Psychologists refer to the “elephant in the room†phenomenon as a condition where people talk about everything except the most important issue. I recently (January 10, 2006) attended a conference at Washington’s prestigious Institute for International Economics on the likelihood of a financial crisis in developing countries. All morning the elephant sat quietly in the room sipping coffee.
The expert panelists puzzled over why global financial markets are so calm despite rising U.S. interest rates and the record trade deficit. Interest rate spreads between the U.S. and emerging market (EM) countries are at record lows, and foreign direct investment is flowing abundantly into these countries. This rosy picture was explained by reference to permanent policy changes. EM countries have improved their macroeconomic policies; run trade surpluses; restrained spending in the boom; and improved public finances by extending debt maturities, lowering their foreign currency debt, and refinancing at lower interest rates.
However, there is another deeper cause of this rosy condition. That cause is export-led growth, which is the elephant’s name. What’s the deal with export-led growth? EM countries export manufactured consumption goods to the US, in return getting financial claims against the US. These exports generate large trade surpluses that fund improved public finances. Additionally, EM countries get large flows of foreign investment since multinational corporations are happy to build export production platforms that take advantage of cheap labor and undervalued exchange rates.
The other side of the transaction has the US getting cheap consumer goods – lots of them. It also runs a trade deficit that American banks finance by issuing dollar deposits to EM countries. To the extent that countries use these deposits to buy US debt, this lowers interest rates, which is good for the US housing market. If they buy US assets, this bids up asset prices and makes US households wealthier. The downer is that the US sacrifices its manufacturing base since existing production and much new investment are off-shored via multinational foreign direct investment.
This configuration explains the health of emerging market economies. As long as the US keeps importing, they can keep exporting and the merry-go round keeps turning. The sixty-four million dollar question is what could stop it? And if it stops, what follows?
One possible stopper is if foreign countries cease holding their earnings in dollars. This would cause the dollar to fall, raising import prices and lowering US consumer import purchases. But foreign governments have no interest in this, as it would kill their “golden gooseâ€. Moreover, alternative yen and euro investments pay lower interest rates than dollar investments.
A second possible stopper is if the Federal Reserve raises interest rates high enough to tank the housing market, driving down house prices. This would make households poorer, likely tip the US into a recession, and reduce consumption spending. That would reduce imports, which would quickly be felt in emerging markets. This scenario is a real possibility, but policy can avoid it.
A third possible stopper is if Americans cease their consumption binge because they feel over-extended. Alternatively, local American banks may tighten lending because they doubt households’ credit-worthiness and think house prices are inflated so that housing collateral is unsound. In this case, the flow of credit financing consumption would dry up at its base, and imports would quickly fall. This is another credible scenario, and it is one that is harder for policy to impact. The Fed controls the price of credit, but a local borrower and lender must seal the deal to activate that credit. Even China’s willingness to lend to local American banks cannot force that transaction.
Once consumption spending falls, the US economy will slow, possibly even falling into recession. Imports will fall, ricocheting back to emerging market countries whose exports will tumble. On the financial side, EM countries’ trade surpluses will fall. On the industrial side, there will be excess capacity and lost jobs. Excess capacity will discourage foreign direct investment, while rising unemployment risks a return of political instability. The depth and duration of such a downturn is the next sixty-four million dollar question. That will depend on the extent of excess capacity and the scale of US household over-indebtedness. It will also depend on whether emerging economies can replace exports with domestic sales, but don’t count on that as their record is poor.
That brings us back to the opening conundrum. Why no mention of export-led growth? One reason is that trade is a touchy subject in Washington, and trade has enough problems without being tied to global financial instability. Export-led growth also shows that trade is not a level playing field, confirming critics’ claims about countries manipulating exchange rates and pursuing mercantilist policies that subsidize their manufacturers. Finally, the export-led growth story implies the US is relying on import-led growth that sacrifices the manufacturing base, which is a doubtful long run national growth strategy. So why do people ignore the elephant? To quote Bill Clinton, “Denial. It’s not just a river in Egypt.â€
Hi Tom.
Good piece and summary of the situation. I’ve written a paper on the history of the $ as the international reserve currency, and I discuss another possibility: a financial attack motivated by a political conflict. While it’s in the Asian countries’ (and it’s mainly these countries that are accumulating $s by pegging their e-rates) interest to prevent a dollar crash, and they can do so in a world of fiat currencies, I argue it is most likely that a $ crash will occur from political motivation. The move to price oil in euros and reduce official holdings of $s is a consequence of anti-Bush sentiments in many countries. I can foresee a scenario where China could use its $ holdings to “attack” the US over a political conflict. For example, China’s largest external supplier of oil is Iran. If the US goes after Iran, would China do this? The short-term costs of a recession might be less than preventing the US from controlling Iran’s oil…?
Besides, if the US experiences a recession there might even be a perverse effect with the Chinese bilateral deficit–a recession could increase Walmart’s sales, and I’ve read that half of our deficit with China is driven by Walmart. My speculative 2 cents.
Hope all is well with you.
Ted
Just a few questions by a Layman.How come the elephant in the room isn`t trade policy or even the housing market itself?Who`s buying these homes since interest rates are just part of home buying? Home buyers can only purchase what they can afford and they can only afford what personal incomes can sustain.If China targets the auto industry, steel,textiles or even dot commer IT folks with all of the obvious advantages they have coupled with the fact that Multi national corperations are forever lobbying against U.S. labor and lenders refuse to finance companies that wont offshore.It seems clear that autoworkers and the rest will lose their jobs and then the house at a deflated price.Then they start all over at entry level low wage jobs with no ability to dive back into the housing market saddled with debit.The ripple effect goes into the next industry and at some point the whole system collapses.That makes it in my opinion a National Security issue because any group that actively benefits a foriegn nation to the detriment of the U.S. in time of war would be considered traiters.Why isn`t replacing guns and bombs with checking accounts and bad monetary policy not considered economic espienage.How come trade policy is not tied to National Security.And if this scenario is acurate where is the national outrage felt in every middle class home represented in our government institutions like the Federal Trade Commision for starters.Is the goal a borderless society based soley on trade and cheap labor?
