Surprising U.S. economy

Federal Reserve Board Chairman Alan Greenspan. - SHAUN HEASLEY/REUTERS

Despite a high level of current account deficit and external vulnerability, the U.S. economy seems to go from strength to strength. What exactly is going on?

"CURIOUSER and curiouser" is the economic story from the United States. The largest economy of the world, and the undisputed boss of the international economy, is now also by most accounts the most externally vulnerable. Its current account deficit exceeds 6.3 per cent of gross domestic product (GDP), and has been growing despite a real depreciation of the U.S. dollar; the country now borrows around $2.2 billion a day to meet its yawning external deficit; the external public debt amounts to more than one-fourth of GDP; foreigners now hold more than half of government securities and have bought more than 68 per cent of those traded in the past half year.

In any other country, alarm bells would have gone off years ago, and the economy itself would probably have been engulfed in a major financial crisis. Yet, the U.S. economy seems to go from strength to strength despite these absolutely crazy indicators, and both the U.S. government and the U.S. public merrily continue to spend their way through the rest of the world's savings without any apparent problem. What exactly is going on?

TO begin with, a few facts. The U.S. economy has been the basic engine of growth for the world economy for several decades now, although the extent to which it has been able to fulfil that role successfully has varied over time. In the Bill Clinton years, the external deficit was created by private sector deficits, as the prolonged stockmarket boom created wealth effects that spurred private consumption and reduced saving, even as the federal Budget moved into a surplus. The regime of George Bush II marked a shift back into large government deficits, caused by largesse to the rich in the form of massive tax cuts, as well as greater military spending on Iraq and elsewhere.

So now both public and private sectors in the U.S. are in deficit. Incredibly, the only positive input to domestic savings in the U.S. comes from the private corporate sector, which has recently been saving more than it invests. The household sector now has a negative savings rate, amounting to -0.6 per cent of private disposable income. (Incidentally, this is the lowest rate ever recorded even in the U.S.) As a result, even though interest rates are historically very low, more than 13 per cent of disposable income is being used to service household debt.

Because of the low interest and mortgage rates, U.S. households have fuelled economic growth by embarking on a debt-driven consumption spree, which includes buying houses. But the increase in house prices, in turn, is one of the primary causes for the increased consumption, as it has contributed, even more than increased share prices, to making people feel better off and willing to consume more.

Obviously, such a situation is unsustainable, even for an economy that has benefited from holding the world's reserve currency. The U.S. cannot expect the supply of foreign savings to continue to flow indefinitely. In any case, as in any other economy, the shift in domestic incentives away from tradable to non-tradable activities will eventually create problems for the U.S.

Despite this, remarkable as it may seem, the worries about this situation all seem to be expressed outside the U.S. Within the U.S., policymakers are all incredibly upbeat about the situation and do not see any major threats to economic stability in the future. A few months ago, remarks by Ben Bernanke, one of the Governors of the Federal Reserve (the U.S.' central bank) were widely quoted to argue that the problem was not of unsustainable deficits in the U.S., but of a "savings glut" in the rest of the world, whereby the rest of the world ended up sending their capital into the U.S. as the most desirable destination.

A more recent version of this argument, and one which is potentially even more complacent, has now been expressed by Alan Greenspan, the Chairman of the Federal Reserve System and an acknowledged guru of the financial markets. After several months of denial in which he described the real estate boom as little more than "froth" on the system, Greenspan finally admitted in a speech on September 26 that the U.S. deficit is unsustainable and even mentioned the grave risks to the U.S. economy from falling house prices and reduced consumption once the housing bubble bursts.

However, the very next day, he made another speech (at the National Association for Business Economics Annual Meeting, Chicago) in which he painted a much rosier picture, essentially describing the capital inflows into the U.S. as indicators of the economy's essential strength and flexibility. First, he emphasised that a collapse of the housing bubble would not necessarily be a disaster as most households could absorb the loss in asset value. "Despite the rapid growth of mortgage debt, only a small fraction of households across the country have loan-to-value ratios greater than 90 per cent. Thus, the vast majority of homeowners have a sizable equity cushion with which to absorb a potential decline in house prices."

More significantly, he argued that the U.S. economy is inherently stronger and more attractive because of its flexibility, which he felt was the result of decades of deregulation, allowing private agents more freedom to operate, as well as new information technologies. According to Greenspan, this deregulation, especially in the financial, telecommunication, transport and energy sectors, led to enhanced competition and was "a significant spur to productivity growth and elevated standards of living". To outside observers, of course, such an assessment is almost laughable. But at another level it is almost reassuring, as it tells us that it is not only our own policymakers who are capable of such self-deception. The debate on productivity gains in the U.S. rages on, but only the foolhardy would claim that there have been significant gains in the U.S. that are greater than in other economies.

As for standards of living, official U.S. data indicate that the real income of the typical household has fallen continuously for the last five years, despite the fact that three of those years were "high growth" periods. Real annual earnings have fallen for both men and women in the past two years, even though hours worked have increased, indicating that real wages per hour have declined quite sharply (Economic Policy Institute, based on U.S. Census Bureau data).

Probably, however, Greenspan would take these indicators as further evidence of the very "flexibility" of the U.S. economy which he extols. However, his perception of the U.S. financial system as "a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter-century ago" surely is one that would cause eyebrows to rise even among diehard free marketeers. The scams and scandals that have rocked Wall Street since the turn of the century, and which exposed so much of the previous 1990s bubble as being created by the wilful deception by speculators, surely should generate greater caution.

