External Imbalances and Adjustment in the Pacific Basin
My contribution to this week's conference at the Federal Reserve Bank of San Francisco's Center for Pacific Basin Studies:
On March 2, 1995, the Washington Post announced that I was a genius. I had, it wrote, warned Treasury muckamucks in April 1994 that they should "pay careful attention" to the late Rudi Dornbusch's predictions of a coming peso crisis, and had written "bottom line: peso overvalued." "TREASURY AIDES' MEMOS WARNED OF PESO PLUNGE... ADMINISTRATION DIDN'T HEED SIGNALS" was the headline that the Washington Post editors gave to reporter Clay Chandler's story.
But Clay Chandler was wrong. I was not a genius. Rather than representing my policy-analytic zenith, my few and brief memos on Mexico in the spring of 1994 represented my policy-analytic nadir. I did write--eight months before the Mexican peso crisis--that everyone should "pay careful attention" to Rudi's analysis. I did write that Rudi's bottom line was that the peso was overvalued and headed for crisis. But Clay Chandler was at that moment doing the bidding of Senator Alfonse D'Amato, who wanted to gin up accusations of incompetence against Clinton political appointees. Thus there was no space in his article for him to report my own bottom line: My bottom line was that I could not conceive of a world in which long-run capital flows from America to Mexico netted less than $20 billion a year, and that given that magnitude of fundamental capital flow, the peso was not currently overvalued.
I'm still not sure where I went wrong. U.S. rich and capital intensive. Mexico poor and capital scarce. Mexico moving from a kleptocratic bureaucracy toward a more open political system more interested in capitalist development. Mexico gaining guaranteed tariff-free access to the largest consumer market in the world. It seemed to me that the consequence had to be a large capital inflow into Mexico--and thus that the fundamental value of the peso was one that supported a substantial Mexican trade deficit.
But American businesses' desires to locate their capital to earn higher profits by taking advantage of Mexico's relatively low wages and relatively literate workers was outweighed by the desires of the Mexican rich to locate their savings in places they regarded as safe. The big risk they thought they faced was something going wrong politically in Mexico, and so they thought one had better have a large Citicorp (or Barclays) account in case one had to suddenly cross the Rio Grande in a small rubber boat. The capital flow in the mid- and late-1990s--the capital flow today--was not out of but into the United States, and the true "fundamental" value of the peso was a low-value one that supported substantial net capital exports from Mexico, not a high-value one that supported substantial net capital imports.
As I said, my policy-analytic nadir. What I had thought was external balance--Mexico's current-account deficit--turned out to not be balance at all.
Since I am here replacing Dooley, I have to ask: Is it possible that what we now see as imbalance is not really imbalance at all? Back in the late-1990s, the standard talking points were that the world economy was out of balance, that it could not function indefinitely with the U.S. serving as importer of last resort, and that it was important that the world economy balance up and not balance down because balance it would, and balance soon.
Since then the U.S. current-account deficit has only grown.
Is the current situation "unsustainable"? For how long could the U.S. continue to run a current-account deficit of, say, 7% of GDP?
We can all do the math. Assume a U.S. real growth rate of 3.5% per year, a real rate of return on foreign capital invested in the U.S. of 4% per year, and a constant 7% of GDP current-account deficit, and find that in 2022 the U.S. net foreign asset position crosses -100% of GDP, with a current-account deficit of 7% of GDP, a trade deficit of 3% of GDP, and net income payments to foreign owners of capital of 4% of GDP. A net foreign asset position of -100% of U.S. GDP is conceivable: Britain, after all, had a net foreign asset position of +150% of then-British GDP in 1913. The trade deficit between now and 2022 has to shrink by an average of a little less than a quarter of a percentage point per year. That's a very gradual rate of closure of the trade deficit. Is the real exchange depreciation necessary to support such a gradual closing of the U.S. trade deficit large enough to make investments in dollar-denominated securities a bad deal at current exchange rates? The private market has voted "no": while it is no longer eager to take up the flow of dollar-denominated assets moving abroad, it is still more than happy to hold the stock of dollar-denominated assets that move abroad in the past.
There is an alternative scenario, one in which foreigners'--including foreign central banks'--desired holdings of dollar-denominated assets shortly hit the wall, and the asset price shifts that result from desired holdings' hitting the wall reduce, or do not increase, confidence in the dollar.
In this alternative scenario, the U.S. has to move about ten million workers out of currently-favored sectors--construction, home-equity-credit financed consumer expenditures, and so on--into export and import-competing manufactures. How much structural unemployment does such a sectoral shift require, and how long does the structural unemployment last? Other countries have to shift up to forty million workers out of export manufactures into other industries, and to generate demand for the products of those industries (without destabilizing their own monetary systems and asset prices, as Japan appears to have done at the end of the 1980s). The U.S. Federal Reserve would have to cope with whatever inflationary pressures are generated by rising import prices. Foreign central banks would have to cope with whatever stresses on their own asset prices are created by enormous losses of value in the stocks and bonds of their exporting companies.
I suffered a big enough shock from my policy-analytic nadir moment a decade ago that I am very cautious about declaring that I know a fundamental external imbalance when I see it. But one thing makes me exceptionally nervous--makes all of us exceptionally nervous right now. The market's current prices appear to give a zero weight to the hit-the-wall hard-landing scenario, and 100% weight to the U.S.-acquires-an-enormous-negative-net-foreign-asset position.