If the U.S. financial authorities are not as scared as they want us to think, what are they really up to? Talking the dollar down is, strangely, one way of talking it up. In the peculiar way of markets, an official public acceptance of the dollar falling can have the perverse effect of lifting the dollar, at least for a while. To some extent, this is a function of relief that everything is out in the open, but it’s also a mark of respect and confidence in a government that hasn’t always earned praise from economists and financial experts on other matters, such as fiscal rectitude and trade protectionism.
But I suspect it’s not about the dollar at all. It’s not about the current account, either, except as a reflection of something else going on — the low U.S. savings rate, which is joined at the hip to the deficit. In short, it’s about nothing less than the sustainability of the U.S. economy.
It’s the other big fact of American financial life: The U.S. is not only a debtor nation, it is also a nation of debtors. The saving rate in the U.S. is only 1 to 2 percent of income, and has been falling for over 20 years. In fact, it has fallen the most since 2000. All value judgments aside, when a country imports capital but then spends it on consumption goods rather than capital investment, it is failing to prepare for the future. From the point of view of the Fed chairman and Treasury secretary as stewards of the economy, it’s not the sustainability of the current account deficit we should be questioning, but rather the sustainability of U.S. growth. Abundant, cheap foreign money has led us onto the path of profligacy, economically speaking.
The high capital inflows have led the U.S. into the bad habit of spending too much and saving too little. How do you induce people to save? In a free market economy, you give them inducements, like higher returns that are more desirable than a better car or another pair of shoes. Higher returns can be delivered via tax breaks, too, but tax breaks are not the Fed’s to give. Higher returns are.
But alas, all that foreign money is literally standing in the way. In September, San Francisco Fed President Yellen got this particular current account panic rolling by saying the Fed wants to normalize interest rates by nudging them higher, but the relatively high dollar is an obstacle. The Fed wants to normalize interest rates to a historically neutral level, thought to be about 3 to 3.5 percent (from the current 2 percent). But the Fed can manage rates only at the very short end of the yield curve. The relatively high dollar draws in foreign capital that allows rates at the longer end of the yield curve to be artificially low.
The last thing the Fed wants is a crisis where it has to raise interest rates to prevent a run on the currency, which is what happened in the UK in 1991. The Bank of England raised rates 3 percent in the space of a few days in an effort to control the pound falling out of the European Rate Mechanism (the occasion of Mr. Soros’ fabled billion-dollar profit). It may not be too fanciful to imagine that the Fed has been deliberately driving the dollar down to avoid exactly this outcome — not because it gives a fig about the dollar per se, but because it wants to set rates in its own time and according to its own ideas.
Consider the Fed’s mandate. Yes, it has to maintain financial market stability, but it’s far more interested in growth and employment than in the terms of trade, except as the terms of trade influence domestic production.
Here is the hidden agenda. The Fed wants to normalize rates, not for the sake of normalization, but to prevent a run on the dollar and to restore the incentive to save. After all, if the U.S. consumed less and saved more, the trade deficit would be substantially lower and no one would feel the urge to stage a run on the dollar in the first place. The U.S. would not need capital flow from foreign countries to fund the current account deficit — it would have sufficient domestic savings to buy all the government and corporate debt instruments on offer. This is not to say the Fed places a moral judgment on saving as a social virtue, but rather as the one truly sustainable mechanism to ensure further growth and employment.
The market talks about the sustainability of the current account deficit.
Financial economists talk about the sustainability of the inward capital flows. But the Fed and the Treasury view both the current account and the capital account as a by-product of real economic activity, and what they talk about is the sustainability of U.S. growth. If it takes a weaker dollar, so be it. The dollar is not the central thing. In this context, it’s only a unit of account. This is the sense in which all the hullabaloo about the sustainability of the current account is a hoax. It is sustainable today, but as the U.S. economy becomes less independently capable of prosperity, the longer it relies on foreign savings.
Now we have come full circle. The current account deficit is not really creating a dollar crisis — the Fed and the Treasury are talking it down. They must know the lower dollar will not cause much improvement in the current account, even if other efforts behind the scenes are successful in pressuring China to revalue the renmimbi. It’s silly to be selling the dollar against the euro and other European currencies when Europe accounts for only about 9 percent of trade. China alone accounts for 30 percent of the deficit, and a growing proportion of it. Asia, including Japan, accounts for over half of the deficit.
But negotiations to get Asian countries, especially China, to repeg or to float their currencies are matters of state, not of economic and financial management. China’s revaluation, which will probably occur within the next year, will provide some minor relief in the current account, but not a permanent fix. After all, China has billions of people willing to work for pennies in order to get a bicycle, a sewing machine and indoor plumbing.
The wildly uneven cost of labor can never be equilibrated by mere currency price adjustments. China will always be able to compete with U.S. companies and export to the U.S. more than it imports.
Because of the unique and unprecedented position of the U.S. in the world economy and financial system, devaluing the dollar is not going to take the current account deficit to zero or transform it into a surplus. Asian revaluation will go a long way toward reducing the horrendous size of the deficit, but even after China, South Korea and the others revalue, we will still have a trade deficit for decades to come. The terms of trade are against the U.S. — Americans simply have too high a standard of living relative to the rest of the world. Moreover, as Greenspan said in Berlin, raising the savings rate in the U.S. will go toward fixing the true current account problem, the dependence on foreigners, but it can’t do the whole job. So, even in the best of all possible worlds, we are stuck with a "structural" deficit. The next job for the market is to decide upon a deficit-to-GDP ratio it can live with. What’s the number? Something south of 5% of GDP.
The true solution to the U.S. current account deficit is to let it wax and wane with cyclical evelopments, but not to depend on offsetting foreign capital inflows. Foreign capital inflows should be the icing on the cake, not the cake. The cake should be domestic savings adequate to fund capital investment.
The only way to lift up the savings rate is to raise the rate of return. Who is in charge of rates of return? The Fed — but also the folks in Washington who pass tax bills. Privatization of Social Security, anyone?
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