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Tuesday, June 29, 2004


This is the second of a two-article mini-series on the alleged dangers that hover over the US economy in the rest of this decade, and two in particular: the rising Federal deficit and the rising US current account . . . trade in goods and services (plus some unilateral transfers). The mini-series was prompted by some worried concerns that were voiced by a visitor, John, set out in the previous article. That article tried to show that the two biggest worries associated with these two deficits in the US economy, the Federal budget and the US current account, reflect fears of "crowding out": 1) either of US private investment as the US Treasury sells more and more securities to finance the growing US Federal deficit --- this year alone, around 4.0% of GDP --- 2) or of US exports, making the trade deficit even worse.


(i.) Crowding-Out Version One: Federal Deficits Harm Private Investment

The first crowding-out fear --- that private investment in the US economy will be cumulatively hurt --- turns on the concern that there is a given pool of national savings . . . at any rate from domestic sources: thus, as the US Treasury competes with private investors seeking to borrow those savings for their own purposes --- particularly US firms wanting to buy new or more machines or offices or plants --- interest rates will have to rise and choke off much of the private investment. Over time, the outcome will be a lower level of investment and hence GDP growth. Some of those who espouse this theory see crowding out of private investment as 100% effective --- a total wash-out: each dollar the US Treasury accumulates from selling new securities to finance the US Federal deficit will, it's argued, be one dollar less that's available for private investment.

In that case, even in a recession, deficit spending won't have any impact on raising short-term GDP growth. All it does is hurt long-term investment and economic growth.

Other economists tend to take a more qualified view, maintaining that at least some crowding out of private investment will occur. Even so, over time, the pace of US economic growth will still suffer until the Federal deficit ends and a surplus is initiated. (A Federal surplus, by way, adds to overall national savings: by firms, by households, and in the government sector. The individual states are generally prohibited from running deficits; and if they do, they won't be allowed to do so for long.)

Are these fears of crowding out sound?

Despite some theoretical debate here among economists, this much can be said with certainty: those fears are exaggerated. The evidence of the late 1980s and again of the early years of this decade is graphic here. As the trends in both periods indicate, Federal deficits can rise rapidly, yet interest rates themselves --- especially long-term ones that count for private firms' investments (and consumers' acquisition of houses) --- not only aren't hurt, they can, as the experience since the end of 2001 recession demonstrates, fall to record low-levels.


(ii.) The Second Version of Crowding Out: US Exports Are Hurt and Create or Worsen
Trade Deficits

Enter the alternative view of crowding out, which links the rising Federal deficit to the rising trade deficit in goods and services. If --- so this twist in the argument goes ---interest rates don't always rise in the US economy as the US Treasury sells bills and bonds to cover the Federal deficit, it's only because foreign capital has streamed into the US economy to supplement insufficient levels of US savings and hence to keep those rates low. And it's true: lots of foreign investors are particularly interested in buying the US Treasury securities: they're safe and liquid and hence easily sold the next day if the investor wants to pull out of them. Nor is there any danger that the US Treasury will ever default on them.

How then does crowding out occur in this second scenario?

The answer: through the impact of the dollar's exchange rate, its price in terms of other currencies. As bursting inflows of foreign capital stream into the US economy from abroad, foreign investors have to sell Yen, Yuan, pesos, euros, or pounds in order to acquire dollars for their investments; in turn, the climbing exchange rate of the dollar hurts American exports abroad and facilitates the sale of foreign exports to American firms and consumers. In this way, US exports are crowded out in foreign markets, import sales boom here, and the excessively fast growing US trade deficit --- current account --- is the result.

That deficit, moreover --- now around 5.0% of GDP --- won't be sustainable. That's the key in this new crowding out version.

Sooner or later, it's argued, a big dislocating adjustment of the American economy will be necessary as worried foreign investors start selling off their dollar investments: the dollar will fall, and there might even be a panic sell-off of their US investments by foreigners. In turn, as the dollar falls rapidly, inflationary pressures will be introduced into the US economy, interest rates will rise fast, and a recession will be needed to squeeze out the inflationary pressures. Otherwise, inflation will continue to rise as the dollar falls, a problem that will be clarified here in a moment or two.

Note that we will deal with these fears of a panic sell-off and rapidly climbing inflation in this article . . . very soon. Note also, right now, that --- as with the first theory of crowding out --- none of this predictable harm is inevitable. The evidence of the period between the end of 1985 and 1991 is again graphic here. In that period, the Federal deficit continued to mount, but the dollar's exchange rate fell sharply. . . thanks to a coordinated decision by the US government with foreign Central Banks to encourage such a fall. In the upshot, the dollar plunged against a basket of major currencies --- especially the Yen and the German Mark (DM) --- by over 50% in the next five years. As it fell, US exports surged; by 1990 they had more than doubled. Simultaneously, imports fell in the US economy; and by 1991 the US current account actually had a slight surplus.

Not only did the US trade deficit disappear, but in addition --- further evidence against either view of crowding out --- the key long-term interest rate in the US economy, the 10-year Treasury bond, actually fell in value throughout the late 1980s and into the 1990s.


What The Current Argument Amounts To

What follows is a continuation of the buggy analysis set out in the previous article in this mini-series. If that initial article showed that the twin fears of crowding out of private investment or US exports are way overdone even though the US ran high levels of Federal deficits for several years, the second article here shows that two other connected worries about the deficits in the US economy --- in the Federal budget and in the US current account --- are most likely exaggerated. We just mentioned both, but it won't do any harm to set them off with bullets:

  • One worry is that the US current account deficit, now at a record high (5% or so of GDP), is unsustainable. As a result, foreign investors in the US economy will grow wary or scared of its size and rush out of their dollar investments. The result, it's argued in the nightmare scenario of this worry, would be a panic sell-off of the $US that would emulate the currency and financial meltdown in Pacific Asia in 1997 or Argentina in 2001.

  • The other worry: even if there isn't a panic sell-off, the inevitable decline of the $US will initiate new inflationary pressures in the US economy as the prices of imports --- now around 16-17% of GDP --- rise in line with the dollar's fall. At a minimum, the Federal Reserve will then have to slow down the growth in GDP, and maybe even cause a recession, to choke off any inflationary expectations. Ouch! Or, worse, foreign imported oil --- now about 60% of US oil use (itself around 45% of overall US energy usage) --- will play havoc with the US economy as the dollar declines and the price of oil rises in world markets, just as it did in the 1970s with so much pain and dislocation to economic growth and management here and abroad.


