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We live in a period of world-wide economic expansion
and prosperity. The world economy is said to grow this year at some five
percent, which will be the third year above the historic average. Even if, in
the coming year, the growth rate should decline a little, the global economy
looks bright and prosperous. Led by some Asiatic countries, especially China and Japan, more countries than ever
before are reporting rapid economic expansion.
But no matter how bright the economic outlook may
be, the international prosperity is exposed to a looming risk, which has even
grown in recent months. The war in Iraq
and the skirmishes in Afghanistan
are an ever-present danger that may destabilize the Middle
East and spread the conflict to more countries. The Islamic republic of Iran, which does not hesitate to
confront American interests and concerns, may upend the peace at any time. But
the greatest concern of many economists is the global economic imbalance
which is clearly visible in the huge balance-of-payments deficits of the United States
and in the corresponding surpluses of the creditor countries. Americans are
said to consume some 70 percent of the world's savings while Japan, China, and other developing
countries are financing the deficits and accumulating American IOUs. Many
economists are convinced that such disproportions and imbalances are
unsustainable in the long run.
Surely, American foreign debt has increased
significantly, but so has individual income and wealth. Total domestic debt has
risen visibly over the last decade, but so have productivity and income. This
economic harmony nevertheless is burdened by considerable risk of global
imbalances that may cause disruption and upheaval in the future. The
debt-and-credit differences of the large national economies continue to grow, the balance-of-payment deficits of the United States
surpass all national surpluses. In 2005 the deficits amounted to some $790
billion, which, in relation to gross national product, exceeded six percent. So
far this year, it may exceed $800 billion, or 6.5 percent of GDP. Moreover,
the federal government continues to suffer huge budget deficits which enlarge
the national debt and add weight to the international concern.
The American mountain of debt is matched by large
balance-of-payment surpluses in developing Asian countries, as well as by
most oil-exporting countries. Many creditors welcome the surpluses. They keep
the exchange rates of their currencies low which, in turn, boosts their
exports and gives employment to millions of workers who, with American
assistance and technology, are learning to produce for the world market. Chinese
banks now hold nearly $1 trillion, which is the highest reserve position in
the world, having passed Japan
this year with some $865 billion. Without such dollar purchases, their
currencies would rise immediately, which would boost
all export prices, curb exports, and depress economic production and
employment.
A few critics believe that the U.S. trade deficits may be the
greatest threat to the economic order. Yet the deficits have neither impaired
the U.S. dollar nor undermined the position of the United States as the primary
economic engine and power. Many observers, therefore, question and disclaim
the dangers of American balance-of-payments deficits. They not only cast
doubt on official statistics that may exaggerate the case, but also point to
the stable rates of exchange which all participants maintain voluntarily. Stability,
after all, benefits everyone.
This economist, nevertheless, is convinced that a
correction is unavoidable. All markets function to adjust and readjust any
maladjustment. They are burdened and strained by the growing mountain of debt
which raises the question of American ability to meet its obligations. If there
ever should be any doubt about the stability of the American economy, the
world-wide demand for U.S. dollars would decline, which would cause the
dollar exchange rate to plummet. American imports would decline, dampening
the surge of consumption and slowing the very growth engines of export
countries such as Japan, China, and
many others. The whole world would feel the American instability. A weaker
dollar and rising import prices also would accelerate the inflation rate
which would pressure the Federal Reserve to raise interest rates. Higher
rates would slow the American economy and boost the rate of unemployment.
Despite such international imbalances, the U.S.
dollar has not weakened significantly in recent months, and the world economy
has not fallen into a global recession. At first, Asian central banks, and
then also the oil-exporting countries, financed the huge deficits. It is in
the economic interest of the Asian developing countries to keep their
exchange rates low in order to keep export prices low and thus keep the
export motor running. Massive purchases of federal obligations support the
exchange rate of the dollar and increase Asian currency reserves.
It is in the interest of the United States, as well as the
Asian countries, that the U.S. dollar maintain its
high exchange value. Some American economists like to speak of a "Bretton Woods II" arrangement, which would resemble
the international system in effect between the Second World War and 1973. Participating
countries supported each other's currencies and thus sustained stable
exchange rates.
In Bretton Woods I, the
member countries supported each other's currencies - in Bretton
Woods II, they eagerly support the dollar. The European Central Bank, which
actively pursues employment policies, manages to avoid the influx of U.S.
dollars by keeping interest rates very low and liquidity plentiful. According
to some estimates, the quantity of money in euro
countries, since 2000, has increased some 25 percent faster than the gross
product. In the United States,
it has grown some 10 percent, and in Japan by 15 percent. The European
Central Bank even surpassed the Bank of Japan, which is inflating its
currency in order to counter powerful deflationary forces. In short, euro liquidity is plentiful and interest rates, seen
historically, are exceptionally low.
As the U.S.-Asian imbalances continue to mount, the
forces of readjustment are gaining strength. There are indications that the
imbalances are correcting slowly and in an orderly fashion. Most governments
agree that greater flexibility of the exchange rates, especially of the Asian
currencies, is an orderly step toward the correction of the global
imbalances. But most governments cling to their old policies. The interest
rate differences are closing slowly, which causes more and more investors to
shun the dollar risk. Moreover, the American real estate market has cooled
off significantly without dramatic crashes. The boom, according to Fed
Chairman Ben Bernanke, has given way in an orderly
and moderate fashion. But there cannot be any doubt that the decline in the
housing market will be felt throughout the economy in months to come.
Some Americans will have to curtail their spending
which is bound to slow down the economy. Will it drag the world economy with
it? The rate of expansion in many Asian countries undoubtedly will decline,
but by less than pessimists predict. Most economic expansion in China, India, and other developing
countries in recent years has been driven by domestic demand and supply. Yet
we must not underestimate the weighty and consequential role played by the United States
in world financial markets. A huge debt casts a shadow on any market; the
rapidly growing international debt of the United States is clouding the
world economy. It cannot grow perpetually; it will be settled sooner or later
either in an orderly and upright fashion or in financial crisis and economic
recession.
The finale of the scenario may be played by the
Federal Reserve System. It may seek to reassure and pacify numerous Asian
creditors by maintaining high market rates of interest or at least
approximate them, or cater to the notions and wishes of most legislators and
their constituents who usually favor monetary
stimulation. Sooner or later Federal Reserve governors will have to choose
between economic consideration or political
preference. Their choice will determine the future of the U. S. dollar.
Dr Hans F. Sennholz
www.sennholz.com
Dr. Sennholz is President of
The Foundation for Economic Education, Irvington-on-Hudson, New York and a
consultant, author and lecturer of Austrian Economics.
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