Tuesday, May 27, 2003

The General always reads Stephen Roach, and so should you! oach turns in another great analysis today of the unstable and unbalanced nature of the global economy. His comments are mostly what he's been saying for months, but there are a few juicy new tidbits thrown in.
"Currently, about 75% of the world�s total foreign exchange reserves are held in the form of dollar-denominated assets -- more than twice America�s 32% share of world GDP (at market exchange rates). At the same time, foreign investors hold about 45% of the outstanding volume of US Treasury indebtedness, 35% of US corporate debt, and 12% of US equities. All of these ratios are at or near record highs. Never before has the world put more stock in America -- both as an engine of growth and as a store of financial value."
With figures like these, the US powers-that-be will surely feel the pressure sooner rather than later of playing Paul Krugman's 'confidence game'. The US Treasury hardly holds the fate of the dollar in its hands, and the temptation will be to play to the fears of all these foreign investors by raising interest rates if they start to spook

What makes the US different from East Asia in 1997 is that Americans have debts denominated in their own currency, and so a sharp decline in the value of the greenback doesn't have nearly the implications for economic collapse which it does in Indonesia or Argentina. That being said, how do you stop all these people from selling dollars all at once? Raising interest rates seems suicidal in the current atmosphere, although just holding the line in face of sure-to-come European rate cuts may be somewhat useful. How much "talking up" can John Snow do?

Think it can't happen here? Let me take you back to late 1978 when foreign investors looked at US inflation and its growing current account deficit (then a whopping $15 billion, or about $35 billion in 2003 dollars!!) and decided it was time to head for the hills. Rather than choose capital controls, President Carter chose Paul Volcker and a radical austerity program that pumped the federal funds rate to over 10%, on its way to over 17% in 1980 and over 19% in 1981. In comparison to East Asia and continental Europe, the US looks positively inflationary today. There's no reason why a repeat of 1978 can't happen.

And the Fed will have to react strongly to any whiff of capital flight since Americans won't save a dime as long as there are deals to be had at Home Depot and Wal-Mart. US consumption is utterly dependent on foreigners' belief in the value of the dollar.

Some look at this scenario and see inflation rather than deflation as the big bugaboo. However, competitive devaluation has already shifted into gear, especially in Japan. A rapidly falling dollar will surely be met with efforts to stop the plunge by buying dollars with yen or euros, slowing the inflationary effect without necessarily keeping money in the US (see dictionary under: Euromarkets). While the US is unlikely to see Japan-like deflation, a deflationesque malaise is certainly in the cards.

Roach sounds the clarion call for global re-balancing, but is anybody listening? Roach shows himself to be a good political economist when he sums up his analysis by saying, "All this speaks ominously of the deeply entrenched forces that are aligned against global rebalancing."


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