A
discussion of globalization triggers passionate
and at times violent responses. Rarely has an
economic topic captured the spirit of the public
so much. What we would like to contribute to the
debate is some insight on how monetary and fiscal
policies affect globalization and their effects on
the dollar.
Federal Reserve (Fed) chairman
Alan Greenspan believes free trade lowers consumer
prices and thus is in the best interest of
consumers. He is opposed to import tariffs
intended to, for example, provide a level playing
field for different environmental standards (and
costs) because it would open a Pandora's box for
special interests,
protectionism and eventually a trade war.
The "pure" free trade argument postulates
that regulation should be localized and market and
political forces will eventually level the playing
field. Beyond that, there is no reason why
labor-intensive industries should be protected, as
competition with low labor cost countries is a
losing battle.
Instead, it is important to
have a flexible society so that resources can be
redeployed more productively in more competitive
sectors of the economy. We also hear warnings that
everyone is worse off with protectionism, just as
the depression during the 1920s was more severe
and longer than it could have been because trade
barriers were raised. Trade barriers tend to
penalize those embracing change and to block job
creation, while subsidizing those who do not
adjust.
Opponents of free trade tend to
focus on the fallout of what is attributed to
globalization. Notably, we see a destruction of
the manufacturing base and jobs in the United
States as corporations outsource manufacturing to
Asia and other parts of the world. We see that
real wage growth has difficulty keeping up with
inflation. We see a growing income gap between the
rich and the poor. It is human nature to resist
change, and there are seismic shifts underway in
societies around the world. Opponents of
globalization criticize that economic interests
are put ahead of human rights and political
progress. As we will see below, fiscal and
monetary policies have a large role to play in the
negative fallout attributed to globalization.
We sympathize with Greenspan's concern
that politicians could easily cause more harm than
good. However, let us start on his home turf:
monetary policy. Low interest rates foster
consumption, foster credit expansion and foster
trade. Conversely, higher interest rates may put a
damper on trade.
Greenspan is allowed to
control trade, but he thinks elected officials
should stay out of it. To remain provocative, let
us look at the dollar. What is "free" about a
pegged exchange rate? Many Asian countries try to
keep their currencies weak versus the dollar to
foster economic growth and exports in the region.
Nobel Laureate Robert Mundell argues that
fixed exchange rates facilitate commerce. Money
will flow to regions that are economically more
attractive; inflationary pressures will be
contained as long as there is enough demand to
offset the supply pouring into the region.
In the case of Asia's growth, lots of
money is flowing into the region. In our
assessment, Asia has been importing potentially
substantial inflation as growth is put ahead of
sustainable economic development.
The
point for purposes of this analysis is that
exchange rates significantly affect trade, and
what we have had over the past years cannot be
considered "free trade". Recent pressures by the
US Treasury Department to have China revalue its
currency is a double-edged sword: the reason we
have had mild inflation in the US on anything we
can import is precisely because Asia has been
willing to subsidize its exports to the US. We use
the term "subsidy" as that is what a fixed
exchange rate amounts to, plain and simple.
Critics of free trade argue that tariffs
should smooth out imbalances. If we have higher
limits on pollutants emitted, then imports from
countries with lax standards or enforcement should
be penalized. If we have an expensive social
security system, and much of Asia does not, we do
not want to undermine our social stability and
should impose tariffs if other countries do not
have comparable systems.
If we believe it
is strategically important to have our own
automotive manufacturing industry, we should have
tariffs to smoothen out any "advantage" other
countries may "unfairly" have. Following through
this line of argument, you can see very quickly
why Greenspan says we should have none of that.
Depending on your political persuasion,
you may prefer Greenspan's line or you may think
we should have barriers in place to protect our
higher environmental standards, protect our social
security, or go as far as protecting ailing
industries. You may also vote with your feet and
try to purchase only domestically produced goods
(good luck doing this consistently).
Effects on job security The
Financial Times recently wrote, "In the Fed's
analysis, the drag from the trade deficit has
required looser monetary policy, to stimulate
domestic consumption and to prevent an
unacceptable drop in US growth."
Without a
doubt, the Fed is very much involved in trade
policy. But there is more to it: the added
stimulus has not gone without its side effects.
Not only has there been a conscious attempt to
increase domestic growth, but growth in Asia,
where much of what we consume is produced, has
also been elevated.
