Sunday, February 19, 2006

another boring post on globalization and the US economy

For quite a while I've wondered what's been sustaining the US economy. Why haven't American businesses overextended themselves, as so often they did in the past? Why have consumers been so exuberant in their spending? How have we been able to keep interest rates low?

I've found some answers. The ones that come to mind (at the moment I'm too lazy to go back to previous posts on this) are -
1. Unusually rational behavior of American businesses following the last debacle. This may be partly due to increased use of automation and the existence of a wonderful, cheap, worldwide, high-speed communications infrastructure. They haven't overloaded inventories, haven't built up payrolls (but have continued to layoff workers), they've learned to outsource to foreign service organizations, and they have shifted away from products that compete with ones that can be produced more cheaply abroad.

2. A not-surprising reaction of American home owners to increases in real estate value and sustained low mortgage rates. American law helps here since it permits easy re-mortgaging and gives tax benefits to mortgage borrowers. So Americans have substituted home equity for personal savings and, by taking out cash when re-mortgaging, have converted much of this home equity into consumption. It's helped that there's been a final shucking off by Americans of the penurious habits of the generations of the 30's, 40's, and 50's.

3. Sustained demand by foreigners for American financial instruments (by which I mean Treasuries, stocks and bonds, and all the other stuff in which foreigners can invest), and this was enabled by the failure of other industrial nations to match the rate of US economic growth, the failure of non-industrial nations with emerging economies to create the stability and other structures needed to attract investment, and the preference of the oil-rich nations for safe (though unspectacular) returns on US investments over risky (though potentially more rewarding) ones elsewhere.
Given that there are so many conditions (and both positive and negative feedback loops, to use some jargon in current favor) on which American prosperity rests, you'd think the war, the hurricane damage, and the unhelpful policies of Congress and the Bush administration would unstabilize and bring down (quickly or slowly) this precarious ediface.

Experts, virtually all of them I think, say the current situation cannot be sustained. There will, definitely will, be a change, and the question is whether it will be quick and painful or slow and reasonably pain-free. Everyone seems to be looking for signs that the changeover has begun.

I read a couple of accounts today giving evidence that it's near:
1. A Reuters report says that in December foreign purchases of US financial assets did not match US purchases of foreign goods and services. Normally inflows from abroad exceed outflows from within the US. This is one of the factors keeping interest rates down. Putting this a bit simplistically, if foreigners do not step forward to fund the US deficit, the US has to increase interest rates to induce them to buy.

The report isn't a warning shout. Over the course of 2005 inflows were considerably higher than outflows. It's just a question as to what the December figures may indicate.

Here's a link to the Reuters report: Dollar supported by 2005 inflows but trends changing, Wed Feb 15, 2006, By Jamie McGeever
2. An opinion piece in the Times of London by an American, Irwin Stelzer, director of economic policy studies at the Hudson Institute, giving a reasonable argument for continued notching up of US interest rates until the Fed rate moves above 5% in coming months. With the cascading effect that the Fed rate has on other interest rates, this would dampen consumer spending (and probably push lots of those who hold adjustable-rate mortgages into bankrupcy).

Irwin Stelzer says: US economic data for January are unrealistically high: retail sales rose 2.3%, factory output was strong, and "housing starts surged to levels not seen for more than 30 years."

While US data are somewhat scary, so too are the numbers from overseas: There is increasing consumer demand in China, Japan, and the oil-rich nations and this along with "continued willingness of American consumers to shop until they drop, might just be sopping up a good deal of the worldwide capacity that has restrained inflation in America."

Here's a link to the piece in the Sunday Times: The Sunday Times - Business, February 19, 2006, Rates must rise if world growth fuels inflation,


1. Stelzer makes an interesting, if unsurprising, comment on layoffs of American workers:
Greenspan persuaded his monetary-policy colleagues that globalisation has made worldwide capacity, rather than only domestic capacity, available to American consumers and producers. No matter if American labour markets tighten; there are all those low-wage Chinese and Indians eager to turn out the goods Americans want and, in the process, prevent American workers from driving their wages to inflation-producing levels. No matter if American factories are at capacity; Asian and Latin American factories will prevent American companies from raising prices.

The availability of that worldwide capacity, along with rising productivity, has indeed kept compensation and prices restrained. And the large pool of Chinese labour will continue to restrain the wages of many American workers.

He also says:
Greenspan once predicted that anyone betting that interest rates would remain low is doomed to lose some money. Bernanke may be the man who imposes that loss on those who failed to take Greenspan’s advice. Unless ... but that’s for another column.

2. The Reuters article says a global upward trend in interest rates is another factor pushing up US rates.:
Behind the headline figures are underlying trends that show shifts in where the foreign financing of America's deficits is coming from and into what U.S. markets it's going.

The vast bulk of foreign inflows last year went into U.S. fixed-income assets, although the burden of deficit funding shifted dramatically to the private sector from foreign central banks.

But with more central banks around the world in addition to the Federal Reserve now raising interest rates, these investors should have more alternatives to tempt them.
It also says an end result of all this will be greater declines in the value of the dollar.

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