O'Neill's Free Dinner

America's Current Account Deficit

By: Dr. Sam Vaknin

Also published by United Press International (UPI)

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See Note - The Real Threats to the Economy of the USA

Only four months ago, the IMF revised its global growth figures upward. It has since recanted but at the time its upbeat Managing Director, Horst Koehler, conceded defeat in a bet he made with America's outspoken and ever-exuberant Treasury Secretary, Paul O'Neill. He promised to treat him to a free dinner.

Judging by his economic worldview, O'Neill is a great believer in free dinners. Nowhere is this more evident than in his cavalier public utterances regarding America's current account deficit. As opposed to other, smaller countries, America's deficits have far reaching consequences and constitute global, rather than domestic, imbalances. The more integrated in the global marketplace a country is - the harsher the impact of American profligacy on its economy.

In a paper dated October 2001 and titled "The International Dollar Standard and Sustainability of the US Current Account Deficit", the author, Ronald McKinnon of Stanford University, concluded:

"Because the world is on a dollar standard, the United States is unique in having a virtually unlimited international line of credit which is largely denominated in its own currency, i.e., dollars. In contrast, foreign debtor countries must learn to live with currency mismatches where their banks' and other corporate international liabilities are dollar denominated but their assets are denominated in the domestic currency. As these mismatches cumulate, any foreign country is ultimately forced to repay its debts in order to avoid a run on its currency. But however precarious and over-leveraged the financing of individual American borrowers—including American banks, which intermediate such borrowing internationally—might be, they are invulnerable to dollar devaluation. In effect, America’s collective current-account deficits are sustainable indefinitely."

In another paper, with Paul Davidson of the University of Tennessee, the authors went as far as suggesting that America's interminable deficit maintains the liquidity of the international trading system. A reduction in the deficit, by this logic, would lead to a global liquidity crunch.

Others cling to a mirror image of this argument. An assortment of anti-globalizers, non-governmental organizations, think tanks, and academics have accused the USA of sucking dry the pools of international savings painstakingly generated by the denizens of mostly developing countries. Technically, this is true. US Treasury bonds and notes compete on scarce domestic savings with businesses in countries from Japan to Russia and trounce them every time.

Savers - and governments - prefer to channel their funds to acquire US government obligations - dollar bills, T-bills, T-notes, equities, corporate bonds, and government bonds - rather than invest in their precarious domestic private sector. The current account deficit - at well over 4 percent of American GDP - absorbs 6 percent of global gross savings and a whopping three quarters of the world's non-domestic savings flows. By the end of last year, foreign investors held $1.7 trillion in US stocks, $1.2 trillion each in corporate debt and treasury obligations - 12 percent, 24 percent, and 42 percent of the outstanding quantities of these securities, respectively.

The November 2000 report of the Trade Deficit Review Commission, appointed by Congress in 1998, concluded that America's persistent trade deficit was brought on by - as Cato Institute's Daniel Griswold summarizes it - "high trade barriers abroad, predatory import pricing, declining competitiveness of core U.S. industries and low wages and poor working conditions in less-developed countries (as well as low) levels of national savings, (high rates of) investment, and economic growth - and exchange rate movements."

Griswold noted, though, that "during years of rising deficits, the growth of real GDP (in the USA) averaged 3.5% per year, compared to 2.6% during years of shrinking deficits ... the unemployment rate has, on average, fallen by 0.4% (compared to a similar rise) ... manufacturing output grew an average of 4.6% a year ... (compared to an) average growth rate of one percent ... poverty rate fell an average of 0.2% from the year before ... (compared to a rise of) an average of 0.3%."

A less sanguine Kenneth Rogoff, the IMF's new Chief Economist wrote in "The Economist" in April: "When countries run sustained current-account deficits up in the range of 4 and 5% of GDP, they eventually reverse, and the consequences, particularly in terms of the real exchange rate, can be quite significant."

Rogoff alluded to the surreal appreciation of the dollar in the last few years. This realignment of exchange rates rendered imports to the USA seductively cheap and led to "unsustainable" trade and current account deficits. The IMF concluded, in its "World Economic Outlook", published on September 25, that America's deficit serves to offset - actually, finance - increased consumption and declining private savings rather than productive investment.

Greenspan concurred earlier this year in "USA Today": "Countries that have gone down this path invariably have run into trouble, and so would we." An International Finance Discussion Paper released by the Fed in December 2000 found, as "The Economist" put it, that "deficits usually began to reverse when they exceeded 5% of GDP. And this adjustment was accompanied by an average fall in the nominal exchange rate of 40%, along with a sharp slowdown in GDP growth."

Never before has the current account deficit continued to expand in a recession. Morgan Stanley predict an alarming shortfall of 6 percent of GDP by the end of next year. The US is already the world's largest debtor having been its largest creditor only two decades ago.

