Of American consumers, Volcker said: "We fill our shops and our garages with goods from abroad, and the competition [between foreign and domestic industries] has been a powerful restraint on our internal prices. It's surely helped keep interest rates exceptionally low despite our vanishing savings and rapid growth." This helps explain what has been a mystery to me: the amazingly low interest rates in the U.S. which have been a major force behind over-the-top consumption and consumer indebtedness.
To me it seems another reason for our low interest rates comes from the preference for U.S. treasury bonds shown by foreign investors and foreign national banks. Their demand for our debt instruments -- in other words, their eagerness to buy the securities that fund our national debt -- helps keep interest rates low. Given its unbelievable size, there is no way we Americans can fund our own debt -- could not even if we cut back on personal indebtedness and increased the amount we save. [For more on the size of the debt see $7,782,816,546,352 In Debt, Washington Post, Washington, April 10, 2005.]
Foreign investors help fund our debt because they've decided the balance of risk and returns is favorable: the prospects of the U.S. economy are better than elsewhere and the U.S. is a relatively safe place to put money. This confidence in our economy and stability is not guaranteed into the future, of course -- as Volcker and heaps of others point out. Foreign national banks help fund our debt for different reasons. The main one has to do with exports of goods that American consumers purchase and the main player is China. China, and other Asian export nations, buy U.S. debt so they can keep artificially low the value of their own currencies. If they did not do this, their currencies would increase in value relative to the dollar and the prices of the goods they sell to Americans would rise. I think I could explain why this is so, but don't want to take the space to do it here, so -- for the time being anyway -- let's just accept it as a well-attested fact.
Trouble lies ahead, obviously, if the confidence of foreign investors is shaken or if foreign national banks decide their continued accumulation of dollars is contributing less and less value to the national economy. The confidence of foreign investors is easily shaken; there are lots of potential triggers: for example, the projection of big increases in the price of oil would be a big one; another might be a big decline in expectations about the ability of the U.S. government to manage the economy; and an obvious third would be the onset of a recession in the U.S., which might be caused by a sudden contraction in the U.S. housing market (the popping of the real estate bubble).
The heads of foreign national banks might change their minds about accumulating dollars if the continued slide in the value of the dollar were to reach a point where the "cost" in holding the dollars was too high relative to the value of the exports that the accumulation sustains. As with foreign investors, I think the main decision-factor is one of confidence -- their faith, that is, in the strength of the U.S. consumer market; in other words the ability of Americans to continue buying the goods they produce.
As Volcker said: "at some point, both central banks and private institutions will have their fill of dollars."
There's nothing very new in all of this. What I've read lately that adds nuances to it has mainly to do with emerging markets. Most surprisingly, Sub-Saharan Africa is experiencing substantial, and apparently sustainable growth. But the impact of that growth is far in the future. There's more immediate interest in how China's economic success is making the Chinese people into consumers as never before. Though the individual Chinese citizen does not rival the individual American in purchasing power, the numbers of Chinese is so large that the effect will, in a relatively short time, be enormous. This is not a new insight, but some implications are interesting, mainly that there will be increased demand for oil and other of the world's resources (ore, agricultural products, ...) and prices will rise. And, as has not been much noticed until now, the economic growth potential of its neighbor, India, is also somewhat stratospheric. China and India are not blind to these expectations and have recently been talking about ways they can help each other grow faster. See for example this good article in the New York Times: India and China Are Poised to Share Defining Moment (By Somini Sengupta and Howard W. French, April 10, 2005). The authors say:
For the United States and the rest of the world, the effects of the sudden awakening of the Asian giants could be profound. In the years ahead, it may mean more downward pressure on wages, the outsourcing of more jobs, greater competition for investment and higher prices for scarce resources. ... Chinese-made toys, toasters and televisions have proliferated across the Indian marketplace. On any given day, a shopper at Chandni Chowk market in Delhi can pick up a Ganesha idol, or electric versions of the traditional oil lamps,or water pistols used to splash passers-by during the spring festival of Holi - all made in China. ... India exports raw materials for China's booming construction industry, largely ore, iron and plastic, and its pharmaceutical companies have begun producing drugs for the Chinese market. ... Indian software services companies, too, have set up shop in China for development and customer support. At least one Indian company, Zensar Technologies, has set up a joint venture with a Chinese firm and is bidding on a large e-government contract in one Chinese province.