Ouch! Ouch! Ouch! Or A Case of Hypochondira?

The first of these two added worries is that the growing levels of the US trade deficit in goods and services, roughly 5% of GDP this year alone, aren't sustainable. Sooner or later, foreigners will grow anxious about the rising size of the US current account deficit --- trade in goods and services --- and hence begin selling off their capital, and so the dollar would fall sharply in value. In the nightmare scenario here, the plunge would be almost overnight.

The Asian Currency Crisis Of 1997: A Relevant Example?

It's a scenario that does explain the currency and financial meltdown of the Pacific Asia countries in 1997. Within a few days, panic-selling by foreigners of their investments in Thailand and then, almost as quickly, in ricochet fashion, in Taiwan, Hong Kong, Singapore, South Korea, the Philippines, and Indonesia occurred. Why?

Such a stampede sell-off can occur, theoretically speaking, whenever foreign investors fear they'll be the last ones stuck with investments in a country that's experiencing a flight out of its currency and its exchange rate plunges. Each 1% fall in the price of, say, the Thai currency or the Indonesian currency meant, in 1997, that foreign investors would suffer a corresponding fall in the value of their investments when they tried to sell them and convert the local currencies into dollars, Yen, DM, francs, or British pounds. In such circumstances, a near panic sell-off could be set off, and in 1997 it was.

But to repeat our question here in different terms . . .


Is the US Vulnerable This Way?

No, not at all . . . however much the fear that the US economy could be menaced this way is voiced by some observers these days, convinced that it can't sustain the high levels of the trade deficit for much longer and that, in consequence, foreigners will sooner or later resort to a capital flight. Among the reasons why the fear is misguided is simply this: Americans owe money to foreign investors in our own currency, dollars.

Quite simply, the US Treasury can never run out of dollars. There can be no worry that --- should there ever be a big capital outflow from the US --- American banks, firms, and the US Treasury that owed foreign investors money wouldn't be able to pay them in full. By contrast, Argentines, Russians, Thais, Indonesians, Taiwanese, and others owed foreign investors money in either dollars or Yen or DM or (after 1999) euros ---- scarce currencies that aren't their own.

More specifically, to return to the currency crises of the late 1990s in Asia and elsewhere, private and official financial institutions in those borrowing countries ---- Thai commercial banks, Indonesian brokerage firms, Argentinean corporations whose stock-holders included foreigners, or the Central Banks in all those countries --- owed foreign investors contractual obligations to pay them in those scarce currencies: dollars, Yen, euros, francs, or British pounds, and not Russian rubles, Argentine pesos, the Thai baht, and so on. Fairly quickly, as foreign investors started withdrawing their investments and demanding dollars or Yen or euros, those home-based financial institutions, including Central Banks, could and did run out of those currencies. At best, they were able to slow down panic-selling if it came to that by getting loans from the IMF --- or a consortium of rich countries like the one the US organized in 1994 to help Mexico when its peso was under way --- always on certain conditions of remedying the excessive borrowing by local business or banking firms or the home-country government. And almost always, to boot, by reforming the accounting and other financial practices of these home-based institutions and Central Bank so as to make their activities more transparent and accurate.

By contrast --- to repeat our main point --- American private borrowers and the US US Treasury can never run out of dollars; and hence foreigners can never be stuck with worthless investments in the US.


Two Further Observations About Foreign Lending and Borrowing

(i.) Scarce (or hard) currencies refer to a handful in the world --- dollars, euros, Swiss francs, British pounds, and Yen --- that any commercial bank or currency broker anywhere will gladly buy at the right price, knowing that they can find another buyer [or borrower] they can easily sell to. Simultaneously, Central Banks everywhere are happy to deal in them too. As for the dollar, it's used to support about 60% of world trade, even though the US accounts for only about 16% of it. It also figures as the main source of foreign reserves held by Central Banks, roughly 65-70% of the total. The rest of the reserves are in the other scarce currencies. (Believe it or not, the reserve role of the $US has actually strengthened noticeably since 1990 despite the creation of the Eurozone in 1999. The $US added up to 51% of total world reserves in 1990, with another 30% added by diverse European currencies --- the DM, the Pound, the French and Swiss francs. In 2002, three years after the euro was introduced, the $US's share of total reserves had climbed to 65%; the euro accounted for only 19%.)

The meaning of the term "scarce" should now be self-evident. Commercial and Central Banks in Latin America, Asia, the Middle East, Russia, or Africa would be delighted to get as many dollars, euros, Yen, Swiss francs, and British pounds as they could. At a minimum, those banks could easily find domestic buyers of them who, in turn, could then buy US or European or Japanese goods to their heart's delight or --- in countries where inflation of the local currency is a problem --- use those scarce currencies to invest in the financial assets of the US, the EU, or Japan. By contrast, American, European, or Japanese exporters or financial institutions will demand that foreign buyers of their goods or financial assets use dollars or Yen or euros or francs for the purchase.

(ii.) Since 1997, almost all the Asian countries and Latin American ones whose currencies were vulnerable have also moved toward more flexible exchange rates, rather than pegging their currencies to the dollar. Such flexibility should slow down an excessive inflow of foreign investment in the future. In particular, if more foreign capital flowed into Argentina in the future as it did in the 1990s, the peso exchange rate --- now flexible --- would automatically rise and tend to slow down the inflow. There could, of course, still be speculative attacks by foreign investors on the peso, but the combination of a rising peso, plus far better financial accountability on the part of borrowing Argentine bankers, firms, and the government, would likely offset the worst. You want evidence? Mexico and Brazil warded off capital flight effectively in the late 1990s, precisely because of floating rates and far greater transparency and accuracy in their financial accounts.


So Much For Theoretical Balm: Shift Now To The Historical Evidence

As it happens, we have a good test-case of what happened when the dollar did fall rapidly, and what we find is that foreign investors didn't sell off their US investments. We're referring again to the late 1980s.

