Auerback Report: Why Lenin was Wrong

Marshall Auerback
September 16, 2003

Problem: The Kindness of Strangers is Killing America

The Fed's flow of funds data that was released last week more than ever highlights America's acute dependence on the kindness of strangers, particularly those of the Asian variety. Globalisation has been turned on its head. Instead of the centre lending capital to the developing periphery, capital is flowing back to the centre—that is, the United States.

Discussion

Even poor nations are lending the United States huge quantities of surplus capital, mainly to keep America afloat as the world's buyer of last resort.

China is the new "bad boy" of the global economy, having displaced Japan as the aggressive emblem of a trading system ferociously out of balance. Congress has begun making increasingly loud protectionist threats as a consequence. Even leading US cheerleaders for freewheeling globalisation (including Federal Reserve Chairman Alan Greenspan) have begun scolding China for excessive ambitions, just as they once criticized Japan, to no avail. The National Association of Manufacturers issued a report warning that 2.3 million US manufacturing jobs have disappeared since 2000, largely due to international competition (not entirely from China). The United States risks losing "critical mass" in manufacturing, says the NAM. A Defense Department technology-advisory group confirmed that so much "intellectual capital and industrial capability" has been moved offshore, particularly in microelectronics, that the Pentagon is dangerously dependent on foreign producers to make its high-tech weaponry.

If the United States falters and can no longer acts as the engine of global growth, the entire system is in deep trouble. Of course, the corollary also applies: With the current account deficit is at 5% of GDP for the first time in history, America's dependency on Asia's central banking fraternity is gargantuan. China, Japan, South Korea and Hong Kong now own a combined total of about $696 billion in Treasuries at the end of June about 46 per cent of the outstanding stock of bonds. China alone now holds $290 billion in US government debt, more than any other foreign lender, according to Chen Zhao of the Bank Credit Analyst Research Group. "The flow of Chinese savings has enabled Americans to borrow and spend more," he explained in the Financial Times. "China is glad to see Americans going on another shopping spree. Its factories are cranking up production at an unprecedented pace.... China's exports to the U.S. jumped 35 percent in the first quarter" compared with the first quarter of 2002.

If the US were a developing country, there would already be widespread speculation as to how long before the IMF was rolled in to help. Compare the situation to that of Argentina: Argentina's problem was too much debt for too small an economic engine. When foreigners stopped investing in Argentina, the music stopped and there were no chairs. The fervent hope of US policy makers is that the US economy will surge, its debt repayment capacity will grow, as the country grows its way out of a looming debt trap dynamic. But the arithmetic is hardly compelling support for such a benign outcome.

It is true that the potentially dire effects on the level of activity since 2001 has been mitigated by a transformation in the stance of fiscal policy, accompanied by a radical change in attitudes to budget deficits, which have suddenly became respectable (even under an ostensibly "conservative, small government" Republican administration). The expansionary fiscal policy initiated by President Bush was reinforced by a further aggressive relaxation of monetary policy so that (real) short term interest rates have fallen almost to zero, thereby giving the consumer boom a last gasp. Yet, with all this help, the recovery from the recession of 2001 has not been particularly robust. Growth has generally been below that of productive potential, jobs have been disappearing, and there is a widespread sense that all is not well.

Today, the US private sector financial balance is almost back to neutral after a long stretch since 1997 in deficit spending territory. Because low interest rates encourage households to keep borrowing and spending, the private sector has yet to return to its traditional net saving position of 1-2% of nominal GDP. Virtually all of the improvement has been on the back of the largest fiscal stimulus in history, as opposed to genuine balance sheet repair.

The deepening trade deficit has confounded the ability of fiscal deficit spending to push the private sector back into a net saving position. That means fiscal policy has had to go alarmingly deep into deficit spending to prevent a private income growth collapse. This is inherently unstable: the rate at which foreign debt has been accumulating is such as to generate a further, accelerating, flow of interest payments out of the country, which might necessitate even larger budget deficits in subsequent years.

Such is the current state of affairs that we now have the reappearance of the "twin deficits" so feared by bond investors in the first half of the Reagan Administration. Investors used to worry greatly about this condition and the dollar's trend was largely established each month by widely scrutinized trade reports which highlighted growing imbalances, even though the external condition of the US was nowhere near as dire as today. Then, America was still a net creditor, the current account at its worst never exceeded 3% of GDP, and the geopolitical circumstances of the era largely ensured the maintenance of the status quo, no matter how economically untenable longer term. The nations of emerging Asia built up their manufacturing apparatuses during the Cold War when they abutted major sites of "communism", which gave the United States an overriding interest in fostering their state-led capitalisms in order to prove that capitalism was superior to the communist systems next door. By the start of the 1980s, when the U.S. began to move from competing in manufactures to dominating through finance-and importing a rising fraction of manufactured goods-capitalist East Asia was well placed to ride the surge of U.S. import demand and even to provide out of its growing financial surpluses the savings needed to cover escalating U.S. current account deficits.

Things have changed somewhat today in the post cold war era. Asia is no longer a cold war ally, but a "strategic competitor", particularly China. Yet, in the economic sphere the US still relies on this old cold war construct: Asia exports its goods into a relatively open American consumer market, and then recycles its savings back into Treasuries. But as countless analysts are now warning, the risk of an external creditor revulsion may finally force foreign investors to demand a higher required return (that is, higher interest rates and lower stock prices) in order to both continue holding their massive US dollar denominated assets, and continue to purchase any new financing issued by US public or private entities. It is possible such demands could derail the US economic re-acceleration, and this must be considered the major downside risk at the moment.

