminent economy. Back then the expectation was that Japan would become the world’s largest economy sometime early in the first decade of the 21st century – about now, in fact. Clearly such expectations were not realised. Today the American economy is still about three times the size of Japan, according to Maddison’s figures. And Japan’s failure helps to explain the lack of debate on America’s decline. Without any clearly rising power there is less focus for the discussion on America’s relative weakness.

Another important factor is the demise of the Soviet Union. While it is clear, at least in retrospect, that the USSR was overrated as an economic power it was a substantial military force. The demise of the Soviet Union, and the switch to what some call a “unipolar world”, has left America as indisputably the largest political and military force.

The reason that the question of America’s decline is once again being posed – at least in the form of the discussion of global imbalances – is the rise of Asia. In fact, from Maddison’s figures, Western Europe has suffered a steeper decline than America in recent decades – falling from 25.6% of global output in 1973 to 20.3% in 2001. In contrast, Asia excluding Japan rose from 16.4% to 30.6% over the same period.

In other words, not only is America declining, but a new global economic bloc is rising with China at its centre. But the comparisons between America and China should not be overdone. America, for example, is still a vastly richer country than China. It would also be a mistake to write off Japan – for one thing it is increasingly integrated with emerging Asia through trade and investment links. But the rise of a bloc increasingly capable of competing with America threatens to destabilise the equilibrium of the existing world order.

Having said that, there is an important counteracting factor which, at least over the medium term, looks set to bolster the resilience of the status quo. The end of the cold war has had important consequences for both domestic politics and international relations.

In the domestic sphere the end of the cold war has brought stability unparalleled in modern times. The demise of the Soviet Union discredited the idea of creating any alternative to the market system. TINA – Margaret Thatcher’s dictum that There Is No Alternative to the market – has come to dominate what passes for political debate nowadays. The recent presidential election in America and the British general election exemplify this trend. Rather than a battle between competing visions of how to organise society, the debate has degenerated into personal bickering and vacuous soundbites.

Such stability in the domestic sphere has important consequences for international relations. Instability and domestic opposition tend to give states less room for manoeuvre in the international sphere. In contrast, during times of domestic stability there is greater opportunity for nation states to operate freely overseas. When domestic stability becomes a global trend there is an added resilience to international relations. Nation states have more scope to build alliances and resolve tensions between them.

This trend is clear in relation to the dollar and global imbalances. The main countries involved have proved willing to take actions that, in other circumstances, might be seen as detrimental to their interests. Asian countries in particular have bailed out America to a huge extent, even though such actions could have negative consequences for their own economies. Keeping interest rates artificially low could, for instance, stoke up inflation and lead to debt problems in many Asian countries. In China, where there is no market-based system of interest rates but the renminbi is tied to the dollar, the currency peg has, among other things, encouraged large speculative inflows. Speculators have put money into China in the hope of benefiting from a sudden revaluation of the renminbi.

But despite the contemporary resilience of international relations, this set-up cannot last for ever. It is likely to becoming increasingly difficult for the countries involved to maintain a highly problematic set of global imbalances. The unstable equilibrium that currently exists will become harder and harder to maintain.

It is impossible to say exactly how the current world order will unravel. There could be a series of small steps that eventually lead to a “tipping point” of sudden change. Another possibility is that disputes between the parties involved will escalate. It is certainly the case that if America takes aggressive action against what it sees as Asian protectionism, it will accelerate the breakdown process.

So it is clear that the current set of global imbalances is not sustainable. Huge current account deficits in America and their counterpart surpluses in Asia are inherently unstable. The same is true of the massive capital flows that finance these surpluses. But the way in which these will unravel and the speed of the process is uncertain.

As for the dollar, its future does not look bright. In many respects its fall against the euro in recent years is likely to prove a sideshow. If and when it is allowed to move significantly against Asian currencies, its trajectory will be more important. In the longer term the special status of the dollar as world money is likely to be increasingly questioned. Those with a short-term investment horizon are likely to be taken by surprise by this trend. But its consequences, driven as it is by America’s decline, are likely to be world-changing.

Contending schools on global imbalances
Classical views
Stephen Roach, chief economist at Morgan Stanley. Global Economic Forum, April 18, 2005. “An unbalanced global economy is at risk of becoming unhinged. Beset by record imbalances between current account deficits and surpluses, it doesn’t take much to derail a system that is already in serious disequilibrium.”

Maurice Obstfeld, a professor of economics at University of California, Berkeley, and Kenneth Rogoff, a professor of economics at Harvard. Financial Times, November 1, 2004. “If current accounts are forced towards balance in the context of a difficult global economy, the effects could include financial crises, higher interest rates and a big drop in global output.”

Warren Buffett, the chairman of Berkshire Hathaway. Letter to shareholders, 2004. “Without policy changes, currency markets could even become disorderly and generate spill-over effects, both political and financial. No-one knows whether these problems will materialise. But such a scenario is a far-from-remote possibility that policymakers should be considering now. Their bent, however, is to not-so-benign neglect.”

Revisionist views
Ben Bernanke, a governor of the Federal Reserve and nominee to chair George W Bush’s Council of Economist Advisers. Lecture on March 10, 2005. “Over the past decade a combination of diverse forces has created a global supply of saving – a global saving glut – which helps to explain both the increase in the US current account deficit and the relatively low level of long-term real interest rates in the world today.”

Alan Greenspan, chairman of the Federal Reserve. Speech to conference, February 4, 2005. “The US current account deficit cannot widen forever but’€¦ fortunately, the increased flexibility of the American economy will facilitate any adjustment without significant consequences for aggregate economic activity.”

Bill Miller, Legg Mason Capital Management, annual shareholder letter, January 2005. “Here is the way I see it. The rest of the world saves too much and consumes too little. If the US had not gone on a relative consumption binge from 1998 to today, where consumption went from 67% to 71% of GDP, we would have suffered not a multi-year bear market but a global deflationary depression, beginning in 1998 and precipitated by the Asian collapse, the Russian debt default and the failure of Long Term Capital Management.

“Instead, US “over-consumption” saved the day, providing demand for the world’s goods and keeping emerging economies from imploding due to their own domestic consumption collapse, high debt and excess production capacity. Our consumption was fuelled first by a strong domestic stockmarket, and when that gave way, by falling interest rates and ample liquidity supplied by the Fed.”