It’s the American Economy Stupid!
By Satyajit Das
There are fundamental economic, financial, political, military and social reasons to doubt that America’s central role in the world is ending.
In a 2011 article, Michael Beckley, a former Research Fellow in the International Security Program at Harvard Kennedy School’s Belfer Centre for Science and International Affairs, concluded that, based on economic, technological and military indicators, far from declining in relative terms America was wealthier, more innovative and more militarily powerful compared to China than it was in 1991.
The US economy remains by some distance the world’s largest. It’s GDP (Gross Domestic Product) at US$ 15-16 trillion is around 25% of the global economy and almost twice that of the second place China.
Americans on a per capita basis, remain relatively wealthy. GDP per capita is around US$50,000. In comparison, China’s GDP per capita is around US$5,000-6,000.
American households have substantial net worth in excess of US$70 trillion, although down from a peak of over US$80 trillion before the financial crisis.
While the global financial crisis has damaged America’s economic power, its position remains superior to many other countries.
Financial market traders believe that: “if you are going to panic, panic first”. America benefitted from first mover advantages during the crisis.
Its problems, which emerged in 2006/ 2007, related primarily to US$1 trillion of sub-standard mortgages (about 10% of the total American mortgage market). While there were flow-on effects, the scale was smaller than say the current sovereign debt problem in Europe.
American policymakers, unlike their counterparts, moved aggressively to recapitalise financial institutions to reduce the risk of contagion. Large government budget deficits and specific industry programs (for the motor car industry) helped prop of demand, reducing the effects of the financial problems on the real economy. While the appropriateness of specific measures is debated, the policy helped ensure that problems were minimised.
The US economy is now growing, albeit modestly. While well below trend and theoretical potential, the growth rate is above that in most developed countries. Jobs are being created slowly although unemployment and under employment remains at unacceptably high levels. Housing prices, having fallen by about 35% on average, have stabilised.
On a comparative basis, even America’s debt statistics are better. Total debt (government, corporate and household) has fallen to about 330% of GDP from its peak of 359% in 2008. Public debt levels have risen sharply, in part because of the crisis. But households and corporations are gradually reducing their level of borrowings. While still high in absolute and historical terms, the debt levels compare favourably to other developed countries.
Government net debt at around 84% of GDP is higher than Germany (58%) but well below that of weaker European nations. Household gross debt (86% of GDP) is higher than many countries. But US household net debt (gross household net debt adjusted for financial assets and liabilities) is negative 235% of GDP, that is financial assets are greater than liabilities. This is better than most nations and only less than Japan amongst developed countries. Corporate net debt (83% of GDP) is in the middle of the range of comparable economies.
Financial institution debt (88% of GDP) is lower than all developed countries except Canada. Banks have decreased leverage, having been forced to aggressively deleverage by selling off assets and raising capital. Banks also have only modest exposure to sovereign debt (8% of GDP) compared to banks in Europe (13-35%) or Japan (83%).
America is also less vulnerable to external shocks than comparable economies. US gross external liabilities (161% of GDP) are lower than most developed countries. US net external liabilities (amount owed to foreigners adjusted for a country’s international investment position) are a manageable 26% of GDP. It ranks behind Belgium (negative 65%), Japan (negative 57%), Germany (negative 38%), UK (8%), Canada (12%), France (16%) and Italy (24%).
America has emerged as the “cleanest of the dirty shirts” of the developed economies.
The Beauty of American (Economic) Weapons
American economic resilience is based on its superior financial armaments.
The US central bank’s ability to use quantitative easing (“QE”)) to monetise its debt gives it flexibility to deal with its problems. Japan, UK and Switzerland and Japan, although not the Euro-Zone, have similar options. But the US dollar’s share of world trade and investment is extraordinary and out of proportion to its economic role, giving American policy makers greater options.
The dollar remains the principal currency for invoicing and settling trade. Around 85% of foreign exchange transactions involve the dollar. 50% of stock of international securities is denominated in US dollars. Central banks hold 50-60% of their foreign exchange reserves in dollars. This is despite the fact that the US’s share of global exports is only 13% and foreign direct investment is 20%.
Central to the US economic strategy has been zero interest rates and (to date) three rounds of QE. While its efficacy in boosting real economic activity is debatable, QE has helped finance US budget deficit. The US Federal Reserve currently purchases around 60-70% of all US government bonds. It does this by directly buying bonds or indirectly by injecting reserves into the banking system which is then invested in Treasuries.
Low interest rates and QE have also helped reduce the value of the US dollar. Despite bouts of dollar buying on its safe haven status, the US dollar has significantly weakened. On a trade weighted basis, the US dollar has lost around 20% against major currencies since 2009. The US dollar has lost around 30% against the Swiss Franc, 25% against the Canadian dollar, 35% against the Australian dollar and 20% against the Singapore dollar over the same period.
The weaker dollar enhances America’s competitive position. The devaluation is a de facto cut in costs, helping to drive export and economic growth.