Recall that in late 1985, Germany, Japan, and a few other key countries agreed with the US government that the soaring rate of the dollar in the 1980s --- caused by huge capital inflows into the US economy in the earlier Reagan era --- had left the dollar badly over-valued in currency markets and was generating too many protectionist backlashes in the US. Together, in coordinated ways, these governments decided to sell dollars and buy DM, Yen, British Pounds, and francs in order to bring the dollar's exchange rate down.

That's exactly what happened. Within a couple of years after 1986, the dollar had fallen more than 50% against a basket of key currencies. Despite this plunge, there was no panic selling by foreign investors themselves in the US economy; there was, to be more precise, no capital flight at all --- just a slow-down in the pace of capital inflows from abroad. The cumulative stock of foreign investment in the US economy kept rising.

Clearly, then --- despite the rapidly falling value --- foreign investors weren't themselves worried, let alone panicked. They continued to see the US economy as a sound place in which to invest, and for several sound investment reasons:

  • little or no inflation in this country compared to other countries,

  • a huge array of financial assets to invest their capital in --- US Treasury securities, the US stock market, private corporate bonds, US real estate, or US firms like MGM (never mind setting up multinational businesses here that they own)

  • and a booming economy that looked like growing steadily, increasing the value of their investments over time.


What Then Might Worry Foreign Investors Here?

The same thing that would worry American investors in the US economy: if inflation started taking off here again, and did so in ways noticeably higher than in the EU or Japan or other countries where they might shift their portfolios for investment purposes. We'll take that up in a moment. A related concern might be if the US economy suddenly lost its vigor --- its growth dynamism. Far from that happening, it looks like sustaining the bursting growth rates in GDP and productivity that marked the US economy in the 1990s.

Nor is that all. For a good several years into the future --- say, for the remainder of the decade --- it would be surprising if the US growth rates here were equaled by Japan or the EU, never mind surpassed by them.


There's Another Point, Made Earlier, Relevant Here.

It concerns the difference between foreign private investors and foreign Central Banks investing in the US economy, at any rate the Asian Central Banks that have been on a buying spree of US Treasury securities --- about $430 billion in 2002, and another $200 billion or so last year!

(i) Private Investors. Foreign private investors are particularly concerned about balancing five concerns when they decide to invest in the US economy as opposed to other countries:

1) the return on their investments compared to the return elsewhere (the predicted return over time, note, takes into account concerns about inflation in the US economy0;

2) the certainty that US borrowers like the US Treasury or Microsoft Corporation can't or won't default (a higher return on foreign investment, say, in some emerging economies in Latin America or Asia might not be nearly as safe);

3) the range of US financial assets they can diversify their investments over;

4) the dynamism of the US economy --- especially important for long-term investors, such as multinational firms or those in the stock-market for their retirement funds, say, or for capital gains over a 2-10 year period;

5) and what the future trend of the dollar's exchange rate will be over the time period involved.

Who are such foreign private investors? Obvious examples of fairly short-term ones: Britons buying mutual funds in London that invest in the US stock market; French or Korean corporations with some extra cash-flow that they invest in US financial assets for a brief period (whether Treasury securities or US corporate bonds or equities they can sell quickly); a crooked Columbia politician using an alias and having an offshore bank launder $10 million for him that the bank invests in Microsoft stock; and so on.

Long-term investors include some of the same people, but add in 1) others like oil-rich magnates in the Persian Gulf looking for a safe investment for decades, fearful that they might have to pick up and high-tail it one day to Miami; and 2) foreign multinational firms setting up business here, either as a start-up or buying an American company. These, needless to say, are only examples, not an exhaustive list.


(ii.) Foreign Central Banks. Two kinds of foreign central bank' motives for buying dollars and investing here have to be distinguished.

*Some Central Banks --- those in the EU (the Bank of England, the Euro Central Bank) or a few elsewhere even in Asia or Latin America or the Middle East --- are motivated mainly by the same concerns as private investors, plus a desire to diversify their foreign reserve holdings: dollars, euros, Yen, pound-sterling, or Swiss francs, hard currencies.

In all these and related instances, their motives are investment-driven. Primarily they want good places to earn safe returns on their huge reserves. Right now, about 65-70% of the world's reserves are denominated in dollars. (If any of the Central Banks abroad also peg their national currencies to the dollar, they naturally will keep dollars on hand --- meaning invested in liquid short-term US financial assets --- to support the exchange rate.)

*But lots of foreign Central Banks --- especially in Pacific Asia, but all around the world too (except for the Euro-Central Bank, Canadian Central Bank, and the Bank of England and its equivalents in Sweden, Denmark, and Norway outside the Eurozone) --- aren't primarily interested in investing in American financial interests for strictly investment-driven reasons.

1. Their main motive is to buy dollars in order to keep the price of the dollar as high as they can compared to their own currency, which in turn stimulates their countries' exports to the US economy . . . or to other economies whose currencies are pegged to the dollar. It's an concern born of export-led GDP growth, AKA neo-mercantilism.

2. Another motive is closely related: by running current account surpluses with the US (and others), Asian countries are able to accumulate more and more $US reserves . . . good insurance, it's said by them, to stop any speculative runs on their currencies of the sort that erupted in panic manner in 1997.

The best example of these two related neo-mercantilist motives? Tersely put, the huge amounts of US Treasury bills that Japan, China, and the rest of Pacific Asian Central Banks have purchased, after selling their currencies in vast quantities to buy dollars. They don't keep the dollars in their coffers; they want to earn safe investment interest on them by buying such US Treasury bills. In 2002, they bought almost $450 billion Treasury bills alone! In 2003, close to $150 billion. The total in their hands, as we note elsewhere in their hands, is around $2.0 trillion, an astronomical figure.


Is the US Economy Hurt By These Two Related Mercantilist Motives? Just the Opposite: They Aid The Forces of Creative Destruction

How specifically do these mercantilist motives help the US economy? Well, by buying US Treasury bills, Asian and other Central Banks are helping to finance the US economic boom . . . a record growth rate of GDP over the the last 3 quarters, not equalled since the early 1980s. Along with private foreign investors, the capital funds that these foreign Central Banks invest here keep interest rates lower than they otherwise would be. In the sequel, American business firms are able to invest more than otherwise too. The same is true of consumption by American households. We're all able to spend more of our disposable income on consumption goods, including durable ones like cars and houses, than we would if we had to save more and help fill the gap between national savings out of domestic sources and domestic investment.

