exp system

[exp]

Global: Worldthink, Disequilibrium, and the Dollar

Stephen Roach (New York)


The big moves in financial markets always seem to be driven by the unwinding of fundamental imbalances. The disequilibria can be economic, geopolitical, or purely financial. Recent examples include the great disinflation from 1982 to 2002, the end of the Cold War, and the popping of the NASDAQ bubble. And now the unwinding of a new disequilibrium is at hand -- the rebalancing of a US-centric world. I continue to believe that this will be a mega macro play for years to come that could have profound implications for world financial markets.

I have been stressing several aspects of this rebalancing theme over the past year -- especially the unsustainability of ever-widening disparities in the world’s external accounts. As the United States squanders its already depleted national saving, its massive current-account deficit can only widen further. And as the rest of the world remains on a subpar consumption path, its large current account surpluses can only keep expanding. The International Monetary Fund has noted that the disparities between the world’s external imbalances have never been greater than they are today -- with both deficits and surpluses now approaching 1.5% of world GDP. This is a fundamental disequilibrium of the highest order.

But there’s another twist to this story that has also been troubling me -- the geopolitical imbalances of an increasingly unipolar world. These concerns were very much in evidence in the debate at this year’s World Economic Forum in Davos (see my 27 January essay, “The Asymmetries of Globalization”). But for me they crystallized when I read a provocative little book by a leading “neo-con,” Robert Kagan (see Of Paradise and Power: America and Europe in the New World Order, Alfred A. Knopf, 2003). Last week, I had the opportunity to spend some time with Kagan at a Morgan Stanley conference in Italy. While I can’t say we’re cut from the cloth of the same political persuasion, I found his arguments elegant in their simplicity and most provocative in their implications.

At the risk of over-simplifying, Kagan’s argument can be summarized as follows: He stresses two strains of deeply rooted historical forces that have come together to create an extraordinary gap between the United States and Europe -- the only two rivals for global power. One element is structural -- the huge disparity between the military capabilities of the two regions. The other is more ideological -- reflecting entirely different perceptions of the concept of power; America, in Kagan’s view, has opted for power projection by military means whereas Europe has moved beyond conventional power -- relying more on the negotiated laws and conventions of transnational integration. For a Europe that has long been torn apart by one devastating war after another, the thought of intra-regional conflict is now inconceivable. In Robert Kagan’s parlance, that is Europe’s true paradise.

Through Kagan’s lens, American hegemony can only increase. It’s not just Europe’s conscious abdication of conventional power. The demise of the Soviet Union was also critical. The post-Cold War absence of a second super-power has left the world without another force to counter-balance the strength of the United States. Kagan suspects that the war in Iraq was a turning point in this new world order and that more US expansion may be coming. America’s military might hints in that direction. Its history, he notes, points to a similar conclusion. The so-called Axis of Evil is but one blueprint of what might lie ahead, in his opinion. Yet Kagan is far from troubled by this turn of events in world history. He believes strongly that US democracy contains its own built-in restraints on the exercise of power -- sheer military limits, economic considerations, and, most importantly, the self-restraint of the American moral conscience.

These are big thoughts. But what do we do with them? As macro practitioners, we tend to focus on the “narrow” considerations of economics and financial markets. But reality is never so neatly compartmentalized. It ultimately reflects the interplay between our narrow perception of economic fundamentals, social considerations, and equally important political forces -- both domestic and geopolitical. A more holistic approach is needed, especially at times like this.

Kagan’s view of the geopolitics of the world fit together all too well with my depiction of an unbalanced, US-centric global economy. A synthesis, if I may be so bold, depicts a condition of profound asymmetries in this unipolar world. And that’s what takes us back to financial markets and economics. In my view, the big adjustments in asset prices are almost always driven by a resolution of asymmetries. Look no further than the post-bubble adjustments now paying out -- not just the round trip of NASDAQ and other major equity markets but the unwinding of related excesses in the real economy.

