U.S. and Trade Partners Maintain Unhealthy Long-Term Relationship By LOUIS UCHITELLE

From: Rakesh Bhandari (bhandari@BERKELEY.EDU)
Date: Sat Sep 18 2004 - 11:34:10 EDT

For years I have been suggesting arguments for Catherine Mann's new
position against the chicken littles on this list and elsewhere. But
now that she has changed her mind--just as when the last bear becomes
a bull--things may well now change.


September 18, 2004

U.S. and Trade Partners Maintain Unhealthy Long-Term Relationship

o organization has been more alarmed about America's constantly
rising deficit in global transactions than the Institute for
International Economics, a center of expertise in this field. A
disaster in the making, declares the institute's director, C. Fred
Bergsten - and one coming soon.

But month after month, indeed year after year, the disaster has
failed to occur and now one of the institute's own trade experts,
Catherine L. Mann, has stopped, as she puts it, crying wolf.

"Because nothing happened, I did a lot more analysis," Ms. Mann said,
"and I have come to the conclusion that a co-dependent relationship
exists between the United States and its trading partners.'' That
situation "may not be healthy for either side,'' she added, but it
"can last for quite some time."

For Americans, the positive side of this equation - known as the
balance on current account - is that they get to consume much more in
goods and services than they produce. As for America's trading
partners, particularly China, Japan and the Asian tigers, they gain
from an overseas marketplace that allows them to expand production
and job creation beyond what their own population can consume.

The downside for the United States is that most of its imports are
purchased on credit extended by its trading partners. The overall
indebtedness is now about $4.4 trillion, nearly twice what it was in
2000 - an increasingly costly arrangement for Americans and a
potentially risky one for the nation's foreign creditors.

While Mr. Bergsten, one of the better-known commentators on the
global economy, remains alarmed that the arrangement could unravel
abruptly, with the dollar plummeting in value and inflation rising,
Ms. Mann represents an alternative view held by a growing number of
economists. This group argues that rather than crisis, the United
States is caught in a gradual, almost imperceptible deterioration
brought on by the yawning deficit in trade and other international
transactions, and the deterioration could continue for a long time.

"If there has been no crisis, there has to be a counterweight that
keeps the crisis from happening," Ms. Mann said. "The counterweight
is that the United States and its main trading partners have a vested
interest in the status quo.''

No one knows how this situation will unwind. The willingness of the
United States to accumulate more and more debt could indeed end
painfully or it could play out gradually and mildly as the nation's
trading partners pull back on their lending and Americans slow their
consumption of imported goods and services.

"I think in the long term what is happening is unsustainable but it
is very hard to predict a turning point in an unsustainable
situation," said Robert Blecker, an economist at American University
who, like Ms. Mann, describes himself as a former Chicken Little.
"You can see why something cannot keep going,'' he said, "but you can
also see why it keeps going."

The scorecard in this process is the current account, which
encompasses the imbalance in the trading of goods and services as
well as the shortfall in all other cross-border payments, from
interest income and rents to dividends and profits on direct
investments. The current account deficit was equal to 5.7 percent of
all domestic economic activity in the second quarter, the Commerce
Department announced this week.

That was a record and an unusually rapid rise from 4.5 percent of
G.D.P. in last year's fourth quarter and 5.1 percent in the first
quarter. The trade deficit, the biggest single component, has risen
to $447 billion over the last year, a 10 percent increase.

What could turn things around? Interest payments on the debt could
finally get too burdensome for American borrowers, for example, or
the Chinese, the centerpiece among the nation's trading partners,
could discover that they finally have enough customers at home and do
not need to sell so much to the United States on credit.

The dollar, in response, would fall sharply in value, forcing prices
to rise in the United States for a vast array of imported goods and
services, leaving Americans, in response, much more dependent on
their own inadequate production.

"At some point the music stops, or slows down, as the two sides
become too unhinged,'' said Lee Price, director of research at the
Economic Policy Institute.

