I have written before that America has its head in the sand when it comes to its quickly deteriorating economic portfolio.
On the one hand, I hate to see America pointing itself in a direction which will make the nation overall a much poorer country — but there are days when my frustration that Congress is failing to curtail the naturally expansive powers of the White House that seeing the dollar fall through the floor might be the only constraint the President pays attention to. It’s tough to support George Bush’s pretensions in the world while so dependent on foreign financiers, particularly China, to keep our economy chugging.
Economist David Hale has just sent me his latest paper, “Economic Risks in 2005.” It is not available online, but I am going to post a long-ish excerpt from this superb survey of potential economic potholes ahead on the East Asian Central Banks.
Here is the excerpt:
The East Asian Central Banks
The east Asian central banks now have $2.4 trillion of foreign exchange reserves or over 66% of the global total compared to 30% in 1990. They have accumulated these large foreign exchange reserves partly for defensive reasons after the 1997-1998 financial crisis and partly to help stabilize their currencies against the U.S. dollar.
The reserve growth was especially pronounced during 2004. During the past twelve months, Japan’s reserves have grown from $673 billion to $855 billion. China’s reserves have increased from $403 billion to $610 billion. Taiwan’s reserves have increased from $207 billion to $241 billion.
Japan has not formally intervened in the markets since March of last year while China has been adding about $10-20 billion per month to its dollar reserves. Japan was able to scale back intervention during the second and third quarters because of improved private demand for dollar securities. The Federal Reserve began to raise interest rates. There was a surge in the export income of commodity producing countries, including Brazil, Mexico, Argentina, and Russia. All of these countries invest their reserves primarily in dollar securities.
In the final weeks of 2004, the dollar fell sharply and nearly touched 102 yen to the dollar. It then rebounded during January 2005 on strong U.S. economic data and speculation about more aggressive Federal Reserve tightening. It is likely that the Federal Reserve will continue to raise interest rates by only 25 basis points at each of its new three meetings. As the November trade data demonstrated, the risk is high that the U.S. current account deficit will continue to expand during 2005 because of the strong growth rate of U.S. domestic spending.
These factors suggest that the dollar could slump further during the next few months. If the dollar threatens to fall through 100 yen, the odds are high that Japan will resume intervening. There has been a sharp slowing in the Japanese economy during the past six months while the Bank of Japan has not yet stopped deflation. The Ministry of Finance will therefore want to prevent the yen from appreciating sharply.
It also appears that China will adhere to a status quo exchange rate policy for another six to nine months. The fact that China is now embarking upon a gradual monetary tightening through rising interest rates will intensify pressure for a currency realignment but China appears reluctant to make a decisive break in its exchange rate policy at the current time. The odds are high that it will therefore accumulate at least another $100 billion of forex reserves during the next six months.
The most likely time for an Asian currency adjustment is late 2005 or early 2006, when the U.S. external deficit will be close to $700 billion and Asian forex reserves will be approaching $2.8 trillion.
The appointment of a new Federal Reserve chairman could also influence attitudes. One of the leading contenders for the job is Harvard Professor Martin Feldstein. He favors a large dollar devaluation to reduce the external deficit.
If the Fed has a chairman who clearly favors significant currency depreciation, it will be more difficult for the Asian central banks to resist market pressures without massive intervention. The Feldstein appointment could thus be a catalyst for both an exchange rate realignment and a rise of U.S. bond yields large enough to reduce the external deficit by restraining domestic consumption.
There is a large economic faultline between the United States and Asia, and the tension building must be relieved or managed at some point. John Maynard Keynes worried about any large economy defecting from a system of global economic interdependence — and what he considered defection was a nation that chronically under-consumed (Japan’s case) or chronically over-consumed (America’s case). Big structural imbalances between any players in the global economic system needed to be addressed.
Feldstein, if appointed, may pursue an ever weaker dollar strategy that finally breaks the dam, raising the cost to Americans of Chinese goods — but it will also create significant pain in Europe and lower the quality of life for Americans used to the narcotic of cheap goods abroad.
I don’t see many ways out of America’s economic mess that don’t negatively impact the living standards of average Americans — but I do think that we need something from the Bush administration that looks and sounds like serious economic strategy.
— Steve Clemons