The challenge ahead with regard to US financial balances is pretty clear: the US trade deficit must be reversed before the fiscal deficit peaks in 2004.

There is no indication the Administration recognizes this challenge, or is even exploring options to address it, beyond the current protectionist rumblings in Congress and the ineffectual if not counterproductive jawboning of Asia, especially China, on the issue of currency pegging. In fact, threats of increased protectionism to counter China's alleged "unfair" pegged rate monetary regime, might well prove counterproductive, given the extent to which the Chinese are now continuing to provide the fuel to motor further US economic growth, the very dynamic American policy makers hope will allow them to escape their debt conundrum.

Further complicating the picture is that too much growth abroad, ostensibly helping the trade deficit, creates other potential problems. Clearly, America's interest rate structure is closely tied to how well growth and investment demand proceeds overseas. This is why the pickup in the Japanese economy is probably the biggest story in global finance, yet it is getting only moderate attention. If that nation ever really did right its economic ship and sail off on a three or more year period of strong growth, the amount of upward pressure the US would experience on market-based interest rates could be astonishing, particularly in the absence of genuine balance sheet repair.

Conclusion

Thus, there is a troubling circularity to US economic policy making. Growth, which is an essential prerequisite to continued debt repayment, is largely fueled by further debt accumulation. And the countries that continue to perpetuate this paradoxical state of affairs, notably China, still face unremittingly hostile pressure from American policy makers to revalue the currency, thereby potentially precipitating the sort of dollar crisis that could well induce sharply lower growth in the US as foreign creditors demand correspondingly higher risk premiums to compensate for a fall in the external value of the greenback.

Given the precarious nature of America's predicament, one would have thought that a prime objective of diplomacy would be to cement good relations with its largest creditors, so as to minimize these economic vulnerabilities. Yet, just two years after the September 11 attacks, the opposite appears to be the case. Traditional alliances in Europe are marked by increased friction; for all of the talk of new "friendships" with Russia, the global economic system's prosperity ultimately rests on the US-EU alliance which, if it really breaks down, will take the global economy down with it. Cancun appears on a knife's edge.

As in Europe, the United States today is finding a new coolness in its relations with old friends in Asia. Whether in Tokyo, Beijing, Jakarta, or Bangkok, the analysis of US objectives and motives is sharply at odds with the standard American rationale. In their view, the US wants a strong and prosperous Asia, but only on American terms - economically sound, politically obeisant to Washington, and largely accepting of the American economic model.

This is also being reflected in the country's current negotiating stance in the impending global trade talks at Cancun. The rights of foreign capital and corporations are to be expanded; the rights of sovereign nations to decide their own development strategies steadily eliminated. A country must not require multinationals to form joint ventures with domestic enterprises. It must not limit foreign ownership of its natural resources. Capital controls are to be abolished. National health systems, water systems and other public services must be open to privatization by foreign companies. Underdeveloped countries must, meanwhile, enforce the patent-rights system from the advanced economies to protect drugs, music, software and other "intellectual property" assets owned by wealthy industrialists. Any poor nation that dares to resist the WTO rule will face severe "sanctions"—huge cash penalties—and possibly de facto expulsion from the trading club. On the other hand, any talk of eliminating agricultural subsidies is quickly shot down and left as a vague subject for future negotiations.

America's hard-line stance might be understandable were its military dominance matched by comparable economic might. But such a position is far less tenable when the US is the world's largest supplicant for global capital flows and fighting an increasingly expensive global war on terror. It is premised on lopsided power play which presupposes that an economically vibrant, strong America can easily press the weak to accede to their terms or else get nothing back at the bargaining table, and very possibly lose their access to foreign capital or development aid. But who is it that is most dependent on foreign capital at this stage?

Asia in particular appears to have learned its lessons well from 1997: policy makers in the region have concluded he who holds the credit, gets to choose when to pull the rug out from under the dependent debtor, and on terms fairly non-negotiable. At best, then, the imperial debtor can try to be cordoned of his consumers of global goods from such blackmailing creditors, thereby undermining their ability to accumulate further claims against him. But since it is in no small part US based corporations or subsidiaries operating out of export platforms in China and other Asian nation, this would be a hard one to pull off without the imperial debtor power slitting its own throat. Lenin's "sell them enough rope and capitalists will hang themselves" theory was incomplete. As China may have figured out, you have to sell them the rope on credit to really hang the little piggies high (or, at the very least, to keep the protectionist wolves at bay).

But the nexus between China and the US is fundamentally unhealthy and ultimately points to the fragility at the heart of the global economy right now.

China's "kindness" is in effect killing America. By allowing the US to buy more than it produces and borrowing to do so, it will eventually force an ugly reckoning. With its ever-swelling trade deficits, the moment of painful adjustment draws closer, but the debt cycle is unlikely to stop until creditor nations conclude that the US debt position is too dangerous and start withholding their capital. Alternately, if China's overheated economy gets mired in financial disorder or inflationary pressures, as appears to be the case today, it might need to bring its capital home—thus pulling the plug on American consumers and the "buyer of last resort" for the global system at large. It would certainly be nice to think that Washington's policy makers would act to deal with this looming threat, but it hardly seems credible with a Presidential election around the corner. Nor would an open acknowledgement of America's current economic failings be the sort of thing one would expect from a President who makes press conferences against the backdrop of aircraft carriers in order to project an aura of supreme American might. The dollar is beginning to roll over, and the US markets are having so much relative difficulty making headway recently in the face of an extraordinarily accommodative monetary and fiscal posture. All of this suggests an underlying awareness on the part of the markets' of the grave challenges facing America in the future.