The focus on whether or not the rapidly growing current account
deficit will produce an abrupt crisis draws attention away from the
continuing deterioration in America's global economic status.

Interest income that once went to lenders within the United States
now seeps overseas to foreign lenders. Foreigners own more than 40
percent of all Treasury securities, up from less than 15 percent a
decade ago. They purchase these securities with the dollars American
consumers pay for imports, in effect lending the dollars back to
Americans for more purchases. The money collected through the
Treasury sales finds its way back to the public through the Bush
administration's deficit spending, and the cycle of purchasing on
credit continues.

"The budget deficit is essentially consumption supported by foreign
lending," said Stephen S. Roach, chief economist at Morgan Stanley,
the investment bank.

China and Japan held $1.3 trillion in Treasuries through June,
according to the International Monetary Fund. That continuing
willingness to invest surplus dollars in Treasuries helps to explain
why the dollar has fallen in value by only about 10 percent over the
last year against a market basket of currencies representing the
nation's trading partners. So far the dollar's preeminence as a
reserve currency and America's importance as a consumer market
outweigh the dangers of one or two lenders holding so much American

"My hope prior to the Iraq war was that the ministers of the major
nations would sit down and address the United States problem," said
Christian Weller, a senior economist at the Center for American
Progress, a research institute. "But the war overshadowed the
discussions and the trade deficit became a sideshow."

The last time something similar happened, in the mid-1980's,
America's trade problems focused more on Germany, France, Britain,
and Japan. Recognizing the crisis, these countries reached an
agreement with the Reagan administration to manage the fall of the
dollar against their currencies. As imports became more expensive,
American production revived, particularly in manufacturing.

This time, China, Japan and other Asian countries are the focus of
trade, and lacking enough demand at home for all their production,
they are eager to keep their goods and services as inexpensive as
possible for American consumers. So they resist letting the dollar
fall in value, defying market forces and ignoring mild prods from the
Bush administration.

While Senator John Kerry, the Democratic presidential candidate, has
said he will "take America in the right direction on trade," Tim
Adams, policy director for the Bush campaign, has said, "We will
continue to work with the Chinese toward a flexible exchange rate."

For the United States, however, the gradual deterioration is bringing
the country to a turning point. Until now, despite the growing
imbalance, income earned by Americans on all of their investments
abroad as well as their exports has exceeded the earnings of
foreigners on their holdings in the United States and their exports
to this country.

Only occasionally have the roles reversed, and then only briefly. But
now a heavy swing in the net income flow appears to be developing,
Mr. Roach says, as interest payments rise on the hoard of Treasuries
held by foreigners.

The net income flow favored the United States by $64 billion in last
year's fourth quarter, but that net dwindled to less than $10 billion
in the second quarter "and it will keep falling sharply," Mr. Roach

Production and job creation also suffer as imports substitute for
goods and services made in America. These imports now account for
nearly 15 percent of total consumption in the United States, up from
12 percent in the mid-1990's and 9 percent in the mid-1980's,
according to government data. Manufacturing within the United States
has simultaneously fallen to less than 13 percent of the gross
domestic product from 15.4 percent in 1998.

With less and less production at home, stimulating the economy in
periods of sluggish growth is becoming gradually more difficult, some
economists argue. The Federal Reserve, for example, was forced to cut
interest rates to rock-bottom levels before the economy started to
recover, in part because a growing portion of the goods and services
Americans buy are imported, diluting the stimulative effect on
domestic production.

How long can this imbalance between the United States and the rest of
the world continue? Indefinitely, says Albert Wojnilower, a Wall
Street economist who argues that no other country has a currency as
reliable and attractive as the dollar.

The downside is that a strong dollar forces the least competitive
American companies to give up or shift operations abroad.

"If this went on forever, ultimately we would import everything," Mr.
Wojnilower said. "But that is not going to happen."

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