Some of Greenspan's arguments in this regard are disingenuous, to say the least. For example, he cites as proof of his assertion: "After the bursting of the stockmarket bubble in 2000, unlike previous periods following large financial shocks, no major financial institution defaulted, and the economy held up far better than many had anticipated." He neglects to mention that this was because of large-scale and often secret bailouts of financial institutions on the verge of collapse, such as the apparently massive (and still undisclosed) Federal Reserve Board intervention to save the hedge fund Long Term Capital Management, which was on the verge of default in 2001.

Nevertheless, Greenspan then uses this argument of greater flexibility and efficiency to suggest that this lies behind the peculiar combination of low interest, high consumption, high deficit growth that currently characterises the U.S. economy. "Success at stabilisation carries its own risks. Monetary policy - in fact, all economic policy - to the extent that it is successful over a prolonged period, will reduce economic variability and, hence, perceived credit risk and interest rate term premiums."

The mechanism explaining both growth and imbalance that Greenspan is suggesting has been fleshed out by other monetary policy authorities, such as Roger Ferguson, the Vice-Chairman of the Federal Reserve Board. Essentially, the hero (not the villain) of the piece in this formulation is said to be productivity growth.

It is claimed that a surge in labour productivity growth in the U.S. had several important consequences. To begin with, it boosted perceived rates of return on U.S. investments, thereby generating capital inflows that raised the value of the dollar. These higher rates of return also led to a rise in domestic investment. Finally, expectations of higher returns boosted equity prices, household wealth and perceived long-run income, and so consumption rose and saving rates declined. All of these factors then helped to widen the current account deficit.

Add to this the slump in demand in the rest of the world - supposedly because their economies are not efficient and flexible and their productivity growth has not been so rapid - and it is possible to make the case that the U.S. is running such large deficits simply because it is currently the only attractive destination for capital, and financial markets are responding to this.

THE problem with this argument, of course, is that several of the basic premises are wrong. The difficulties with assuming dramatic increases in productivity growth per se in the U.S. have already been noted. Labour productivity has been increasing practically everywhere else, and in many countries (including in the Eurozone and much of the developing world) at a faster rate than in the U.S. This essentially reflects changes in technology rather than the superiority of any particular institutional set-up. And all other indicators suggest that the U.S. is entering a phase of relative long-term decline rather than enhanced economic power.

Second, the rising asset prices in the U.S. bear all the hallmarks of a speculative bubble rather than a real economic shift, and in any case have been aided by government policies such as tax breaks for housing finance. It is commonplace during a bubble for those in it to feel it will go on for ever - the danger is when policymakers start thinking the same way as well.

But the most substantial difficulty with the argument put forward by Greenspan and others relates to the causes of the capital inflow into the U.S. Despite all the talk of "savings glut", in fact savings rates across the world have not increased. Rather, investment rates have come down - most significantly in many "emerging markets" - and this has created the shift towards investment in U.S. markets even by countries whose own need for investment is still all too apparent.

The international domination of finance, which has resulted from national policies of financial deregulation and created the possibility of large possibly destabilising movements of speculative capital, has played an important role in determining this. At one level, increasingly all developing country governments guard against the possibility of damaging capital flight by building up substantial foreign exchange reserves even when these may involve large fiscal losses.

But the fears generated by financial market behaviour have a more telling consequence, of imposing deflationary fiscal and monetary policies upon governments. Across developing countries, public sector savings have emerged as the most important marginal contributor to higher savings rates where they have been in evidence. In the majority of developing countries, where savings rates have not increased, the increase in net lending abroad has been generated by lower investment rates, driven by compression of public investment.

The process that is actually at work can, therefore, be described as follows: Financial mobility and its implications have created deflationary policies almost everywhere in the world except in the U.S., which benefits from the fact that it is perceived as the world leader and holds the world's reserve currency. This, in turn, suppresses investment and growth, and causes investible surpluses to be directed towards the U.S., where they are used by both public and private sectors to fuel a debt-driven boom. Financial integration, consequent upon deregulation, has greatly facilitated the transfer of such savings from poor to rich countries. Paradoxically, the U.S. economy then emerges as the only engine of growth and all other countries are obsessed with ensuring increases in net exports to the U.S. as the means for sustaining their own growth.

It should be apparent that what is critical in all this is the perception that assets denominated in U.S. dollars remain the safest in today's volatile and uncertain financial markets. This is fundamentally dependent upon the rest of the world's notions about the U.S. as the leader of the world and the dollar as the only available reserve currency. We know from economic history that neither of these is immutable and that both must change over time.

However, from the point of view of the U.S., it is obviously important to keep such perceptions going as long as possible, since they enable the U.S. to grow almost at the expense of all other economies. There are many means by which the U.S. tries to keep people of other countries assured of its supremacy, such as trying to ensure its control over the world's natural resources such as oil.

But winning the psychological battle about economic superiority - even in the face of completely contrary evidence - may be just as important. To that extent, the comments by Greenspan, Bernanke and others may be more than just the optimistic outpourings of deluded American policymakers. They may be important inputs into a process of ensuring that confidence in the U.S. dollar continues, at least for a while, and therefore contributes to the persistence of even this unbalanced and unequal world order.