Such a disorientating swing has been experienced only by Britain following the Great War. In five years, US net obligations to the rest of the world will grow from one eighth of its GDP in 1997 to two fifths of a much larger product, according to Goldman Sachs. By 2006, a sum of $2 billion dollars per day would be required to cover this yawning shortfall.

Rogoff - and many other scholars - foresee a sharp contraction in American growth, consumption and, consequently, imports coupled with a depreciation in the dollar's exchange rate against the currencies of its main trading partners. In the absence of offsetting demand from an anemic Europe and a deflation-struck Japan, an American recession may well translate into a global depression. Only in 2003, the unwinding of these imbalances is projected by the IMF to shave 3 percentage points off America's growth rate.

But are the twin - budget and current account - deficits the inevitable outcomes of American fiscal dissipation and imports run amok - or a simple reflection of America's unrivalled attractiveness to investors, traders, and businessmen the world over?

Echoing Nigel Lawson, Britain's chancellor of the exchequer in the 1980's, O'Neill is unequivocal. The current deficit is not worrisome. It is due to a "stronger relative level of economic activity in the United States" - he insisted in a speech he gave this month to Vanderbilt University's Owen Business School. Foreigners want to invest in the US more than anywhere else. The current account deficit - a mere accounting convention - simply encapsulates this overwhelming allure.

This is somewhat disingenuous. In the last three years, most of the net inflows of foreign capital into the spendthrift US are in the form of debt to be repaid. This mounting indebtedness did not increase the stock of income-producing capital. Instead, it was shortsightedly and irresponsibly expended in an orgy of unbridled consumption.

For the first time in a long time, America's savings rate turned negative. Americans borrowed at home and abroad to embark on a fervid shopping spree. Even worse, the part of the deficit that was invested rather than consumed largely went to finance the dotcom boom turned bust. Wealth on unimaginable scale was squandered in this fraud-laced bubble. America's much hyped productivity growth turned out to have been similar to Europe's over the last decade.

Luckily for the US - and the rest of the world - its fiscal stance during the Clinton years has been impeccable and far stronger than Europe's, let alone Japan's. The government's positive net savings - the budget surplus - nicely balanced the inexorable demand by households and firms for foreign goods and capital. This is why this fiscal year's looming budget deficit - c. $200 billion - provokes such heated debate and anxiety.

Is there a growing reluctance of foreigners to lend to the US and to finance its imports and investment needs? To judge by the dollar's slump in world markets, yes. But a recent spate of bad economic news in Europe and Japan may restore the global appetite for dollar-denominated assets.

This would be a pity and a blessing. On the one hand, only a flagging dollar can narrow the trade deficit by rendering American exports more competitive in world markets - and imports to the USA more expensive than their domestic imperfect substitutes. But, as the late Rudi Dornbusch pointed out in August 2001:

"There are two kinds of Treasury Secretaries ­ those like Robert Rubin who understand that a strong dollar helps get low interest rates and that the low rates make for a long and broad boom. And (those) like today's Paul O'Neil. They think too much about competitiveness and know too little about capital markets...

Secretary of the Treasury Paul O'Neil, comes from manufacturing and thinks like a manufacturer (who) have a perspective on the economy that is from the rabbit hole up. They think a weak dollar is good for exports and a hard dollar hurts sales and market share. Hence they wince any time they face a strong dollar and have wishy-washy answers to any dollar policy question."

The truth, as usual, is somewhere in the middle. Until recently, the dollar was too strong - as strong, in trade-related terms, as it was in the 1980's. Fred Bergsten, head of the Institute for International Economics, calculated in his testimony to the Senate Banking Committee on May 1, that America's trade deficit soars by $10 billion for every percentage rise in the dollar's exchange rate.

American manufacturers shifted production to countries with more competitive terms of trade - cheaper manpower and local inputs. The mighty currency encouraged additional - mostly speculative- capital flows into dollar-denominated assets, exacerbating the current account deficit.

A strong dollar keeps the lid on inflation - mainly by rendering imports cheaper. It, thus, provides the central bank with more leeway to cut interest rates. Still, the strength of the dollar is only one of numerous inputs - and far from being the most important one - in the monetary policy. Even a precipitous drop in the dollar is unlikely to reignite inflation in an economy characterized by excess capacity, falling prices, and bursting asset bubbles.

A somewhat cheaper dollar, the purported - but never proven - "wealth effect" of crumbling stock markets, the aggressive reduction in interest rates, and the wide availability of easy home equity financing should conspire to divert demand from imports to domestic offerings. Market discipline may yet prove to be a sufficient and efficient cure.

But, the market's self-healing powers aside, can anything be done - can any policy be implemented - to reverse the deteriorating balance of payments?

In a testimony he gave to the Senate in May, O'Neill proffered one of his inimitable metaphors:

"All the interventions that have been modeled would do damage to the U.S. economy if we decided to reduce the size of the current account deficit. And so I don't find it very appealing to say that we are going to cut off our arm because some day we might get a disease in it."

