Fears of a double-dip global recession have depressed bourses the world over, inducing a flight to treasury bonds. Economists (and indeed The Economist) are singing gloomy jeremiads.
Double-dip recessions are rare. Why then are markets expecting it? Mainly because the recession of 2001, unlike most others, did not end the excesses caused by the preceding bubble. There are many reasons why recessions occur. But an important one is that booms induce unsustainable borrowing and consumption. This bubble inevitable bursts, and a recession is a way of painfully reducing the overconsumption and overborrowing.
However, the recession of 2001 did not extinguish the excesses of the 1990s. US investment fell, but consumption kept rising, fuelled by rising consumer debt. One consequence is that the US is now running a current account deficit not far short of $ 500 billion, or 4.5 per cent of GDP. Historically, countries running a deficit of that magnitude have almost always suffered a big bust and painful contraction. Many economists fear that the US must suffer such a fate. This could take the form of either a double-dip recession or near stagnation for several years as the excesses are worked off. Either way, the prospects for global recovery would be gloomy.
I think the argument is overblown. History is a poor guide to the US situation, for a very special reason. America can pay its debts with its local currency, the dollar. All other countries have to settle their external accounts in foreign exchange. Not the US.
Remember that for centuries, countries settled their debts and trade imbalances in bullion. It did not matter whether they were formally on a gold standard or not (that is, whether they had tied their local currency issue to gold reserves). They had to service external dues in gold or silver. Lucky countries like South Africa and the Soviet Union, the two biggest gold producers in the world, did very well in this situation. They could settle all external dues with their metal output.
The gold standard is long gone. The world is now, effectively, on a dollar standard. The bulk of the world’s foreign exchange reserves are held in dollars. So the US can literally export dollars, just as South Africa exports gold. The dollar is in many ways more acceptable than gold: you do not have to incur costs insuring and guarding it.
This suggests that the current account deficit of the US is no more unsustainable than the gold production of South Africa. In theory, the world could suddenly suffer a panicky flight out of dollars. But this is no more likely than a flight out of gold, probably less so.
Every time a country runs up a trade surplus with the US, it typically puts half to three-quarters of that surplus into US securities as part of its forex reserves. In other words, up to three-quarters of the US trade deficit is automatically financed by the rise in demand for reserves by its trading partners.
US Treasury Secretary Paul O’Neill has, famously, derided the current accounts deficit as a meaningless concept. This deficit is the mirror image of the net inflow of capital into a country. O’Neill claims that when the world insists on investing huge sums in the fabulous US economy, the accounts have to show a correspondingly huge current account deficit. This is a triumph, not a problem, says O’Neill.
Now O’Neill exaggerates the attractions of the US economy. Foreign investors have burned their fingers badly in the US. Corporate profitability in the US is nowhere near as high as in the 1960s. Fortune magazine estimates that the average profit of the 500 biggest companies is only 3.3 per cent of sales.
But investment demand is by no means the only reason why money pours into America. The demand for foreign exchange reserves is another key factor. In the absence of a gold standard or any other anchor, the world has voluntarily moved to a dollar standard, creating a huge additional demand for dollars.
World trade has been rising much faster than world GDP, contributing to the rising demand for forex reserves. The globalisation of finance and the Asian financial crisis are additional reasons for countries to build up forex reserves. These are needed not just to finance imports but to provide a credible buffer against capital flight. India’s RBI aims to match at least half the inflow of portfolio investment with increased reserves. Other central banks are dong the same. So the demand for dollars for reserve purposes is rising fast.
So is the demand for dollars simply as currency. Few Indians realise how many countries have been hit by hyperinflation, how many households the world over keep their savings in dollar notes under their mattresses. A recent article by Kenneth Rogoff of the IMF says that the US has outstanding currency of $ 620 billion, of which probably three-quarters is held abroad. Russians are believed to hold more dollars than roubles. Ditto for Argentineans. Ecuador has joined Panama in formally dollarising its economy: in these countries, the official currency is the US dollar.
Apart from households, much US currency is held by drug traffickers and criminal gangs for cash payment. Cash is the only anonymous way to settle accounts, and so is greatly favoured by criminals of all sorts. This further adds to global dollar demand.
So, while a current account deficit of 4.5 per cent of GDP would be unsustainable for any other country, it could be sustainable for the US, for many years if not forever. I do not take a fundamentalist position on this. Possibly a weakening dollar will induce some flight to other currencies, raising interest rates in the US and causing a double-dip recession. But while this is possible I do not think it is probable. In all likelihood, the demand for dollars will remain high, and the global economy will recover notwithstanding American excesses.