Larry Elliott on the $ bubble and Robert Brenner

["Ian Murray" <seamus2001@xxxxxxxxx>]

The bubble to beat all bubbles

Larry Elliott
Monday May 27, 2002
The Guardian

All good things come to an end, and for the mighty dollar the end is
definitely in sight. The only surprise is that it has taken as long as
it has for the financial markets to accept the inevitable. Countries
that live beyond their means eventually pay a price.
Anybody who believes, however, that the overdue fall in the currency
means a painless rebalancing of the global economy is in for a rude
awakening. Soft landings are to the world of contemporary economics what
snow leopards are to the world of nature: everybody has heard of them;
few have actually encountered them.

In theory, what should happen is that the weaker dollar makes American
exports more competitive, allowing the US to close its frighteningly
large trade deficit. Domestic demand in the US grows less strongly, with
the slack taken up by consumers in Europe and Japan. Once this has
happened, the fundamental improvement in US economic performance over
the past decade will again be reflected in a higher growth rate.

Theory is fine for the textbooks. In the real world, things tend to be
different. The strong dollar has been the glue that has held the core of
the global economy together even as bits on the periphery have flaked
off. Consumer demand in Europe and Japan is weak, and the only reason
there is even the semblance of growth is that their exporters in Munich
and Nagoya are using the weakness of the euro and the yen to feed
America's spending habit. But at some cost. The strength of the dollar
and the debt-fuelled spending spree in the world's biggest economy means
that the US has a current account deficit that dwarfs anything in its
history.

US manufacturers are complaining like mad, one reason why the Bush
administration has slapped tariffs on imported steel. But international
investors have also grown alarmed. The dollar's real exchange rate -
higher than at any time since the Plaza agreement of 1985 organised a
global effort to reduce its value - is eroding corporate profitability.
With official interest rates at just 1.75%, and no sign that the Federal
Reserve plans to raise them soon, overseas investors believe that they
are not being rewarded for the risk of a hefty dollar devaluation. So
they are selling dollar assets, making devaluation more likely.


Trendsetter

But as the American historian, Robert Brenner, points out in a new
book*, there has been a pattern to the performance of the big three
economies since the "Golden Age" came to an end in 1973. When the dollar
has been strong, Europe and Japan's export-driven economies have done
well. When the dollar has been weak, as it was from 1985 to 1995, Europe
and Japan struggled.

Far from being a spontaneous improvement in economic performance caused
by the development of new technology, America's industrial renaissance
was based on an investment boom made possible by a cheap currency, tax
breaks for the corporate sector and a ferocious squeeze on real wages
under Reagan, Bush senior, and Clinton. Since the 1990s, the dollar has
appreciated by about 60% against a basket of currencies, putting strain
on profits.

The show was only kept on the road by the scale of America's stock
market bubble, underwritten by Alan Greenspan at the Fed, which
encouraged consumers to run down savings and made it easy and cheap to
raise funds for projects that had no chance of being profitable.

Brenner argues that the international economic expansion of 1999-2000
was like the other cyclical recoveries since the start of the long
downturn almost three decades ago. "As in those previous ones, the US's
main rivals and partners in western Europe - especially Germany and
Italy - in east Asia and Japan thus depended as usual upon a combination
of the sizzling growth of the US import market, historically
unprecedented US current account deficits, and sharply reduced exchange
rates vis-à-vis the dollar (notably the very low euro) to generate
growth of demand not only for high-technology investment goods, but also
for traditional consumption imports, like cars."

Bill Martin, chief economist at UBS global asset management, has been
warning for years that this could not go on indefinitely. His research
shows that the US faces a prolonged hangover from the excesses of the
late 1990s, and that the rest of the world is not really in a position
to compensate for the weakness in American domestic demand that is
necessary to rectify the trade deficit and reduce the indebtedness of
the private sector to more normal levels.

He argues that a weaker dollar would not be welcome in those parts of
the world already suffering from high levels of unemployment and that
resorting to protectionism merely invites retaliation. Ideally, Europe
and Japan would use reflationary macroeconomic policies to boost
domestic demand, but there is not much chance of this happening.

A higher exchange rate represents a tightening of monetary policy, while
cuts in interest rates are ruled out in Europe by the central bank's
paranoia about inflation and in Japan by the fact that they can go no
lower than they are already. Martin says that as far as fiscal policy is
concerned, Europe's stability and growth pact prevents easing, while
Japan's repeated doses of pump priming mean that any further use of
Keynesian remedies would be ineffective.

The dollar has weakened by 5% since the start of April, and despite
intervention by the Japanese last week, still has a lot further to go.
The difficulty is that we now have all three of the world's big trading
blocs trying to do the same thing at once - use cheap currencies to
export their way to growth. But this is an impossibility. If the dollar
weakens, then something else strengthens, and that means the euro and
the yen.

Brenner argues that this struggle for export markets is increasingly a
zero-sum game, and he is right. Two trends have developed. The first is
that it has encouraged overcapacity on a colossal scale, which has put
downward pressure first on prices, then on profitability and now on
stock markets. The second is that a devaluation-induced expansion in one
country leads to a crisis of exports and manufacturing in another.


Aggressive

At the same time, rising exchange rates attract capital, making
imbalances worse and generating speculative asset-price bubbles.
Thailand was an early example of this, but only an overture to America's
bubble to beat all bubbles.

Greenspan is now in a fix, although his willingness to tolerate, even
encourage, the stock market bubble means he only has himself to blame.
Low interest rates are needed to keep the economy growing, but higher
interest rates are needed to attract an inflow of funds needed to
prevent a sharp fall in the dollar and fund the current account deficit.

It is clear that interest rates would have to be raised aggressively to
compensate foreign investors for holding the dollar, but as Brenner
asks: "Could interest rates be simultaneously kept high enough to allow
for the funding of the current account deficit and to prevent a flight
of capital, and also low enough to avoid choking off growth?" The
answer, almost certainly, is no.

. Robert Brenner; the Boom and the Bubble; Verso £15

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