Now that the dollar has dropped 43% from its high against the euro, the process of global rebalancing has finally begun. The U.S. trade and current account deficits have begun to shrink relative to American and world GDP. Asian current account surpluses are about to start to shrink as well--especially if growth slows markedly in America in the aftermath of the end of the housing boom. At the moment Europe is feeling most of the pain, as its currency's value has risen furthest and fastest against the dollar. But Latin America and Asia will start to feel some economic distress as well, as the United States steps out of the role in the global economy it has occupied for a decade: that of the world's importer of last resort.
As long as the unwinding of global trade and capital flow imbalances proceeds slowly and smoothly, the magnitude of economic distress created by the global rebalancing should be relatively small. It will not seem small to exporters and their workers who lose their American markets, or to Americans who lose access to cheap capital provided by foreigners. But on the scale of the global--well, the next few years are certain to bring up some more threatening and more serious political-economic problem than the unwinding of global imbalances. Yes, the United States might well enter a small recession--the odds are roughly 50-50. Yes, an American recession might spill over to the rest of the world and cause a world recession. Yes, growth over the next five years in the global economy is unlikely to be as rapid as growth in the last five years. But a formal recession is not an overwhelming probability, and is likely to be small. We as a species appear to have a safe harbor in sight: the fears of a truly hard landing--that global investors would wake up one morning, suddenly recognize the unsustainability of the U.S. current account, dump dollars, and bring about a crash of the global economy to rival what 1997-1998 did to the Pacific Rim economies--were not overblown and y not passed, but the dire scenarios they painted are becoming less likely with each day that passes.
However, there are two scenarios for the unwinding of global imbalances that could easily come to pass and that could cause regional if not global depression.
The first unpleasant scenario that has not yet begun to recede over the horizon might come to pass if China does not accelerate the rise in value of the renminbi, and continues to attempt to maintain full employment in Shanghai, Guangzhou, and elsewhere not by stimulating domestic demand but by trying to further boost exports by keeping the renminbi stable against the dollar and falling in value against the euro. The effort to maintain the dollar-renminbi exchange rate at a level China's State Council approves of has already led to an enormous increase in the financial liquidity of China's economy. We see the consequences in inflation in real estate and stock am. We have not seen it in rampant and uncontrolled consumer price inflation. If China does not accelerate the rise in value of the renminbi, we might well see a large burst of consumer price inflation in China in the next two or three years. If so, the economic and political consequences would be dangerous for Asia's economy--a choice between the destructive runaway inflation familiar from much post-WWII Latin American experience on the one hand and stagflation on the other. But the dangers from this scenario will be largely confined to Asia.
The second unpleasant scenario is more dangerous, and dangerous for the entire world. In this scenario, once again China does not accelerate the rise in value of the renminbi, and continues to attempt to maintain full employment in Shanghai, Guangzhou, and elsewhere not by stimulating domestic demand but by trying to further boost exports by keeping the renminbi stable against the dollar and falling in value against the euro. But this time the Chinese government manages to restrain domestic inflation, and so the trade deficit of America with Asia stops falling and starts rising again, alongside a rising trade deficit of Europe with Asia as well. Latin America finds itself in difficulties as it is priced out of its export markets. And five or six years hence the world economy faces the danger that it faced two years ago--although this time the fear is not of a sudden crash in the value of the dollar, but a sudden crash in the value of the dollar and the euro against Asian currencies.
Four years ago I would have said that the principal source of international economic disorder was made in America. That has passed as a result of the decline in the value of the dollar and the ebbing of the political strength of right-wing populist factions in the United States that seek ever-greater redistribution to the rich fueled by ever-increasing tax cuts and ever-rising long-run deficits. Today the principal source of international economic disorder is made in China, in the form of factions inside China's government that hope to avoid a more-rapid appreciation of the value of the renminbi. I cannot judge the strength of these factions, or whether they know that while the ebbing of the U.S. current account deficit and the decline of the dollar lessens the urgency of adjustment for the rest of the world, it does not lessen the urgency of adjustment for China.
Nixon-era U.S. Treasury Secretary John Connally once said to a group of European worthies that while the dollar was America's currency its misalignment was Europe's problem. There is an analogy to today: the dollar is America's and the euro is Europe's currency, but their misalignments against the renminbi and other Asian currencies are increasingly becoming Asia's problem.