14 Responses to “A slowing US could brake the world”

Comments

1. Willem H Buiter: I find myself in broad ‘qualitative’ agreement with Martin’s analysis. The US consumer has been on an extended saving holiday for over ten years. Two major asset bubbles, first the tech bubble that crashed in 2001, and since then the housing bubble (now at an end with house prices tottering on the edge of a precipice), have encouraged and enabled the consumer to engage in what would have been obviously financially incontinent behaviour had asset prices reflected fundamentals. The Greenspan Fed encouraged this recklessness by sending the consistent message to households and markets that while it would do nothing to dampen an asset price bubble (whether through interest rate increases, increased margin requirements or open mouth operations), it would respond aggressively to any sign of an asset price collapse. It will be interesting to see whether the ‘Greenspan put’ for those exposed to the threat of a drastic fall in the US stock market will be repackaged as the ‘Bernanke put’ for those exposed to a drastic tumble of US house prices. I hope and trust that this will not be the case.

   The rest-of-the-world counterpart to the spendthrift behaviour of the US consumer have been the extraordinarily high saving rates in a number of key emerging markets, mostly in Asia, and notably in China. These have been paired with a willingness of the authorities in these countries to accumulate US dollar-denominated fixed income securities in staggering amounts, often as foreign exchange reserves, despite their low interest rates and the likely prospect of major capital losses through US dollar depreciation.

   The correction of these global imbalances and asset market anomalies could, in principle, be smooth and orderly, provided governments in both financial deficit and surplus countries take the right policy measures, and provided the private sector responds appropriately to asset price signals. Martin argues that such a soft landing is possible but not likely. His argument is based in part on the belief that a truly massive reduction in US demestic demand is required to put a serious dent in the US current account deficit.

   I believe that the magnitude of the adjustment faced by the US (and its counterparts abroad) is significantly smaller than suggested in Martin’s column. Let’s assume that the present roughly seven percent of US GDP current account deficit has to be cut in half, to 3.5 percent of GDP. Martin argues that since US imports are only about one-sixth of US GDP, a reduction in US (household) demand would improve the external deficit only a little. If imports are 17 percent of GDP and the current account deficit is seven percent of GDP, then imports are about 16 percent of US aggregate expenditure or ‘absorption’, the sum of consumption, investment and government spending on goods and services. Let’s also assume that the marginal propensity to import (the change in imports as a fraction of the change in absorption is the same as the import share in absorption, that is, 16 percent. It’s clear that if a 3.5 percent of GDP reduction in the current account deficit has to be brought about exclusively through a reduction in US imports, at given terms of trade (relative price of imports to exports) and at a given real exchange rate (relative price of traded to non-traded goods), the reduction in US expenditure would have to be huge – well over 20 percent of GDP.

   The reason this is way too pessimistic is that a reduction in US aggregate expenditure not only reduces US imports, it also increases US exports. This is lost sight of if one thinks of exports exclusively as goods demanded by the rest of the world. Foreign export demand for US goods (at given terms of trade and real exchange rate) depends on foreign aggregate expenditure, not on US aggregate expenditure. However, exports also have to be supplied. Export supply equals the excess of US production of exportable goods over US domestic demand for its own exportable goods. At given terms of trade and real exchange rate, US production of exportables does not change when US aggregate expenditure falls, but US domestic demand for its own exportable goods will fall. This then releases US exportables for the export markets. I know of no estimates of the US ‘marginal propensity to spend on its own exportables’, or even of estimates of the share of US spending on its own exportables as a share of total spending. US exports are about 10 percent of GDP, which is much smaller than the share of manufacturing in value added (say 16 percent) plus the share of tradable services in GDP. Even if we take tradable services to be as little as 10 percent of GDP (which would be ridiculously low), then US expenditure on its own exportables would be the same (as a share of GDP or of total spending) as its spending on imports. That would halve the estimate of the reduction in total US expenditure required to achieve a given reduction in the current account deficit.

   It gets even better. If 16 percent of a reduction in total US expenditure falls on imports and 16 percent on exportables, then the remaining 68 percent represents a reduction in US spending on non-traded goods. Even if we hold the terms of trade constant, this reduction in demand for non-traded goods would depress the relative price of non-traded to traded goods (a depreciation of the real exchange rate). If this releases resources from the production of non-traded goods to the production of exportables, there now would be an increase in the US production of exportables, to reinforce the reduction in US demand for exportables. In the extreme case where resources are extremely responsive to a change in the real exchange rate and are highly intersectorally mobile, the reduction in US demand for non-traded goods would be transformed into an equal increase in the production of exportables and in the volume of exports. In that case a reduction in US aggregate demand by 3.5 percent of GDP would, at given terms of trade, reduce the current account deficit by 3.5 percent of GDP.

