Bill Robinson: Japan can rebalance our economic yin and yang

Two years ago the hot topic for macro economists was the so-called imbalance in the world economy: the large payments deficit of the US, the strength of the dollar and the weakness of the euro. A year ago the focus was on the dot-com share price boom and its implications for the real economy. Today, of course, the questions concern the likely length and depth of the US recession and its effect on the world economy, including that of the UK.

Two years ago the hot topic for macro economists was the so-called imbalance in the world economy: the large payments deficit of the US, the strength of the dollar and the weakness of the euro. A year ago the focus was on the dot-com share price boom and its implications for the real economy. Today, of course, the questions concern the likely length and depth of the US recession and its effect on the world economy, including that of the UK.

These issues are linked. The effect of the US recession will depend on the policy responses of the major players, which in turn will depend on how the recession affects the imbalances. To answer that, we have to understand what caused them in the first place.

The story starts with the extraordinary growth performance of the US economy in the late 1990s. America boomed because there were exciting new opportunities in the telecoms, media and technology sectors. This led to rapid growth in business investment and great excitement on the stock market about the value created by this investment. The rise in share prices meant that ordinary share-owning Americans felt wealthier and more confident about the future. As a result, they chose to save less.

It was this conjunction of an increase in investment and a fall in savings that created the US payments deficit. Americans were not prepared to forgo consumption in order to make additional resources available for investment. But foreigners, notably the Japanese, were. Indeed, their willingness to invest in the US boom was greater than the investment finance required by companies. The surplus went to households. Americans borrowed to consume as well as to invest. And the willing inflow of capital from abroad kept the dollar strong, despite the large and growing current account deficit.

That precarious equilibrium has now been disturbed. The dot-com bust is the symbol of a much wider problem. Investors wonder if the pay-off from all the investment opportunities so enthusiastically pursued in the upswing will be as great as expected. The stream of disappointing results from major US corporations, which started late last year, suggests that they will not be. This, then, is a classic recession based on disappointed expectations. The US downturn reflects a fall in domestic demand caused by the collapse of both consumer and business confidence.

What are the implications for those imbalances, and hence for policy? The fall in US demand for goods and services, many of them imported, will reduce the current account deficit. But it could be reduced much faster if the US resources no longer going into consumption and investment were now diverted into exports. That would minimise the job losses that always follow a downturn in demand. It would mean that as Americans consume less, the Japanese and the Europeans consume more.

There are two ways of inducing the rest of the world to buy more US goods. One is to increase demand worldwide. The other is to make the goods cheaper. The Bush administration is pursuing the first option. That is why it wants the European Central Bank to match the interest rate cuts made by the US Federal Reserve.

The policy does not look too promising. The UK, also running a sizeable current account deficit, has now had two quarters of surprisingly slow growth. Japan, dogged by debt deflation, shows little sign of emerging from the doldrums. And continental Europe is concerned to keep inflation under control and avoid US-style boom and bust.

A much better policy would be to engineer a rise in the euro against both the yen and dollar. A stronger euro would both address the ECB's inflation concerns and, by boosting US and Japanese exports, help to lift two weak economies.

The US interest rate cuts should help to pull the dollar down, as will the weaker US stock market. So US monetary policy is pointing in the right direction. But so is the ECB. High European interest rates will also help undermine the dollar. Lecturing the ECB on the need for cuts is counterproductive.

The US authorities would do better to spend their time talking to the Japanese, on whom much depends. If Japan Inc could be encouraged to invest its surpluses in Europe rather than the US, the euro would rise and the dollar would fall. This would do a lot to rebalance the world economy and minimise the impact of the US recession on the rest of us. You cannot expect any government to talk its currency down in public. But a quiet word in private between the new Bush administration and the new Koizumi administration might do wonders.

* Dr Bill Robinson is head UK business economist in corporate finance and recovery at PricewaterhouseCoopers