[Mb-civic] You need us and we need you

Wed Apr 6 14:45:24 PDT 2005

You need us and we need you
Apr 6th 2005
>From The Economist Global Agenda

America and foreign central banks are locked in a codependent relationship:
America is addicted to spending, and the banks can¹t stop throwing money at
it in order to keep their currencies down. This is unhealthy for both
parties, say the IMF and the World Bank. But is there any political will to
change it?

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AMERICA has been warned many times in recent years that its profligate
spending is dangerous, for itself and for the world economy. So far,
however, Americans have ignored such doom-mongering, gleefully driving their
current-account and budget deficits to record levels. Now the World Bank and
the International Monetary Fund (IMF) seem to be trying to stage an
intervention. This week, both have come out with reports on the global
financial situation‹and both reports give warning that America¹s fiscal
irresponsibility poses serious risks to the world economy.

Neither organisation issues the kind of scathing indictment that might
offend its most powerful constituent. Nonetheless, both make it pointedly
clear that America¹s copious spending is a real, and growing, problem for
the rest of the world. America¹s 12-month current-account deficit now stands
at $665.9 billion, or 5.7% of GDP. Since a negative balance in the current
account must be complemented by a positive balance in the capital account,
this means that foreign funds are streaming in. America is mortgaging its
future to pay for current spending.

Part of the reason this spending is so hard to get a grip on is that it is
happening on multiple levels. With interest rates low, consumers have been
tapping into their home equity and taking on credit-card debt‹the latest
figures from America¹s Bureau of Economic Analysis show individuals¹ savings
were just 0.6% of their income in February. Meanwhile, even after massive
tax cuts, the Bush administration has forged ahead with ambitious spending
programmes. Thus, in 2004 the federal government¹s budget deficit hit $412
billion, a worrying 3.6% of GDP. It is projected to fall only to $365
billion, or 3% of GDP, in 2005.

The gap between income and spending has been financed by foreigners,
especially central banks; more than half of all publicly available Treasury
bonds are now held abroad (see chart). But the central banks that are buying
up all this paper, particularly Asian ones, are trapped in something of a
vicious circle.

The natural adjustment mechanism for America¹s rapidly growing foreign
liabilities would be a declining dollar, which would lower demand for
imports and make America¹s exports more attractive on foreign markets. But
the Asian central banks are stalling this process because they want to keep
their currencies from appreciating against the dollar and thus becoming less
competitive‹and buying sackloads of dollars and then dumping them into US
Treasuries achieves just that. This simply enables America to borrow more,
making the inevitable adjustment sharper when it comes. That risk, of
course, makes dollar-denominated assets less attractive, meaning that the
Asian central banks have to go to ever-greater lengths to keep their
currencies from appreciating.

We can¹t go on like this

The World Bank estimates that roughly 70% of global foreign reserves are now
in dollars. That growing portfolio of dollar assets is vulnerable to
currency correction. This is not such a problem if the dollar declines
gently, but an abrupt change in its value could spell trouble, as central
banks find themselves with gaping holes in their portfolios.

Central banks have another problem: many are reaching the limits of their
ability to ³sterilise² their currency transactions. In order to keep their
exchange-rate operations from causing inflation at home (the natural result
of keeping one¹s currency undervalued), central banks sell bonds on the
domestic market in order to mop up excess money supply. However, this is
expensive, since in many cases the interest rates on domestic bonds are
significantly higher than on the Treasuries the central banks are buying.
The World Bank estimates that this differential costs emerging-market
central banks $250m a year for every $10 billion they hold in reserves.

There are further, institutional, limitations. The Reserve Bank of India,
which is forbidden to issue debt or sell rupee assets on international
markets, is running down its inventory of securities to sell. Last autumn,
South Korea¹s central bank bumped up against the annual limits on the sale
of government debt. And China, a huge consumer of American debt, has been
stuffing securities into its state-owned banks at below-market rates. This
has made its already-fragile financial sector even weaker, and cannot go on
indefinitely.

But as the IMF notes (and the World Bank agrees), dollar depreciation cannot
be the only mechanism of adjustment for current global imbalances. They want
developing countries with artificially cheap currencies to make their
exchange rates more flexible. Europe and Japan are urged to stimulate
domestic demand, taking the pressure off America to be the world¹s
customer‹though this seems a little unfair to Japan, which has been
energetic, if ineffective, in pursuit of consumer stimulus. And America, the
Bank and Fund make clear, must get its fiscal house in order, cutting its
budget deficit and encouraging consumers to save.

I can quit any time

Unfortunately, like much good advice, these recommendations seem to have
little hope of being implemented any time soon. The political pressure in
Asia to subsidise exports with low exchange rates is intense. Interest rates
in Japan have been near zero for four years, giving the central bank little
room for additional action; meanwhile, the European Central Bank seems to be
preparing for a rise in interest rates this autumn, to keep inflation near
its target of just below 2%, which will hardly do much for demand. And in
America, the political will to reduce deficits seems to be all but extinct.

Given all these reasons to worry, it might seem surprising that both the IMF
and the World Bank are broadly optimistic about the world economy. But as
they point out, growth in 2004 was robust, and the world is currently
enjoying high levels of macroeconomic stability. Alan Greenspan is expected
to deliver steady increases in interest rates, slowing American demand, and
forcing its consumers to rebuild shaky savings; it is hoped that this will
help bring about an orderly adjustment in the dollar¹s value. This will not
be pain-free for the rest of the world‹developing countries that have got
sweet debt deals from investors fleeing low American interest rates will
find their borrowing less easy to finance. But the resulting decline in
imports should allow central banks to cut back on the breakneck pace of
growth in reserves. And who knows? Perhaps once ordinary Americans are
forced to live within their means, they will start demanding the same from
their government.