   I don’t believe that this extreme story is the appropriate one for the US. It requires that world demand for US exports is perfectly elastic at the given terms of trade, and that resources flow frictionlessly between the traded and non-trade sectors in the US. It is, however, a good ‘Ron McKinnon’ antidote to the equally extreme assumption employed in the horror stories about US current account adjustment told by Roubini, Rogoff and Obstfeld, that, at given terms of trade and real exchange rate, a reduction in US aggregate expenditure influences the trade balance only through US import demand.

   Focusing on the responsiveness of US exportables production to changes in the real exchange rate and to changes in the terms of trade (because imports are used in the production of exportables) and focusing on the responsiveness of US demand for its own exportables also leads to the conclusion that the equilibrium response of the terms of trade and the real exchange rate a given reduction in aggregate expenditure is likely to be much smaller than that indicated by analyses focusing exclusively on the elasticities of US import demand and rest-of-the-world export demand with respect to the terms of trade and/or the real exchange rate. In the ‘Ron McKinnon universe’, a change in the current account balance brought about by a change in US aggregate expenditure will not require any change in international relative prices. Again, that is not the world we live in, but neither is the elasticity pessimism world in which mechanical application of the Marshall-Lerner conditions implies that getting the US current account from its current level to a sustainable level would require a real depreciation of the US dollar of fifty percent or more. When confronted with such an estimate, the sensible thing is to halve it, and then to halve it again at least one more time.

   In my view, even a disorderly adjustment of key global current account imbalances is unlikely to be a major economic disaster.

   Posted by: FT Economist Forum | September 28th, 2006 at 11:53 am | Report this comment
   

2. Martin Wolf: Willem has posted a wonderful comment that focuses on the central issue of how adjustment of the US current account deficit and the rest of the world’s surpluses might proceed. He focuses, in particular, on the core question of the scale of the relative price changes needed to secure this adjustment if something reasonably close to full employment is to be maintained in the US, during the process.

   I should state, first, that my reference to the consequences for imports of a reduction in spending was not because I believe this is the only route to adjustment. It was rather for lack of space. In previous columns, I have looked at this issue in a more general framework: that of the needed reduction in the excess demand for tradeables, which do, of course, include both import substitutes and exportables. To be fair to Obstfeld and Rogoff (see “The Unsustainable US Current Account Deficit Revisited“) and other academic authors in this field, their models, too, look at tradeables and non-tradeables, not just imports.

   My second point is that the outcome will depend heavily on the time allowed for adjustment. I would presume that the relevant price elasticities are far higher in the long run than in the short run. Thus, if the deficit were to be reduced by, say, 3.5 per cent of GDP overnight, that would have to occur largely through the impact of falling demand on the level of imports. If the adjustment could occur smoothly over many years, the needed shifts in the structure of demand and above all, of supply, might occur in response to what might be relatively small, (though, in my view, still significant) relative price changes.

   Third, the reason I believe large price changes may be needed is partly that the US is a very large economy, as Willem has noted. So terms of trade changes will be required. But I also wonder how exportable many US tradeables really are and, for that matter, how easy it would be to expand US supply of import substitutes. The world market for cars, washing machines, refrigerators and other goods made specifically for the US market is likely to be modest, even with very large price changes. Equally, the US has next to no supply capacity in the production of many imported manufactures. Think of all the many components of a PC: screens; memory chips; and so forth. And I cannot see how the US can convert its recent investment in housing and other non-tradeable services into the balance of payments with ease. Not only will labour need to be reallocated, but a different capital stock will also need to be created. I suspect that this will need quite large relative price changes. Of course, I agree with Willem that a recession would lower the relative price of non-tradeables (so that some of the needed real exchange rate adjustment would occur without any depreciation of the nominal exchange rate). But the crucial point is that this would first require a large reduction in the demand for labour - that is, unemployment. The political impact of that is precisely what worries me.

   Fourth, it is partly because I believe time will be needed that I think it is desirable to start sooner rather than later. The needed adjustment is likely to get bigger over time, not least because the net income account is likely to become increasingly negative.