The wider outcome? Thanks in part to the capital inflows from abroad, plus the more intense competition from abroad that American firms face as sales of foreign exports boom here --- forcing our firms to innovate more rapidly than they otherwise would --- the US relative economic performance has improved noticeably since 1980, the start of the 24 era when we have been running large current account deficits with the rest of the world.

Does that mean there was no harm at all from the current account deficits, the counterpart of the capital inflows that create a surplus in the capital account of the balance of payments?

No, but the harm was sectoral --- or more specifically, to employment levels in certain sectors, not to the overall US economy. If anything, the bursting import-competition accelerated the pace of what is called the forces of creative destruction. and hastened the shift to a more knowledge-based economy.

Three points stand out here by way of clarification.

(i.) Certain sectors have to shed redundant labor faster.

In certain manufacturing sectors, thanks to an overvalued dollar in the early 1980s and since 1995 again, a few domestic manufacturing industries have had to adjust faster than otherwise as imports that compete with them have streamed into the US economy and caused the dollar to rise to such heights in both periods. In those manufacturing industries --- autos, integrated steel, textiles, parts of chemicals --- the levels of employment have been noticeably cut since 1980. No surprise. Employment, as it happens, would have declined anyway, what with the shrinking size of the US manufacturing sector in the overall economy: around 40% of the labor force in 1950, and now around 12%.

The more basic causes have little to do per se with the price of the dollar or surging import competition. Two such causes stand out.

Most of all, globalizing forces --- including the spread of standardized technologies to Europe and Asia and parts of Latin America --- have been largely behind that shrinkage. Compared to their rivals abroad, these US industries were losing their competitive edge in both the US and foreign markets: their levels of productivity were not rising as fast, their costs of production were excessive, the quality of their products was often inferior, and hence there was increasingly redundant labor in them. On all these grounds, the firms in these industries needed to be drastically pruned and restructured. Enter the second major cause: new breakthrough innovations in the US economy in computers, communications, and information-processing were making those older, more standardized industries increasingly obsolete, especially as new industries utilizing the breakthrough technologies gained more and more market share, first in the US economy, then in foreign markets . . . a point we'll illuminate in a moment or two.

At most then, to summarize this first point, the accelerated inflow of capital into the US economy --- which raises the price of the dollar in currency markets and hence creates the US current account deficits --- has intensified the elimination of such redundant labor at a faster pace than might have otherwise been the case. In the wake, please note, those industries --- autos, integrated steel, mini-steel production, the more technologically based textiles, and chemicals --- have also been rennovated and become more competitive, even if at much lower levels of employment. The latest two J.D. Powers reports on the overall quality of US vehicles compared to foreign ones finds that the US firms are outdoing the Europeans across-the-board save for BMW sedans, while the quality-gap with the Japanese has narrowed considerably.


(ii.) So much for sectoral harm: consider the US economy as a whole now.

Overall, to repeat, the US economy itself has benefited from the faster shrinkage of redundant labor in those industries. Since 1980, in particular, our pace of growth in both GDP and productivity relative to West Europe and Japan has increased considerably, and so too has our pace of innovation in the new advanced technologies of ICT (information and communication technologies), bio-tech, and now nano-tech.

Come to think of it, macro-economic management has been much improved in the US economy since 1981 too.

Between 1945 and 1981, it's worth stressing here, we experienced a recession every 4-5 years. In the 1970s, we experienced both recessionary and inflationary tendencies at the same time --- the death blow to Keynesian fine-tuning of the macro-economy. By 1980, we had a nightmare economy of double-digit inflation. Since then, after the deep but quickly ended recession of 1981 and early 1982, the US economy has had only two recessions: one in 1990-91, and the other more recently in 2001. Both were short-lived, and both were shallow. That's a huge turnaround in recessionary threats. What's more, despite an upward tick in the inflationary index --- rightly seen by the Federal Reserve as essentially transient (mainly earlier oil price rises this year, now reversed) --- inflation has been tamed too.

Untitled Document
Business Cycle Peaks and Troughs in the United States
Peak Trough Peak Trough
July 1890 May 1891 Aug. 1929 Mar. 1933
Jan. 1893 June 1894 May 1937 June 1938
Dec. 1895 June 1897 Feb. 1945 Oct. 1945
June 1899 Dec. 1900 Nov. 1948 Oct. 1949
Sep. 1902 Aug. 1904 July 1953 May 1954
May 1907 June 1908 Aug. 1957 Apr. 1958
Jan. 1910 Jan. 1912 Apr. 1960 Feb. 1961
Jan. 1913 Dec. 1914 Dec. 1969 Nov. 1970
Aug. 1918 Mar. 1919 Nov. 1973 Mar. 1975
Jan. 1920 July 1921 Jan. 1980 July 1980
May 1923 July 1924 July 1981 Nov. 1982
Oct. 1926 Nov. 1927 July 1990 Mar. 1991
    Jan 2001 Oct 2001

Source: Christina Romer, "Business Cycles" The table is taken directly from Romer's article.
All references should be strictly to it.

If you want more evidence of the growing flexibility of the US economy since the early 1980s, consider the peak levels of unemployment in the US economy through the 1970s, when the US economy, like all other industrial economies, was badly dislocated by harmful supply side shocks: two big oil price rises and confusion for a decade in how to deal with both rising unemployment and rising inflation, something that the dominant Keynesian approach to macro-economic policy (especially the Phillips curve tradeoffs between them) claimed shouldn't happen (data taken from Greg Kaza:

Unemployment peaked at 7.5 percent in July 1958, three months after the 1957-58 recession ended (April 1958).

The rate peaked at 7.1 percent in May 1961, three months after the 1960-61 recession ended (February 1961).

Unemployment peaked at 6.1 percent in August 1971, nine months after the 1969-70 recession ended (November 1970).

The rate peaked in May 1975 at 9.0 percent, two months after the 1973-75 recession ended (March 1975).

Unemployment peaked in December 1982 at 10.8 percent, one month after the 1981-82 recession ended (November 1982).

