Reply #64: Trouble Ahead—Trouble Behind (Ugh)

[54anickel]

http://www.pimco.com/LeftNav/Latest+Publications/2004/Dialynas+Paper.html

Today, the global economy is on the threshold of upheaval. The U.S. has borne the majority of the costs associated with the substantial structural change in the global economic architecture of the past ten years. Severe trade and financial imbalances pose grave risks to international stability. Keynesian spending policies and monetary stimulus predicated upon by Adam Smith’s free trade dogma, and the importance of global growth have produced the vulgar externalities of unsustainable indebtedness in the U.S. and Japan and excessive reliance on foreign capital in the U.S. As shown in Charts I and II below, domestic, non-financial business debt outstanding in the U.S. roughly doubled from approximately $3.8 trillion in 1994 to approximately $7.6 trillion today. Over the same period, the U.S. current account deficit soared from approximately 2 percent of U.S. GDP to nearly 6 percent, or by about $3 trillion, accounting for 75 percent of the increase in U.S. debt formation. Absent a long overdue global restructuring, status quo policies yield to these imbalances. The U.S. current account deficit is forecast to grow to 8 percent of GDP in a few years.

The potential for a dangerous financial crisis exists wherein the burdens of increased debt in the U.S. are transferred from the suppliers of leverage, mainly Asian central banks, back to the leveraged, namely U.S. citizens. Capital inflows into the U.S. have provided for debt formation, which has in turn resulted in an even greater U.S. dependency on foreign capital. Misguided Federal Reserve policy based on a flawed understanding of the natural rate of unemployment is at the heart of the problem. During time of war, such as today, full employment must prevail at all times, so Fed policy is constructed around a variable, theoretical rate of unemployment that is itself a fiction. Current and past Fed policies have promoted consumption, encouraged debt formation and contributed substantially to the trade and global imbalances of today. The objective function for the Fed therefore requires immediate Congressional amendment. Congress needs to impose trade and financial balances as critical variables in central bank policymaking.

The links between an accommodative Fed, consumption, debt accumulation and the explosion in the U.S. current account deficit are captured in Chart III below. Note first in Chart III that the money supply, a measure of the liquidity injected into the economy by the Fed, has expanded substantially from 1994 to 2004. To complete the link, note the explosion in domestic, non-financial business debt outstanding during the period and the surge in the current account deficit as a share of the economy.

What might motivate some members of the cartel of Asian central banks that hold massive dollar reserves to sell these assets? Perhaps it is their belief that U.S. policy makers will be foolish enough to take them out of their positions. Perhaps they will decide that their industrial development is well enough advanced that they no longer need to support the U.S. dollar as the cost for growing market share, importing technology, and expanding production becomes too great. Alternatively, perhaps they will realize that U.S. policy makers have changed their trade agenda such that their products are not welcome.

Ultimately, it does not really matter what motivates the change in behavior. Today, the potential exists for policy makers in a few Asian countries to immediately direct a sale of the holdings of their U.S. assets, and re-direct the proceeds to other countries or to domestic uses. Such a policy shifts would produce a very hard landing in the U.S. which could include: a rapid increase in U.S. interest rates; sharp depreciation of the dollar; a fall in the stock market; a contraction of global trade; a reconfiguration of political/military alliances away from the U.S.; and, at the extreme, even military confrontation as the U.S. moved to sever its excessive reliance on foreign capital.

The scope of the global imbalances and the potential for crisis makes piecemeal, orthodox solutions to the global imbalance problem unworkable and far too slow. The U.S. service-based economy, with more limited economies of scale than those of newly industrializing economies such as China, will not be able to export its way out of the problem. The greatest demand for U.S. goods will be in industries such as aerospace and high technology. These are industries where exports pose national security risks. U.S. dollar devaluation by itself, especially if it is progressively slow, will increase inflation, interest rates and currency volatility without substantially improving the trade deficit. Tariffs would also work slowly and eventually invite counter-tariffs that could cripple global economies.

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