While this sounds
wonderful at first, high commodity prices are a
direct result of growth at any cost. Why should
you care if you are an American consumer? You
should care because not only does it affect your
pocket book (eg at the fuel pump), but also
because it reduces your job security. It reduces
your job security because corporate America is
squeezed by high raw material prices and low
consumer goods prices because of the flood of
cheap imports from Asia.
Another reason
for low consumer prices is that consumers are
heavily in debt and may not be able to afford
higher prices. That leaves corporate America with
little option but to squeeze maximum efficiencies
out of its labor force to remain competitive. In
plain English: if you are working in the
manufacturing industry, expect your real wage
growth to be lackluster at best, expect that your
employer may outsource your job to lower cost
countries.
Sensitivity to interest
rates Following the tech bubble burst after
2000 in the US, corporate America had a recession.
However, US consumer spending never declined,
courtesy of massive fiscal and monetary stimuli.
While balance sheets of corporate America were
cleaned up, US consumers were encouraged to take
on ever greater amounts of debt.
US
government debt also rose sharply during this
period. Now we are in a situation where both US
consumers and the government are highly sensitive
to changes in interest rates: many US consumers
have taken out adjustable rate mortgages and the
US government suspended sales of the 30-year bond
a couple of years ago. Both of these actions lead
to increased sensitivity to changes in interest
rates.
Effects on growth and
inflation The recent "employee discount"
program offered by automotive companies is a sign
that the American consumer is ready for a break.
US housing prices may also be beyond their peak,
as much consumption has been financed through home
equity extraction in recent years; this is another
sign that we are heading for a slowdown. Even
though imports from Asia have had a dampening
effect on inflation, consumer prices recently grew
at a rate not seen in 18 years. Even the rate that
excludes food and energy is steadily climbing,
making the Fed nervous.
The US economy may
be slowing down just as inflation is picking up.
Worse for the Fed, because of an economy that is
more interest-rate sensitive, even small rate
increases may cause a recession, yet not be
sufficient to stave off inflation. You may have
noticed that much of the talk about raising rates
has been about getting rates into "neutral"
territory.
One does not fight
inflation with a "neutral" monetary policy, especially
one that we have not yet even reached. You can
justify such lax monetary policy only if you
believe inflationary pressures are transient.
Nominated Greenspan successor Ben Bernanke earlier this
year said elevated oil prices were transient - they
certainly were, they did not stay long at $40 a
barrel but went up to over $60.
"Globalization" and "free trade" are
blamed for many job losses. Politicians influence
the speed of the transition. They accelerated this
trend beyond its "natural" rate through policies
fostering consumption rather than savings and
investment. The pace fostered by monetary and
fiscal policy is causing a transition that is fast
and painful, leaving the US economy vulnerable.
Vulnerable economically as households are deeply
in debt. Vulnerable socially as leveraged households
have much less resistance to shocks: if you
lose your job or have other unexpected expenses,
it is easy to fall behind in your credit payments.
Greenspan admires the increased "efficiency"
of the US economy (if you lease or buy
on credit rather than pay in full for everything
you consume, your monthly salary takes you much
further.
The Fed's
reaction There may well be more fallout.
Greenspan and Bernanke have to guide US monetary
policy. Bernanke promised when he accepted his
nomination that he would do everything in his
power to preserve American prosperity. This is
laudable in principle, but confirms us in our
belief that he will continue to promote consumer
spending over savings and investment.
Savings and investment are an essential
part of a balanced economy –just as it is crucial
for the success of every household. There is a lot
of talk about Bernanke's desire to target
inflation. The only thing we know for sure is that
Bernanke is very much afraid of deflation, that he
does not like to see inflation edge too low.
Deflation per se is not bad – if you have
money, your purchasing power increases as prices
decrease. Technological progress has allowed us to
enjoy lower prices on many goods and services over
the years. The Fed is afraid of deflation when it
is associated with reduced consumption, as it
could lead to an economic downward spiral.
Deflation is also very painful when you have a lot
of debt.
The US has every incentive to
promote inflation as it reduces the value of
outstanding debt. This equation works well if you
have Asia continue to sell cheap goods to the US
and dampen inflation. However, inflation is not a
switch that the Fed can turn on or off, it is a
cancer that will spread slowly and is more
difficult to fight the further it has spread; just
because we do not see the symptoms show up
everywhere does not mean we can be complacent.
