On the surface, the global economy seems to be off to a great start in early 2006. The Great American Growth Machine has revved up again after a Katrina- and energy-related sputter in the final period of 2005. Japan is back, and even Europe is stirring. For China, India, and the rest of the developing world, vigor generally remains the name of the game. The global growth dynamic looks synchronous and increasingly powerful. With inflation remaining low, isn't this the best of all possible worlds?
Beneath the surface, the answer is a resounding "no." Contrary to widespread expectations, synchronous growth in an unbalanced world compounds the imbalances it doesn't resolve them. When imbalances reach the magnitude they are today, rebalancing actually requires an asynchronous global growth outcome. Excessive growth in the deficit country (the United States) needs to slow, while lagging growth in the surplus countries (especially Japan and Europe) needs to pick up. The latter seems to be happening, but the former is not. America's record $68.5 billion trade deficit in January 2006 says it all: US imports and exports are now so far out of balance, that sustained solid growth in the US economy can only beget larger and larger external deficits. This could well be a major yet largely unappreciated point of vulnerability for the global economy and world financial markets.
Consider first the arithmetic of the problem. In the United States, total imports of goods and services are now 59% larger than exports. With the US still running a small surplus on services of around $5 billion per month probably not for much longer, I may add that cushion masks an even larger mismatch in the goods piece of the trade balance. In fact, America's imports of tradable goods are currently 89% larger than US exports of manufactured products. This astonishing mismatch between purchases of goods made abroad and overseas sales of American-made products is an important outgrowth of a huge surge in import penetration into the United States over the past 20 years. Goods imports rose to 37% of America's domestic purchases of goods in 4Q05 up dramatically from readings of 27% in 1995 and 20% in 1985.
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High levels of import penetration pretty much pre-ordain the vicious circle of ever-expanding trade deficits for economies with vigorous growth in internal spending. Again, it's hard to argue with the math. Given the high import content of domestic demand, a given increment of consumption growth, for example, produces a much larger surge in imports than would have been the case in days past when import content was considerably lower. Moreover, the extreme imbalance that now exists between goods imports and exports makes it next to impossible for the US to export its way out of this problem. Exports would now have to expand at twice the growth rate of imports just to hold America's outsize trade deficit on goods constant!
Consider next the analytics of the problem. There are two distinctly different strains of thought that are used to explain America's gaping trade deficit the micro of competitiveness and the macro of saving. The former speaks to the rough and tumble battle in the arena of global trade and often involves politically contentious trade disputes between nations. Taken to its extreme, disputes over competitiveness can lead to trade frictions and even protectionism hardly a trivial concern these days in light of the outbreak of China-bashing now evident in Washington.
The other rationale follows from the classic saving-investment identity of orthodox macroeconomics that nations with shortages of domestic saving will attempt to import surplus saving from abroad in order to maintain investment and overall growth objectives. That means they must then run massive current account deficits in order to attain the foreign capital. Moreover, with the trade deficit accounting for fully 93% of the US current account deficit, this explanation also implies that the extraordinary imbalance between imports and exports is very much an outgrowth of an equally extraordinary shortfall in domestic saving. With America's net national saving rate having plunged into negative territory for the first time ever to the tune of -1.2% of national income in 3Q05, it is next to impossible to avoid large trade deficits. For the US, there is an important twist to the macro underpinnings of the trade deficit: Inasmuch as the surging wealth of American consumers biases the income-based personal saving rate sharply to the downside, the trade deficit is also an outgrowth of the asset-dependent character of the US economy.
The truth as to what lies behind the US external deficit is undoubtedly a combination of the micro and the macro. But the bottom line is that these external imbalances are getting worse rather than better even in the face of an apparent resynchronization of the global growth dynamic. In my view, that reflects the dominance of the macro aspects of the problem. The income-based saving of America's asset economy is so low and the import penetration of its real economy is so high, that more growth in US aggregate demand simply begets ever-mounting trade and current-account deficits. This imposes enormous strains on the international financing mechanism to keep the game going. In 2005, the US needed about $3 billion of foreign capital inflows each business day of the year up dramatically from the $2 billion daily funding requirement just two years ago in 2003.
