The Great Game

David H. Levey and Stuart S. Brown wrote an article for the most recent issue of Foreign Affairs. This article, called "The Overstretch Myth" attempted to show that double deficits that America is experiencing are not a threat to U.S. economic hegemony. In my rebuttal I demonstrate that Levey and Brown have ignored the major threat to the U.S. economy, namely the Bush administration's own fiscal policy.

Jax

Would-be Cassandras have been predicting the imminent downfall of the American imperium ever since its inception.

For every Cassandras there is also a Pollyanna.

A new threat to the sustainability of U.S. hegemony has emerged: excessive dependence on foreign capital and growing foreign debt. As former Treasury Secretary Lawrence Summers has said, "there is something odd about the world's greatest power being the world's greatest debtor."

The U.S. economy, according to doubters, rests on an unsustainable accumulation of foreign debt. Fueled by government profligacy and low private savings rates, the current account deficit -- the difference between what U.S. residents spend abroad and what they earn abroad in a year -- now stands at almost six percent of GDP; total net foreign liabilities are approaching a quarter of GDP. Sudden unwillingness by investors abroad to continue adding to their already large dollar assets, in this scenario, would set off a panic, causing the dollar to tank, interest rates to skyrocket, and the U.S. economy to descend into crisis, dragging the rest of the world down with it.

Nice attempt to concentrate on the doomsday version of the “debt crisis”. This ignores the gradual decline which is more likely.

Despite the persistence and pervasiveness of this doomsday prophecy, U.S. hegemony is in reality solidly grounded: it rests on an economy that is continually extending its lead in the innovation and application of new technology, ensuring its continued appeal for foreign central banks and private investors.

This lead is being challenged by the rise of research spending in Europe and Asia. Europe has already passed the U.S. in total research spending. China has a plan to create 100 world-leading universities in the next decade. Not to mention the immigration rules in the U.S. are driving top-notch talent to other countries, mainly in Europe but also to Canada. Without the talent and without the research America's technological lead will falter. Wireless telecommunications is an example of a field where America is well behind the cutting edge. The assumption that the U.S. Will hold its lead in technology is far from certain.

The dollar's role as the global monetary standard is not threatened, and the risk to U.S. financial stability posed by large foreign liabilities has been exaggerated. To be sure, the economy will at some point have to adjust to a decline in the dollar and a rise in interest rates.

Has someone missed the appearance off a currency that is backed by an economy larger then that of the U.S.? The Euro is a viable competitor for the role of global monetary standard, even if the advantage still lies with the dollar. The thing to remember is that an American decline is not a certainty, but the existence of a credible alternative means that the U.S. has to be more careful in its economic policy. Flagrant attempts to squeeze every last ounce of gain from America's position as world economic lead will push investors, businesses, and governments to adopt the Euro as a standard currency.

Discussion of the United States' "net foreign debt" conjures up images of countries such as Argentina, Brazil, and Turkey, evoking the currency collapses and economic crises they have suffered as models for a coming U.S. meltdown. There are key differences, however, between those emerging-market cases and the current condition of the global hegemon. The United States' external liabilities are denominated in its own currency, which remains the global monetary standard.

This is true and it represents significant advantage for the U.S..

[Its] economy remains on the frontier of global technological innovation, attracting foreign capital as well as immigrant labor with its rapid growth and the high returns it generates for investors.

Those returns are limited by a declining dollar. As long as the dollar declines Europe need not post as strong economic growth to have higher returns on investment. If the dollar slips 5% versus the Euro then that is an relative 5% return on investment for any one holding assets in Euros. This strengthens the Euro as a competitor to the dollar. The declining dollar goes a long way to offsetting any high growth advantage the U.S. has.

The statistic at the center of the foreign debt debate is the net international investment position (NIIP), the value of foreign assets owned by U.S. residents minus the value of U.S. assets owned by nonresidents

