Tuesday, December 07, 2004
Well, I'm still yorking stuff up, but it's no longer green. So I guess I can blog again.
The cover story of the latest Economist is about the dollar, the trade deficit, and the coming global economic apocalypse. Message from The Economist: Americans need to cut the budget deficit or the world economy is doomed.
Now, I'm nervous about the dollar. And about the world economy. But I find it very hard to get overly excited about America's budget deficit. The fact is, the US is about in the middle of industrialized countries in terms of public finance. Here are three key numbers: government consumption as a percentage of GDP, the deficit (or surplus) as a percentage of GDP, and overall public debt as a percentage of GDP. The first number gives you some measure of how much of a drag the government is on the economy. I presume that government spending is, in general, less productive than private spending, and how that spending is financed is secondary to the actual amount being spent (deficits are just taxes on future earnings). The third number gives you some measure of the burden of past spending; financing and paying off that public debt is the tax on current and future earnings I was talking about. And the second number gives you some measure of how fast that burden is growing.
How does the US stack up against the rest of the G-7 on these measures? Like I said: we're in the middle somewhere.
Country...........Gov't Spending/GDP.........Budget Balance...............Public Debt/GDP
(Numbers are from The Economist and are from 2003.)
Our budget deficit is almost exactly average, slightly above the mean and exactly at the median. Our total public debt and our total government spending are below both the mean and the median. So to me, frankly, it doesn't look like America is out of line in terms of its public finance.
Now, the Economist doesn't specify but I suspect none of the numbers above include unfunded liabilities that are off-budget - i.e., entitlements. But that probably makes America look better by comparison, not worse; our demographics look better than Europe's or Japan's. The other thing to recall is that America spends vastly more on defense as a percentage of our GDP than any other G-7 country (in total dollars, of course, the comparison is even more extreme). If America spent as little on defense as Canada did, our budget would be very nearly in the same state as Canada's - we wouldn't quite be in surplus, but we'd be close to balanced. Of course, defense spending is an economic drag like other government spending, in some ways more so (if the government builds bridges or roads or buildings, these at least can be used productively). But current US defense spending, while below even the lowest levels of the Cold War era, is somewhat elevated due to the War on Terror, a (presumably) temporary condition. If the US has a serious public finance problem, what about Europe, where France and Germany each have higher deficits, higher public debts, higher government spending, and much lower defense outlays? And if the deficit is the cause of the dollar's fall, why is the dollar falling against the Euro, given that public finance is arguably in worse shape in Europe than it is here?
Of course, there's a key variable I left out of the above: the percentage of public debt that is externally financed. The United States, unlike the countries of Europe and Asia, finances the majority of its large debt overseas. Look at Japan, for instance. Japan has been running obscene deficits for years, and has a public debt so high that the government is, effectively, bankrupt. But this debt is financed almost entirely domestically, by private Japanese savings. The Japanese people, in effect, owe this money to themselves. Their public finance is a mess, and could result in political unrest if the government tried to solve its problem by a massive redistribution of wealth. But that redistribution would be entirely within Japan, so it doesn't really implicate Japan's exchange rate.
So why is so much of America's debt financed externally? Well, there are two schools of thought about this. The one argues that America over-consumes and under-saves. We therefore run a trade deficit and a capital-account surplus: we buy goods from overseas and we borrow money from overseas to pay for those goods. In effect, this argument starts with the trade deficit, and says that the capital-account surplus is the inevitable consequence, as foreigners have nothing else to do with their dollars but buy American securities, primarily government debt. The other argument starts with the capital-account surplus. It says that America has the most efficient developed economy in the world, consistently delivering high returns on investment, and therefore attracts more return-seeking capital than we can generate domestically. Just as a trade deficit necessarily implies a capital-account surplus, the opposite is also true; in this account, foreign buying of American securities drives down the cost to Americans of financing our consumption, and props up the value of the dollar, hence producing a trade deficit. The first argument clearly implies that America has a problem - under-saving and over-consumption - that needs to be fixed. The latter argument implies that somebody else has a problem - the imbalance in the global economy is caused by relative American success, by our extremely efficient capital markets, and not by our failure.
How do we know which story is right? Well, let's start with some axioms. Specifically, let's assume that markets basically know what they are doing, and that these sorts of imbalances would self-correct if one or another government didn't do something to intervene in the market. That's not 100% true - markets aren't infallible, they're just smarter, on average, than the overwhelming majority of individual market participants - but it's close enough to true for my purposes. So if Americans are over-consuming and under-saving, there must be a reason. Or, conversely, if other countries are over-investing in America, ballooning our capital-account surplus, there must be a reason for that, too. And in each case, the reason must be government intervention.
As it happens, there are government culprits to point to for both sides of the argument. In the second half of the 1990s, the US ran large trade deficits, the American savings rate plummetted, and yet the dollar was very strong. Why? Foreign money fled to the US from other currencies that were collapsing because of their own domestic economic problems; the American economy was growing rapidly and productivity growth was also high, producing very high returns on invested capital; and American interest rates were globally competitive. The "American success" explanation for the trade deficit was the most logical one. Now, we're still running large trade deficits, and the dollar is falling, especially against the Euro. Why? American growth is still reasonably strong, certainly compared with much of the industrialized world, and productivity growth is notably high, which is the primary driver of returns on invested capital. But American interest rates are very low. Short-term rates are, frankly, alarmingly low considering how quickly the economy has been growing, how the dollar has been falling, and how commodity prices have risen. But long-term rates are very low as well. These low rates make it very cheap for Americans to consume, and we sure are consuming; we just went through the first recession in memory where savings rates didn't rise and household debt didn't fall. The story of the 1990s - that America is doing great and that's why money is rushing to the country - no longer adequately fits the facts. Something else, besides magnificent economic performance, is keeping our trade deficit up: artificially low interest rates.