   Finally, even if one broadens the adjustment out in the ways Willem suggests, it is still quite large. Take the assumption that the total supply of tradeable goods and services is 25 per cent of GDP and that current demand for tradeables is 32 per cent of GDP (the difference, of course, being the external deficit). Assume, too, that this gap needs to fall from 7 to 3.5 per cent of GDP. Assume, finally, that marginal and average expenditure on tradeables are the same (ie close to one in three). Then, as Willem notes, without any shifts in the pattern of demand and supply (expenditure switching), what would be needed is a reduction in overall spending of about 10 per cent of GDP. That would reduce spending on tradeables by the needed 3.5 per cent of GDP. This, of course, would also mean a deep recession.

   So the question is how big a depreciation in the real exchange rate would be needed to bring about this external adjustment with a reduction in the overall spending level of just the minimum theoretically required: 3.5 per cent of GDP. For reasons I have suggested above, I believe it would still be quite large, because the US would need a different economic structure from today’s to achieve this result.

   The bottom line: yes, if the adjustment is given plenty of time, a soft landing is certainly possible. But is that what is going to happen? I wonder.

   Posted by: FT Forum - Martin Wolf | September 28th, 2006 at 4:22 pm | Report this comment
   

3. Wynne Godley: I strongly support the structure of the argument in Martin Wolf’s article with its increased emphasis on the danger of recession in the US if personal saving now rises to a more normal level.

   I think the best approach to strategic planning is to consider, not an unconditional forecast, but the worst case that is reasonably on the cards and then to work out what could be done to put things right.

   The potential scale of the possible slowdown in the US is perhaps best indicated, not by what is happening to house prices, but by the fact that, after allowing for repayments, households in 2005 borrowed $1.24 trillion by way of mortgages, consumer credit and other loans. If household debt were now to rise no faster than disposable income – not a very strong assumption – the fall in borrowing and the implied rise in saving could be enough to generate a prolonged growth recession if it happened slowly or an outright recession if it happened quickly, as in 1989-91.
   If such an outcome threatened, it could only be avoided if the US economy were to receive an unprecedented boost from net export demand. For this to happen there would surely have to be both a depreciation of the dollar and also a reduction in saving in the rest of the world. But there is virtually nothing the US authorities, on their own, can do to ensure that either of these conditions is met. Market forces, on present form, are certainly not going to do the trick by themselves.

   Martin Wolf is right to be worried.

   Posted by: FT Economist Forum | September 28th, 2006 at 7:03 pm | Report this comment
   

4. Stephen Cecchetti: It is hard to disagree with Martin’s assessment that the large US current account deficit poses substantial risks to the world economy. As he rightly notes, the question is not if adjustment will occur, but when and how. Obviously, I don’t know the answer – and if I did, well…

   In trying to think this, I believe it is worth asking both how far it must adjust, and how it is likely to get there. On the first, my sense is that the US can support a deficit that is roughly 3 per cent of GDP without too much trouble. The reason is that, at least for now, US Treasury securities form the reserves of the world’s banking system. If you are emerging market banker and want to hold a low risk, highly liquid asset, would you hold your government’s debt or that of the US? As the world economy grows, banking system assets grow, and the absolute dollar level of reserves held outside the US grows with it.

   But 3 per cent is a far cry from 7 per cent; where will the other 4 per cent come from? Martin suggests that one source could be a household shift from consumption to saving. The big concern is that would create a slowdown in the US that would then cascade, bringing the rest of the world with it.

   Here, I have several observations. First, I am in the camp that thinks potential GDP growth is likely to fall back below 3 per cent. Domestic investment has simply not been high enough to sustain anything more. There is a reason that American corporations have so much cash – they can’t find any profitable projects inside their companies! My guess is that the US will slow relative to the rest of the world, and this will help the current account shift toward balance.

   Second, we are having a big debate about household behaviour. One the one side, there is the argument that households are not saving, and this has to change. And when it does, the economy will slow significantly. I wonder. Looking at the latest reading, the current ratio of wealth to consumption in the US stands at 5.8. With the exception of the extraordinary period from early 1997 to mid-2000, that’s as high as it has been at any time in the last 50 years. In fact, by historical standards current consumption levels are consistent with wealth that is $3,000bn lower. That suggests we could withstand a fair sized drop in real estate valuations without having to make any adjustments, and that growth in the US is likely to stay a bit over 2 per cent.

