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Monday, September 22, 2003

Global Turning Point?

Following the G7 decision in Dubai, the financial markets are more than a little nervous . Stephen Roach, in contrast, is so ebullient you would almost say he was apocalyptic:

An unbalanced global economy has finally come to its senses. At the just-concluded G-7 meetings in Dubai, the world’s major industrial economies have endorsed the basic premise of global rebalancing -- a long overdue adjustment in the dollar. This could well have profound and lasting implications for the world economy. It is an unequivocally positive development, in my view............

For the US, Dubai was also a watershed event. The motivation is not hard to fathom. At work is an increasingly powerful interplay between economics and domestic politics, as America’s jobless recovery appears on a collision course with the Bush Administration’s re-election hopes. With America’s fiscal and monetary levers already fully engaged, the currency option takes on new and critical importance as the only means left to provide macro stimulus to a beleaguered US labor market. It remains to be seen as to whether such tactics will work -- especially with IT-enabled outsourcing creating a new and lasting global labor-cost arbitrage that biases US employment growth to the downside. But the Bush administration has evidently concluded that a currency adjustment needs to be added to America’s reflationary policy arsenal. In doing so, US politicians should benefit by having fundamental economics on their side, as America’s massive current account deficit screams out for a weaker dollar.

History tells us that the US dollar has only just begun its downward descent. On a broad trade-weighted basis, the dollar (in real terms) has fallen about 8% from its early 2001 highs. In a full-blown current account adjustment, a drop of around three times that magnitude can be expected -- not all that different than the 30% real deprecation of the dollar that occurred in the late 1980s when the current-account disequilibrium was far less acute. In the end, a lopsided world has no choice other than to accede to a weaker dollar. The G-7’s Dubai communiqué now puts the major economies of the world on the same page with respect to the global rebalancing that such a currency realignment can trigger. The road ahead will be long and arduous -- and not without risk, especially in oft-volatile currency markets. But the economics I practice suggest it is the only way out for such an unbalanced world. As someone with a long-standing gloomy bias on global prospects, I am now encouraged for the first time in four years.
Source: Morgan Stanley Global Economic Forum

I've only one big question in the face of this, where does the growth come from? This is the problem. If there is a BIG dollar 'correction', then US consumption will be affected, the US consumer will be able to buy less. Remember Andy Xie's calculations to the effect that each dollar ex-China, becomes 6 or 7 dollars for the US consumer. To dent those imports the change in the yuan has to be fairly big since there are a lot of US china-based margins to trim - and of course there's no sign of any change at all at the moment, in fact there are a lot lot of arguments inside China that the Chinese financial system wouldn't stand a revaluation of the necessary order. Of course all of this could be seen as a tremendous gamble, a gamble to force the Chinese to conform, to 'be reasonable'. But if they don't it could be a gamble with a double backfire, in Europe and Japan.

Because if the Chinese prove either unwilling or unable to respond, make no mistake it will be the EU and Japan who get to do the 'heavy lifting'. And it's this other part, the rest of the world thing I don't see, at least not in the OECD. For Stephen Roach the optimism is easy, the problem is lack of structural reform, and what we will now get are structural reforms. Fine, he's happy. But I worry. I worry because nobody even seems to be thinking about the other part of the problem, the ageing part. The US is outside this a bit, since the demography is much better, but even so, look at the problems the 'baby boom' is about to cause for federal finances.

Obviously if the structural components of the US economy were sound, then the loss of jobs to India wouldn't be a problem. But the fundamental structurals are not sound. So where we go is anybody's guess. Japan is on the upside of the cycle, but will this last? How will Japan cope with a much higher yen? There are a tremendous number of questions. Even the geopolitical dimension is hardly resolved - we're just conveniently forgetting about it. My guess is - ex China, India, Turkey, Brazil - next year's growth forecasts will not be fulfilled.

What I want to say is that all of this is very unstable, and as Roach in his other mood says, one little shock can have big consequences. When we talk of growth this year of 3-4% in the US, just look at the budget deficit you need to get this. It is the rate effect that is important here. The deficit has gone from 2% positive to 4 points negative in a very short time. This is a big stimulus. But next year, they cannot repeat this, they cannot add another 6 points to the deficit, they can only maintain it as it is. So if the growth doesn't arrive, then they have !% to drop on the money side, and very little possible extra stimulus on the fiscal one. Remind anyone of Japan?

One important thing is the corporate debt component. With strong disinflation they cannot get the debts off their necks. So they have to fight about margins, and hence they outsource. The latest numbers on H1B visas speak for themselves on It work in the US, and the bulletin boards are full of disgruntled IT workers. The new jobs at the moment seem to be in construction (housing boom) and health care (ageing). The drop in the dollar could send a river of money out of the US, hit treasuries hard, and cause long term rates to rise. What effect this would have on the 'recovery' is anybodies guess.

The US is at a crossroads, and it is in some ways reminiscent of the UK post WW1. Certainly it is very ironic that they win a war, and then face all this. Of course, I'm not trying to say that devaluing the dollar is a bad thing. For the US, despite short-time living-standard impacts, there could be more solid growth later, and as Brad keeps pointing out their debts are in dollars, so the real bill is paid elsewhere. (Of course, whether this is just is another question, being the reserve currency it seems only has advantages, on the way up you get to be able to borrow a lot, and on the way down you get to burn-off much of the debt). The problem is Europe and Japan. They can't afford to allow their currencies to go up so much. So in fact I end up agreeing with Roach, at the heart of the problem are the global imbalances, with the gap between OECD and the rest being at the top of the list. I'm also trying to suggest that this is not a 'theory problem', but a real empirical one that may not be well anticipated in the theories. There may be no easy short-term solution. Look at the choppy markets today. Maybe they are a sign of things to come.

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