But this saga is not about the bubble. It is about the unwinding of a more profound asymmetry in the global economy -- the rebalancing of a US-centric world. History tells us that such asymmetries are not sustainable at current asset prices. And that same history tells me that the resolution of this disequilibrium will ultimately hinge on a realignment of relative prices -- namely the prices of dollar-denominated assets compared to those of non-dollar-denominated assets. Ironically, America’s post-bubble shakeout has had limited consequences for such relative prices. US financial assets -- stocks as well as bonds -- have held up much better than their counterparts overseas. And, up until recently, the most important relative price of them all -- the US dollar -- has remained Teflon-like in its invincibility.

Yet the tensions continue to build for a world seeking a new equilibrium. That’s certainly the message from America’s gaping and ever-widening current-account deficit. It’s also the message from a potential backlash to the Kagan hypothesis of America’s unfettered geopolitical dominance. While I hardly claim any expertise as an historian, I well remember a thesis of Yale’s Paul Kennedy that had as much notoriety in the late 1980s as Kagan’s arguments do today. In The Rise and Fall of the Great Powers (Random House, 1986), Kennedy documented repeated examples of global empires that extended their military reach beyond their economic base. This ultimately resulted in the demise of the great powers -- from China’s Ming dynasty of the 15th century to Europe’s Spanish, Napoleonic, and British empires that followed. Needless to say, this interpretation of history poses a critical question for today’s unipolar world: Can a saving-short US economy continue to finance an ever-widening expansion of its military superiority?

My answer is a resounding “no.” The confluence of history, geopolitics, and economics leaves me more convinced than ever that a US-centric world is on an unsustainable path. Balance of payments disparities tell us that, as does America’s ever-widening military superiority. These are the asymmetries that must eventually be resolved one way or another. Financial markets have always played a critical role in providing the means by which such disequilibria are vented. And I don’t think it will be any different this time. In my view, a sharp decline in the value of the US dollar will be central to the global rebalancing that must now unfold. While the dollar has been quite weak of late, the risk is it is not weak enough. On a broad trade-weighted basis, the dollar surged by some 47% from May 1995 through early 2002; to date, it has fallen only 9% from that peak.

As I see it, the dollar’s recent decline is still far too modest to trigger the wholesale rebalancing that a US-centric global economy so desperately needs. The model of the current-account adjustment is pretty clear on what to expect. Based on the experience of some 25 current-account adjustments that occurred among industrialized countries over the 1980-97 period, a Fed study points to the likelihood of four developments -- a 20% drop in real exchange rates and nearly double that in nominal terms, higher real interest rates, reduced growth in domestic demand, and faster growth overseas (see Caroline L. Freund, “Current Account Adjustment in Industrialized Countries,” Board of Governors of the Federal Reserve System International Finance Discussion paper #692, December 2000). In other words, to the extent that the past is prologue, there is a good chance that the dollar’s recent decline barley scratches the surface in terms of the ultimate impacts of America’s increasingly urgent current-account adjustment.

I continue to believe that a sharp depreciation in the value of the dollar is the single most important force that might foster a long overdue rebalancing of a US-centric world economy. The impacts of higher real interest rates should show up first in the form of weakening US domestic demand -- a key outcome if America is ever to rebuild its aggregate saving rate back to historical norms. Initially, the impacts should also entail potentially severe consequences for Europe and Japan, with euro and yen strengthening likely to crimp external demand in both regions -- thereby unmasking a near stagnant pace of domestic demand. Global rebalancing works only if Europe and Japan then respond to this currency realignment by taking actions on structural reforms that have the potential to unlock pent-up domestic demand. Conversely, global rebalancing fails if Europe and Japan resist dollar weakness and engage in policies of competitive currency devaluation and protectionism.

The world is not functioning as a global economy. It is in fundamental disequilibrium -- in economic and geopolitical terms. Financial markets don’t always have the final say in how the asymmetries are vented. But in this instance, I suspect they won’t be faulted for lack of trying. For a lopsided global economy, a weaker dollar may well be the only way out.

(Stephen Roach is still the only economist I follow...the boldfaced question is precisely the one I have been focusing on for some time)