A contradiction is stalking the global economy. With US growth set to top 3.5% again this year and unemployment remaining low, Japan staging a comeback, Germany claiming the title of the world's largest exporter and India threatening to join China in the 10% annual growth club, we would seem to be living in the best of times. Yet the US trade (technically, current account) deficit for 2005 has been reported at $804 billion (nearly 7% of GDP) as scrap metal and waste paper became two of the country's biggest export items.
Meanwhile, US senators are threatening punitive tariffs against China if it doesn't revalue the renminbi, Warren Buffett is investing billions of dollars in foreign currencies and former Federal Reserve chairman Paul Volcker is predicting a 75% chance of a major international financial crisis within four years. So is it the best or worst of times?
The crux of the matter lies in the fact that the world is tilted. Global growth is unusually robust and widespread, but it is the result of a very peculiar division of labour. All the demand in the global economy is in the US; it is the only net buyer. All others such as Japan, the EU, China and the Asian 'tigers' are net sellers and exporters. Moreover, the bulk of the savings and investment in the global economy are in Asia, while the US has a negative savings rate and a relatively low rate of investment.
Last year, US households spent about $500 billion more than they earned, and America as a nation consumed about 7% of GDP, or $800 billion more than it produced.
Thus, the global economy runs largely on the fuel of US demand. Of course, in order to spend more than you earn and consume more than you produce, it is necessary to borrow and the US borrows a net of $3 billion every day from the rest of the world, largely by selling US Treasury bonds.
In this way, it can be said that the role of the US in the global economy is to buy and borrow, while the role of all others is to save, produce, export and lend.
If all the players could and would promise to continue to do exactly what they are doing now, the result might be nirvana. But none can or will because the current situation is unsustainable. For one thing, US demand and growth is based to an extraordinary degree on housing construction and rising housing prices. To keep up their spending even as household income has remained flat, Americans have been extracting equity from their homes in the form of home equity loans with adjustable interest rates.
With short-term interest rates rising and house prices beginning to plateau, the end of this game is in sight.
At the same time, as a result of high export strategies and constantly accumulating trade surpluses, the central banks of the world outside the US are holding enormous sums of dollars. Japan, for example, holds over $1 trillion, while China will hit that figure in June 2006. As these figures mount, two concerns become ever more pressing. One is the possibility that the US might try to reduce a lot of this debt by inflating it away.
Were it to do so, the dollar holders would suffer severe losses. To avoid this, it is likely that Japan, China and Saudi Arabia (the key dollar buyers) will become increasingly reluctant to keep buying dollars, and this may well trigger eventual dollar devaluation along with rising US interest rates.
A second possibility is that a chance event such as the Russians turning off the gas to Europe or the failure of a major bank or hedge fund triggers a crisis. In either case, the result will almost surely be a dramatic fall of the dollar. Indeed, bringing the US trade deficit down by even half is likely to require a 50%-80% devaluation of the dollar versus key Asian currencies. The reason is that the US industrial base has shrunk so much that a falling dollar is not likely to do much to stimulate exports because there is simply not adequate productive capacity to quickly ramp up exports. That means the adjustment will have to come largely through reduced consumption and, over time, through a transfer back to the US of substantial production of both goods and services.
Executives who base their strategic thinking on the notion that out-sourcing offshore is the wave of the future should reconsider urgently. They should pose themselves the question of what the implications for their supply chains would be of a 50%-80% devaluation of the dollar, because that's where it's going one way or the other.
Maybe that plant in Timbuktu doesn't really make that much sense, after all.
- Clyde Prestowitz is the author of Three billion new capitalists: the great shift of wealth and power to the East. He is also president of the Economic Strategy Institute and formerly served as counsellor to the Secretary of Commerce in the Reagan administration.
Source: World Business magazine May 2006