Global Policy Forum

By Larry Elliott

Everything's going to be all right. No, not Bob Marley, but every policymaker from Alan Greenspan to Wim Duisenberg. The A side of 2003 was a bit grim, but turn the record over and the second half will be better. The controls are set to go, the policy framework is solid, better times are ahead. Sound familiar? It should do. This has been what policymakers and their bullish camp followers in the markets and the media have been arguing in each of the past three years. Every year, they say the good times are coming back, and every year so far, they have been wrong.

This time, they say, it's different. Stock markets have rallied since the end of the war in Iraq, oil prices are lower and the United States' economy is showing signs of revving up. Once the American juggernaut has really started to roll, so the conventional wisdom goes, the global economy will be dragged along behind. But what if the conventional wisdom is wrong, not just about the imminence of recovery but about the underlying health of the global economy altogether? As one correspondent to this page put it, is there a chance that we could be heading for the "big one", an economic crisis the like of which has not been seen since the 1930s?

It's certainly worth considering, and the place to start looking is the US trade deficit, at present running at more than $50m an hour. Far too little attention has been paid to the giant tab the US has been running with the rest of the world in order to satisfy demand for goods and services that cannot be provided domestically, with economic logic turned on its head to argue that the spendthrift habits of the world's biggest economy is actually a good thing.

The difficulty, however, is that there is no mechanism for bringing the US current account back into balance, and it has been the absence of such a mechanism since the break-up of the Bretton Woods fixed exchange rate system that has contributed to the growing problem. In essence, the Bretton Woods system was an updated form of the gold standard; both ensured there was a self-stabilization mechanism whereby countries running either surpluses or deficits were forced to take remedial action.

In the case of the gold standard, a country's money supply was linked directly to its stock of gold. Nations that ran trade surpluses would accumulate more gold, which allowed them to expand the money supply by creating more credit. Easier money fuelled booms, which in turn fuelled inflation. Higher prices relative to other countries made exports dearer, thereby reducing the trade surplus.

The system worked in the opposite way, of course, for countries with trade deficits. The gold standard was suspended during the First World War, revived in the 1920s and collapsed in the 1930s. Bretton Woods was seen as a substitute for the gold standard, and pegged the dollar to gold at $35 an ounce, with every other currency linked to the dollar at fixed rates. Bretton Woods was more flexible than the gold standard but the premise was the same: trade imbalances led to flows across national borders of gold, or more usually dollars, and this forced domestic adjustment.

The breakdown of Bretton Woods, following Richard Nixon's decision to suspend convertibility of dollars into gold, means there is no longer an adjustment mechanism. The US has permitted itself to run bigger and bigger trade deficits, a cumulative $3bn since the early 1970s, financing them by printing more dollars. The fact that the dollar has traditionally been the world's reserve currency of choice has helped, because central banks in other countries have seen little point in sticking their stash of US currency in a bank vault but instead have sought to get a return on them by investing in American assets.

As Richard Duncan points out in his book, the Dollar Crisis (Wiley), the result of this has been to create a reservoir of global liquidity, growing bigger and bigger all the time. The extra liquidity sloshing around in the global financial system lay behind the explosion of credit, not only in those countries running trade surpluses but in the US as well, because that was where the creditor countries reinvested their dollars. This is obviously a far cry from the gold standard-Bretton Woods mechanisms.

Inherent flaws

"The current international monetary system has three inherent flaws that will eventually cause it to collapse in crisis," Duncan says. "First, it allows certain countries to sustain large current account or capital and financial account surpluses over long periods, but it causes those countries to experience extraordinary economic boom and bust cycles that wreck their banks and undermine the fiscal health of their governments." Here, he means countries like Japan in the 1980s and Thailand in the 1990s. "Its second flaw is that this system has made the wellbeing of the global economy dependent on a steady acceleration in the indebtedness of the United States." At some point this will have to stop.

"The third flaw is that it generates deflation." Why? Because the credit bubble has encouraged over-investment in just about every global industry, which has created an imbalance of supply over demand, bearing down on prices. The upshot was the dotcom bubble and its collapse. The remedy of global authorities has to be pump in more liquidity, thereby inflating new bubbles in the US in house prices, mortgage refinancing and bonds. One way of looking at this is that Alan Greenspan has learned from the 1930s and is determined that easy money is a vaccination for depressions. The other is that pumping up liquidity is like handing an alcoholic a bottle of whisky.

The American analyst, Kurt Richebächer, says the authorities are looking in the wrong place for the cause of the problem. "For the first time ever in the postwar period, many countries around the world, not only in America, are experiencing a prolonged economic downturn in the absence of any monetary tightening. In essence, there must be causes other than the credit crunch. Nobody questions the need for action. But it should be clear that easy money can only be the cure for tight money, not for any other causes depressing the economy. For us, the real and disturbing story about the US economy is that with all its imbalances it has reached the stage where it requires permanent, massive monetary and fiscal stimulus to garner just a tepid economic response - and to prevent the bubbles from deflating."

This is certainly true. The interesting thing about the easing of policy in the past three years is how ineffectual it has been. Between 2000 and 2002, the federal budget moved from a surplus of $295bn into a deficit of $257bn, and is heading towards a $500bn shortfall in 2003. During the same two years, credit expanded by $4.4 trillion. "And what was the effect of this credit and debt deluge on the economy?" he asks. "GDP grew in real terms by $248bn and in nominal terms by $621bn. To us, this is an outright policy disaster."

The dangers should be obvious. The dollar might act as a gradual adjustment mechanism but is more likely to come down with a crash. US consumers could decide to tighten their belts rather than face savage retrenchment if they continue on their rake's progress. But the chances are they will not, and that a plunging dollar will spread America's recession to the rest of the world. There is no global financial system worthy of the name, merely a Potemkin village. Could this be the big one? You bet.

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