Recessions have always been both painful and salutary. While they bring distress to households and corporations, they also have a cleansing effect on the economy's imbalances, such as excess inventories and burdensome debt, that build up during the good times.
However, this business cycle is different in one key respect: The U.S. trade deficit and the enormous external debt it created still hang ominously over the economy. Both the trade gap and its financing needs will swell further as the recovery picks up speed. That will hamper the upturn in manufacturing, and it could set up potential problems for the dollar later this year.
During a recession, currencies usually lose value and trade gaps typically narrow. True, the December deficit shrank by $3.3 billion, to $25.3 billion. But much of the shrinkage came from lower oil prices, and when adjusted for inflation, December's trade gap was not much lower than its year-ago level.
The amazingly strong performance of the U.S. dollar has helped to keep the trade deficit wide. Since the economy began to slow in early 2000, the broad trade-weighted dollar has appreciated 12%, to levels not seen since the superdollar of the mid-1980s (chart). Moreover, since the official start of the recession in March, 2001, the greenback has gained nearly 3%, a decidedly atypical recession pattern, especially for a country that has external debts totalling more than 4% of its gross domestic product.
The dollar's rise indicates foreigners are still willing to buy and hold American assets, in part because no other economy offers the potential payoffs the U.S. does. And the strong greenback helps to finance the U.S.'s propensity to consume more than it produces, with no threat from inflation.
THAT WINDFALL, though, comes at a price. In the short run, U.S. manufacturers, who now export about 20% of their output, will continue to get hammered by the strong dollar, which makes their goods less competitive in foreign markets. Plus, since the recovery in the rest of the world will lag behind the U.S. upturn, foreign demand will be slow to strengthen. At the same time, a pickup in U.S. demand will draw in cheaper imports at a faster rate.
The result will be a wider trade gap by the end of this year, which may trigger a longer-run cost for the U.S. Financing the trade gap will require one of two things: Ever-increasing amounts of foreign capital attracted by high expected rates of return. Or a weaker dollar that would force a realignment of the U.S. trade balance. The worry: a suddenly weaker dollar that could lift inflation and interest rates in 2003, and choke off the recovery.
For now, investors are not thinking that far ahead. Instead, they are focused on the economy's increasingly bright recovery prospects, a key factor keeping the dollar strong. The latest data on the leading index, consumer confidence, and durable goods orders are generally upbeat. And Federal Reserve Chairman Alan Greenspan sounded cautiously optimistic when he delivered his semiannual report on monetary policy and the economy to Congress on Feb. 27, which included the Fed's latest economic forecast.
The Fed chief suggested that any tightening of monetary policy this year won't come anytime soon, because the Fed expects only a moderate recovery and because the inflation outlook is excellent. In fact, the dollar's brawn in the past year is a key reason for inflation's subdued performance. Over the past year, prices of imported goods excluding petroleum have plunged 5.2%, the largest yearly drop since records began in 1988. Plus, inflation tends to decline in the first year of a recovery, because the economic slack created by the recession limits pricing power.
GREENSPAN'S COMMENTS were consistent with the latest data, which suggest that the upturn is coming on a bit stronger than anyone thought possible late last year. In particular, the Conference Board's composite index of leading indicators, those that foreshadow the economy's path, rose 0.6% in January, following jumps of 1.3% in December and 0.8% in November. That adds up to the strongest three-month advance since 1982, just before the powerful 1983 recovery.
Consumers say they were more cautious in February, according to the latest reading of consumer confidence. But that hasn't stopped them from shopping. Store sales remain healthy, and car sales are holding up far better than anyone thought possible after the late-2001 boost from dealer incentives. As a result, more and more economists are boosting their forecasts for first-quarter and first-half economic growth.
However, what's good for the recovery will not be so good for the trade gap. The U.S. still imports 34% more goods and services than it exports. That means, just to keep the deficit from widening further in the coming year, exports will have to grow a third faster than imports. But that's not going to happen, as the U.S. leads the global recovery.
The capital-goods sector will probably account for much of the trade gap's deterioration this year. Both imports and exports of tech equipment stabilized at the end of 2001, after declining for a year (chart). And the recent increases in factory orders, including a 2.6% gain in January bookings for durable goods and another rise in capital-goods orders, suggest that U.S. companies are starting to lift their capital spending. That means imports of business equipment, especially high-tech goods, should bounce back before exports do.
DESPITE THE WORSENING OUTLOOK for trade, the dollar is likely to retain its lofty status among the world's currencies at least through most of this year. That's because the U.S. is still the world's preeminent site for investment opportunities.
Clearly, the Japanese yen will offer no competition this year. Japan's economy remains a basket case, with little progress on restoring health to its banking sector or on broader reform efforts. In fact, much of the dollar's appreciation in the past year has come at the expense of the yen. The greenback's main potential challenge will come from the euro. But even here, Europe's recovery will be restrained by tight monetary policy, growing fiscal excess, and only a modicum of reforms to its labor markets and pension systems.
As the trade deficit widens, though, the U.S. will continue to pile up debts owed to the rest of the world. By the end of next year, the current account deficit, the broadest definition of U.S. foreign obligations, is likely to hit a record 5% of GDP.
At some point, investors will bring about a balancing of the lopsided U.S. position, most likely by bidding down the dollar. But with U.S. growth prospects for 2002 looking better than those of anyplace else, the dollar's day of reckoning is most likely to come later rather than sooner.
By James C. Cooper & Kathleen Madigan