The rate peaked in June 1992 at 7.8 percent, 15 months after the 1990-91 recession ended (March 1991

And the rate peaked in June 2003 at 6.3%, 20 months after the 2001 recession ended (September 2001)

As you can see, the peak of unemployment rose from 1971's 6.1% to a very painful 10.8% --- the highest level in the US economy since the 1930s, and by the way the roughly the levels reached by the EU in the early-mid 1990s and again right now. Since then, each time we've had a recession --- in 1992 and 2001 --- the decline in GDP was not only shallow and short-lived, so too was the resulting unemployment.


(iii.) Enter revolutionary technological change: the high-pulsating forces of creative destruction.

Seen from this angle, then, the stepped-up import-competition in the US economy has also stepped-up the speed of overall innovative change thanks to what's called creative destruction. Meaning? Meaning that a rich, complex national economy can't foster new and dynamic industries --- thanks to revolutionary technological breakthroughs that arrive in clustered waves --- without letting old standardized industries run down and transferring capital, managerial talent, engineering and scientific talent, R&D, and skilled workers to those new, more promising industries. The new industries can't emerge and grow large, along with their beneficial spillovers to the rest of the national economy, until the old are eliminated or drastically pruned.

The gales of creative destruction --- fast-paced revolutionary technologies that render old industries more and more obsolete in the major innovating economies --- ensure that both occur simultaneously.

Sidebar Clarification: It's a novel concept, creative destruction --- developed earlier in the last century by the great theorist of radically restructuring technological change, and how it has occurred every 50-60 years since the industrial revolution in clustered long-term waves: Joseph Schumpeter, an Austrian by birth who moved to Harvard in the early 1930s. He's also the champion, as were a few of his Austrian colleagues, of the key role of the bold, self-driven entrepreneur in bringing about such revolutionary innovation. Fortunately --- though neglected by mathematical economists both in Keynesian and later new classical economics (Milton Friedman, John Lucas, Robert Barro, Thomas Sargent, Martin Feldstein, and others) --- the huge technological breakthroughs of a radical sort that we have experienced since the 1980s has reawakened interest in this great economist of innovation.

In the next article we'll return to these concepts --- radically restructuring technlogies, long-wave clusters, the forces of creative destruction and the key role of raw entrepreneurial innovators in bringing about radical industrial change --- taking up the theme again why the US economy, contrary to theories of convergence catch-up growth, has outperformed all its competitors in innovation and per capita income for over 120 years now . . . with all the consequences for the global distribution of power.

In the meantime, shift your attention and ponder the next point here:


Can You Block The Forces of Creative Destruction?

Sure, but at a big cumulative cost --- growing structural rigidities in the national economy. This, in a nutshell, has been the fate of rich countries with high wage costs --- Japan and most of the EU --- whose governments have sought to block the forces of creative destruction (read: radical economic change) by means of politically motivated subsidies, protection, and regulations that protect redundant labor and increasingly uncompetitive industries.

Most established corporations, moreover, are only too happy to peg along without being forced to meet the new innovative challenges head-on . . . whether generated internally within their own national economy or from abroad. No surprise. They want a comfortable life. Their organizational structures, managerial mental habits, and internal labor-relations tend to be rigidily established, locked-in on all sides by walls of established routines and standard operating procedures. Hence, as once example, recall the inability of IBM to deal effectively back in the 1980s and early 1990s with new dynamic start-up companies: Microsoft, Apple, Intel, and Cisco. In technical terms, big corporations if they survive over time in oligopolistic competition earn "monopoly rents" --- a return on their investment capital and other costs of production higher than would be the case in a perfectly competitive market; the new innovative firms, almost always dynamic start-ups of the sort just mentioned, erode those monopoly rents and force the old established corporations either to change drastically themselves or go under. (IBM's ultimate fate is instructive here. Thanks in no small part to the pressures exerted on IBM's top management by the US stock market and millions of shareholders --- its top management eventually did adjust to the new competition and made the company over in the 1990s into an efficient, up-to-date provider of information services. By contrast, in Japan and most of the EU, share-holders have traditionally had little influence on management decisions. That's largely because corporations in both places get most of their investment capital from big long-term customer banks, with which they develop cozy relationships. In such circumstances, poorly performing corporations hardly have to worry --- traditionally anyway --- about the price levels of their stocks, let alone about take-overs by specialists who encourage shareholder rebellions.)

Over time, as we now know, such a strategy of blocking the gales of creative destruction will only backfire.

It will multiply structural rigidities in their governments' national economies, around which vested political interests will gel, and hence delay the necessary adjustments that are needed to let the new technologies flourish and make the economies more competitive. When the inevitable adjustments occur, they will therefore be all the more painful. Until then, not only will those economies in Japan and West Europe lag behind more dynamic and flexible ones like the US that let free markets work more effectively, but worse, they will find that their protected industries with their high wage costs and rigid labor markets will invariably lose competitive edge to faster growing developing countries . . . including new industrializing ones like those in East Asia.


An Alternative View: Pacific Asia and the US Form A
De Facto Regional Trade and Monetary Zone

There's another way of looking at all the Asian-US relationship that downplays the mercantilist side in Asia, and instead analyzes our links as a de facto form of economic and monetary integration, analogous to the Eurozone in the EU --- only without the institutionalization, organizationally speaking, or any of the restrictive policies such as the Eurozone Stability and Growth Pact that limits deficit spending by any member-government to 3.0% of GDP annually . . . a policy by the way violated by the French, Germans, and Italians for two or three years now.

How, in more concrete language, are Pacific Asia and the US integrated in analogous ways?

The analysis that follows --- most of the points anyway, not all --- is taken from a very good up-to-date article by Stephen Len: see The US Dollar As A Currency For The World The latter two points about the US$ and US financial assets playing a role in the US-Asian Trade and Monetary Zone of financial intermediation are best explained by a recent and important academic study, Michael P Dooley, David Folkerts-Landau, and Peter Garber, "An Essay on the Revived Bretton Woods System" (Working Paper 9971. ) If you have a good grounding in international monetary economics, you might find a paper critical of the Dooley article informative, even if it overdoes its criticisms: Barry Eichengreen, "Global Imbalances and the Lessons of Bretton Woods," May 2004, working paper 10497,

  • More than 50% of Pacific Asian trade occurs within Asia. 25% more is with the US. All the Asian Pacific countries depend on export-led growth; and if almost all are running trade deficits with China, they achieve large export surpluses in their trade with the US. In fact, of all the major economic powers in the world --- Japan, the US, or the EU --- only American authorities don't manage the value of the currency (the $US), don't try to accumulate foreign currency reserves, and have been generally happy to live with trade deficits in goods and services, the current account, for decades. The exception: when, as in the early and mid-1980s, protectionist backlashes erupt in certain sectors of the US economy in competition with imports, and some import relief is sought through efforts to coordinate with other governments a decline in the exchange rate of the dollar.