Such external dependency of any nation is simply without precedent in the annals of globalization and international finance. Moreover, it is the diametric opposite of the flows that drove the globalization of the late 19th and early 20th centuries, when surplus saving of rich European countries was used to fund the development of newly settled developing countries in the Americas and Asia/Pacific. Today, China still one of the poorest countries of the world in terms of per capita income has played an increasingly critical role in funding the US hegemon. The rules of engagement in foreign aid have been turned inside out rather than flowing from the rich to the poor as once was the case, capital is now moving from the poor to the rich. Nor does the saving-short US seem to have much appreciation for the precarious nature of this arrangement. Not only is China bashing on the rise, but Washington politicians are becoming increasingly heavy-handed in attempting to manage the external lifeline of capital inflows.
The Dubai port incident, unfortunately, is only the tip of a much bigger iceberg. There was also last year's high-profile rejection of a bid to buy Unocal by a Chinese oil company. Moreover, in recent weeks, Washington's increasingly xenophobic politicians have gone even further. A leading US senator floated the possibility of legislation preventing cross-border acquisitions of US companies by foreign state-owned entities. And during last week's negotiations over the debt ceiling bill with a lifting of the government's debt limit required only because a saving-short US has decided to up the ante on deficit spending there was actually an attempt made to restrict foreign ownership of US Treasuries. The good news, if you want to call it that, is that this latter attempt has since been watered down "only" to require a detailed accounting of the overseas holding of US government debt. But the irony of these politically motivated efforts to throw "sand in the gears" of America's external funding mechanism is especially striking: At precisely the moment when the US has pushed its external funding requirements into unprecedented territory, it is becoming more and more aggressive in dictating the terms of the requisite inflows.
Meanwhile, there's another very important shoe about to fall in the arena of global capital flows the likely shrinkage of current-account surpluses by the world's largest biggest savers. Japan, China, and even Germany are all making determined efforts to stimulate internal consumption in order to promote balanced and sustainable economic expansions. This will have the effect of drawing down their excess saving, reducing their trade and current account surpluses, and leaving them with less external capital available to fund America's saving shortfall. Japan is leading the way in that regard; on the back of a marked pickup in domestic demand, its trade balance has gone from surplus to deficit for the first time in five years. China is also increasingly focused on transforming its export-led economy into a consumer-driven growth dynamic; that emphasis is very much in evidence at this year's National People's Congress currently in session in Beijing. These developments in both Japan and China are further examples of the pitfalls of a renewal of synchronous growth in an unbalanced world: Unless the deficit nation (the United States) starts saving again, a drawdown of saving elsewhere in the global economy will only complicate the world's current-account financing tensions.
To me, all this speaks of an increasingly treacherous endgame for the current state of tranquility in world financial markets especially the all-important expectational underpinnings of the dollar and longer-term US real interest rates. Investors are nearly unanimous these days in dismissing the mounting economic and political tensions of an unbalanced world arguing that it is in everyone's best interest to keep the game going. The retort of increasingly smug US fund managers is typically something along the lines of, "What else are the Chinese going to buy euros?"
At the same time, I worry about an even more treacherous aspect of the endgame. An earlier era of globalization was brought to a tragic end by two world wars in the first half of the 20th century. While history rarely repeats itself, the rhymes never cease to amaze me. The current wave of globalization is occurring against the backdrop of a very different mosaic of geopolitical risks than those which prevailed a century ago. Nation-specific rivalries have given way to threats coming from the amorphous terrorist ranks. Yet there is a worrisome common thread: In both cases, the integration of economies and capital markets clashed with the fragmentation of geopolitical order. Add in the current tensions associated with widening income disparities, real wage stagnation in developed countries, and the growing outbreak of trade frictions and protectionism, and today's world looks far from secure. The tripwires of globalization are now being set.
By Stephen Roach, Morgan Stanley economist, as published on the Global Economic Forum
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