Interestingly, at least in public, the two giant countries, which have been political enemies in the past, now see not only potential synergies, but also ways they can learn from each other. Expressed as an Indian challenge to China, the NYT article says:
Chinese have also begun openly to question the kind of growth their authoritarianism has spawned.
"We are using too many raw materials to sustain this growth," said Pan Yue, China's environment minister, in a recent interview with the German magazine Der Spiegel. "To produce goods worth $10,000, for example, we need seven times more resources than Japan, nearly six times more than the United States and, perhaps most embarrassing, nearly three times more than India. "Things can't, nor should they, be allowed to go on like that," he said.
Others worry about China's seeming addiction to large investment, which leads to huge waste and steep cyclical downturns, a shaky financial system imperiled by a huge burden of nonperforming loans, and rampant official corruption.
"In India there is a lot more room to move around," said Zhang Jun, director of the China Center for Economic Studies at Fudan University in Shanghai. "Their capital markets are good, their banking sector is better than in China, and there is entrepreneurialism everywhere in India, along with well-protected intellectual property rights. All of these are things that China lacks."
Pressed for a prediction, Mr. Zhang said he saw the two countries' positions converging within 15 or 20 years, by which time they may rank as the two largest economies in the world, if still far below the United States and other top economies in terms of per capita wealth.
The implications of this growth potential are worth putting in a broader context. The populations of the industrial nations are aging. As Mr. Zhang says, the per-capita wealth of these populations will remain high. An implication of this greying of the industrial nations is worth pointing out. In an IMF press conference held last Wednesday, Raghuram Rajan (who is director of the IMF research department and one of my favor sources of info on the global economy) said
Rich countries should be saving more and ... poor countries should be investing more. [The rich ones] should be sending capital to younger, poorer developing countries. This will enable Adrian and Becky to draw on their foreign investments in their old age even while the younger, increasingly skilled Abebe or Nafisa receive the capital to remain productive today.
So, Volcker says what needs to be done in the short term: reduction of U.S. debt, increases in savings of U.S. households, improvements in the economies of Europe and Japan, and increased flexibility in exchanges rates for Asian currencies. And Rajan says what needs to be done in the long term: a wholesale restructuring of the world economy so that money that now flows into the U.S. to fund our deficits is redirected to investment in developing economies and, U.S. consumerism gives way to saving and participation in this world investment. At this point there aren't many signs of either of these transitions taking place. As Rajan says, the attitude of world leaders seems to be "like St. Augustine's 'Lord, give me chastity, but not just yet.' ... We are running out of time, and markets may not be willing to wait until after the next election. The world needs action now."
Many have pointed out that one of the best ways to show how we're running out of time is to think about oil. It's a limited resource, of course. Demand for it is high and supplies are somewhat vulnerable (think how much of U.S. foreign policy is aimed at assuring that we'll have enough of it). There's also increasing competition for it. As Rajan points out, the Asian export nations run on imported oil and, as their populations become wealthier, "even at a conservative estimate, over the next quarter of a century China should see car ownership multiply 15 times, and India will be only a little behind." An oil crisis could easily provoke a world economic crisis.
As I said at the beginning, America's low interest rates have been a mystery to me. It helps to have Volcker's explanation that they're partly the result of competition: the low-prices charged for clothing produced in China and the low wages of services that have been outsourced to India, for example. I hope it's obvious that they're also a result of the confidence that foreign investors and foreign national bankers have placed in the U.S. economy. Their funding of our deficits -- their high demand for U.S. investments -- keep our rates low. Put differently, at one remove, you might say that the fears Europeans have over the inability of Europe to afford its welfare state and the continuing difficulties the Japanese have in pulling out of their decade-long recession are keeping U.S. interest rates low.
