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July-August 2007
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< previous | 1 | 2 | 3 | 4 “Of course we are not there yet,” Cooper notes. “Actual foreign investment was about $1.2 trillion in 2005, and U.S. investment abroad was less than half that. That means that in getting from here to there—what economists call the stable state—the deficit could actually grow as a share of GDP,” he explains. “It can’t grow forever as a share of GDP, but it could grow for a while, as it has been doing in the last decade.” How high could it go? Rogoff says that, at least in an accounting sense, we could handle deficits “until the debt level gets as high as 100 percent of GDP without breaking a sweat at today’s interest rates.” For his part, Cooper believes that the deficit will eventually stabilize at an absolute level, and that as long as the American economy continues to grow, the deficit will slowly decline as a percentage of GDP. Larger deficits over the medium term may arise as a consequence of what Cooper calls “a demographic revolution.” Pension funds in countries such as Japan and Germany (the second- and third-largest economies in the world) are purchasing large quantities of U.S. securities because their populations are aging more rapidly than that of the United States. Everywhere, he points out, people are living longer, but in many developed countries they are also having fewer babies. “There has been a lot of discussion in the U.S. about how we are going to finance social programs, but our problems are trivial compared with the European countries and Japan,” Cooper argues. “The U.S. is a big demographic outlier. All the other rich countries, and all of the East Asian countries, have had a crash in the total fertility rate.” “For a society just to reproduce itself, the number of children per couple has to be slightly above two, to allow for infant and child mortality,” Cooper notes. By this measure, the United States is roughly reproducing itself, he says, but “in Spain, Italy, Japan, and Russia, the number is around 1.2, way below the reproduction rate, and in the other rich countries it is somewhere in between.” In addition, the United States has about a million immigrants arriving each year (more, if illegal migrants are included). Consequently, 20- and 50-year projections find the U.S. population and labor force continuing to grow. “All these other countries are expected to peak and decline,” he says. “Japan actually peaked in 2005, and Germany peaked last year.” We have no experience managing economies where the number of young adults is actually declining, he adds (the singular phenomenon of World War I excepted), so “We will all learn from the Japanese and the Germans, who are leading the way. They will experience less new household formation, less demand for housing, less demand for equipping new members of the labor force, less demand for schools and other public services, and more demand for healthcare.” Faced with less investment required for population growth, and aware that they won’t have as large a workforce to support their growing numbers of retirees, these peoples are deliberately saving a lot of money. “If I’m running a pension fund or a life-insurance company representing an aging population, where would I put my investments?” Cooper asks. “I want good yields and I want high security.” Emerging markets offer the best returns, but financial shocks in Russia, Argentina, and other countries have “taught us that foreign investments are very risky.” In the United States, by contrast, “property rights are secure, and the dispute settlement system is reasonably fair and efficient, so it looks like a good place to put your money. Put those two arguments, globalization and demographic changes, together and it means that the U.S. is just a very attractive place to invest. Looking ahead, it is a more vigorous economy than those of the other rich countries.” Thus, Cooper argues, the main cause of the current account deficit is foreign investment in the United States. “Conceptually, the current account is just the negative of net foreign investment in the United States,” he points out. Furthermore, “There is all the difference in the world between” this recycling of dollars and “the government of Brazil or Argentina going out and borrowing in the world interbank or capital market.” For one thing, U.S. debt is in our own currency, he says. “When Argentina and Brazil borrow in London, they typically borrow in dollars, yen, or euros, so they are exposed to currency risk if exchange rates shift.” That is what sank Argentina in 2001. Although magnitudes of debt are not unimportant, he adds, the structure of the debt is more important in assessing viability. Most of our debt is also long-term, Cooper says, and therefore manageable in a growing economy. And “although central banks buy a lot of short-term Treasuries, the truth is that, on the scale they require, they have no place else to go.” Cooper doubts that