  • To facilitate the growing intra-Asian trade, Japan included --- focused however increasingly on the massive Chinese economy --- the vast bulk of such trade is carried out in dollars, not Yen or Yuan or the other local currencies. South Korea, for instance, conducts about 80% of its trade --- exports and imports --- in dollars. Even 67% or so of Japan's trade with the rest of Asia is done in dollars.

  • By far, almost all the Asian Central Banks --- as we've noted --- prefer to hold their foreign exchange reserves in dollars, roughly 85-90% of the $2.2 trillion total reserves that they now hold.

  • Asian countries, Japan included, are massive savers. They have to export their excess savings abroad, otherwise they would face a huge mismatch between the level of savings and investment within their national economies that would reduce interest rate yields there and, unless investment picked up, lead to slower GDP growth and even recession. Some of those excess savings in Pacific Asia stream into China for the non-Chinese countries; some go to offshore commercial banks in Asia, in dollars; and the rest --- the huge bulk --- stream into US financial assets in this country.

  • In turn, finally, the capital inflows of high-level savings from Asia into the US has a double beneficial result:

      • 1) It keeps US interest rates lower than otherwise, facilitating higher levels of US investment, economic growth, and US consumption --- the latter of which would otherwise have to decline in favor more US household savings;

      • 2) The faster US economic growth, in turn, facilitates what all the Asian countries want: export-led growth, with American firms and consumers buying more of their exports than we otherwise would. Remember: if Asian private and official investors didn't invest their excess savings in US financial assets, the dollar's value against their currencies would depreciate and sooner or later erode their export surpluses. So much for their hopes for export-led growth.


The Mutually Beneficially Bargain that Results for Asia and the US

In effect, seen in this light of an integrated trade and monetary zone, the US serves as a country of financial intermediation between Asian countries' high savings and American firms and consumer' desires for ever higher levels of savings to sustain investment and to keep our consumption higher (otherwise, American households would have to cut consumption and increase savings).

It's a bargain for both of us. Hence the claim in the Michael Dooley et al article just mentioned a few moments ago that we are now living in a revived Bretton Woods sytem. How so?

In the earlier post WWII system that existed from 1945-1972, the US economy and the dollar served as a core for the fast-growing periphery of Japan and West Europe, their fast rising GDP heavily dependent on export-led growth to the US. In that system, the world was on a de fact dollar standard. The US remains, it's argued, the same core again, only in the revived Bretton Woods system the fast-growing, export-led periphery is now Asia, with Japan very much a part of that system. Again, from this viewpoint, Asia is on a dollar standard and its governments and private investors only too happy with the overall bargain --- the US economy full of good and diverse financial assets of a sure-fire sort for their investments, and the higher the levels of their investments, the more they enjoly export-led growth back in their home countries as the dollar rises in currency markets.


Can The Bargain Last?

Will the bargain be sacrificed if, over time, Asian lenders to the US worry about the ability of the US economy to sustain current account deficits on the order of 5.0-5.5% of GDP?

No one can answer with certainty. About all one can say is that the bargain can run on for several more years, and maybe longer, without any need for major adjustment. It might be threatened, as we have indicated, by American backlashes against massive import competition, though that's not likely. As for the Chinese --- and maybe other Asian countries --- facing inflationary pressure, their Central Banks would eventually have to let their national currencies float upward (or peg to the dollar at a higher rate) to help fight inflation.

For their firms and workers, that might be painful. We mentioned this earlier. For US firms and workers, by contrast, it's hard to foresee how a decline in the value of the $US would have any disadvantages for us . . .

Unless, that is, the second major worry that bothers makes some observers fret --- a declining $US could set off inflation here --- is a cause for genuine concern.



Let's assume that, at some point, the pace of capital inflows into the US economy from abroad did slow down in the future --- exactly as they did in the late 1980s. What would happen then? Two possible bad things.

(i.) Interest Rates, It's Feared, Might Rise.

First off, if American investment needs stayed the same --- high relative to our national savings at home --- then, conceivably, interest rates would rise as capital inflows slowed down . . . a form of crowding out, remember.

Note the term here: conceivably. Our reply here is the same as earlier: no such crowding out occurred in the late 1980s, a laboratory test-case of this fear. Federal deficits continued to rise rapidly, and the dollar continued to fall. At the same time, the pace of foreign investments slowed down (not reversed). Yet the 10-Year Treasury Bond --- a key long-term interest rate --- continued to fall, not rise. Apparently, what was determining the interest rate of that key bond wasn't a fixed pool of savings --- domestic or foreign --- but the expectations of savers offering to lend their money to US borrowers regarding inflationary dangers.

Tersely put, by the late 1980s --- despite the falling dollar --- the fears of general inflation had largely disappeared on the part of US and foreign savers willing to lend their money to US investors seeking loans. (A foreigner investing in a US financial asset --- a Treasury bond, Intel equities, MGM for sale --- is in effect lending money to the US issuer of the contract who is borrowing it: the US Treasury, Intel Corporation, MGM movie corporation etc.)

And that is relevant to the second possible bad thing.


(ii.) Would Inflation Be Set Off? No, Unlikely So.

Assume that the exchange rate of the dollar fell in the future against the major Asian currencies --- as it has against the euro the last two years (though it's back, essentially, to the exchange rate when the euro entered into existence in 1999, around 1 euro = $1.20). How much it would fall against the Yen or the Yuan or some other Asian currencies would, of course, depend on what Asian Central Banks would then do. Would they increase their purchases of dollars to stop the fall, precisely to keep their export machines to the US market whirring at high-octane speed? Or would they decide that, for whatever reason, it would be desirable to let the dollar fall --- probably by no more than 10-20%? (Until now, note, the EU Central Bank hasn't tried to support the euro against the dollar by selling euros for it. Most likely, it would probably intervene should the euro threaten to rise against the dollar by more than 5-6% over one year or so. That shouldn't worry us. We are mainly concerned with the over-valued exchange rates of the Yen, Chinese Yuan, and two or three others in Pacific Asia.)