Interesting, because all of the concern I have read about has revolved around the total debt of the U.S. government and the rate it is increasing. Assuming that the bush administration actually tries to halve the deficit over the next four years as they promised, the U.S. will have to acquire a trillion dollars in new debt. Given the past record of this administration, halving the deficit is most likely a pipe dream. Remember Dick Cheney is on record saying that Reagan proved deficits don’t matter, and Bush himself has said they are just numbers on a page. Bush’s track record in business is not inspiring either. I personally expect the U.S. budget deficits to increase over the next four years. It is these deficits that threaten the U.S. economy and the U.S. hegemony. Budgets deficits put downward pressure on the U.S. dollar and large deficits put more pressure. A declining dollar threatens one of the pillars of the dollar as global monetary standard: it stability. Simply holding U.S. dollars, is a money losing proposition. I would not want to hold dollars if the currency is in decline. Another more distant issue is the question of default. The American debt sits at $7,756,000,000,000 or 70% of its GDP. If the Bush administration does nothing to rein in spending that figure could rise to $ 10 trillion or 85% of GDP by the 2008 election. The question of whether the American government is good for its obligations would then be an open question.

Unpacking the NIIP gives a better sense of the risk it actually poses.

If you missed it, the issue is total debt and the rate it is increasing.

In the next section titled “False Alarm” Levey and Brown discuss why America’s declining NIIP is not a threat to the countries global dominance. Given that the NIIP is not the center of our concern we will ignore that section and its occasional errors in logic.

A SOFTER LANDING

Whichever perspective on the current account one favors, the United States cannot escape a growing external debt. The "hegemony skeptics" fear such debt will lead to a collapse of the U.S. dollar triggered by a precipitous unloading of U.S. assets.

A precipitous sell off is unlikely, a gradual decline is a much more likely scenario. The large holders of American bonds, the Asian central banks are unlikely to participate in a panicked sale of U.S. assets. In the event of a precipitous decline they will most likey hold their assets and wait for a recovery. A more likely scenario is the same banks slowing or stopping the rate at which they purchase these assets. If American fiscal policy continues to favour a declining dollar the Asian banks will have a disincentive towards buying more American assets, given the ones they already hold are losing value.

Another area to watch is the oil markets, though it is unlikely that anyone will try to force the U.S. to pay in other currency, oil producers may be interested in receiving payment in a currency that is not losing value. Europe may be able to pay for its large imports of oil in Euros. If the oil trade becomes a multi-currency market a lot of dollars will become redundant and the dollar will decline with the detrimental effects described earlier.

But even if such a sharp break occurs -- which is less likely than a gradual adjustment of exchange rates and interest rates -- market-based adjustments will mitigate the consequences. Responding to a relative price decline in U.S. assets and likely Federal Reserve action to raise interest rates, U.S. investors (arguably accompanied by bargain-hunting foreign investors) would repatriate some of their $4 trillion in foreign holdings in order to buy (now undervalued) assets, tempering the price decline for domestic stocks and bonds.

This overlooks that the main driver of American consumer confidence is the property price bubble. A rise in interest rates would threaten this bubble, and would most likely break it. The damage caused by a breaking property-price bubble can be seen in Japan still (though for structural reason America would most likely recover a bit quicker. A collapse in housing prices, as the subsequent economic damage would again drive the dollar down and raising the relative price of oil. Given that oil price shocks have correlated to all American recessions since the 70’s a energy driven decline in the American economy would then be coupled with a consumer-insecurity driven decline. Eventually the lower prices will bring in bargain hunters but that takes time, by then the damage may already be done.

The U.S. dollar will remain dominant in global trade, payments, and capital flows, based as it is in a country with safe, well-regulated financial markets.

Assuming American economic policy does not force business to find a more secure economic harbour.

For foreign central banks (as well as commercial financial institutions), U.S. Treasury bonds, government-supported agency bonds, and deposits in highly rated banks will remain, for the foreseeable future, the chief sources of liquid reserve assets. Many analysts have pointed to the euro as a threat to the dollar's status as the world's central reserve currency. But the continuing strength of the U.S. economy relative to the European Union's and the structure of European capital markets make such a prospect highly unlikely.

There is nothing Europe can do for the next decade that can allow the Euro to dislodge the dollar from its pedestal. American economic policy can dethrone the dollar. Collapsing the value of the dollar by running outlandishly large government deficits is exactly the sort of policy that will encourage business to find a different default currency.

The strength of the dollar has been based on four factors: The size of the American economy, the advanced nature of its capital markets, the stability of its currency, and its record of economic growth. Currently the U.S. has lost one of these pillars. With the expansion of the European Union its economy is now larger then that of America. The second pillar, stability of currency is now under attack by the Bush administration. Should either of the two remaining pillars be damaged, the dollar’s preeminence will be severely challenged.