U.S.: Chairman Greenspan's Cautionary Tale
The U.S. pays a price for being the economic Atlas that is carrying a world beset by recessions and rocky economies. The cost has been the severe deterioration of its foreign trade position. The trade deficit hit a record high in 1998 and appears set to widen further in 1999, pushing the U.S. further into debt with the rest of the world. For now, the pile of foreign IOUs is not a problem, because the U.S. economy is extraordinarily robust and its financial markets are the only game in town for global investors.
But what happens when Atlas shrugs? That is, what will occur when the U.S. economy slows and growth elsewhere picks up, or if the bull market stumbles?
Federal Reserve Chairman Alan Greenspan addressed that concern and more when he testified before Congress on Feb. 23. Greenspan warned about the rapidly growing current account deficit --the U.S. external debt comprised of the shortfalls in trade, net investment income, and foreign transfers. "The rapid widening of the current-account deficit has some disquieting aspects, especially when viewed in a long-term context," said Greenspan. "Should the unsustainability of the buildup of our foreign indebtedness come into question, the exchange value of the dollar may well decline."
For the outlook, a cheaper dollar would be a mixed blessing. It would help the ailing export sector, but import prices would no longer hold down overall inflation, as they have in the past (chart). Moreover, U.S. credit markets might have to offer higher interest rates in order to compensate foreign investors for the returns eroded by a weaker dollar. And higher rates would hurt the stock market and curtail domestic demand for housing and capital goods.
WHAT HAS POSTPONED the dollar's day of reckoning? If any economy is capable of financing a large external debt, which in 1999 could match the 1986 record of 3.5% of gross domestic product, it would be the U.S. For now, at least, the U.S. remains the strongest economy in the world, and its investment fundamentals are extremely solid. Greenspan reeled off the list, including productivity gains, technological innovation, the determination of workers to improve their skills, and the "welcome advent of a unified [federal] budget surplus, freeing up funds for capital investment."
However, in a tone that seemed more aggressive than in recent remarks, Greenspan also said "the economy appears stretched in a number of dimensions." In addition to the huge external debt, he pointed out that the extreme tightness of the labor markets cannot continue without cost pressures lifting inflation. High equity prices raise questions about overvaluation. Domestic debt levels are rising. And the U.S. remains vulnerable to developments overseas.
In light of these risks, Greenspan said that the Fed was ready to move policy quickly in either direction to protect the expansion. But he stunned the bond market when he said that the Fed would have to decide "whether the full extent of the policy easings undertaken last fall to address the seizing up of financial markets remains appropriate as those disturbances fade." The Fed chief made it clear that a 1999 rate hike was not off the table, contrary to market sentiment. The yield on 30-year Treasury bonds jumped from 5.36% on Feb. 22 to 5.43%, a six-month high.
FOR NOW, THE FED expects the expansion to sail through 1999, although more slowly than in 1998. The central-tendency forecast of policymakers projects real GDP to grow between 2.5% and 3% in 1999, down from 4.1% in 1998. Consumer prices will rise between 2% to 2.5% this year, up from 1.5% in 1998. And the unemployment rate should end the year close to its current 4.3%. As Greenspan noted, "the economy evidently retains a great deal of underlying momentum."
Most of the credit for that strength goes to consumers. Even though growth in household outlays does appear to have eased a notch this winter, any slowdown is likely to be short-lived because consumer fundamentals remain so vibrant.
In particular, consumers think the economy is currently in the best shape it has ever been in (chart). The Conference Board's overall index of consumer confidence rose to 132.1 in February, from 128.9 in January. The index of the present economic situation jumped from 172.9 to 178.4, the highest on record. The board said that very favorable job-market conditions are making consumers optimistic about their financial situations and, thus, very apt to spend more freely.
That spending spree is the major reason why the U.S. is growing faster than most other nations. But this divergence has meant that the U.S. is importing goods at a far greater pace than it is exporting. As a result, the trade deficit swelled 53% in 1998, to a record $168.6 billion. In December, the trade gap narrowed to $13.8 billion from $15.3 billion in November, but that is not indicative of the trend. The December shrinkage resulted from a drop in imports, but with demand so strong, imports will likely rebound in coming months.
For merchandise alone, the 1998 gap rose 25%, to $248 billion, with increases everywhere, including the five largest country deficits (table). The combined gap with the troubled Asian nations of Hong Kong, Korea, Singapore, and Taiwan leapt 185% in 1998 from 1997.
GREENSPAN ALLOWED THAT the rising trade deficit carries some benefits. Overseas production has been a safety valve, restraining pressure on U.S. capacity. And American purchases of imports cushioned the economic weakness of U.S. trading partners. In addition, Greenspan said, "decreasing import prices, which partly came from the appreciation of the dollar through midsummer, contributed to low overall U.S. inflation."
However, the Fed chief worried that the dollar's decline since last summer signals an end to falling import prices. Indeed, the prices of nonpetroleum imports have risen slightly in three of the past four months, something that hasn't happened in 3 1/2 years.
To be sure, inflation remains benign in the U.S. Total consumer prices edged up just 0.1% in January. Excluding food and energy, core prices also rose just 0.1%, and just 2.4% from a year earlier. Cheap imports, though, have exerted a disinflationary effect on the U.S. economy because they prevented domestic producers from raising prices. If import prices rise, U.S. businesses--in the midst of a profits recession--will be bolder in hiking prices.
It is just that type of inflation risk that worries Greenspan and other policymakers, since rising inflation could short-circuit this expansion's long run. For now, the U.S. looks healthy enough to continue carrying the rest of the world. The Fed just wants to ensure that the economy's towing power doesn't flag before the rest of the world can get back up to speed.