[PEN-L:33316] Martin Wolf on the triple debt trap

[Michael Pollak <mpollak@xxxxxxxxx>]

[If we're going to do the economic watch on the Rhine, I think I still
prefer the Wynne Godley overall argument of inevitable drastic
readjustment to betting on the housing bubble.  Here's a recent riff off
(and pretty good summary of) Godley by the FT's Martin Wolf of all people,
who seems to be saying that it's no longer a matter of whether, but rather
of when.  Although I fully hope that by saying that out loud I will jinx
it :o)

[Here the nut grafs, which occur a bit of the way in (this is written more
like a magazine article than a normal FT article -- he spends a while
going through each of his subsidiary arguments first]:

<quote>

[Here is a triple debt trap. To understand how vulnerable this makes the
US, note the following points.

[First, if the current account deficit were to continue at 5 per cent of
GDP, US net external liabilities would be above 50 per cent of GDP in less
than five years. Second, should the personal sector return to its normal
financial surplus and the corporate sector and current account also remain
where they are, the deficit of the public sector must reach 8 per cent of
GDP. A nightmare? Yes, Japan's present nightmare. The obvious alternative
of a big reduction in the current account deficit would shift the
adjustment, painfully, on to the rest of the world.

[How does the US escape from its triple trap? With difficulty, is the
answer, so long as demand in the other big economies remains so weak.]

<end quote>

Financial Times; Dec 18, 2002

COMMENT & ANALYSIS: The current account deficit, weak corporate investment
and high personal indebtedness will limit the ability of the new US
economy

By Martin Wolf

What is the sound of one hand clapping? To an untutored westerner, the
answer must

be silence. If so, the prospects for the world economy are grim. Only the
American hand is moving. Japan and the eurozone are almost motionless.

In 2001, the US generated 31 per cent of world product, at market prices.
The European Union generated another 26 per cent, while Japan's
contribution was 15 per cent. The big three, with 72 per cent of world
output, dominate the performance of the global economy.  Even China
generates less than 4 per cent of world gross domestic product, at market
prices, a fifth less than the UK. Yet of the big three, only the US has
managed much recovery this year.

If the forecasts of the Organisation for Economic Co-operation and
Development prove correct, the US will generate 52 per cent of the
increase in world demand, in real terms, this year. Total domestic demand
in the US is forecast to grow by 2.8 per cent, against 0.7 per cent in the
European Union, 0.4 per cent in the eurozone (shorn of the UK's
contribution) and minus 1.4 per cent in Japan.

Yet even the US is not clapping hard enough for George W. Bush. In firing
Paul O'Neill, his Treasury secretary, and Lawrence Lindsey, economic
adviser, the president has demonstrated a desire for a new start. John
Snow, the new Treasury secretary, and Stephen Friedman, head of the
National Economic Council, are expected to generate further action,
principally in the form of tax cuts.

Mr Bush remembers his father's fate: glorious in war; inglorious on the
economy; a one-term president. With productivity growth soaring, demand
needs to accelerate. To lower unemployment, rather than just prevent it
from rising from today's 6 per cent, the economy must grow by over 3? per
cent.

In the near future, big increases in demand will come only from households
and the federal government. The Federal Reserve is doing what it can to
keep households borrowing and spending. Armed with their supply-side
theories, the Republicans, now in control of Congress and the White House,
will help with tax cuts. To understand what this might imply, it is
helpful to examine the balances between income and expenditure in the
foreign, public and private sectors of the economy, which must add up to
zero.

In aggregate, the US is now spending just under 5 per cent more than its
income, the difference being the current account deficit. This deficit is,
at the same time, the net lending by foreigners to the US and the
purchasing power injected by the US into the world economy.

Until 2000, the domestic counterpart of this external deficit was entirely
in the US private sector. This deficit peaked at 5.5 per cent of GDP in
the third quarter of that year (see chart). Since this was bigger than the
current account deficit, the public sector ran a surplus. Wynne Godley,
the Cambridge University academic (from whom come these data), notes that
the private sector deficit was unprecedented. The swing from surplus into
deficit in the 1990s was an extraordinary 11.5 per cent of GDP. This is an
indication of how much faster private spending grew than incomes.

Then came the bursting of the stock market bubble. By the third quarter of
this year, the private sector deficit of spending over disposable income
had shrunk to 1.3 per cent of GDP. But, because of the weakness of demand
in the rest of the world and the health of the dollar, the current account
deficit grew rather than shrank. The public sector took up the slack, with
an aggressive shift of 5 per cent of GDP, from modest financial surplus to
a large deficit, in just two years. If this had not happened, there would
have been a deep recession. At a time of economic stress, increased
borrowing by the world's most creditworthy borrower is desirable. The US
federal government is, of course, that borrower.

