Why is the dollar so strong? It has soared 25 per cent on a real trade-weighted basis in the past four years, evoking memories of ascents in the early 1980s and at the turn of the millennium. In the previous cases, the result was a widening of trade and current account deficits. What might be the outcome this time?
The answer to the first question is that the US has far stronger demand, relative to potential output, than the other big economies: the euro zone, China and Japan. The answer to the second is that it will impose strong deflationary pressure and weaken demand for US output, making it harder to tighten policy than the Federal Reserve imagines.
As Daniel Alpert of Westwood Capital notes: "No economy is an island." This realisation is what was missing from the analysis of the current state of the euro zone by Jürgen Stark, a former member of the board of the European Central Bank. He said: "Germany has reliably pursued a prudent economic policy. While others were living beyond their means, Germany avoided excess." Yet income and spending have to add up across the world economy. Some can live within their means only because others do not. The prudent depend on the imprudent.
Moreover, what one saw inside the pre-crisis euro zone was the combination of low interest rates with a burgeoning of cross-border net lending. As Michael Pettis of Peking University says, it is nearly certain the soaring excess of savings over investment in Germany caused excess borrowing and spending elsewhere.
Integrated system
The global economy is an integrated system. Ignoring that reality is futile. At present, among the most important realities is the chronic weakness of private sector demand relative to potential incomes, in important economies.
People who doubt this need only ask themselves how long-term nominal and real interest rates have remained so low for so long. This is not the result of quantitative easing – a largely irrelevant bogeyman, as can be seen from the fact that rates are also low in the US and the UK, where central banks are no longer creating money to buy assets. The US and British governments can borrow for 30 years at 2.4 per cent and 2.6 per cent, respectively, in nominal terms and at near 0 per cent in real terms.
Imbalances between private income and desired spending are now huge in the euro zone, China and Japan. These economies would be helped by running far larger current account surpluses. All are running, or are likely to run, monetary and other policies that might bring about just this result.
The counterparts for these surpluses cannot now be emerging and developing countries: they are not creditworthy enough. The ideal counterparts are countries that can bear the risks of large net capital inflows. By far the most capable is the US, because of its size and ability to borrow in dollars, the world’s money. The drivers in each of these giants are strong. In all three, the result is progressive easing of monetary policy, radically so in Japan and the euro zone.
Crisis and retrenchment
In the euro zone, the “sudden stop” in lending to the vulnerable economies triggered crisis and then retrenchment in both private and public sectors. In the absence of any offsetting expansion in the creditor countries, the euro zone as a whole has struggled to become a bigger Germany. Between 2008 and 2013, the current account of the euro zone swung from a small deficit to a surplus of 2.8 per cent of GDP. This cushioned the collapse in GDP: while real domestic demand shrank by 5.9 per cent between the first quarter of 2008 and the first quarter of 2013, real GDP shrank by 3.5 per cent (although the drop was hardly small).
Today, the monetary policies of the ECB will work only if the falling euro helps promote a boom in net exports. It is hard to believe in a sustainable domestic spending boom, given the large debt overhangs in vulnerable countries, the absence of fiscal expansion and the fact that households and businesses in creditor countries are reluctant to spend.
China faces similar challenges. In the run-up to the crisis, it balanced the economy by running a trade surplus that peaked at 9 per cent of GDP in 2007. In the aftermath of the crisis, it replaced lost exports with a huge credit-fuelled investment boom, which saw investment rise to half of GDP – unsustainable in an economy whose rate of growth is falling rapidly.
How will China now manage its excess supply of savings without suffering a deep recession? The answers are likely to include a rise in trade surpluses, promoted by a weakening exchange rate.
Finally, there is Japan. There, the corporate sector is the main source of excess savings. But, unlike Germany, Japan has been willing to offset the huge financial surplus of the corporate sector with a huge financial deficit in the public sector, the result being exceptionally high levels of government debt. Today’s ultra-loose monetary policy will not eliminate the excess savings. A resurgence in the current account surplus would, however, alleviate the consequences. Again, the strong dollar and weak yen can only help the cause.
Demand deficiency
In a world in which the private sectors of big economies suffer chronic demand deficiency syndrome, we are sure to see a hunt for such scraps of demand as exist. In its World Economic Outlook of October 2008, the IMF analysed the fall in the global imbalances and was inclined to believe it would last (see chart). This may prove too optimistic. At the very least, US spenders will, once again, have to pull not only their own economy but much of the rest of the world. This time, it is unlikely to work for long. It is also going to be quite hard work. The Fed must take due note. martin.wolf@ft.com – (Copyright The Financial Times Limited 2015)
