America's Economy Tests Conventional Wisdom

America is about to put a long-standing economic theory to the test. Well, not a theory, but a rule-of-thumb. Economists have long held that if a country’s trade deficit exceeds 5 percent of its GDP, its currency will head south, and quickly. Americans’ love for foreign goods is leading them to import a record amount of cars, washing machines, television sets, trainers, and other consumer goods.

Meanwhile, slowdowns in Europe and Japan are constricting the markets for made-in-the-U.S.A products: America’s exports slumped by 1.3 percent between July and August, with vehicles and auto parts leading the rout. Result: a record trade deficit that reached $38.5 billion in August.

That means that when the final totals are in at year end, the United States probably will have passed the magic 5 percent threshold. Which is why some economists at the International Monetary Fund are beginning to consider just what would happen if the dollar were to begin a precipitous, 40 percent drop in value. And it is why Bush administration economists and strategists are increasingly angry with the failure of America’s trading partners to take steps to prop up demand in their own countries, rather than attempt to export their way to growth by using America as the importer of last resort.

The U.S. contingent left the last round of IMF-World Bank meetings in Washington in an angry mood. Japan had refused to give unequivocal assurances that it would take the steps necessary to wipe the soured loans off the books of its banks so that they can resume lending to healthy businesses. The Germans had refused to pledge the labor-market and other reforms needed to end its current stagnation, and avoid a more serious deflationary cycle. The French showed no signs of being willing to ease the protectionist policies that keep America’s three leading export industries—agriculture, aircraft manufacture, and audio-visual products—from making greater inroads into EU markets. Britain’s Gordon Brown seemed to be the only European in the crowd who understands how to operate a counter-cyclical fiscal policy.

So the trade deficit continues to mount. America now owes foreigners some $2 trillion, net of what foreigners owe us. That means that foreigners have shipped capital into the United States by buying shares and bonds in American companies, and the IOUs of the U.S. government. What worries some policy makers is that foreigners might tire of holding these dollar assets, sell them in order to repatriate funds or purchase shares in companies in other countries. In short, they would be unloading a great pile of dollars on international money markets, driving down the price of those dollars, scaring still other foreigners into unloading dollars—in a cycle that could cause chaos in currency markets and force U.S. interest rates up at a time when most experts would prefer to see them go down.

Fortunately, that is not about to happen. The dollar remains a safe-haven currency in a world on the brink of war. And if oil prices do shoot up when America moves on Saddam, other countries will have to buy more dollars to pay for that oil, because oil is traded in dollars on the world market, something that rankles euro fans, who unsuccessfully tried to persuade the Russians to take euros instead of dollars for their oil.

More important, in the end a currency’s strength reflects the relative strength of the underlying economy. It is certainly true that America’s is showing signs of weakness. Retail sales “were weak across the nation,” according the last week’s monthly Federal Reserve survey, and consumer confidence is weakening.

Other sources report that auto sales in the first two weeks of this month were 12 percent below the first two weeks in September and 30 percent below the same weeks in 2001. Because the automobile industry accounts for about 4 percent of U.S. GDP, a slowdown in sales and production will have important ripple effects.

As would a slowing of house sales and construction. There are signs that the high end of the market is cooling in some cities. Any easing of house prices would dry up an important source of consumer funds—the refinancing they have been arranging to withdraw equity from their increasingly valuable homes and pump the money into current consumption.

But for all of these nervous-making signs, any drop in the U.S. growth rate below, say 2 percent, seems unlikely, and even a modest recovery in business investment should produce an acceptable 3 percent increase in GDP in 2003 . Despite some regional soft spots, the Fed survey concluded that the housing market remains strong. The jobs market is not in terrible shape, real incomes are rising, consumers’ debt burden is not out of line with the high end of historical experience, and businesses are gradually getting their financial statements to a point where investors can actually believe the numbers.

Most important, productivity keeps rising. Federal Reserve Board chairman Alan Greenspan said last week that he remains certain that the economy is becoming increasingly efficient, at a rate well above that of earlier decades. In the end, it is rising productivity—the ability to produce more with fewer resources—that is the source of rising living standards.

And that is where America remains the world leader, and by an increasing margin. Which is why investors continue to prefer dollars to the currencies of Japan, with its shaky banking system; Germany, with its anti-growth fiscal and regulatory policies; and Latin America, with its increasingly left-wing and unstable governments. And any thought that investors would pull their funds out of the United States and move them into emerging markets went up in flames with Bali’s discos. The recent fall-off in inbound investment is more a reflection of a merger deals dearth than a loss of confidence in the U.S. currency.

So what of the 5 percent rule? One young Treasury analyst I asked about it last week said, “The rule is sound. Maybe it just doesn’t apply to America.” He was joking—I think.

This article appeared in London’s Sunday Times on October 27, 2002, and is reprinted with permission.