eliminating the U.S. current account deficit is even possible, because in order to do so, other countries would have to move in the opposite direction, sustaining a huge decline in their current account surpluses. “The world is a closed economy,” he points out, “so if we go from a huge deficit to zero, somebody has to be on the other side to the tune of the whole $850 billion. Who is it going to be? It has got to be the big economies: China, Germany, Japan, and others.” Because these economies are internally less flexible than the United States, and are “export dependent,” their people and leaders won’t stand for it, he says, and will adopt policies that prevent it from happening. Living with the “Financial Balance of Terror”Although Cooper’s arguments have impressed his colleagues, they don’t share his relaxed view. If he is correct that the current account deficit is primarily a consequence of investment, what would happen, they wonder, if world investors changed their minds about parking their capital in U.S. government debt or mortgage-backed securities? Former Treasury Secretary Summers thinks the weakness of the “diversification finance” argument is that “it relies a lot on psychology of the kind that could prove to be quite fragile. The U.S. is borrowing at a rate that is unsustainable,” he says. “The question is whether the adjustment will be a gradual one, in which case it is not likely to be terribly disruptive, or will be a sudden one. If there was a sudden interruption, that would complicate the system of economic management in the United States and around the world”—in ways that might be far less benign than Summers’s language suggests. Kenneth Rogoff agrees: “The real danger is that the current account might change very rapidly.” The United States would have a harder time adjusting than did other countries cut off by foreign lending in the past, he says, because its exports are a smaller percentage of GDP. Instead of having to increase exports 10 percent to make up for the lost flow of capital, for example, exports might need to increase twice as much, implying a hefty depreciation of the dollar. Rogoff has estimated that in a sudden adjustment, the dollar might lose as much as 40 percent of its value compared to 2005 levels, with the result that “the dollar would fall like a rock and interest rates would skyrocket.” The price of imported goods would go up almost overnight, as happened to Mexico within a few months in 1994. Gasoline, food, foreign parts for cars, tools, toys, and television sets would cost so much more that it would put an enormous strain on middle- and lower-income Americans. And even though the United States has a robust financial system, a hard landing would mean reduced economic activity. This, says Summers, “would in turn reduce confidence, lead to larger budget deficits, lead to more pressure on interest rates, and so there are a variety of vicious cycles that could kick in.” In such a situation, the Federal Reserve Board would face “a difficult dilemma,” he continues, “because on the one hand you want to provide liquidity [by reducing interest rates] at a moment when foreigners are withdrawing assets, and on the other hand you want to strengthen the currency and strengthen credibility [by raising rates], and you can’t both ease and tighten with one policy instrument.” Nor could the federal government easily help, given that it is already running annual budget deficits of about $270 billion and facing increasing interest costs ($406 billion in 2006) to service the national debt of $8.8 trillion—$2 trillion of it held by foreigners. A dollar crisis for the United States would be in nobody’s interests, of course. If the currency dropped 40 percent, nations holding dollar reserves would see the value of their holdings drop by a like amount. Doing anything that might precipitate a dollar crisis, including suspending purchases of dollar debt, would therefore hurt everyone. (Summers refers to this as a “financial balance of terror.”) But that is not enough to guarantee that such a thing might not happen, either by accident or as the result of a diplomatic crisis, says the Business School’s Rawi Abdelal. “World politics is about countries doing things that are not in their narrow economic interests, but that serve some political agenda,” whether a crisis like Suez, or the long-term maintenance of export-related jobs. “The nightmare scenario,” says Mohamed El-Erian, who as chief executive officer and president of Harvard Management Company (HMC) oversees the investment of Harvard’s $30-billion endowment, “includes the possibility, for example, that Taiwan does something to upset China; the U.S. allies itself fully with Taiwan; and you have a political crisis with economic implications.” A conflict over the Taiwan Strait, agrees Abdelal, “could lead China to diversify quickly out of dollars. I think that things could turn out very badly, very quickly.” The most important domestic remedy, says Jeffrey Frankel, who served as a member of the Council