Worries About the U.S. Current-Account Deficit Are Hitting Closer To Home, Including at the Fed
By William Pesek Jr.
It seems the newest thing about the New Economy is the U.S. dollar. The greenback's remarkable resilience during Wall Street's near-collapse two weeks ago has analysts grasping at a new currency paradigm to explain why it, too, didn't plunge. In reality, though, the old rules still apply to the dollar, which is why concern is growing about a plunge in the world's reserve currency.
The last years of the 20th century have given global policy makers plenty to worry about. Southeast Asia fell off a financial cliff. Russia's economy imploded, sending shock waves through world markets. Latin America nearly returned to the crisis days of the 'Eighties. And Japan, already 10 years into its malaise, continued to generate headwinds for the rest of the international economy. But the U.S. economy and dollar were safe harbors amid these stormy seas.
But attention is turning to the ultimate potential systemic problem of the century: The U.S. economy's external imbalance. While policy-makers in Frankfurt, Hong Kong and Buenos Aires have been worried about it for some time, the gaping U.S. current-account deficit is getting more consideration, especially in Washington and New York. Currency and bond investors, fearing that the old paradigm that says currencies with massive current-account deficits are vulnerable still applies to the dollar, are getting jittery.
"Where the dollar's concerned, the old rules are still relevant," says Anne Parker Mills, economist at Brown Brothers Harriman. "They haven't so far because markets don't believe the recent slump in stocks is for real and they see it as a buying opportunity." Indeed, a side effect of Wall Street's irrational exuberance is that it may be keeping the dollar artificially high given the breadth of the U.S.' current-account imbalance.
Group of Seven officials, meeting in Washington recently, were quite candid in their concerns about what a sudden shift in market psychology would mean for economies near and far. They would prefer a slow, orderly reversal. The International Monetary Fund listed the U.S. current account as a growing risk to the global outlook.
The bond market lost ground last week, in part because of concerns about the dollar's outlook, and it remains vulnerable to any shifts in sentiment on the greenback. Some bond selling reflected concerns about Federal Reserve rate hikes. The equity markets' ability to stabilize after recent volatility also played a role; investors who'd moved into bonds for safety stepped back into stocks. The yield on the 10-year note rose to 5.99%, compared with 5.85% a week earlier. Among shorter maturities, the two-year note yield hit 6.35%, up from 6.29% a week earlier. The 30-year issue lostless ground thanks to the Treasury Department's repurchase of another $2 billion of longer-term debt; the long bond yielded 5.83% by week's end, compared with 5.79% a week earlier.
Publicly, Washington says the currentaccount imbalance -- which is running at a record $400 billion, or 4.3% of gross domestic product -- is really a sign of strength, not weakness. With much of the global economy doing poorly in recent years and the U.S. expanding briskly, investors naturally are favoring dollar assets. So the U.S. is getting plenty of financing from abroad.
But privately, the sheer size of the imbalance -- and the fact that it's growing -- is bringing furrows to the brows of some normally unflappable policy makers. What if the rest of the world becomes more reluctant acquirers of U.S. assets? At the end of the day, the current-account is funded with capital inflows; that's why it's called a balance of payments. The question is: What set of exchange rates, interest rates and assets prices is needed to attract the capital? And interest rates and asset prices are where these seemingly foreign factors hit home. It may surprise Wall Street folks to learn that some high-ranking Fed officials are far less concerned about inflation than they are about the nation's external imbalance. "The current-account problem is a bigger one than inflation," one top Fed official told Barron's. "If prices heat up, we can work with that. But if tons of capital are pulled out of the U.S., capital we need to finance the deficit, then that's a systemic risk."
Few phrases frighten policy makers more than "systemic risk." It was omnipresent at the height of the Asian crisis, during the Russian meltdown that toppled Long-Term Capital Management, and throughout the Orange County and Barings debacles of the mid-'Nineties. But now that other major economies are snapping back and American markets are showing signs of fatigue, officials in Washington and financial capitals around the world are doing some soul-searching about the U.S. outlook.
The feeling is that something must be done to prevent volatile U.S. asset markets and a record current-account deficit from triggering a sudden and sharp reversal in global economic fortunes. Treasury Secretary Lawrence Summers favors a "balancing up" through faster global growth, rather than a balancing down through reduced U.S. growth. It's a strategy that underlines the precarious position in which Summers finds himself.
The traditional methods of reversing a current-account problem -- higher interest rates and a weaker currency -- are unappealing because they could slam the stock market, a major force supporting the economy. (That dynamic was evident in 1987, when the current-account last loomed this large. As the world lost faith in the dollar, interest rates soared and stocks crashed in October.) Particularly in an election year, it's not something Summers wants. Hence the allure of the balance-up-not-balance-down approach. If stronger growth in Europe, Asia and Latin America enables their consumers to buy more U.S. goods, then the current account could narrow, with fewer deleterious effects on the dollar and U.S. interest rates.
Salomon Smith Barney economist Robert DiClemente thinks the pickup in global growth and moderation in oil prices, which have boosted the deficit of late, will trigger an orderly reversal. By early 2001, DiClemente thinks the current account will shrink to 3.7% of GDP-still a prodigious percentage.
But many observers fear the worst. The U.S. has never before been so dependent on foreign money to finance its economy. It's bad enough to be running a large current-account deficit, but even worse when there's no end in sight to its growth. And if the adjustment is less benign than Summers hopes, the result would be rising inflation from a weak dollar and a weaker economy from higher interest rates -- the worst of all possible worlds.
The dollar ended the week at 105.84 yen, compared with 104.78 a week earlier and 105.48 the week before that. The euro, meanwhile, ended the week at $0.9386, versus $0.9612 a week ago and $0.9547 two weeks ago.
For the global marketplace, the repercussions of America's adjustment would not be positive. There would be spillover effects-volatility in world markets and the loss of the world's economic engine. Morgan Stanley Dean Witter economist Joseph Quinlan recently published a report on the degree to which Asia's stability relies on America's prosperity. It was entitled: "Fatal Attraction? Asia's Rising Export Dependence on the U.S."
Neither would a plunging greenback be helpful to Europe. While it would bolster the flagging euro, the knock-on effects from a less vibrant U.S. economy would hardly be helpful just as Europe begins to get in growth mode.
But as the events of October 1987 should serve to remind investors, the effects of a dollar crisis can come home to haunt Wall Street.