   Finally, there are foreign governments and investors – the people who are financing the US current account deficit. I am sure they will use the resources they have available to them to protect their dollar-denominated investments. This means keeping the dollar from collapsing and interest rates from rising.

   So, while it will be very tricky to navigate through all of this, my conclusion is that the US economy will slow naturally and that the current account will adjustment gradually. But then, for the past three years I’ve been betting that long-term US interest rates would rise….

   Posted by: Stephen Cecchetti | September 29th, 2006 at 1:46 am | Report this comment
   

5. Willem Buiter: Martin’s response to my comment is both balanced and to the point, while my comment only aimed for the latter quality. In what follows, I shall try to emulate him in both dimensions.

   It is true that the importance of the supply of exportable and import-competing goods has been part of the canon for a long time. The first formal derivation of what became known as the Bickerdike-Robinson-Metzler and Marshall-Lerner conditions goes back to 1937 and the great Joan Robinson - denied the Nobel Prize in economics by a coterie of reactionary fuddy-duddies who objected to the (admittedly rather demented) Maoism she espoused in her twilight years. The problem is that the empirical (or at any rate numerical) exercises applying this approach to the US economy appear to me to be far too pessimistic about the scope for shifting resources between the non-traded, exportable and import-competing sectors.

   I agree that the responsiveness of the supply of exportables and of import-competing goods to changes in the terms of trade and in the relative price of traded and non-traded goods will be greater the longer the period allowed for adjustment. I therefore support Martin’s recommendation that corrective measures be introduced sooner rather than later, as this will permit the adjustment to be more gradual and less costly.

   I am much more optimistic than Martin about the capacity of the US economy to shift resources swiftly and relatively painlessly out of the non-traded sectors and into the production both of exportables (and actual exports) and of import-competing goods and services. Martin, I believe, focuses too much on the manufacturing sector. The US economy is 80 per cent services and about 60 per cent privately produced services. The ICT revolution and other technological and political drivers of globalisation have massively reduced transportation and communication costs, have created many new traded services and have turned many traditional non-traded services into traded services. The internet has increased the share of tradable goods and services in total GDP and has reduced the cost of switching sales between domestic and foreign markets for many goods and services. I export consultancy services from the UK to the European continent and to the US without ever leaving my office desk at home.

   Of course, there remain non-traded sectors. Even if existing non-traded goods and services cannot be transformed into exports or import-competing goods and services, a very similar outcome can be achieved by moving resources (capital, labour, management) out of these non-traded sectors into traded sectors. Here it is important to note that the US remains one of the most efficient market economies in the world. Intersectoral and interregional mobility of labour, capital, management and firms is higher than in most other countries. Almost all European nations would incur much higher intersectoral resource reallocation costs if they were faced with the need for a current account adjustment of the magnitude confronting the US today.

   There is indeed no such thing as frictionless, costless factor mobility. Both sunk (fixed, irreversible) and convex (speed-of-adjustment-related) costs will be incurred, even if markets function efficiently and there are no Keynesian effective demand failures. The US economy has significant nominal rigidities, and any sizeable reduction in effective demand will cause transitional Keynesian unemployment and excess capacity, on top of the unavoidable problems of sectorally mismatched human and physical capital. The sign of the effects is clear. Their magnitude is not.

   Fundamentally I am, as far as the US is concerned, a supply-side optimist when it comes to the speed and magnitude of realistically achievable intersectoral resource reallocations. I expect that, provided the necessary steps are taken promptly by the US Federal, state and municipal authorities and by the private sector, the US external deficit can be brought down to sustainable levels without the need either for reductions in overall spending much in excess of the magnitude of the required reduction in the external deficit, or for a very large depreciation of the real exchange rate of the US dollar and/or a significant worsening of the US terms of trade.

   Posted by: Willem Buiter, London School of Economics | September 29th, 2006 at 2:19 am | Report this comment
   

6. Ronald McKinnon: To reduce the US current account deficit from 7 to 3.5 per cent of GDP, adjustment must start with in fall in total US absorption relative to income of at least 3.5 per cent. Willem Buiter assumes, at least initially, no change in the dollar’s real exchange rate - defined as the terms of trade between US tradable goods and those produced in the rest of the world. Instead, Buiter in his excellent analysis correctly focuses on the more relevant price, that of nontradables relative to tradables (both importables and exportables), for adjusting to the hypothetical fall in absorption within the American economy.

