<B>Unhealthy dependence</B>

Javier Carrillo. Professor. Instituto de Empresa

1 January 2005

The U.S. fiscal policy is shaky. What will happen if this house of cards collapses?

On Nov. 4, 2004, the managing director of the International Monetary Fund, Rodrigo Rato, declared that the main economic problem facing the re-elected U.S. president during his new mandate is the large public deficit of his country’s economy.

Rato encouraged the administration to act, because the problem is currently “one of the grave imbalances of world economy,” and must be “corrected partly through the country’s policy of internal savings.” Rato added that the balance could not be corrected by the U.S. alone, since it is a “complex, global problem” requiring both growth in Europe and the recovery of Japan, as well as the adjustment of Asian currencies to the present economic reality.

In general, analysts agree that the re-elected Bush administration will not make any great effort to solve the problem, which was estimated at the record figure of U.S.$422,000 million in 2004 (5 percent of GDP) and at $2.3 billion for the coming decade in accumulated terms. Despite electoral promises which included a commitment to reducing the deficit by half over the next five years, the Republican’s second-term agenda includes ambitious economic plans which will cost the public treasury billions.

The aim is to make the tax cuts adopted in 2001 and 2003 permanent before they expire in 2010. This will cost an estimated $1 billion in 10 years. Another $2 billion will go for partial privatization of Social Security, so workers can invest their contributions in their own accounts in the private market. It seems that the pledge to reducing the deficit is only possible with drastic cutbacks in social spending, and without guarantee of sustained growth of GDP – perhaps due to the costs of wars in Iraq and Afghanistan.

Another view sees the deficit as a threat to the stability of the world economy. The excess in spending on goods, services and transfers to the rest of the world totals U.S.$600,000 million, almost 6 percent of GDP. As is well known, this foreign deficit compensates the lack of internal public and private saving in the U.S.

For years, the nation’s economy has been consuming more than it produces and investing more than it saves. This activity has been financed by the rest of the world - especially China and other Asian countries. Since 2001, Asia’s official reserves have increased by U.S.$1.2 trillion, which is equal to two-thirds of the deficit accumulated by Washington in the same period.

Purchase of U.S. assets by private foreign investors is explained by the benefits of its economy in terms of growth and productivity. However, in recent years, the flow of international saving has not financed additional earnings in productivity in the U.S., but rather more consumption and public debt.

One can say that a model for international saving and consumption has been established - consequently one of world growth - where the U.S. buys goods from the rest of the world at the same time as the rest of the world loans money to the U.S., so it can buy those goods – and all at historically low interest rates. It is obvious that this model is not indefinitely sustainable and appears to be reaching its limit.

Financial fix or global crisis?

At this time of writing, the euro stands at a new record, above U.S.$1.30. This is partly due to added tension in the Middle East following the death of Yasir Arafat, but above all is a clear indicator of investors’ concern for America’s public deficit problem. The U.S. currency has tumbled over 40 percent against the euro since the maximum levels of October 2000.

After a certain amount of stability this year, the foreseeable continuity of White House policy, together with the apparent conformity of the Central European Bank with the strength of the euro, has taken the single currency to its highest value since it first appeared in 1999. In a context of increasing oil prices, strength in its currency is helping Europe control inflation and hold back rising interest rates, which could slow a recovery in its economy. However, appreciation of the euro is also having a negative effect on the competitiveness of European exports, including the already-battered Spanish sales, which are suffering from a differential inflation that still hasn’t been put right.

As for the other main currencies, since the G7 summit in Dubai in September 2003, the need for Asian monies to assume their responsibility in the unavoidable adjustment of the dollar has been continuous. The Central Bank of Japan has intervened to slow appreciation of the yen (sales for 20 billion yen in 2003, double its trade surplus). China’s government holds firm to a fixed (and undervalued) exchange rate of 8.28 yuan per dollar.

The solution to this conundrum requires correction of the unhealthy dependency between U.S. spending and international saving. In practical terms, it demands a fiscal policy that encourages saving in the U.S., moderating the public deficit problem and the private financial deficit, to reduce dependence on foreign saving. It requires recovery of economic growth of the European bloc, assisted by an expansive monetary policy.

This in turn calls for maintenance of controlled inflation, thanks to improvements in productivity resulting from pending structural reforms. It also requires flexibilization of the Asian exchange system. These circumstances would prompt a gentle depreciation of the dollar and an orderly readjustment of the world economy. It would also help consolidate economic recovery. Unfortunately, these circumstances are unlikely to ever happen.

An alternative and dramatic way of solving this mutual dependence would be an international financial crisis. If nothing changes, and we come to the limits of the current model, we will probably witness a heavy fall in the dollar’s value, which would drag stocks and shares markets with it and force the U.S. to adopt emergency fiscal restrictions and raise interest rates.

The consequent economic recession would, in effect, help solve the financial problems of America’s economy (it would import fewer goods and save more). But this solution is not desirable, especially when other economies, with the notable exception of China, do not seem yet able to assume the role, currently played by the U.S., of being the driving force behind world growth. We can only hope the manuals are wrong.


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