But what's keeping interest rates so low? Alan Greenspan controls the short-term rate, and he's consistently underplayed the threat of inflation and emphasized the softness of the economy. He may well be right about the economy, but commodity prices seem to be saying something else about inflation - not to mention that we have a national housing bubble, and asset-price inflation is not irrelevant. But long-term rates are set by bond-buyers. And these, as noted, are mostly overseas. Specifically: the governments of China and Japan have been consistent and aggressive buyers of American government debt. Why are they buying American government debt? Both of these countries operate quasi-mercantilist economies. Their economies are overwhelmingly driven by export industries, and they try to consistently run trade surplusses (and, hence, capital-account deficits). When their economies stall - as Japan's has been stalled for years, though it now seems to be coming out of its slump a bit - they are more inclined to stimulate demand abroad by purchasing foreign debt, holding down foreign interest rates, than to stimulate it at home. China, specifically, keeps its currency pegged to the dollar. Based on fundamentals, the Chinese currency should rise against the dollar. To defend the peg, the Chinese government must purchase American government debt. Japan, then, to defend its competitive position vis-a-vis China, must also purchase American debt, lest the Yen rise dramatically, pricing Japanese goods out of the American market.
So what's happening is that the Asian countries are over-buying American debt, artificially holding down American interest rates and stimulating American borrowing and consumption, and hence the trade deficit. This, in turn, makes Euro-denominated assets much more attractive, because prevailing interest rates in Europe are higher. Thus the dramatic rise in the Euro, which threatens Europe's economies by pricing their goods out of the market.
The position of the Bush Administration is, effectively, that the Asians have got to stop this game, but that we're not in much of a rush to make them stop because the Europeans, ultimately, get hurt worse by these shenanigans than we do. (We get cheap Asian imports and cheap mortgages; the Europeans get high unemployment and cheap vacations in the US, further stimulating the US economy.) But the Economist is ultimately right that the consequences, if the game goes on too long, could be very negative for the US as well as for the world economy. A sharp rise in American interest rates would be economically devastating. But if rates are being held artificially low, that's what we'll eventually get. Even worse would be a catastrophic drop in the value of the dollar, which could jolt confidence in America around the world and threaten the dollar's status as the reserve currency. (Though I think the Economist implies a higher likelihood for that scenario than is the case.) So what can we do?
There are, broadly, four things we could do.
First, we could attempt to end the imbalance by fiat. Warren Buffet has called for setting a quota on the total dollar amount of imports, equal to the total dollar amount of exports. This would legislate an end to the trade deficit. It would also absolutely wreck the US and world economies. Buffet is a smart investor, but his economic advice has been frequently lousy. My own inclination is to believe that Buffet gauges the health of the economy by whether he sees lots of investment opportunities. Given that he's a value investor, looking for undervalued securities, this is almost the opposite of the truth. Buffet's reputation was made in the 1970s, when stocks were doing poorly, business confidence was low, and there were lots of inefficiencies that he could exploit. The fact that Buffet is frustrated means a lot to me as an investor; it means there probably aren't a lot of good investment opportunities, and that low returns are more likely than high ones going forward. But that doesn't mean he's going to give good advice on how to run the economy as a whole.
Second, we could argue with the governments of China and Japan to let their currencies rise more against the dollar. We're trying that right now, and we can keep trying it. These countries may be convinced that they are having they best of the mercantilist game they are playing; they are saving a lot, and investing that money, so they probably figure they are getting wealthier and wealthier - plus, by virtue of the fact that they own so much American government debt, they probably figure they've gained political influence over us as well. We've got to convince them that the end of the game is ugly for them, too: their savings will be wiped out by a catastrophic fall in the dollar, and they won't have a developed internal market to fall back on when global trade drops, so when it does their unemployment rates will go through the roof.
Third, Alan Greenspan could raise interest rates. Little could do more to shore up the dollar short-term than a rise in short rates. That would also cool down the American economy and hence reduce the trade deficit. I happen to think interest rates are too low. But I will point out that this sort of logic ultimately ends in cutting off your head to cure a headache. Our primary economic objective, after all, is to achieve robust real growth over the long haul. We can always reduce the trade deficit simply by slowing the economy. But that's not what we want to do. I think short rates are too low because commodity prices are high and the dollar is falling, not because Americans are getting too rich and are spending their money on imported toys.
Fourth, we can try to shift other government policies such that they encourage savings and discourage consumption. For example: America has one of the highest corporate tax rates in the world, and is one of the few industrialized countries not to have a consumption tax such as a VAT. Relative to many other industrialized countries, our tax system is somewhat more biased towards consumption and against savings and investment. The Bush Administration's tax bills have generally been oriented towards redressing that balance by cutting taxes on earned and especially unearned income. But they have also made the tax code more complex and hence less efficient. And I wonder whether it makes sense to be cutting taxes on, say, dividend income, which is frequently spent by the retirees who favor income-producing securities, rather than eliminating the corporate income tax and creating incentives to save income rather than consume it. Bush is talking a big game about tax reform in this term. He's hinted that he's going to bring on yet another economic team, which I hope is true; Snow has not been impressive. I hope he's serious, and I hope he's serious about the right kind of reform. The right kind of reform would not only address the inefficiencies and perverse incentives in the tax code, and would not only keep the overall level of taxation at internationally competitive levels, but would also start to address the American savings deficit that is an important cause of the current global economic imbalances.