   Let us presume that the 3.5 per cent absorption decline is not abrupt, but nevertheless is fairly definite as part of corrective government program, i.e, highly visible fiscal improvement and no more housing or other bubbles on the part of the Fed. If well signalled and spread out over some years, the fall in absorption itself one would gradually bid down the price of U.S. non-tradables relative to tradables - which remain buoyed by robust external demand. This natural fall in the relative price of non tradables then gradually releases resources, capital and labor, for greater U.S. production of both importables and exportables. Of course nobody would know exactly (least of all economists!) how much the relative prices of non tradables would eventually fall, but the United States has a very flexible economy where workers and firms continually adjust to various shocks - and a 3.5 per cent fall in absorption spread out through time isn’t all that large.

   Adjustment should start with a gradual but definite fall in domestic US absorption while maintaining monetary and exchange rate stability, and then let relative prices seek their own level. However, starting with some abrupt change in the exchange rate, e.g. a large dollar devaluation, would be a bad mistake. This is the wrong relative price, and abruptly changing it would actually make reduction in the U.S. current account deficit - from our hypothetical 3.5 per cent fall in domestic absorption - more difficult.

   In the short run, a deep dollar devaluation would turn the terms of trade against the United States so as to widen the current account deficit. In the medium term, there would be perverse spending effects. The US would look to multinational corporations and others to be a more attractive (less expensive) place to invest and possibly stimulate an investment boom. Conversely, foreign countries with sharply appreciated currencies could suffer investment slumps - with their economic downturns reducing the demand for U.S. exports. This kind of slump happened to Japan from the sharply higher yen from the mid 1980s through its lost decade of the 1990s. Finally, a deep devaluation of the dollar would force inflation in the United States (as in the 1970s) or deflation abroad (Japan again) - but nobody would know quite the exact trade off between the two.

   In conclusion, I agree with Willem Buiter that today’s trade imbalances are not harbingers of an imminent disaster. Nevertheless, the US should respond in the sensible way by gradually reducing its excess absorption. However, reaching for the wrong instrument by driving or talking the dollar down in the foreign exchange markets would be a major international calamity.

   Posted by: FT Economist Forum | September 29th, 2006 at 10:26 am | Report this comment
   

7. Robert Hunter Wade: Wolf’s column and accompanying charts of global financial imbalances should remind us that a global monetary system which permits this amount of instability is not much of a system. His warnings are all the more pertinent because he was one of very few economic analysts who from the beginning of the East Asian/Russian/Latin American crisis of 1997-99 emphasised that the deep cause was a development strategy of economic growth with foreign inflows of capital, and the proximate cause was whiplash movement of capital across the exchanges. Most other analysts, in contrast, zeroed in on “cronyism”, “excessive state intervention”, and other stable structural features, the better to deflect attention away from the dangers of open capital accounts and reliance on foreign savings for financing economic growth. Many of his readers cannot have been pleased.

   Wolf points to the need for substantial inter-state coordination of economic management, in which the US finally begins to cut its external deficit while surplus countries expand their domestic demand. The problem, of course, is that the need is not mother of the action. His line of solution throws into relief the night-to-day discrepancy between the reasonably robust mutilateral governance of trade and the patchwork multilateral governance of finance and macroeconomic policy ( on which his column last week on the IMF is germane). Mechanisms for achieving the needed inter-state coordination scarcely exist.

   Thinking beyond the box, we should aim at a multilateral financial system which can impose more symetrical obligations and costs on both surplus and deficit countries–such as an interest charge on surpluses as well as on deficits. And one which uses a distinct currency unit for international transactions separate from any national currency. It could be called a global currency unit, or GCU, and be based on the inflation-adjusted real GDPs of the major economies. Governments and companies wcould issue bonds denominated in the GCU and hold them in their reserves. Countries would make cross-border payments in their own currency, with the payments settled inside an international clearing union using the GCU as the base unit of measure. Exchange-rate changes would be made in-house in line with changes in reserves, at regular intervals. The exchange rates would reflect costs and production and demand, not gambling against future movements. (See further, my op-ed “The case for a global currency”, International Herald Tribune, 4 August 2006; and Jane D’Arista, “Reforming the Privatized International Monetary and Financial Architecture” , Challenge, May-June, 2000.)

