"Risks faced by the global economy"
(hyper inflation, interest rates, on the horizon?)
thehindubusinessline. ^ / Oct. 04 / S. Venkitaramanan
DOOMSAYERS abound in the world of the dismal science of economics. Recently, there have been many economists forecasting that the end of the world is nigh. Not all of them are credible. However, we have to listen carefully when the doomsday forecast comes from a practitioner as eminent as Fred Bergsten, Director of the Institute of International Economics, a think-tank located in Washington.
He has made a well-considered forecast of impending risks to the global economy in a special article published in the Economist of September 11, 2004. Prof Bergsten believes that the global economy faces a number of risks which, especially in combination, would throw it back into rapid inflation, high interest rates, currency conflict and protectionism.
The present combination of risks can by itself lead to decisions by the Fed to go back to high interest rates and as a result rising unemployment. Much rides on how these risks will be handled, especially given the emerging uncertainties in US politics and geo-political developments governing energy supplies.
Mr Bergsten's analysis rests on his hypothesis that five major risks threaten the world economy. Three of these centre on the US — its renewed sharp increases in current account deficit leading to a crash of the dollar, a budget profile that is out of control and an outbreak of trade protectionism.
A fourth risk relates to China, which faces a possible hard landing. The fifth risk arises from oil prices, which could rise to $60-70 per barrel.
The litany of America's troubles is well known. The US is living well beyond its means — on the funds lent to it or invested in it by the rest of the world. The estimate of deficit figures pointed out by Prof Bergsten, however, is mind-boggling. According to him, the US' current account deficit has already reached an astronomical figure of $600 billion — well above the alarm trigger of 5 per cent of the GDP.
Projections cited by Prof Bergsten would indicate that this deficit will now be rising by a full percentage point of GDP per year. Given such a trajectory, the deficit on current account would well reach $1 trillion per year by 2010. The reasons for this dismal development are obvious. First, America's imports are rising faster than its exports.
According to Bergsten, the level of exports is today only half that of the imports. They would have to grow twice as fast as imports, in order to catch up. Such a decline in the current account gap can be brought about only if there is a massive fall in the dollar.
Further contributory factors leading to the deficit are the relatively rapid growth of America compared to some of its trading partners as also the fact that the large debtor position of the US leads to larger outflows on account of returns on its large liabilities as interest and dividends to lenders and investors.
If adjustment is delayed much longer, the dollar may have to decline more sharply than otherwise, says Bergsten. Sharper dollar depreciation, inevitable at a later stage, may also bring larger dollops of inflation into the US economy. According to Bergsten, the former Chairman of US Fed, Mr Paul Volcker, believes that there is a 75 per cent possibility of a sharp fall of the dollar in five years.
An equally pressing problem is that of handling the massive flow of red ink that characterises the US budget. Official projections score the fiscal imbalance of the US at a cumulative $5 trillion over the next decade.
This would increase further if there is greater burden of military and security expenditure as also greater resort to tax cuts.
Both these seem likely since both Presidential candidates seem all set to open the floodgates with proposals on security and tax cuts.
This would lead to a further loss of confidence in the US dollar. Bergsten quotes Robert Rubin, the former US Treasury Secretary to say "there are serious psychological implications for financial markets of expectations concerning the US budgetary deficit".
Confidence in America's financial instruments and currency could crack. The dollar could fall as sharply as it did in 1971-73, 1978-79, 1985-87 and 1994-95.
Market interest rates could rise substantially and the Fed Reserve could have to push them further to limit the acceleration of inflation.
A further possible complication is that in two years, we will see a new Chairman of the Fed Reserve with Mr Alan Greenspan completing his dream run. Bergsten concludes that while a hard landing is not inevitable, it is not unlikely.
The most important possible counter-attack is for the US President to pursue a credible programme of cutting the federal budget deficit at least in half over the coming four years and to sustain the improvement thereafter.
This will require an inevitable combination of spending cuts, revenue increases as well as rapid economic growth to pull in revenues.
Such a programme, says Bergsten, would also maximise the prospects of US economic growth by avoiding the crowding out of private investment. In the absence of such developments, the risks to American economic growth and hence global economic growth would be higher.
Prof Bergsten has also made some sensible suggestions for managing a more stable energy price environment. He feels that the US and its allies should move decisively on energy.
He is suggesting that the US use aggressive sales from its abundant oil reserves as well as those of its allies, which amount to 1.3 billion barrels.
Sales from reserve should be signals to OPEC of America's and its allies' intention to counter OPEC price increases.
Similarly, the US should expand its own production, particularly in Alaska and introduce energy conservation measures, including a higher tax on gasoline, to limit consumption. Bergsten says that such a policy would, in effect, counter the OPEC policy of raising crude prices and thus constitute a more effective jobs programme for the US Administration.
Otherwise, OPEC's uncontrolled price increases will effectively cast a drag both on US and global economic growth and hence pull down job growth.
Bergsten offers a similar suggestion for other heavy energy importing countries, like China and India. He suggests that America should seek agreement from such countries to offer the oil producers to stabilise prices within a fairly reasonable range, say centred at about $20 per barrel.
Under this arrangement, consumers would buy oil for their reserves to avoid declines below the floor price and sell from their reserves if the price goes above the ceiling. The resultant stabilisation of oil prices would help both the producers and the consumers.
While the proposed energy stability pact sounds elegant, it is not clear whether OPEC will play along. Much depends on the US' imaginative diplomacy, which seems in short supply at present.
Turning to the risk contributed by China, Bergsten's suggestion for these concerns lies in its reining in its economic growth in an orderly way and in particular revaluing the Chinese currency, the remninbi.
According to Bergsten, a sizeable remninbi revaluation is crucial for global adjustment because much of the fall of the dollar has to take place against Asian currencies and, in particular, the remnimbi.
The crux of Bergsten's suggestion, coming as it does on the back of a number of similar pleas put forward by US officials, is difficult to refute.
But China will find the proposal a difficult pill to swallow. Bergsten seems to argue that China should take the lead in formulating an Asian Plaza agreement to ensure that major Asian countries also make their necessary contribution to global adjustment.
These policy changes are attractive, but not easy to implement. Whether or not the winner in the US Presidential stakes will take up any of these remedies, they will surely simmer for a while among the Washington's power elite.
India has to prepare for meeting the risks highlighted by Bergsten. We have to evolve a plan to meet the possible demands by US Administration for a contribution to solution of the global impasse by revaluing the rupee.
Whether that is in our best interests is not at all clear. It is, however, in our interest to keep our possible response ready in case Bergsten and his ilk succeed in converting the successful Presidential candidate to their views or something similar.
The risks to the global economy are patently large and centred on American policy. But the temptation of economic leaders of powerful nations is to pass the buck to others to solve their own problems. We cannot expect the Americans to behave otherwise.
We have, above all, to be prepared to face the coming collapse of the global dollar-based system. Bergsten's paper presents the challenges and possible solutions as clearly as anyone can.
It is up to us to deal with the profile of risks as spelt out by him and others. Let us not say we have not been warned that we are teetering on the edge of a precipice.
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