Lounsbury: FT- Wolf: On the US Economy.

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October 01, 2003

FT- Wolf: On the US Economy.

Martin Wolf has yet another briliant article on US macro-economics. I am glad he is back from vacation.

In any case, the article is
Martin Wolf: A very dangerous game
By Martin Wolf
Published: September 30 2003
http://news.ft.com/servlet/ContentServer?pagename=FT.com/StoryFT/FullStory&c=StoryFT&cid=1059480235461&p=1012571727126

In general, and as he has commented on over the past year, the US macro-economic position is quite worrying. But let's take a look at what Martin has to say:

Martin quotes Rogoff in regards to the US recovery, such as it is ""The US has the best recovery that money can buy. It has a very high fiscal stimulus, a huge current account deficit. It's borrowing a great deal in order to sustain this very high recovery." ... But, as he explained, this is not just the best recovery that money can buy. It is the best recovery foreign money can buy. For how long will the foreigners continue to oblige?"

Indeed that is a worrying question, one that far too few Americans, even those with a degree of financial sophistication, appreciate. I recall, for example, back sometime in the Fall of 2002 on the SDMB arguing with Scylla over the issue of foreign withdrawals of capital from the US in a political-economic context, and Scylla blithely asserting that simply there were no other choices for investors seeking returns and low risk. Quite simply a false presumption, one that was more than a bit provincial, and yet all too typical. But then Scylla also told me back in the Spring that he felt that Iraq risk was 'properly priced.' Pity he didn't know to listen to me. This aside, let's get back to Wolf.

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

In essence, to explain, Wolf is arguing, correctly I believe, that Asian investors and governments are, as the Japanese did in the 1980s, seriously overpaying for US assets. For a foreign investor investing in US bonds, the interest rate offered, or rather the price paid, should cover the substantial risk of a serious depreciation (Wolff is being a bit loose in saying devaluation as normally that implies official action) by the US dollar, something that just about all economic pressures are pressing for. Clearly at the paper thin rates now on USG bonds, there is no such protection, and when - I think it is indeed a question of when- it happens, it will be painful for bond holders.

Now Wolf notes, correctly that this buying of overpriced US assets has allowed "the world's richest country and sole superpower to spend far beyond its means. It is not as grateful as it should be. [Interjection: Hah, I would say most of America and even most of the political class is blissfully unaware of the degree to which the US depends on foreign capital inflows to finance itself, either public or private sectors. Ignorance is bliss.] The fiscal deficit, forecast at 6 per cent of gross domestic product this year, is almost fully matched by the current account deficit, forecast to exceed 5 per cent of GDP in the IMF's World Economic Outlook. This year, according to the IMF, the US national savings rate will be an astonishingly low 13.6 per cent of GDP. The US gross investment rate, though much higher, at 18.3 per cent of GDP, will be below the rate in the eurozone, Japan and newly industrialised Asia, let alone Asian developing countries (see chart). Since the US investment rate has fallen, over the past three years, by almost three percentage points of GDP, the capital inflow should be viewed as a means of financing government and private consumption, not investment.

This last bit is the most dangerous. Borrowing to spend on investment in future productivity is a fine thing, and high levels of debt for that, while not always healthy -above all if mis-invested- is usually not negative, and often positive. However, borrowing for current consumption, well that gets you in trouble. Now, I am not sure that Wolff's sweeping declaration that I have underlined is fully supportable, but it is surely correct that much current borrowing is to finance current consumption and not investment - and indeed there is every sign of overconsumption and lack of saving domestically in the US. This is not a positive thing at all.

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

That is the past foreign currency crises in Asia have created an inflated and unhealthy demand for US assets, above all sov. securities as a hedge against future currency crises there. The conspiracy part of course is silly (and meant to be so) as it presumes a degree of foresight rather lacking in Washington, but unintended consequences and all that. And stacked decks perhaps.

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

Nice structure, eh what? Wolff has hit on this before, I should note, and I do believe he has to be correct in regards to the gullibility as I can see no good reason to be accumulating US bonds at such low rates when it is all too clear that there is a serious risk of a substantial depreciation (a risk that should be inputted into the required return) - and that if you're translating your dollar holdings into another currency, you're looking at potentially taking a bath.

I rather like, by the way, how Wolff calls a spade a spade in calling a depreciation a partial default, although it is in the end perhaps both too harsh and perhaps not fully accurate.

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

So we have several scenarios, which he runs through. If you're an FT suscriber, check out the article directly, the graphical supports are very helpful and informative.

Wolff hypothesises that under postponed dollar depreciation US domestic demand rapidly rises to a annualized real rate of over 4 percent, which will drive a larger bigger current account deficit, as he says "probably rising to well above 6 per cent of GDP." With a dollar stabilized at near current levels, the current account deficit would continue to increase as "the rest of the world would, by definition, be willing to accumulate claims on the US at an increasing rate."

That poses several problems, Wolff cites to the analysis of Andrew Smithers of Smithers & Co in "Profits and Cash Flow Problems for US Companies", September 22 2003) noting that if the current account deficit is to increase, net borrowing by the US (government, corporations and households) must continue to rise as a share of GDP. Hwoever, consumer or household debt appears to be maxing out and household savings are far more likely to rise than fall as consumers begin to pay back accumulated debt. Mechanically, that means either the fiscal deficit worsens or corporations lay on more debt, or both. Then you get a ugly little cycle, as added official debt at this stage is likely to start hitting confidence in the US, whereas increased corporate debt loads is likely to do the same in US corproations, "unless it reflects a surge in investment that seems much more likely to yield good returns than did the doomed surge of the late 1990s." Well, will anyone believe that so soon after a bubble?

As Wolf says, "[t]his scenario looks implausible."

The second scenario, "a dollar rout" looks as ugly. Wolff adds that the G7 ministerial note from Dubai earlier this month introduced some risk of that. He notes, (although the dollar fell back on a serious Bank of Japan intervention) "[a]lready the yen has risen to �111 to the dollar, from �117 in mid-September. Any substantial further appreciation would threaten Japan's fragile recovery. A big rise in the euro would also be dangerous for the eurozone. Moreover, a collapsing dollar would undermine foreign willingness to buy US bonds. The resulting jump in long-term US interest rates would threaten the US recovery."

Sounds like fun, eh? Sounds like recipe for a nice global financial crisis, which I do not want to see personally, however intesting it might be to watch say from Mars.

The last scenario is a smooth global adjustment. Wolff notes for this, we need an improtant increase in demand across the board, globally. Further, that the Asian governments change tack, instead "of continuing to lend more money to the US Treasury, Asian governments, including China, would accept joint appreciation against the US dollar, combined with greater spending at home. Stronger growth of demand is no less an imperative in the eurozone, particularly Germany."

Now, I fully expect to see pigs fly before such conditions are met, although I do think there is something short of this idealized scenario that might produce similar effects.

In short an excellent article, even if Wolff's argument may be over strong at some points, the dangers and issues are all too real.

October 01, 2003

FT- Wolf: On the US Economy.

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