   In the absence of effective multilateral governance of finance and macro policy many developing countries will continue their strategy of seeking trade surpluses as an engine of investment and growth, and hence intervene in currency markets to keep their currencies undervalued. But what makes sense for one country adds up to collective folly. When the next series of financial crises opens “policy windows” analysts should be ready to ride ideas for a global currency into the center of the debate.

   Posted by: FT Economist Forum | September 29th, 2006 at 11:08 am | Report this comment
   

8. Martin Wolf: These are very interesting additional comments.

   The points made by Willem Buiter and Ronald McKinnon are, at heart, empirical. The question concerns the size of the relative price changes needed to convert a given reduction in absorption (ie demand) into the balance of payments rather than into the level of domestic output (and so a recession). They are more optimistic on this than I am. But where we agree is that the longer and slower the adjustment, the smaller the relative price changes would need to be.

   Ron McKinnon has, of course, a wider agenda, which is to return the world to fixed exchange-rate regime. I understand the argument for this. But experience has persuaded me that this is quite impossible under present economic and political circumstances.

   Of course, if the world took up Robert Wade’s suggestion for reciprocal obligations on creditors and debtors, the situation would be different. But that, like a return to Keynes’ idea for an international settlement currency, is not going to happen. It may, however, be the case that the US is the one country whose currency will always obtain some support from its creditors, as Steve Cecchetti suggsts, thus cushioning any currency adjustment - “the dollar: our currency, your problem” as one US Treasury secretary famously said.

   May I add two modest points of dissent on what Steve Cecchetti wrote.

   First, I find a little puzzling the proposition that people don’t save, but the nominal value of their assets is soaring, so the low savings don’t really bear on the likely (or, presumably, needed) level of future savings. If rising asset prices reflect a realistic expectation of higher future incomes, that makes sense. But Steve thinks expectations of future economic growth are over-optimistic (because of low savings and investment). So this does not seem a strong justification for a continuation of the non-existent household savings. But I do accept that higher corporate savings (also shown in the reasonably strong equity prices) are a good reason for households to save less, since they own most of the corporate sector (along with foreigners).

   Second, contrary to what he says, if growth slows, that is likely to make adjustment more difficult, not easier. Adjustment of the external deficit requires a reduction in the growth of demand relative to that of output. If output grows more slowly than expected, as Steve suggests, then demand must also grow more slowly, if the US is to achieve a given rate of reduction in the deficit. That makes adjustment more painful to the American people, not less.

   Posted by: FT Forum - Martin Wolf | September 30th, 2006 at 2:07 am | Report this comment
   

9. Akio Mikuni: The US economic growth is, to a great extent, dependent on uninterrupted growth in indebtedness of the household sector. Its outstanding amount which surged from about 80 per cent of GDP during the decade ended 1995 to about 120 per cent in 2005 indicates that the household indebtedness in excess of 80 per cent of GDP appears to be supported not by economic activities, but by rising house prices. This could be a typical bubble, as we saw here in Japan during the 1980s.

   The current economic slowdown indicates a possibility of significant declines of house prices in the future. This should lead to reduction in housing investments and related consumer spending, resulting in the decline in current account surplus and capital inflow. I am afraid this could lead to the depreciation of the dollars, and reduction in excess liquidity.

   Assuming that the housing market no longer performs the role of a locomotive, its only alternative might be found in the corporate capital outlay. I agree with Martin that declining consumer demand would provide a negative impact on such spending. But with the meaningful depreciation of the dollars against currencies of Asian surplus nations, profitability of domestic production might be improved sufficiently to justify a major rise in capital investments in tradable goods for the purpose of replacing imports. But, reduced deficits should attract less capital from abroad, and the US economy should remain subdued.

   I have observed economic policy developments in the past two decades in Japan - whether the government could change its policy to drive economic growth from one dependent on external demand to domestic demand. My conclusion has been that such change would not come from the policymakers. The economic system is too firmly imbedded in the Japanese political system to be changed.

   I dare to argue that America could slow down the world “ excluding Japan”. The Japanese export-led economy does not appear well prepared for the US slowdown. If the US slowdown should occur, capital might come back to Japan from the US, resulting in the strong yen. I hope that the Japanese officials in change, when facing such development, will find themselves in hospital or on a skiing trip, and not be able to be summoned in time. Then, Japan could have a great potential for the domestic demand expansion. The strong yen could reduce substantially import costs, thereby increasing purchasing power of consumers, and, furthermore could bring back both currency and purchasing power by exchanging the useless dollars for the usable yen.

