Bernanke Maps The Future

In a speech given yesterday Ben Bernanke gave us a few hints about the future of the world economy. Unfortunately most of his commentary is similar to speeches given throughout the years by other American officials.

The main story line deals with ‘imbalances’. This is central banker speak for the really big deficits or surpluses that haunt the global stage and are viewed as primary causes of much of the current trouble.In particular are the various trade balances between the US and its main trading partners, and the seemingly unending Chinese surplus that is a source of destabilizing capital flow.

The problem is this: the US consumes too much and does not save. It therefore has to borrow money from other countries to maintain its standard of living – as long as standard of living is defined as GDP growth. This is an historical anomaly of huge proportions because in bygone eras the then dominant economy was always a creditor – it lent some of its surplus wealth to other countries who could then improve their economies. The US is the first dominant economy to depend on weaker or growing neighbors for its growth.

The early years of American development was largely financed by European – particularly British – capital. So as the US grew is sucked in money and ran deficits in order to build for the future. Those deficits were tolerable because they were contributing to future wealth. They could be paid off comfortably from that wealth once the economy became self-sustaining.

Right now this scenario is being played out backwards.

China, which is roughly analogous to the young America, is not sucking capital, it is exporting it. Instead of consuming its capital through domestic investment, and therefore constructing the platform for future wealth, China is content to grow more modestly and export its cash to the US. The reason is straightforward: the US is China’s largest market and therefore it is in China’s interest to have the US continue to consume and grow. Slower US growth is seen, in this scenario, as a threat to Chinese strategy.

Other Asian countries are doing the same thing: they are relying on the US to keep going deeper into debt in order to prop up its consumption habit.

All these trading partners of the US are implicitly suppressing their own domestic demand and are relying on growth abroad to provide an engine for their own growth. This is one reason why the American implosion last year ricocheted so quickly around the world economy: it wasn’t simply that the US financial system crippled the world, it was that the subsequent US contraction in demand left Asian suppliers with an overhang of unused production.

The flip side of this dependence is, of course, that the US is able to run huge deficits with comparative impunity: foreigners are more than willing to pour capital into the US in the belief it is the safest place to invest. Unfortunately this allows the US to avoid confronting its own issues, notably its rapidly deteriorating competitive position and its long run loss of advantage with respect to innovation, education, and other aspects of economic infrastructure. This is why I call the economy at present an ‘illusion’: it looks as if it is healthy, but underneath it is compiling problems and debts at a prodigious rate.

These imbalances have been around for decades: the US shifted into debtor status and a dependency on foreign capital in the Reagan years, but it took the emergence of China and other Asian economies to bring the issue to a head.

The flood of capital flowing onto the world market from the trade surplus countries was a primary cause of the financial bust in the US. Money from China, Japan, Germany, and Asia generally swamped the US economy, drove down interest rates here, facilitated persistent Federal deficits, and ended up being channeled into things like the sub-prime market because there was a lack of sensible investment opportunities here: our manufacturing sector has migrated abroad.

This is odd because in a high wage economy like the US it is normal to see a constant attempt by capitalists to substitute capital – which is relatively cheap – for expensive labor. This constant substitution should drive productivity higher and thence allow the retention of those high labor costs. It was exactly this effect that drove the emergence of the Industrial revolution in the early 1800’s – British wages were much higher than anywhere else, so capitalists were driven to invent automated ways to perform production tasks, the result being a virtuous cycle of higher productivity followed by yet higher wages and thus a new impulse to innovate.

The problem we have had is that our industry has simply off-shored to lower wage nations rather than innovate or invest. So the virtuous cycle was more muted here than it ought to have been. That has allowed the steady erosion of competitiveness and, more recently, threatened US wages. Instead of inventing its way to a higher wage scenario the US has accepted the need to lower, relatively speaking, wages here.

This means that the inflow of capital caused by our constant deficits and our debtor status has been used to support consumption rather than investment – it has not been turned into expanded future wealth opportunities at all.

This unfortunate trend has been noted for years by a succession of American and foreign experts, but there was never the predicted crisis to bring to a head the needed international reforms. In particular thee was never the will to deal with the American deficits – American consumers grew attached to spending what they didn’t earn. On the contrary during the Bush years concerns about deficits were dismissed as the silly whining of old fashioned analysts, and the American ability to keep growing its debt was seen as a virtue – it spoke to the romantic, but not economic, notion that there was nowhere safer than America to invest. That the rest of the world was apparently to keep on plowing cash into the maw of American consumption was, from the Bush administration’s view confirmation of American superiority rather than a symptom of long term degradation. Foreigners went along with the ruse as long as they could extract good returns, and besides, the Us is the world’s largest economy – where else could they invest?

This charade is now teetering on the edge. Foreign countries like China make periodic references to the massive amounts of dollars they now own, and to the inevitable risks that position entails. There is even talk of ending the dollar’s role as a reserve currency due to its over abundance o world markets.

This is where Bernanke steps in: he is simply stating the obvious. The US will have to start to consume less as a proportion of its total GDP. That means it will import less and will want to export more. The problem then becomes what to do about those foreign export dependent economies? How do we get the Japanese, Chinese and Germans to consume more and rely less on America for sales of their goods? The answer is clear, and Bernanke lays it out in plain terms: they have to shift their domestic economic policies towards encouraging spending and placing less emphasis on saving.

That is all easier said than done.

Shifting Americans from their obsession with acquiring ever more stuff, or getting Germans to save less and spend more, will require heavy lifting.

Here in the US we also have to get to grips with our Federal deficit which will require us to raise taxes and to face difficult spending cuts: in particular we are likely to have to confront our defense bill, which in turn, implies a re-evaluation of our role in the world. It is nice to have a huge military presence with which to bully the world, but the long term cost should not be the hollowing out of the domestic economy and the loss of our standard of living.

Likewise, the American system of entitlements needs to be tightened up and made more cost effective. This is the major impulse underlying my support of health care reform: those dollars need to be allocated towards future wealth generation and not simply consumed on today’s generations health issues.

That Bernanke spoke about all of this is symptomatic of the concerns in Washington that the US is finally wearing out its welcome as a debtor. We will be reliant upon the inward flow of capital for many more years as we re-tool our economy to produce more domestically. So we cannot be precipitous in our actions: quick movements in the dollar could undermine confidence in the US economy and threaten that flow of cash. Likewise a continuation of the Bush era indifference to deficits is also destructive: that too would imply a devaluation of the dollar and thence could cause the same ill effects.

So Bernanke needs to keep reminding the world of our determination to get our house in order, and our understanding that the Reagan/Bush era’s dependence on debt will end. Given the short term explosion in the Federal deficit this is doubly true.

But he also needs to communicate that we will not be shifting to a more conservative, and therefore anti-Reagan/Bush, fiscal policy too soon: we need to get past the crisis first.

Which explains the fact he keeps on turning up saying the same thing and then ignoring his own advice when he gets back to his desk.

This is all about positioning and preparation. So that map he keeps showing us is one for the future – let’s say 2011 and 2012 – rather than right now.