Friday, November 26, 2004

Stephen Roach drinks the Kool-aid

Here's Mr. Roach, chief economist at Morgan Stanley, discussing the falling dollar today in his NY Times Op-Ed piece "When Weakness Is a Strength":

"Suddenly all eyes are on a weakening dollar. In recent days, the American currency has fallen against the euro, the yen and most other currencies around the world. The renminbi is a notable exception; China has kept its currency firmly pegged to the dollar for a decade.

The fall of the dollar is not a surprise. It is the logical outgrowth of an unbalanced world economy, and America's gaping current account deficit - the difference between foreign trade and investment in the United States and American trade and investment abroad - is just the most visible manifestation of these imbalances. The deficit ran at a record annual rate of $665 billion, or 5.7 percent of gross domestic product, in the second quarter of 2004.

While a decline in the dollar is not a cure-all for what ails the world, it should go a long way toward bringing about a sorely needed rebalancing. With a weaker dollar, economic and even political tensions among nations would be relieved, helping to promote more sustainable growth in the global economy.

America's consumption binge has its mirror image in excess savings elsewhere in the world - especially in Asia and Europe. For now, America draws freely on this reservoir, absorbing about 80 percent of the world's surplus savings. Just as the United States has moved production and labor offshore in recent years, it is now outsourcing its savings.

This is a dangerous arrangement. The day could come when foreign investors demand better terms for financing America's spending spree (and savings shortfall). That is the day the dollar will collapse, interest rates will soar and the stock market will plunge. In such a crisis, a United States recession would be a near certainty. And the rest of an America-centric world would be quick to follow.

The only way to avoid this unhappy future is for the world's major central banks to carefully manage a gradual but significant depreciation of the dollar over the next several years. America, and the world, would gain in several ways.


First, there would be a gradual rise in interest rates in the United States - compensating foreign investors for financing the biggest debtor in the world. That would suppress growth in those sectors of the American economy that are most sensitive to interest rates, like housing, consumer durables like cars and appliances, and business capital spending. The result: a higher domestic savings rate and a reduced need for foreign capital - a classic current-account adjustment.

Second, when the dollar falls, other currencies rise. So far, the euro has borne a disproportionate share of the change. That puts increased pressure on Asian nations - including China - to share in the adjustment by allowing their currencies to strengthen. Most currencies in Asia are now rising, but the renminbi has remained conspicuously unmoved.

Third, as the currencies of Asia and Europe strengthen, their exports will become less attractive to American consumers. This will force Asia and Europe to work to stimulate domestic demand to compensate - resulting in a reduction of both excess savings and current-account surpluses. This is easier said than done, especially since it may require painful structural reforms, like a loosening of domestic labor markets, to unshackle internal demand.

Fourth, a weaker dollar might defuse global trade tensions. Dollar depreciation will support American exports, and higher interest rates should slow domestic demand and reduce imports. That means the United States trade deficit should narrow - tempering protectionist risks. And with Asian countries allowing their currencies to fluctuate, Europe gets some relief and may be less tempted to resort to protectionist remedies.

What's certain is that a lopsided world needs to be put back into balance. The dollar is the world's most widely used currency, but its fall affects more than just foreign-exchange rates. A weakening dollar is an encouraging sign that the world's relative price structure - essentially the value of one economy versus another - is becoming more sensible. If the world can manage the dollar's decline wisely, there is more reason for hope than despair."

Roach's piece certainly accentuates the potential upside of a weak dollar, but it's not particularly convincing. For the sake of discussion, let's set aside the possibility that in calling for a gradual weakening of the dollar in the first place, he's effectively arguing we slow down the big honking snowball that's already steaming down the side of the mountain.

Rising interest rates will almost certainly slow consumer spending, but it's not a sure bet that they will increase savings. This is because many Americans have already purchased those big ticket items to which he refers (homes, cars) using means with adjustable interest rates such as ARMs and credit cards. Buying in these sectors has already slowed to some extent, and any increases in interest rates are going to pinch a lot of people who bought over their heads because of favorable rates. We can leave the discussion of how savings have been negatively affected by increases in consumers' health care costs (premiums, deductibles, copays) and education costs for another day.

The Chinese are not going to allow their currency to strengthen v. the dollar as long as keeping it pegged to USD continues to work to their advantage. As John Makin wrote for the AEI as early as last fall,

"China, however, poses a major problem as the U.S. pushes for a weaker dollar. Given that the Chinese yuan is pegged to the U.S. dollar, a weaker dollar only enhances China's already substantial competitive advantage in global markets, especially in Asia. "

It's also not clear how letting the dollar slide and putting pressure on the rest of the world to go through "painful structural reforms" while the U.S. runs up record-beating deficits is going to ease international pressures of any sort. In case Roach hasn't noticed, a good portion of the developed world is pretty pissed with the Boy King's "My Way or the Highway" approach to foriegn policy, and they probably aren't interested in hearing any advice he has to offer about how they can mend their ailing economies.

But the most intriguing aspect of Roach's piece is how it seems to ignore the appraisal of the U.S. economy offered last week by an economist named, um, Stephen Roach:

"Stephen Roach, the chief economist at investment banking giant Morgan Stanley, has a public reputation for being bearish.

But you should hear what he's saying in private.

Roach met select groups of fund managers downtown last week, including a group at Fidelity.

His prediction: America has no better than a 10 percent chance of avoiding economic 'armageddon.'

Roach sees a 30 percent chance of a slump soon and a 60 percent chance that 'we'll muddle through for a while and delay the eventual armageddon.'

The chance we'll get through OK: one in 10. Maybe.

In a nutshell, Roach's argument is that America's record trade deficit means the dollar will keep falling. To keep foreigners buying T-bills and prevent a resulting rise in inflation, Federal Reserve Chairman Alan Greenspan will be forced to raise interest rates further and faster than he wants.

The result: U.S. consumers, who are in debt up to their eyeballs, will get pounded.


Roach marshalled alarming facts to support his argument.

To finance its current account deficit with the rest of the world, he said, America has to import $2.6 billion in cash. Every working day.

That is an amazing 80 percent of the entire world's net savings.

Sustainable? Hardly.

Meanwhile, he notes that household debt is at record levels.

Twenty years ago the total debt of U.S. households was equal to half the size of the economy.

Today the figure is 85 percent.

Nearly half of new mortgage borrowing is at flexible interest rates, leaving borrowers much more vulnerable to rate hikes.

Americans are already spending a record share of disposable income paying their interest bills. And interest rates haven't even risen much yet."


Blogger O.Green said...

I think Greespan should continue to rise rates, at least to end behaviours leant to consuming instead of saving. The sliding of the dollar may last enough to correct some of the external deficit. Even this is wishful thinking, we can hope productivity may allow some job creation to sustain consumers demand or at least to reduce the impact of the rise in rates...too many hopes i guess...For the fiscal deficit i would appeal to Lockheed and peers. The may help. I think the G-s should tackle international problems more seriously...unless they rely on market solutions, easily invoked but with some solutions difficult to digest.

10:28 AM  

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