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Thursday, May 29, 2003

Devaluation advocates in Washington must think hard

Amidst all the folly, in a piece I neglected to post, Andy Xie, as usual, is talking some sound sense. Obviously the US deflation argument is controversial, and I am not advocating it. The problem is that the simple 'the liquidity trap's the problem' argument fails to convince (I'm sorry Paul). It fails to convince because it has no real argument to explain why we are (globally) falling into the trap, and why now. It also fails to convince because putting up an inflation target, and complying with it doesn't tell us what we need to do two or three years from now. It doesn't tell us because it is a-historic. It is Darwin in abstract state space, and this is a mistake. We need to deal with the concrete specificities of the time we have been allotted (even if my use of language here is rather ugly). So maybe there is no way out of deflation, maybe the global economy just made a 'phase transition' and maybe we need to think again, and get more to the heart of the matter. I don't know, I am thinking aloud. But isn't that what blogging is all about. Mein Gott, mein angst!! Meanwhile note the point that the structure of global trade, and the fact of the US dollar as the reserve currency (very path dependent this) means, as Andy says, that the combination enables the US to determine global prices. That for all the dropping of the dollar, the price of a PC, or the price of a pair of shoes, doesn't change much. Forget the textbooks for a moment, go out and take a look at what is happening. Remember, theory is grey, but life is green!

The US dollar adjustment against the euro is about income share rather than current-account balances, in my view. Euro weakness allowed the euro zone to gain export competitiveness. The US and the euro zone had similar export performance prior to 1997. The euro zone’s exports have risen by 17% since 1997, compared with stagnation for exports from Japan and the US. Pushing the euro back to its 1997 level eliminates the euro zone’s competitiveness. The euro has already appreciated beyond this level.

Lifting the euro well above its 1997 level may backfire. The euro zone’s demand may weaken to such an extent that other regions would not benefit from the euro’s strength. The US must put a stop to the current round of competitive devaluation soon. Competitive devaluation is likely to boost the US economy for perhaps 12 months. It will then have to face deflationary pressure again. Mild deflation is the right solution for the US, in my view. The stock market bubble drove the US consumer to over-consume in 1999 and 2000. Some deflation would flush out this excess. It would also trigger debt reduction -- the counterpart of over-consumption in the balance sheet.

If the US insists on reflating the economy, consumption will continue to rise. Even if a stronger euro boosts US exports to Europe temporarily, we do not think this would be sustainable. When price competition becomes the main demand factor, production usually shifts to China.

A strong yen, for example, boosted US exports to Japan by 12% in 1994 and 20% in 1995. However, US exports to Japan have declined by 20% since 1995. The income-starved Japanese went searching for better deals -- their search always ends up in China.

I think that we are seeing a replay of the Japan story. Everyone is enjoying the euro party at the moment. The euro zone is likely to import more from everywhere in the near future. This will put pressure on European companies, and they will likely do what Japanese companies did under the same circumstances – move production to China. The US is trying to grow out of its problem, i.e., exporting more to pay for its excessive consumption. With a shrinking export base and a huge trade deficit, this strategy is likely to fail. Even if the dollar’s recent depreciation is magnified by 200%, the US still could not export out of its problem, in my view.

While the US tries to reflate out of its problem, the dollar’s integrity -- the foundation of the global economy -- is not yet under threat. The US dollar isn’t just another medium of exchange. It is a vehicle for wealth storage for those who try to accumulate wealth in societies that don’t respect property rights. Without US dollar wealth as a safe-haven asset, the global economy would collapse, in my view.

Federal Reserve Board Chairman Alan Greenspan commented that the paper money system resembles the gold standard, because central banks have done their job too well. This is precisely the point. The US is the largest and most open market in the world. East Asia has surplus labor and capital. The combination allows the US market to determine tradable prices. When the euro rises by 20%, the US dollar value of a PC or a pair of shoes remains the same.

The US dollar’s predictable purchasing power is the reason that East Asians are accumulating the currency (see our report, Green Fetters, dated August 28, 2001). The US dollar is today’s gold standard. Globalization functions on the US dollar’s predictable purchasing power. All other currencies can sustain appreciation against the US dollar only if their underlying economies gain competitiveness against East Asia. This is virtually impossible, in my view.

American policy makers are talking about reflation. Unfortunately, this will not work unless US dollar prices rise significantly. As China is adding capacity rapidly in a world that already has excess capacity, reflation is an impossible task, unless the US destroys the US dollar’s integrity.

This is my worry. Conventional reflationary policies would only prolong the large trade deficit in the United States. US external liabilities could increase by a further US$1 trillion in two years. Would the US accept the deflation solution in 2005, when the current bout of stimulus may lose its potency, to preserve global stability, or would the US be tempted to destroy US dollar integrity to renege on its external liabilities, which may have reached US$4.5 trillion by that time?

American policy makers should understand that, if the US dollar collapses, the US would likely cease to be the superpower. At the moment, in my view, Americans can enjoy their living standard and still spare so much for defense because of low labor costs in East Asia. If this were no longer the case, Americans would have to do everything themselves and might not be able to put together the war machine that they possess today. Devaluation advocates in Washington must think hard, I believe.
Source: Morgan Stanley Global Economic Forum

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