The world economies are finally mounting a recovery from last year's slump. Even the latest word on Japan is a bit more upbeat. The reason, of course, is the upturn in the U.S. economy. The U.S. led the world into a downturn that hit different regions with varying impact, and it will be the locomotive for the recovery.
But therein lies a problem. U.S. financial obligations to the rest of the world are once again on the rise as America grows ever more dependent on foreign capital to finance its growth. Back in March, Federal Reserve Chairman Alan Greenspan noted that over the past six years, about 40% of the increase in the U.S. capital stock was financed by foreign investment, a pattern that will require an ever-larger flow of interest payments going out to foreigners. "Countries that have gone down this path invariably have run into trouble," said Greenspan, "and so would we."
Greenspan was highlighting the fact that the gap between what an economy consumes and what it produces cannot continue to widen indefinitely. At some point, foreigners come to the belief that either the country's overconsumption requires a policy adjustment, or that investment opportunities elsewhere begin to look more attractive.
The most important result of this shift is the softening of the debtor nation's currency. For the U.S., a weaker dollar won't be a problem if the adjustment occurs slowly and orderly. However, currency markets rarely move that way. And any sharp change in the dollar's value could wreak havoc in the financial markets as well as portend a higher level of inflation as the price of imports begins to rise. Consequently, the U.S.'s mounting external debt is clearly the most crucial structural problem facing the economy. And unlike other recent economic troubles, there may be no easy way out.
TYPICALLY, A RECESSION helps narrow the trade deficit. But last year's slump was anything but typical, and the U.S. external imbalance did not improve much. Now, renewed growth in U.S. demand, coupled with the potent buying power of the U.S. dollar, is drawing in imports by the boatload (chart), which once again means the U.S. trade deficit is widening sharply. The January and February increase in imported goods was the largest two-month rise in two decades.
The trade gap is the main component of the current-account deficit, which is the broadest measure of U.S. financial obligations to other countries. After last year's respite, the external debt is starting to mount up anew. Last year's current-account gap hit 4.1% of gross domestic product, and it could reach 5% by the end of of 2002. That would be the largest rate in the industrialized world and larger than in many emerging-market nations.
Finance ministers from the Group of Seven industrialized countries informally voiced concern about the U.S. current-account problem in Washington on Apr. 20 during the spring meeting of the International Monetary Fund and the World Bank. Europe, in particular, expressed worries that the imbalance could eventually put the dollar, financial markets, and U.S. and world growth at risk.
One solution would be a gradual weakening in the dollar. But stemming the dollar's rise has proved difficult. Even during the official recession months of 2001, the broad trade-weighted value of the dollar continued to rise (chart). And while last year's economic slump was much worse in the U.S. than in Europe, the dollar remains slightly stronger vs. the euro, compared with this time last year.
WHAT'S PROPPING UP THE DOLLAR? Foreigners still see U.S. assets as better investments than other opportunities around the world. Indeed, in one sense, the U.S. may have become a victim of its own success. Thanks to its high-tech overhaul of the 1990s, the U.S. economy can grow at a fast rate without stoking future inflation. That means big payoffs for stocks, bonds, and direct capital investment. The U.S. potential growth rate is higher than that of most other countries, particularly those in Europe. That has made the U.S. a magnet for foreign investment while also giving the Fed unprecedented maneuvering room to keep interest rates low in order to assure a strong recovery.
And make no mistake: The Fed is committed to establishing a hearty recovery. In his testimony before the Joint Economic Committee on Apr. 17, Greenspan made a surprisingly clear statement about the near-term direction of monetary policy. While acknowledging that the current level of Fed-controlled interest rates was too low to keep inflation in check over the long haul, he also said that with near-term inflation prospects so favorable, he still was not prepared to raise rates until a sustained, solid expansion was in view.
That comment sent Fed watchers scurrying to revise their timetables for when policymakers would move to raise rates back up to a level more consistent with a neutral policy that would neither spur nor retard economic growth. Given the first quarter's burst of growth, expectations had been increasing for a Fed hike in June. Now, most economists don't look for any rate action until August, at the earliest.
IN FACT, THE FED could well be the last major central bank to lift interest rates in this global recovery. In recent weeks, Sweden and Canada have already done so. Britain may be next, and the European Central Bank is already expressing unease that a recovery is emerging with both wages and prices growing too fast for comfort, with industrial operating rates not having fallen very much, and with policy now very stimulative.
But the Fed's policy timing also sets up a dilemma. The more the Fed does to assure a strong U.S. recovery, the more imports will soar, further widening the trade gap (chart). That will increase the U.S.'s need for foreign capital. Consider that out of every dollar the U.S. spends on goods, excluding oil, about 25 cents goes to imports. And since U.S. imports are a third greater than exports, exports have to grow a third faster than imports (a respective 12% vs 9%, for example) just to keep the trade deficit from deteriorating. With U.S. domestic demand showing every sign of picking up this year, imports will outpace exports. That divergence will cause a wider trade gap and put the dollar at greater risk for a correction.
The day of reckoning may not fall within 2002 or even 2003. And its impact on financial markets and the dollar will depend greatly on the response of fiscal and monetary policymakers. The departure of Alan Greenspan from the Fed, whenever that might occur, could well be a critical time in this adjustment process, given the trust the world has placed in the Fed chief's adept management of the U.S. economy. Indeed, for all of Greenspan's hand-wringing over our external debt, the fallout could be the next Fed chairman's first big headache. By James C. Cooper & Kathleen Madigan