Global Balancing Act

WSJ.com - ECONOBLOG : "In 1944, officials from the Allied nations gathered in the sleepy New Hampshire resort town of Bretton Woods to plan to rebuild the global economy after the end of World War II. Their meeting would give birth to the World Bank, the International Monetary Fund, and an agreement that each nation would maintain its exchange rate relative to gold. The system eventually fell apart in 1971, when the U.S. abandoned the gold standard.

But economists in recent years have argued that the world has tilted back to a new -- if not formally agreed upon -- Bretton Woods-style system of fixed global exchange rates. Some say that this new system is fundamentally stable and will allow the U.S. to continue to finance its large and growing current-account deficit for a long time. But others say that this apparent re-emergence of a global fixed-rate regime won't last, and that it will unravel more quickly than it did the first time and at great cost to the world economy.

The Wall Street Journal Online asked economists Michael Dooley of Deutsche Bank and Brad Setser of RGE Monitor to explore the roots and potential dangers of this global economic balancing act.

Michael Dooley writes: Why has the U.S. current account deficit reached about 6% of gross domestic product? Why have long-term interest rates in the U.S. remained very low at this stage of the business cycle as the Federal Reserve has pushed short rates up? Why has the dollar depreciated by a large amount against floating currencies such as the euro but remained quite strong relative to currencies (mostly Asian) that are actively managed by their governments? Finally, how long will this situation last and how will it end?

Our primary message in these papers is that an economically important bloc of (mostly Asian) countries manages exchange rates to promote export growth and rapid industrialization. Their primary economic problem is the rapid assimilation of hundreds of millions of workers into a modern economy (China) or an economic recovery (Japan).

Asian development policy has generated very large purchases of international reserves and exports of savings to the rest of the world. We believe that the U.S. current-account deficit is a byproduct of the ability of U.S. households and firms to capture and profitably utilize this supply of internationally mobile savings. A recent Fed study suggests that the extra supply of savings and goods in the U.S. has reduced long real interest rates by about 1.5 percentage points. It would be foolish to pass up such a bargain.

The U.S. deficit and low interest rates will last as long as Asian savings are placed in the international market by Asian governments and as long as other industrial countries are too weak to bid those savings away from the U.S. We predict that this will last for a decade, although the dollar will slowly depreciate and U.S. rates will slowly rise during this long adjustment period.

From the start we have predicted that the Asian governments will want, and be able to, feed international credit markets as a part of their development strategy. Brad and his colleagues have argued that the system should have collapsed years ago and in any case cannot last till year's end. They announce that China will overheat, reserve holders will dump dollars, and the U.S. will protect itself from low-priced goods. Moreover, the system will end with a crisis a la Argentina by the end of this year. It is October, and we have enjoyed being right for 28 months. Are you still looking for the end of the world by year end?

Brad Setser writes: I read that to mean that there is no cause to worry if U.S. net external debt -- that is, the gap between American assets abroad and what the U.S. owes the rest of the world -- rises from around 20% of U.S. GDP in 2003 to something like 75% of U.S. GDP in 2013. That will happen even if the trade deficit stays at around 6% of GDP. Right now interest payments on U.S. external debt are small, but they won't stay that way for long. By 2013, the current-account deficit, which includes interest payments, would reach 9% of U.S. GDP even if the trade deficit stabilizes. Put differently, it is OK if the U.S. doesn't save, since the U.S. can outsource saving to Asia for some time.

I -- and my colleague Nouriel Roubini -- do think these trends are unsustainable. They imply a lot of external debt for a country that doesn't export much. And since external debt is ultimately a claim on future U.S. exports, it implies further falls in the dollar -- just as Argentina's rising external debt burden eventually led to falls in the peso. Those now lending to the U.S. in dollars for long terms at low rates risk large losses.

But we never said the system would collapse at the end of 2005. A collapse in 2006, maybe. A collapse before 2008, likely; before 2010, almost certainly. This year, a tax holiday is encouraging U.S. firms to bring their accumulated foreign profits home. Plus, we argued that as other countries peeled away from the Asian dollar-financing cartel (Japan and Korea have more or less stopped intervening), China would initially assume a larger share of the burden of financing the U.S. It will take a bit of time before the burden becomes too big even for China. Finally, it sure seems the world's petrodollars are making their way to the U.S., one way or another. I'll grant you that oil exporters have joined the new Bretton Woods system, big time, this year.

Next year poses more risks. The tax holiday will end. The Bush administration seems intent on financing guns, prescription drugs and Katrina without any increase in tax revenues -- as Jim Cramer notes, President Bush is "making Johnson look like a fiscal conservative." And election year politics will no doubt lead the U.S. administration to push for further renminbi appreciation -- and potentially less Chinese financing for the growing U.S. budget deficit.

So even if China and the world's oil exporters want to continue to subsidize the U.S., I am not sure that the U.S. will be willing to accept the gift. We haven't exactly found a way to make sure all parts of the economy share equally in this subsidy -- talk to someone who works for Delphi. Do you all really think China will be able to continue to rely as heavily on exports for growth in 2006 as it did in 2005?

• The winners from the current U.S.-China trade don't realize that U.S.-China trade is responsible for their success. Home owners in Orange Country and real estate brokers in Florida are not lobbying for China to hold on to the yuan peg. The U.S. Treasury -- the biggest winner of all in some sense -- is lobbying China to change the peg.

• The upper Midwest is the epicenter of the (very troubled) U.S. auto industry. China's auto sector is developing fast. A slowing U.S. economy, no matter why the economy is slowing, will increase, not decrease, demands for protection.

• China (and others) may not be willing to continue to accept low-yielding U.S. assets, and so far, the U.S. has been willing to trade Treasury IOUs for Chinese goods, but not to trade U.S. oil companies for Chinese goods. A Chinese de Gaulle would rail at the inequity.

• The transition from a win/win (fast growing exports/falling real rates) system to a don't lose/don't lose (existing exports/relatively low rates) may prove difficult.


I also wanted to discuss how oil exporters have become a key part of the Bretton Woods II system, but I guess I should save that for my next post.

If continuing on the current course poses large risks, what should be done?

• The U.S. should close the structural gap between tax revenues and government spending.

• China should let the renminbi rise more now, and the rest of Asia should follow. It also needs to get off a dollar peg for real, and take a series of steps to boost consumption. Less government savings would help, as would a modern social-insurance system.

• The Middle Eastern oil exporters should stop pegging to the dollar. Surpluses countries should not peg to the world's biggest deficit country.

• The evidence from Germany suggests that labor-market reforms, on their own, are as likely to drag down European domestic demand as raise it. I wouldn't bank on them to spur global rebalancing. But steps to make German consumption more responsive to low euro rates would help. More generally, macro policies in Europe need to be stimulative."