One outcome of low interest rates has been the U.S. consumer orgy that helps fuel Chinese growth. Another that you don't see discussed as much is the great increase in the value of U.S. housing. On Crooked Timber, John Quiggin discusses the housing aspect in a posting called The market can stay irrational longer than you can stay solvent. He points out that as low interest rates have driven house prices up, Americans have refinanced and used the proceeds to increase their consumption, but they've also, as we all know, bought bigger and ever more costly houses to live in. He also points out what should be obvious, that buying bigger and bigger houses makes sense only if you believe that the economy is going to continue growing -- and your income rising -- so that you can afford to have your money tied up in this asset and all that's required to maintain it (taxes included). In fact he says, "The asset values we are observing make sense only if a substantial acceleration in the rate of economic growth is imminent. And without such an acceleration, the arithmetic of compound interest will produce a blowout in the current account deficit, necessitating a sharp, and probably painful, adjustment process." There's a good chance the bubble will burst.
There's a front-page article in today's Washington Post on the absurdities of the house market in the Washington DC metro area [In Real Estate Fever, More Signs of Sickness; Some Economists Warn of Housing Bubble, By Daniela Deane, Sunday, April 17, 2005; Page A01] It says prices here have risen 89 percent in the past 5 years and interest rates are on the rise, yet "To afford ever-pricier homes while keeping monthly payments under control, buyers are routinely taking out interest-only loans, adjustable-rate mortgages or even negative-amortization mortgages, where a buyer borrows more than the purchase price of the home, something that worries even the most bullish of housing economists and builders."
So here's another area in which policy makers can be said to be running out of time.
One last long quote on the theme of running out of time; this one from Brad DeLong, Our Twin Financial Puzzles: The Long Run May Come Like a Thief in the Night. He says no one knows what's in store. Unlike most economists, who like to speak of hard landings and soft ones, he contrasts rapid change -- the "thief in the night" with "long, slow, gradual realization:"
If it comes as a sudden shock rather than as a long, slow, gradual realization, it will come on that day when the gestalt of the players on Wall Street and elsewhere changes, and when they collectively regard holding dollars as the more risky rather than the less risky strategy in the short run, when they collectivley regard being long long-term U.S. Treasuries as the more risky rather than the less risky strategy in the short run. On that day the long run future will be, as football coach George Allen used to say, now.
When will that day come? Tomorrow? Next month? Next year? On January 21, 2009? A decade from now? We macroeconomists who believe in financial market equilibrium have, today, a certain similarity to Millenniarists: our models of when The Day will dawn are not much better than the models of those who base theirs on a rule that transforms HILLLARY RODHAM CLINTONN into the number 666.
Should that day come, keeping a financial crisis from becoming a major disaster may well require swift and rapid action by a Federal Reserve and a Treasury Department that have powerful and unconditional White House and Congressional support. Mexico in 1995 had a recession that only reduced Mexican GDP by six percent. That "only" is the result of Bill Clinton's backing his economic policy team when they said that supporting Mexico was the thing to do--even though others in the room were making sure that he was well aware that money loaned to Mexico in the crisis might well not come back. That "only" was a near-run thing: Senator Dole let Senator D'Amato slip his leash, and D'Amato came remarkably close to doing major damage both to Mexico in 1995-1996 and to East Asia in 1997-1998.
Remember that Alan Greenspan is supposed to retire next January. What is the scenario by which competent technocrats--in the Treasury or the Federal Reserve--manage to climb to a position in which this White House and this congressional leadership of Bush, Frist, Hastert, and Delay will give them the baton to handle as they think best whatever financial crisis may appear in the next several years?
Despite all this (maybe some extent because of it if you consider the need to maintain confidence all around), "top economic policymakers from the world's richest countries expressed confidence yesterday that the global economy remains on track for "solid growth" this year." This according to another article in today's WaPo,
G-7 Issues Upbeat Growth Outlook, Pledges Action on Trade Imbalances; No Mention Made Of China Keeping Its Currency Low, By Paul Blustein, Sunday, April 17, 2005; Page A25. Note, however, that the extent of the confidence is limited to "this year."
I expect none of my, very few, readers will have stuck with me to this end, but it's been instructive -- to me -- to have written this down, so -- I'm telling myself -- it's not a complete loss.