What, to be more precise, would happen if the dollar fell as it did in the late 1980s? There are two sides to the answer.

  • On the positive side, such a fall would clearly boost US exports, reduce over time US imports, and improve the trade deficit. At some point, if the dollar fell sufficiently against other currencies --- as it did in the late 1980s --- the trade deficit would vanish sooner or later. Other countries, dependent on export-led growth --- the Pacific Asians, Mexico, and much of the EU --- might be unhappy with the turnabout in their growth-stimulus, but it's hard to see why Americans would be --- just the opposite.

  • Oppositely, a downside to the dollar's fall could rear up: inflationary pressures that such a fall, if it went very far, could entail. Or so it's argued.


A Trio of Charts

We'll treat this danger in the next sub-section here. Before we do, let's illustrate the positive side --- the way exports rise and imports fall for the US as the dollar's value itself falls. Naturally, the opposite happens when the dollar rises against other major currencies.

Here are three charts. The first traces the trends in US trade in goods --- note, just in goods (manufactured and agricultural products, plus some minerals and coal and raw lumber). The current account also includes the trade in services, where the US has had a surplus for two decades or so now . . . roughly offsetting about a 5-10% of the deficit in the goods sector. (The current account also includes a figure for what's called "unilateral transfers", such as foreign aid.) Note the sharp fall in the deficit for trade in goods when the dollar fell rapidly after 1985 through 1991.

The source once more is Robert Blecker, "Let It Fall" (Oct. 2002)

The second chart traces deficits in the trade in goods and services since 1993, a period when the dollar started to rise again --- and very rapidly after 1995. The deficits are stated as a % of US GDP. (Frankly, this chart has been in my files for about 11 months now, and I can't find the original source. It might just be from the Commerce Department, which oversees US trade and our national income accounts.)

Bureau of Economic Analysis. It shows how the current account has behaved since 1996.

* Keep in mind that when the US economy is growing far more vigorously than its competitor economies abroad in Europe and Asia (save for China, with its heavily undervalued Yuan), it will naturally export less to them because their consumers and firms don't buy as much either at home or abroad. Simultaneously, our own consumers and firms will be importing much more from them than they would if GDP growth were much slower, let alone in recession. This too has been the case since 1995. Hence part of the reason for the large growth in the US current account since then.

* Ordinarily, in such circumstances --- a boom here, slow growth abroad for our major trade partners --- the dollar's value would fall. This too, as the dollar fell, would slow down the current account deficit; over time, the deficit could be reversed. Since 2001, a fall in value has happened only against the euro and pound sterling among major currencies, and to an extent the Canadian dollar. Against the Mexican peso and the major Asian currencies --- owing to Central Bank's continued efforts to buy dollars --- no fall of any note has occurred, just the opposite in some instances.

* Causing a recession is another way to rectify a current account deficit, all depending on two things: 1) the % share of imports in a country's GDP --- the greater the %, the faster a recession will ordinarily choke off imports; 2) what's called the MPI, the marginal propensity to import. The smaller import are as a % of GDP, and the smaller the MPI, the more severe a recession has to be to cure a current account deficit. In the US, imports of both goods and services are now around 15-16% of GDP --- still fairly low --- and a recession would have to be severe and probably prolonged if it were the major adjustment process. In any case, to repeat, a more effective way that hasn't many costs historically is simply to get other countries to let the dollar's value fall.)

Some Clarifying Remarks Why The Danger Of Major Inflation Isn't Likely To Materialize

The causal connections behind the inflationary fears from a falling dollar are easy to set out, even if they're exaggerated --- and maybe just plain wrong.

1. For a start, as the dollar fell against other currencies, American firms and consumers wouldn't be able to reduce our dependence on imported goods at an equivalent pace. That's because the quantity demanded by Americans for some of these imported foreign good --- think of foreign oil –can't be quickly reduced (or substituted for) for as their prices rose. This reflects --- to stay with the case of oil --- a low price-elasticity of demand: the quantity demanded isn't very responsive to price hikes.

After all, it takes time for firms and consumers to substitute away from foreign oil (or oil whatever its source, the global oil market being an integrated one) --- say, a few years before Americans stopped buying gas-guzzling SUVs, switched to better gas-mileage cars, bought hybrids, or took public transport to work. As they did substitute away --- conservation included --- the price elasticity of demand for oil would increase: it would move leftward and downward and show far more sensitivity to the price of oil . . . exactly what happened after the two oil price rises of 1973-74 and 1979.

2, Something else would then come into play to reduce the demand specifically for foreign oil as opposed to both foreign and domestic oil: as the price of oil rose, oil companies in the US would increase their search for new oil wells or to find ways to tap existing wells better.

3. Simultaneously, at some point --- exactly as happened by 1983-84 --- US and foreign oil companies would have intensified their location of new oil wells abroad that could be tapped at the higher price --- say, in the former Soviet Union or offshore of Siberia or in the Chinese sea.

4. At the same time, American manufacturing firms and energy-producing ones would switch away --- as they did in the 1980s and into the next decade --- from oil to natural gas or coal. These are immediately available. Natural gas, generally, is more benign to the environment than oil production. Coal is at least as harmful, though the use of stackers and other forms of reducing the smoke pollution have helped considerably here (the main environmental damage is to the land, strip-mining being the major technique for extracting coal).

All these effects --- called substitution, conservation, and income effects as prices rose for goods, whatever the price elasticity of demand for them --- involve the short- and mid-term, roughly 1 or 2 years up to 10 or 15. In the case of oil, as we've said, the price elasticity of demand isn't responsive at the start of a price rise: it's price inelastic. Hence the adjustment effects here would take time. But they would work. What's more,

  • eventually, over the decades, we would be able to switch away from carbon-based fuels, period. As these processes of reduced purchases, conservation, substitutions, and alternative sources or energies occurred, the imports would diminish; but to repeat, that takes time.)


So, Given The Time It Takes To Adjust, Could A Rise in General Inflation Occur?