Administration fixated on
growth This administration has been very
consistent in that it promotes growth. At any sign
of slowdown, tax cuts and other fiscal stimuli
have been proposed and implemented. Spending bills
authorized and proposed will ensure a fiscal
stimulus in the coming year, independent of
whether tax cuts will be made permanent or not.
We are rather concerned that this stimulus
in the pipeline will further escalate commodity
prices and act as a wrench on the consumer. After
this holiday season, we expect consumers to have a
rude awakening. Regulations that have come into
effect recently double the minimum payment due on
credit cards; interest charges on balances carried
are higher; heating bills this winter will be a
shock.
In what may be the perfect storm
for the consumer, we expect the Fed to be more
concerned about an economic slowdown than
inflation. In our view, the odds are high that the
Fed will raise rates far enough to let the economy
tumble into recession, while not raising rates
sufficiently to stop inflation from progressing.
Asia's reaction As US
consumption slows, the question is how Asia will
react. Asia has been supporting US economic growth
by subsidizing their exports through artificially
weak exchange rates. Many economists believe that
Asia must cave in soon and let their currencies
rise.
While this may happen eventually,
let us not forget why Asia has pursued this policy
in the first place. Asian leaders are interested
in political stability, which they can keep as
long as jobs are available. If we are stunned by
the rapid transformation the US is undergoing,
changes in Asia are far more radical.
Globalization has allowed over a billion
people to participate in the global marketplace,
most of them with very modest wage demands.
Countries such as China are eager to produce goods
to sell to American consumers. China may be a
low-wage country, but it is not a low-cost
country; aside from bureaucratic hurdles pushing
up costs, China is an importer of raw materials,
squeezing Chinese corporations' profitability.
By de facto fixing its exchange rate
versus the dollar, China is not only providing a
stimulus to the US economy, China is also
importing inflation as investments take place in
areas that would not be profitable in a free
market environment. The sound reaction for Asia
would be to slow down growth, among others, by
letting their currencies rise. However, we believe
Asian politicians are too concerned about the
fallout a serious slowdown would have.
If
you take away the punchbowl from an inflated
economy, the resulting trough could lead to social
unrest. We would not be surprised to see much of
Asia react erratically as US consumption slows.
Notably, we would not be surprised if Asia were to
try to sell to American consumers even at a loss.
Another reaction we may see is more
aggressive moves by Asia to diversify its "client
base". This means that Asia will try to sell more
goods to Europe in order to reduce its dependency
on the United States. Efforts by Chinese companies
to enter the European marketplace or to strengthen
their foothold in Europe are intensifying.
Further, we would not be surprised to see China
increase its euro reserves as it diversifies away
from the US dollar; China can use its basket of
currencies' as a strategic tool to guide trade.
Odds favor a recession If we
have a slowdown in US consumption, we will enter a
recession, unless corporate growth or government
spending will take up the slack. Given that the US
economy is highly dependent on the US consumer,
odds favor a recession. Corporate America is awash
in cash, but has been reluctant to invest. We
believe this is a direct result of the global
imbalances where corporate America sees that
investments in any industry where Asia can also
compete are an uphill battle.
Not
surprisingly, "new economy" companies have done
very well, as these are companies focusing on
industries able to thrive in this environment;
however, "old economy" companies are at serious
risk a situation only exacerbated by untenable
pension obligations.
Effects on the
dollar It is not good for an economy to
allow a current deficit to get out of proportion
–no country has been able to maintain its currency
with a current account deficit of 6% over an
extended period. As the US economy slows, will
foreigners still be willing to purchase US
dollar-denominated assets at a rate of $2 billion
a day?
As less money may be attracted into
the US, bond prices may fall, increasing borrowing
costs. The United States next year is likely to
pay more interest to foreigners on its obligations
than it collects in interest from assets owned
abroad. As borrowing costs rise, there is a chance
that the current account deficit may even
increase, even with a slowdown in consumption. The
result may be further pressure on the dollar.
Unless policies are instituted to foster savings
and investment, structural pressures on the dollar
are likely to remain in place.
Summary Highly accommodating
fiscal and monetary policies in the US over the
past couple of years have created numerous
bubbles, both in the US and Asia, while eroding
the US manufacturing base and driving the US
consumer further into debt. As interest rates were
declining, increased debt financed consumer
spending. Now, however, as interest rates are
rising, the leveraged US economy is more sensitive
to rises in interest rates and consumers may soon
need to cut spending.
