A V Rajwade: Living on borrowed money

WORLD MONEY

The tendency manifests itself at both the national and household levels in the US.

Some time ago, John Kay of Financial Times neatly summarised the American attitude to borrowing. The analogy he used was that "my rapidly rising credit card bill, far from being a measure of overspending, is a demonstration of the credit card company's confidence in my future" "" in other words, of his increasing creditworthiness.

The tendency to live on borrowed money manifests itself at both the national and household levels: at the former, in terms of the gargantuan "" and growing "" twin deficits (fiscal and current account); at the latter, in a low savings rate and a household debt approaching $10 trillion, well in excess of aggregate disposable income.

Meanwhile, monetary policy continues to be accommodative of the hunger for debt. True, the Fed funds rate has been increased five times since mid last year but short-term rates are still negative in real terms. Even the sharp hike in oil prices over much of last year has not dented the monetary authorities' confidence that inflation outlook remains benign.

This is remarkable given that, over the past three years, the dollar has fallen almost a fifth in terms of its external value against a basket of currencies. Despite the number of headlines about record lows against the euro, the dollar's fall has not been all that sharp in 2004 as the accompanying table shows.

If the fiscal and current account deficits are prima facie different variables "" the former domestic and the latter external "" and are linked through the savings investment imbalance: the external deficit is a mirror image of the excess of domestic investments over domestic savings.

The fiscal deficit "" in other words, negative savings "" by the government sector, is thus, indirectly reflected in the deficit on the current account.

But to attribute a direct cause and effect relationship to the twin deficits would be an oversimplification: after all, the US was sustaining deficits on the current account even in the second half of the 1990s, when a substantial fiscal surplus was built up.

The difference between then and now is that in the 1990s, the private sector financial deficit deteriorated sharply even as the fiscal balance improved. Since 2000, both the trends have reversed "" some improvement in the private sector financial balance but an even bigger increase in the fiscal deficit.

There are weighty commentators predicting doom. Martin Wolf argued in Financial Times (August 8, 2004) that "the US is now on the comfortable path to ruin. It is being driven along a road of ever rising deficits and debt, both external and fiscal, that risk destroying the country's credit and the global role of its currency."

Former Federal Reserve chairman Paul Volcker has been quoted as saying that there is a 75 per cent chance of a financial crisis in the US within the next five years.

The one force keeping the dollar from falling more, and rapidly, and simultaneously financing the fiscal deficit, is the Asian central banks: their reserves' growth has financed much of the deficit on the current account through purchases of US treasury bonds.

As of now, more than 50 per cent of government debt is owned by foreigners. The Asians have a vested interest in supporting the dollar, namely protection of domestic growth and jobs. There were rumours that, because of international pressure, the Chinese would revalue the yuan at the end of last year. This has not happened.

Indeed, a sharp drop of the dollar, which many believe is necessary for correcting the external deficit, would have a deflationary impact on the world economy. The resulting fall in US demand for foreign goods is unlikely to be compensated by a corresponding rise in US exports.

The reason is simple: the manufacturing industry is now only a small part of the economy and there are limitations to how much it can export. Equally important, a fall in sales to the US would reduce incomes and purchasing power in the rest of the world as well.

So what is the likely scenario? If employment growth stalls, trade protectionist lobbies will gain strength. Meanwhile, the administration, happy with the currency's fall so far, will keep pressuring China to upvalue the yuan.

On the budget front, at least some observers believe that the cavalier disregard for any kind of fiscal rectitude is aimed at creating a scare and get political support for cutting expenditure. Transfer payments to the poor, the unemployed and the old, an integral part of the right-wing ideology, could well be on the agenda of expenditure cuts.

There is some possibility that the current account deficit could get a one-time improvement in 2004 because of a recent change in tax laws: any profits repatriated to the US in the current year by subsidiaries abroad, will attract a tax of 5 per cent as against the normal rate of 35 per cent. Some analysts expect that the total of such repatriations could amount to $250 to $300 billion in the current year.

Email: avrco@vsnl.com