Dear Tom Palley,
I congratulate you on writing an excellent piece that is both clear and lucid. I especially liked your line “Import led growth.” The fallacy of export led growth is that has gone on for too long fueled by an unsustainable imbalance: low US interest rates, extremely high US debt, and a stable dollar — the correction of this imbalance can not come about, as you succinctly note, without world-destabilizintg consequences particularly in East Asia and perhaps less so in the oil exporting economies. Also a fallcy of export led growth: the idea that all countries can become little Chinas. This goes against considerable evidence that China is actually eating the export markets of almost everyone: this could or may already have shrunk export/gdp ratios in certain highly export dependent countries. In any case, thanks so much for your excellent piece.
Wasiq N Khan
Tom, that was a nice summary. One comment: all of the current situation fits with the Bushwhacker’s general policy of pushing all costs into the future and trying to get as many benefits now. Having a lot of wealthy US consumers now helps maintain political popularity (despite all the other things going on, like Iraq), while buying a lot of stuff from export-promoters makes their relatively market-oriented policies look more successful than they would be otherwise. So neoliberalism looks great! but it’s on borrowed time.
Also, this “model” of world growth has a strong family resemblence to what prevailed in the late Clinton era. Instead of housing in the US being pumped up, it was mostly the stock market.
Jim
I don’t see how developing countries can hurt America by subsidizing their manufacturers. If they manipulate exchange rate downward, the cost is born by their importers. If they subsidize manufacturers directly, they are giving free cash to American consumers.
Save manufacturing base in the America? Only 15% of American workforce is employed in the manufacturing sector, I don’t see why the rest of us (who are the majority) should voluntarily “subsize” them by paying for more expensive made-in-America manufactured products.
Plus, developing countries get very small share of the manufacturing profits. They get at most 1 dollar from every pair of shoes exported to the America. Who keep the rest of the profit? Americans!
Some constructive critism: if you want to attract a wider audience for your writings, don’t use phrases like “issuing dollar deposits”; mego sets in big time when a non economist comes across that sort of thing. Be more concrete.
The export-led growth system was pioneered by the Japanese after WWII and aided and abetted by Wall Street and the CIA. The Japanese have known since the 19th century that the key to state power was a strong industrial base for trade and military purposes. Their interests were in avoiding colonization and hanging onto their elite power. As a result, Japan was never colonized and became the world’s 2nd largest economy. China and the rest of Asia now want to emulate their success.
Re R-Squared’s comments; if you segment the world into elites and peons you will see that the elites gain, even though workers do not. Multinationals get lower costs, Stockholders (most shares are owned by the wealthy) gain profits and dividends, Asian political leaders gain infrastructure and technical know-how (as well as rich corruption opportunities) which enhances their power on the global stage. The only losers are workers–both here and in Asia. Asia’s high savings rate is the result of government policy to curtail spending, not any culture of thrift.
Since wage income ultimately determines consumption, we are cannibalizing the purchasing power of the US working class. Asian workers are being denied a portion of the fruits of their labor. This is bad policy for the nations as a whole, but it serves the interests of the elite decisionmakers on both sides of the Pacific.
Good stuff. It’s good to know there’s good, readable academic style writing on the Internet, since I now live in a country which hasn’t very many good libraries. Followed the link from wto_forum. Wish I had more time to read economics.
R-Squared–Look at it this way. When companies are subsidized by any government, those companies have an unfair advantage…All the subsidized companies have to do is wait—wait until they put all of the other companies out of business (with an overproduction of products–which lower prices below normal market level prices) and then swoop in for the kill once everyone else is gone (or in the process of dying)—Then they have the market all to themselves. Just look at what China is doing by enticing companies to “hand over” technology and technology know-how in order to gain access to China’s “huge” market…Then China (like the smart rulers they are) fund sibling companies that have been handed that technology for free—and just happen to be subsidized by the Chinese government….While the US (the biggest suckers in the world) trade our technology and know-how for more cheaper junk (which is provided by cheap loans thanks to the Chinese government)—It sounds like a win-win deal to me.
R squared you miss the point that the cost is not born by their importers because they arent importing anything but manufacturing jobs in the form of equipment to platform their export base economy at a discount. And the subsidizing undercuts the foundation of fair trade driving more American companies out of business.This creates more dependence on foriegn imports since we`re losing our capacity to produce domesticly.The 15% percent of the U.S. workforce that you dismiss so selfishly is still a pretty significant number when added to the unemployment rolls and if they are union jobs and wages your counting, throw another 15 % in their for the nonunion paired wages employers pay to pursuade employees to keep unions out of their shop.They will drop at an equal rate.Last thing is the dollar per shoes the developing countries keep.The rest of that money goes to the largest group of shareholders representing the smallest portion of our society driving the race to the bottom.Corperate shareholders and Venture capitalists who don`t worry much about America at the Davos Party nor do they give much thought to the rest of the world when they are relaxing down in the Cayman Islands tax free.I think the poverty stricken nations of the world are giving us a pretty good idea of what not having an economic social contract with its citicens awaits us.Gates,Guards and Guns cost a lot more than good policy.