This, again, is dissimulation. This administration - heated protestations to the contrary notwithstanding - resorted to blatant trade protectionism in a belated effort to cope with an avalanche of cheap imports. Steel quotas, farm and export subsidies, all manner of trade remedies failed to stem the tide of national red ink.

The dirty secret is that everyone feeds off American abandon. A sharp drop in its imports - or in the value of the dollar - can spell doom for more than one country and more than a couple of industries. The USA being the global economy's sink of last resort - absorbing one quarter of world trade - other countries have an interest to maintain and encourage American extravagance. Countries with large exports to the USA are likely to reacts with tariffs, quotas, and competitive devaluations to any change in the status quo. The IMF couches the awareness of a growing global addiction in its usual cautious terms:

"The possibility of an abrupt and disruptive adjustment in the U.S. dollar remains a concern, for both the United States and the rest of the world ... The question is not whether the U.S. deficit will be sustained at present levels forever - it will not - but more when and how the eventual adjustment takes place ... While this would likely be manageable in the short term it could adversely affect the sustainability of recovery later on."

Another embarrassing truth is that a strong recovery in Europe or Japan may deplete the pool of foreign capital available to the USA. German and Japanese Investors may prefer to plough their money into a re-emergent Germany, or a re-awakening Japan - especially if the dollar were to plunge. America requires more than $1 billion a day to maintain its current levels of government spending, consumption, and investment.

There is another - much hushed - aspect of American indebtedness. It provides other trading blocks and countries - for example, Japan and the oil producing countries - with geopolitical leverage over the United States and its policies. America - forced to dedicate a growing share of its national income to debt repayment - is "in growing hock" to its large creditors.

Last month, Arab intellectuals and leaders called upon their governments to withdraw their investments in the USA. This echoed of the oil embargo of yore. Ernest Preeg of the Manufacturers Alliance was quoted by the Toronto Star as saying: "China, for example, could blackmail the United States by threatening to dump its vast holdings of U.S. dollars, forcing up U.S. interest rates and undermining the U.S. stock market. Chinese military officials, he claimed, had included this kind of tactic in their studies of non-conventional defence strategies."

These scenarios are disparaged by analysts who point out that America's current account deficit is mostly in private hands. Households and firms should be trusted to act rationally and, in aggregate, repay their debts. Still, it should not be forgotten that the Asian crisis of 1997-8 was brought on by private profligacy. Firms borrowed excessively, spent inanely, and invested unwisely. Governments ran surpluses. As the IMF puts it: "To err is human and this is as true of private sector investors as anyone else."

Note - The Real Threats to the Economy of the USA

June 16, 2004

The outcry about offshoring (outsourcing - the relocation of domestic jobs to more efficient and cheaper suppliers abroad) is politically motivated. Outsourcing affects the vocal, politically active, emblematic, and well-connected hi-tech industry in a year of presidential elections. No wonder it has become a campaign issue.

But outsourcing is far from being a real threat to America's economic well-being and prospects. As technologies mature, outsourcing is both inevitable and welcome. It encourages the optimal allocation of economic resources, frees up capital and labor for more productive uses, and, in the medium to long run, generates more jobs than it eliminates.

The largest economy in the world is faced with other, structural, more daunting dangers, though.

1. Huge costs are imposed on the American economy by the global geopolitical realignment following the Cold War and its manifestations - ubiquitous instability, ethnic and national tensions, and terrorism. Military budgets soar and the private sector is crowded out of the credit markets.

2. The ageing of the population in the United States portends a crisis of mammoth proportions in the pension and social security systems. The shrinking of the productive age group is not fully compensated for by immigration.

3. The decline of American science and technology requires the importation of brainpower from other countries. This process - of net brain absorption - is about to reverse and become net brain drain as American scientists flee restrictions in the free flow of scientific information and religious constraints on research (e.g., on stem cell studies).

4. The rise in religious sentiment, the "esoteric sciences", and sheer superstitions carries an economic price tag. As economic decisions - for instance: the allocation of funding for research and the arts, foreign aid, the workings of the Internet - become less rational the allocation of scarce economic resources is rendered more wasteful.

5. The shift from productive economic activities to speculative and derivative pursuits (i.e., trading in financial instruments) transformed the United States into a "paper economy", both literally and figuratively. Consequently, as it increasingly opens up to international trade, it imports more than it exports (generating unsustainable trade deficits). The resultant excess capacity (slack) prevents rapid and energetic recoveries from slumps and recessions.

6. American fiscal and personal profligacy buried the United States and its denizens under a mountain of debt. America has a monopoly on printing US dollars and these have become its main export. A global shift in the composition of international reserves (e.g., the emergence of the euro as a reserve currency) threatens America's ability to erode its debt through inflation. The increasing ubiquity and intrusiveness of government - both Federal and in the various states - adds to the economy's underlying inefficiency.

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