   Posted by: Akio Mikuni | October 2nd, 2006 at 7:27 am | Report this comment
   

10. Wynne Godley: Stephen Cecchetti takes comfort from the high personal wealth/income ratio. But against that, the ratio of net household saving to disposable income is negative on a previously unheard of scale; the Fed’s financial obligations ratio was already at a record high in 2006 Q1 and has certainly increased since then; and household debt has been increasing about twice as fast as disposable income. These are trends which cannot continue over any strategic time period.

    I have some difficulty understanding Willem’s position. He comes close to saying that if household expenditure now falls, there will automatically be a substantial and largely offsetting rise in exports. This seems a bit tenuous – previous falls in domestic demand have certainly not been offset by increases in exports. It is not even clear that falls in domestic demand have increased exports at all.

    Second, he suggests that “corrective measures” should be taken immediately “by the US Federal, state and municipal authorities and by the private sector” without making it clear what exactly those measures would be. He can hardly be proposing fiscal restriction at this stage of the game?

    Posted by: FT Forum - Wynne Godley | October 2nd, 2006 at 6:37 pm | Report this comment
    

11. Fred Bergsten: The only problem with Martin Wolf’s analysis of the risks now facing the world economy is that it is too sanguine.

    He is quite right to compare today’s situation with that of the early 1970s, after the last period of such robust growth. In fact, the present dangers look very similar to those that brought a full decade of turmoil from 1973 forward: more energy shocks, dollar declines, trade protectionism and indeed invention of the term “stagflation”. We are now clearly at an inflection point for the world economy and the historical parallel is much more unsettling than reassuring.

    It is also too sanguine to conclude, as Martin does, that the US current account deficit is being driven solely by surplus savings and demand for dollar assets in the rest of the world so that US policymakers “must keep demand well above output levels”. To the contrary, there is a high degree of autonomy in the growth of excess US demand during this decade, driven by the dissipation of the budget surpluses of only five years ago and the stunningly low interest rates engineered by the Federal Reserve. The United States bears a large part of the responsibility for aligning its domestic economy with a sustainable pattern of global growth, which is almost certain to occur via unexpectedly high interest rates in the absence of substantial fiscal correction.

    The protectionist implications of the inevitable global adjustment are perhaps the most frightening of its many worrisome aspects. Imagine the United States in a year or two with growth below 2 per cent or even recession, unemployment rising to or beyond 6 per cent, a global current account deficit of $1 trillion with a bilateral imbalance of $300 billion with China and the dollar still overvalued by 25 per cent or so, continued suspension of the Doha Round and thus no bicycle of liberalization, and perhaps a Democratic House of Representatives and/or Presidency for good measure. The outlook for the global trading system would be grim indeed.

    Martin’s final understatement in all this concerns the role of China. Its global current account surplus, cyclically adjusted to account for its booming growth, is calculated at 11-12 per cent of its GDP by my colleague Nicholas Lardy. It is set to become the world’s largest exporter next year or in 2008. Its laudable openness, along with its size and rapid growth, provide it with both the capability and responsibility to contribute positively and preventatively to the essential global adjustment. This joint leadership to move the world toward a soft rather than hard landing is the real agenda for the United States and China.

    Posted by: C. Fred Bergsten | October 2nd, 2006 at 11:49 pm | Report this comment
    

12. Martin Wolf: I seem to find myself about half way between the optimists (Willem Buiter, Ronald McKinnon and Stephen Cecchetti) and the pessimists (Wynne Godley and Fred Bergsten). I am quite comfortable with this position

    May I also make the following comments on what Fred has just written.

    First, we agree on the protectionist dangers and the disturbing parallels with the early 1970s. We agree, too, that China is a big part of the solution. I am writing about this topic this week and, I expect, also next week. But I do not agree that it would have been better for the US to have followed significantly more restrictive monetary and fiscal policies in recent years, unless that would have led others to alter their exchange rate and macroeconomic policies. Otherwise, the outcome would have been weak growth in both the US and the rest of the world. I am unpersuaded that this would have been a sensible choice.

    If a country cannot influence the relevant policies of others, it has to respond to them. I believe the US has responded reasonably sensibly to the impossible position in which it has been put by the surplus savings and associated exchange-rate policies of much of the rest of the world.