The weaker US dollar improves America’s external position. US foreign investments and overseas income gain in value.
The major benefit relates to debt owned by foreigners. Foreigner investors, China, Japan and “others”, principally oil exporting nations, Asian central banks or sovereign wealth funds, hold about 35% to 40% of America’s US$16 trillion in government debt. As almost of US government debt is denominated in dollars, devaluation reduces the value of its outstanding debt, making it easier for the US to service its debt.
A weakening dollar should logically discourage further foreign investment in US debt. But the position of the US dollar as the pre-dominant reserve currency has a perverse effect, ensuring the ability of America to find investors in US treasury securities.
The relative credit quality of the US, the unparalleled size and liquidity of its government bond market ensures investor support. Given its reserve currency and safe haven status, US dollars and government bonds remains a cornerstone of investment portfolios of foreign lenders, especially central banks with large foreign exchange reserves.
Investors must keep buying dollars and reinvesting in dollar denominated US government bonds to avoid realising currency losses on their existing investments. Foreign central banks must also purchase dollars to avoid even more rapid appreciation of their own currencies. In effect, devaluation forces existing investors to double down to lower their average cost of US dollars and US government debt.
America’s financial strategy entails lowering the value of its currency and decreasing the wealth of foreign investors to improve its competitive position.
Foreign investors, including China and Japan which have around US$2 trillion invested in US government bonds, face a significant loss of their national savings. Between 2008 and 2012, the depreciation in the US dollar resulted in a loss of over US$600 billion for foreign creditors.
America risks financial retaliation. Other countries may undertake their own QE programs or take other steps to offset American actions. With US policy makers contemplating a phased reduction in monetary accommodation, a high US dollar may undermine the strategy.
At the moment, the US is gambling that its economic recovery is sufficiently self-sustaining to withstand these pressures. In any case, interest rates remain low and fiscal policy loose. Policy makers also have the option of slowing the reduction in QE programs.
The US is less reliant on the world than the world is on the US.
America’s economy is focused on its substantial domestic market. It is less exposed to trade (around 15% of GDP) than other large economies. Reliance on trade is lower if trading with Canada and Mexico under the North American Free Trade Agreement (“NAFTA”) is excluded.
The US remains a major food producer with agriculture being a major industry. It is a net exporter of food, controlling almost half of world grain exports.
It is also rich in mineral resources. Historically dependent on oil imports which constitute a substantial part of its $600 billion trade deficit, the US is seeking to cut imports and increase its energy independence through increased production of shale gas and oil.
In its 2012 World Energy Outlook, the International Energy Agency forecast that the US could become self-sufficient in energy by 2035. This dramatic reversal is based on new technology which has enabled America to access oil and natural gas, especially shale gas, from previously geological formations that were previously inaccessible.
US oil output has risen 25% and is forecast to increase an additional 30%, to 11.1 million barrels per day by 2020. In combination with energy conservation measures, increased production has reduced US petroleum imports to around 40% of total consumption from 60% in 2005. American shale gas production has increased over 35% of total natural gas production from 2% in 2012.
The forecasts are probably overly optimistic. Current high levels of US oil and natural gas production rely on high oil prices to make high cost domestic sources competitive. Rapid growth of shale gas extraction is a function of massive speculative financial investment in the sector, which is unsustainable at lower gas prices resulting from the current oversupply. There remains considerable uncertainty about depletion rates of shale gas reservoirs, environmental consequences and the true level of reserves.
While US energy independence is not likely in the near term, increase in domestic energy production and reduction in imports provides America with a significant competitive advantage and reduces its reliance on foreign suppliers.
The increase in domestic gas production has also reduced prices significantly. US gas prices are 50% to 70% below prices in other countries. US gas prices were around US$4 to US$5 per million BTUs (British Thermal Units), compared to around US$9 in Europe and US$17 in Japan. If continued, this will provide America with lower cost electricity and fuel for industry as well as low cost feedstock for many industrial processes.
American dominance of key industries makes it an indispensable monopolist, ensuring demand for many of its products. In technology and software, pharmaceuticals, complex manufactured products (aerospace, defence hardware, heavy machinery), entertainment and services, the difficulty in finding substitute suppliers or high switching costs limits potential loss of markets for American products.
A weaker dollar also reduces the cost base of domestic production encouraging a shift of production, manufacturing and assembly work back into the US. Based on changes in the value of the currency adjusted for wage rises and inflation, the dollar has devalued by 35% over the last decade. Combined with lower energy costs if sustained, this may encourage the nascent trend of Re-shoring, relocating offshore production back to America.
This should assist in creating the jobs needed to reduce unemployment. Stronger growth and lower unemployment will assist in reducing the large US budget deficit and addressing its public finances.
In an advertisement for Chrysler cars shown during the US Super Bowl in 2011 to the largest television audience in US history, an aging Clint Eastwood gruffly states: “it’s half time, America. And our second half is about to begin”. It was an interesting riposte to the advocates of an Asian or Chinese century. The game certainly isn’t over!