of Economic Advisers under President Bill Clinton, and on its staff under Martin Feldstein during the Reagan administration, is to try to raise the national savings rate, in order to reduce our need to borrow from abroad. The difficulty is that the biggest single driver is a decline in private savings. Households that used to be saving about 10 percent of their income as recently as two decades ago are now saving nothing. But, says Richard Cooper, “We don’t know how to make Americans save more.” Summers allows that, “While, arithmetically, a great deal is explained by the changes in private savings, we have much more effective policy methods for changing public saving than we do for changing private savings.” That means running a federal budget surplus, either by raising taxes or cutting spending. This is the one remedy on which virtually everyone agrees. But national policy cannot provide a complete solution (see “Not Your Daddy’s Deficit,” page 48) to a problem that is global in nature. If the current account deficit can be managed, that will occur only as the result of international collaboration—but there is little immediate incentive for any country to move. Notes El-Erian, “It is the classic ‘prisoner’s dilemma.’ Whoever moves first [in adjusting exchange rates upward, for example], without assurances that others will also move, could be worse off. The good outcome requires collaboration, but we don’t have adequate mechanisms for that right now.” For El-Erian, the problem is not hypothetical: he and his HMC colleagues want to take advantage of investment opportunities in what he calls “a global growth handoff,” but they must think carefully about how best to hedge against the risk that a market accident or a policy mistake could unwind the imbalances chaotically. In a class El-Erian taught at the business school, he worked with his students to construct investment portfolios based on two different scenarios: portfolio A, which assumes the global imbalances are sustainable, and portfolio B, which assumes they are not. “Then we said, ‘In a world where the imbalances are sustainable, the first portfolio returns in the 20 to 30 percent range, while the second portfolio returns in the 2 to 3 percent range because it is very defensive. But in a world where the imbalances are not sustainable, in portfolio A you lose a lot of capital, and in B you don’t.’” Which do you choose? “The problem is that there are not enough facts right now for you to have sufficient conviction about what will happen,” El-Erian continues, “so you have to be open to the possibility of incorporating more information as you go forward. So we position ourselves to explicitly allow for different states of the world to play out. The reality is that we think there are arguments for both. So we try to benefit from what we do know and manage the risks of what we don’t know.” Frankel says the current situation is frequently compared to the Bretton Woods system as it worked in the 1960s. “There were constant meetings then among the U.S., the Europeans, and Japan where everybody agreed not to sell dollars. They realized, ‘If any one of us sells dollars, we are going to bring the whole thing tumbling down.’” That worked for a time. But back then, Frankel says, the European central bankers “met with each other every other month and looked each other in the eye and agreed not to sell. Today, there is no agreement at all. The Asian countries and the oil exporters don’t meet each other regularly, they are not political allies, and there is no sense of propping up the system. The Chinese and the Japanese, the two biggest holders, are kind of at odds. And then you throw in Saudi Arabia and a whole diversity of countries that have nothing in particular in common, and you could argue that, even if they all got together and came to an agreement not to sell dollars, there would still be a huge temptation at some point to defect. But,” he adds, “they are not even trying to agree. That says to me that at some point, somebody is going to start selling. Ideally, we would negotiate a coordinated policy package, but at the moment, in practical terms, that is,” says Frankel, “unthinkable.” Alfaro, who is originally from Costa Rica, has a distinctly personal perspective on the ramifications of the imbalances. Although she remains optimistic that they can be corrected slowly, “It is the impact in the rest of the world that worries me,” she says. “The U.S. hasn’t had a real recession for a while.” In a contraction, “There would be bankruptcies. Some Americans would lose their houses, and many people would have to adjust their standard of living. But the U.S. will still be the richest country on earth. But for the rest of the world, a 1 or 2 or 3 percent recession in the U.S. would be a catastrophe. That is the part of the U.S. role in this that I think is really irresponsible—the failure of leadership in the world.” Jonathan Shaw ’89 is managing editor of this magazine.  
 
 
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