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Samuel Brittan: Watch the dollar, not the euro
Financial Times, October 12 2000

The biggest flaw in the world economy is the US current account deficit, which could place a strain on the currency

Distance in time and space lends a little perspective. When I first began to discuss the high level of Wall Street (Viewpoint, May 13, 1999), the most widespread concerns related to the earnings and dividend yields, which seemed to be historically low even if allowance was made for the growth possibilities of the "new economy".

But not being a Wall Street specialist, I was personally more struck by two other factors. One was the close parallel between the behaviour of Wall Street in the 1920s - which culminated in the famous 1929 Great Crash - and in the 1990s.

My second worry was that so many Wall Street forecasts of the growth of equity earnings did not make any sense in the longer term unless one assumed either a return to double digit inflation, or a rise in profits as a proportion of the US national income so large that the resulting revolution in Washington by US workers would make Kosovo seem a haven of peace.

Since then the Nasdaq index, which the IMF describes as the benchmark for the information technology sector, has indeed had a bubble which has been punctured, although not quite burst. But if you look at the broader indices of US equity prices they climbed only slightly higher in the second half of 1999 and early 2000, and have since then been more or less on a plateau. Excluding technology, media and telecoms stocks - which account for slightly less than two fifths of the total valuation - the impression of a plateau going back to late 1998 is even more pronounced. This is in sharp contrast to 1929.

So far a hard landing has been avoided. But if US equities were too high in 1998-99, they are still too high today. While most market commentators have warned about the inflationary implications of Wall Street's behaviour, a minority of discerning commentators including Wynne Godley of Cambridge, Bill Martin of Philips & Drew and the Clare group of British economists, have worried much more about the threat of an ensuing recession if US savings recover to a normal level.

According to the official national accounts, a large private sector deficit in the US is offset partly by the government budget surplus and partly by the overseas inflow. One version of the argument is that the US private sector has been willing to spend above its income because of the wealth effect from rising equity prices and real estate values. If the asset boom comes to an end, the fear has been that savings would return to normal, and slump rather than overheating would be the problem.

The strongest response of the "don't panic" school has been that US savings are wrongly measured, because at least some element of capital gains ought to be taken into account in measuring income. I have previously been inclined to dismiss this apologia because it seemed to involve circular reasoning: savings are understated because income is understated; and income is understated because of capital gains. So the whole edifice depends on a rising level of asset prices.

What has given me pause is a study by economists at the Federal Reserve Bank of New York, who have shown that income is understated even if only realised capital gains are taken into account and not simply paper profits (Current Issues in Economics and Finance, Sept 2000). Moreover, consumption has not risen faster than wages, suggesting that the statistical reduction in savings has come from recipients of investment income.

This argument could take a long time to settle. What cannot be explained away is that the US boom has been accompanied by a widening current balance of payments deficit approaching 5 per cent of the US gross domestic product. In itself, this is not harmful. Rapid growth within specific regions of a single currency area often have produced current account deficits financed by savings from the rest of the country. That is almost certainly how London and the south east financed the expansion of the Midlands and north during the industrial revolution 200 years ago. As the philosopher David Hume observed, the 18th century was lucky not to have balance of trade statistics for regions of individual countries; and fortunately we do not have them today.

If we had a world currency - or at least an international currency widely used for trade and payments - we could forget about the US balance of payments. We would almost be able to do so if we had a tripartite agreement for currency stability involving the dollar, the yen and the euro, as a number of economists, including Robert Mundell and Ronald McKinnon have advocated.

But without such an agreement, the US payments deficit could indeed matter. It is now financed by large overseas inflows, which have been increasingly of a portfolio nature. If these were to dry up, the US would not go bankrupt, or any such nonsense, but the dollar would have to fall to a level at which it would attract a speculative inflow of short term funds. With US inflation at 3½ per cent - just within the tolerance limits even allowing for oil - the Fed would not feel able to ignore the dollar depreciation.

An exaggerated feeling of security is sometimes derived from the fact that overseas trade accounts for only a modest proportion of the US national product. But it is not only actual imports that affect the US price level, but potential imports with which domestic producers have to compete. These international linkages are not disproved by episodes of depreciation during a severe recession, such as when the UK left the Exchange Rate Mechanism in 1992 and inflation did not take off. With a much lower dollar in current boom conditions, US prices would soon start to rise faster.

The most important currency to watch is the dollar. The fall of the euro, which so preoccupies commentators, is only another way of looking at the rise of the dollar. It is true that the IMF dollar index shows a smaller dollar rise, but that is overinfluenced by the Canadian dollar and the yen.

If anything, a sharp recovery of the euro would be worrying. This is not only because it would reverse the improvement in euro zone competitiveness. The main point is that the mirror image of a sharply recovering euro is a sharply falling dollar. This is something that the US Treasury and the Fed would like as much as a hole in the head. Indeed Larry Summers, the US Treasury secretary, insisted that he was in favour of a strong dollar, even while he was being dragged into an act of intervention designed to push the US currency down.

Although the US economy has performed better than that of the euro zone, it is also more precariously balanced. This is a only a paradox if one thinks that good things go together.

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