The bigger question, in the short term, concerns the private sector. All
the adjustment so far has been in the corporate sector. Squeezed by
falling profitability and a collapsing stock market, companies have
slashed their spending. A moving average (over three quarters) of the
corporate financial deficit has moved from a peak of 3.6 per cent of GDP
in 2000 to balance this year. The counterpart has, of course, been cuts in
investment.

Yet the personal sector's deficit has continued unchecked. Historically,
the personal sector has run a financial surplus averaging 3 per cent of
GDP. For the past three years, however, it has run a deficit of nearly 2
per cent. This has sustained consumption, which should rise by more than 3
per cent this year. Now Mr Bush wants still more. Yet to sustain personal
spending at current levels, in relation to incomes, borrowing must also
continue at a high level. This, in turn, implies a further rise in the
ratio of personal indebtedness to GDP, already up from 106 per cent of
disposable income in 1993 to 131 per cent this year.

Sustaining US demand at a rate sufficient to generate economic growth of 4
per cent a year, given the drag from the external deficit and the
likelihood of persistently weak investment, entails rapidly rising
external, personal and government liabilities, in relation to GDP. Here is
a triple debt trap. To understand how vulnerable this makes the US, note
the following points.

First, if the current account deficit were to continue at 5 per cent of
GDP, US net external liabilities would be above 50 per cent of GDP in less
than five years. Second, should the personal sector return to its normal
financial surplus and the corporate sector and current account also remain
where they are, the deficit of the public sector must reach 8 per cent of
GDP. A nightmare? Yes, Japan's present nightmare. The obvious alternative
of a big reduction in the current account deficit would shift the
adjustment, painfully, on to the rest of the world.

How does the US escape from its triple trap? With difficulty, is the
answer, so long as demand in the other big economies remains so weak.

Nothing can be expected from Japan, even in the medium term. If it did get
policy right, it would end up substituting a bigger current account
surplus for part of its fiscal deficit. The mechanism would be a more
expansionary monetary policy, one of whose by- products, in the near term,
would be a weaker yen. It would be impossible to absorb its private sector
surplus in the domestic economy, in the near term.

The UK is already doing its bit for world demand, with total domestic
demand rising by 2.6 per cent in 2001 and 2.3 per cent this year,
according to the Organisation for Economic Co-operation and Development.
The culprit is the eurozone and, above all, Germany. The OECD's survey of
the German economy, out yesterday, notes that total domestic demand shrank
by 0.8 per cent last year and forecasts a further shrinkage of 1.1 per
cent this year. With this huge drag from an economy that accounts for a
third of eurozone GDP, the weakness of the zone as a whole is inescapable.
The OECD forecasts growth of demand at 1.8 per cent next year. This is not
sufficient to reduce domestic slack, let alone help the US adjust.

For the moment, then, the world economy depends on the ability of Mr Bush
and the Fed, under Alan Greenspan, to stoke up US demand, never mind the
rising indebtedness. In the long run, however, the current US position
will have to change. For that reason, continental Europe must find a way
to generate stronger internal demand. If it cannot do so in the private
sector, it will be forced to do so in the public sector.

In present circumstances, desperate attempts to cut eurozone fiscal
deficits, in accordance with the growth and stability pact, are far more
likely to deepen recessions than to increase private sector economic
activity. At the least, that would occur only if the European Central Bank
were to be far more willing to pursue an aggressively expansionary
monetary policy, on the lines of the Fed's, in response to agreed fiscal
tightening.

The big picture is of a weak recovery driven by an increasingly
unsustainable long- term position in the US, necessitated by stagnation
elsewhere. Yet there are risks to even this single-handed recovery. One
such risk is war in Iraq. An analysis for the Centre for Strategic and
International Studies, in Washington, concludes that oil prices could jump
to $40 a barrel if the war took up to four months.* This would take the US
and rest of world economy close to recession.

A second group of risks is financial. In its latest Global Financial
Stability Report, the IMF points to weaknesses in Japan's and Europe's
financial sectors. Also possible are further declines in stock markets.
The US market, in particular, though much cheaper than 2? years ago,
remains expensive by long-term historical standards. Yet another risk is a
big emerging market default, perhaps in Brazil.

Yet such risks are not the essence of our story. More important is the way
the world economy depends on a pattern of recovery in the US that must be
unsustainable, in the long run. If the recovery ahead is to be smooth and
dynamic, the rest of the world must recover its vigour. The longer demand
remains weak elsewhere, the longer it may be happy to finance the US. But
the longer this continues, the more painful the ultimate adjustment is
likely to be. The US is doing whatever it can. Japan is largely impotent.
It is time for Europe to play its role.

* http://www.csis.org/features/ attackoniraq_summary.pdf

martin.wolf@xxxxxx