    Posted by: FT Forum - Martin Wolf | October 3rd, 2006 at 1:04 pm | Report this comment
    

13. Joseph Stiglitz: Martin Wolf is, I believe, absolutely right to be worried — a slowdown in the US economy would have global consequences, especially in Europe, whose nascent resurgence is still not on firm ground. For the past five years, America’s economy has been sustained by consumption — on a basis which is not sustainable. Americans have taken money out of their houses, to finance consumption beyond their income. Even without a rise in interest rates and a decline in housing prices, this could only go on for a limited time. But the day of reckoning may not be in the too distant future, as housing prices soften. There is a certain irony that one of the things keeping the economy going is pessimism: this has contributed to the inversion of the yield curve, so mortgage rates have not increased (or housing prices not fallen) as much as one might have expected, given the increase in T bill rates.

    What will fill the gap? Firms have the liquidity, but they are unlikely to expand investment as consumption growth is tempered. Huge fiscal deficits are putting the reins on more government spending. Exports are unlikely to increase enough, especially if an American slowdown contributes to a global slowdown. Large changes in the exchange rate would clearly help (though even then, the lags in response of exports/imports are sufficiently long to leave one more than a little worried)—but these large changes in exchange rate would themselves set off huge readjustments of asset prices all over the world, the kind of costly adjustment that Wolf seems rightly worried about. And, as Wolf points out, if it works, America’s gain will be largely at the expense of the rest of the world, which will see their exports decrease and imports increase.

    There is an old saw about someone being asked for directions, and the reply coming, “I wouldn’t start from here.” America, and the world, is now dealing with the legacy of a series of momentously bad decisions made in 2001-2003: tax cuts that provided only limited stimulation, in spite of huge deficits, necessitating low interest rates which, for the most part, did not finance investment but rather a consumption binge. The resulting weak balance sheets on the part of government and households reduces room to manoeuvre; there was a high probably that there would be problems down the line—and this prognosis remains as valid today as it was then.

    Currently, global “co-operation” in addressing these fundamental problems consists of a variety of fora in which each country can lecture the other. America can tell Europe to grow faster and China to revalue its exchange rate. Everyone can lecture America about reducing its fiscal deficit. But it’s clear these lectures aren’t doing much — and often for good reason. Much of the discussion focuses on symptoms, rather than the underlying systemic problems; doing something about the symptoms can actually make the underlying imbalances even worse, at least in the short run. As I’ve explained elsewhere, were China to revalue, America’s multilateral trade deficit would be little changed, but there would be increased difficulties in financing this deficit. The underlying problem is the dollar reserve system. It is already fraying. Will we wait until a full blown crisis before we address the problem?

    Posted by: FT Forums | October 4th, 2006 at 10:13 am | Report this comment
    

14. Martin Wolf: I find myself largely agreeing with Joe Stiglitz on this occasion. I have just three comments on what he has said.

    First, I have argued elsewhere that the roots of today’s difficulties lie in the financial crises of the 1990s, not only in the mistakes of 2001-03, and I suspect Joe would at least partly agree. As Joe argues, these crises did indeed reflect the defects of the present global financial and monetary systems.

    Second, I agree that the fiscal policies of the US under this administration were both inefficient and inequitable. But strong fiscal action was surely needed after the bursting of the bubble in 2000. If action had been left to the Federal Reserve alone, we would probably have seen zero interest rates in the US, as we did in Japan.

    Finally, we need to ask what we are going to do about the monetary and financial systems that inhibit most countries from running current account deficits and so have left the US as borrower of last resort. There are, I think, three options. The first is a move back to something like the old gold standard - ie fixed exchange rates and a common monetary policy. This is Ron McKinnon’s position, as I understand it. The second is a move toward exchange controls, with an international settlement currency, of the kind originally proposed by John Maynard Keynes. This is Robert Wade’s preference. I don’t know how far Joe would go in this direction. I dislike it, because it is far too dirigiste (and very difficult to implement). The third option is to embrace a world of freely floating major currencies, though with some regional currency unions (as now in Europe) and other currency arrangements (eg dollarisation and euroisation), with each country, large and small, borrowing almost entirely in its own currency and so with the currency risks borne by the creditors. My preference is the last. I intend to write further on this big issue in the near future.

    Posted by: FT Forum - Martin Wolf | October 4th, 2006 at 4:54 pm | Report this comment
    

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