Stick with oil --- the worst of the dislocating, inflation-prone goods imported from abroad.

The nightmare scenario related to it is a repeat of the late 1970s: a huge price-rise could, in principle, play major havoc with the supply side of the economy, leading --- as in the mid- and late-1970s --- to the nightmare of rising inflation and rising unemployment as firms, stuck with higher costs of production and facing less demand for US goods and services, laid off workers. That said, is the theoretical worry about such major dislocating effects and inflationary pressures sound these days?

The best guess: not nearly as much as in the 1970s, almost the opposite . . . and for several reasons.

(i.) For one thing, the huge oil price rises of the 1970s --- a four-fold increase in 1973-74, then a doubling again of the price in 1979 --- occurred in an economy where energy itself was about 7.0% of US GDP. Since then, thanks to conservation and other measures, it has fallen to around 3-4% of GDP --- yes this, despite the growing dependence on foreign oil since 1990 again (now around 60% of US petroleum use, with petroleum around 45% of overall energy usage.)

What this means is that a big hike in the price of oil is very unlikely to have the same dislocating effects. And if you want concrete evidence, consider that the price of oil did double in the late 1990s --- and it had no ripple effect on US inflation to speak of. It continued to come down. Nor did it cause unemployment. It was the recession of 2001, including the 9/11 attacks and the crash of the stock market (plus brokerage house and accounting scandals), that caused unemployment to grow the next 30 months from around 4.0% of GDP to over 6.3% in the spring of 2003.

Unemployment now, by the way, is around 5.6% and still headed down.

(ii.) For another thing, the dislocations in the US economy after 1974 --- and elsewhere, it should be added ---- resulted from misguided macro-policies, especially on the part of the Federal Reserve. The Carter Administration moved to offset the growing unemployment with larger federal deficits, and the Fed Reserve accommodated them: that meant it didn't raise interest rates to offset them. Small wonder that by 1980 we were in a nightmare of rising unemployment --- the federal deficits had no lasting impact on boosting job-creation --- and double-digit inflation. Immediately, starting in 1980 or 1981 the Fed reversed course. It now had good evidence that what fuels general inflationary pressures aren't dislocations caused by sudden bursts of price rises of this good or that good --- even oil --- but rather, once the immediate ripples of the price rises fade, the expectations of the public that prices will continue to rise.

To put it differently, a rise in the general price level can't occur when only some goods rise in price. Those rises would --- unless the Federal Reserve increased the money supply --- necessarily entail reductions in the prices of other goods as consumers and firms spent more on those goods until substitutes and conservation could occur.

Again, the evidence of the late 1980s is overwhelming here. The exchange rate of the dollar fell, to repeat, by about 50-60% against the basket of key foreign currencies. Far from causing new inflation, the general price level in the US economy actually went down the first year of the dollar's fast fall(1986), then rose slightly as you can see from the following chart until 1991, then fell again throughout the early 1990s and through the rest of the decade. Source:
US Treasury.


A guiding principle here can be stated: don't exaggerate the harm of the Federal deficit as it is now shaping up or of the trade deficit, and for three reasons:

  • In particular, the rising Federal deficits since the recession of 2001 have helped generate the new booming economy and the more recent job creation. As we pointed out earlier, the fast-paced GDP growth since the spring of 2003 has already generated an added $100 billion tax revenue that is already offsetting some of the still high deficit spending. As for the trade deficit, its counterpart is the huge capital inflow into the US economy that has helped keep interest rates lower than they otherwise would be, adding to GDP growth that way.

  • Moreover, contrary to simple-minded mercantilism, the growth of overall employment in a large rich economy like the US has little to do foreign exports to us. Yes, some jobs will be lost, and outsourcing --- like US multinational relocation abroad (offset by even faster foreign multinational location here in the US) --- will hurt some Americans, but far fewer as the Bureau of Labor stats mentioned earlier note: so far, 4300 in number owing to outsourcing abroad! As long as GDP is growing, so will job-creation on balance. Each year, to illustrate this, we normally find in a very flexible, dynamic economy like the US's that about 3 million jobs are lost each month, whereas about 3.2 million new jobs are created. Yes, that's right. Almost 20% of total US jobs --- roughly 140-145 million --- are lost each year, almost all to dynamic changes in the national economy.

Oppositely, export-led economies like Japan's and Germany have scarcely created any new net jobs for their populations the last 14 years. The most you can say is that without trade surpluses in goods, their economies would be even more stagnant.

  • Then, too, neither the Federal nor the trade deficit will keep rising forever. And a correction to the trade-deficit --- assuming for the reasons just mentioned a falling dollar wouldn't lead to serious inflation in the US economy --- would probably be, on balance, helpful to the US economy, and more harmful to export-led countries abroad. What's more, as the experience of the 1985-1991 period shows, a falling dollar doesn't stop capital-inflows from abroad, it merely slows their pace down.


The Federal deficit: Two Possibilities

As for the problem of the rising Federal deficit, two outcomes seem likeliest to materialize --- both generally bringing about a soft happy landing of the economy.

1) The next President and Congress agree to keep the 2002 tax cuts permanent --- maybe, in the case of John Kerry and a Democratic-controlled Congress, with some switches from high-income earners to favor the middle class. Whatever, they would then have to agree on cutting government expenditures as compensation. The haggles would be over what to cut. There is lots of fat in government spending, though hardly all of it. And here, of course, partisan preferences would appear.

Whatever the outcome of these compromises, the tax cuts would largely be matched by cuts in government expenditure. Whether the right expenditures would be cut is, however, more problematic and also a matter of partisan outlooks.

2) Alternatively, the likeliest outcome seems to be that even if Congress and a President agreed to raise taxes to the pre-2002 level to offset the Federal deficits, American investors and workers would hardly be hobbled. Those rates would actually be lower than in the boom period of the 1990s, thanks to the 2001 reductions. They would, in any case, be far from a return to the excessive tax rates that seem to hobble EU competitiveness in most countries --- not to mention the encouragement of an underground economy, caused by tax evasion, that's about double to triple the size of the one in the US: 7-8% of GDP vs. 15-20% in the EU (worse in the Latin countries and Greece).

By contrast, all the doom-doom scenarios, including this high tax one, seem misguided or far-fetched.