Hamish McRae: Paulson is in for a rough ride but he has the nous to handle it

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The Independent Online

A new face is announced to head the US Treasury - a top-of-the-range one too - and what happens? The dollar plunges.

It was not the most confident of welcomes that greeted the appointment of Hank Paulson to the Treasury, less confident indeed than the response of the arguably more important appointment of Ben Bernanke to the Federal Reserve. The markets have subsequently become more concerned about the Bernanke appointment because they feel he has given conflicting signals about Fed intentions, which indeed he has. Will Mr Paulson have a surer touch?

Well, he certainly ought to. He is head of the great Goldman Sachs and the one thing that Goldman people unquestionably understand is markets. But while the two jobs interact in the sense that they hold the key levers on the US economy, they are very different in nature. It is not just that monetary policy is qualitatively different from fiscal policy, or that one appointment is apolitical while the other is intimately political. It is that the Fed has one policy instrument, short-term interest rates, over which it has a high degree of control, whereas the Treasury has many instruments, but over which it has much less control.

The Treasury is not as important, in relative terms, in the US as it is in the UK. The administration's tax and spending plans have to be negotiated through Congress and while the President proposes, Congress disposes.

Still, appointing someone of the calibre of Mr Paulson signals seriousness, seriousness in particular of making some progress towards the President's stated aim of halving the fiscal deficit by 2009. Put at its lowest, given reasonable growth, there is a fair prospect that the fiscal deficit will move on to a downward trajectory. The financial markets ought to like that. So why the adverse reaction? Why did the dollar fall?

Half the answer is that there are always two sides to every transaction and the weaker dollar was actually a stronger euro. There has been new evidence that European growth is nudging upwards, as indeed is inflation, and the European Central Bank is widely expected to increase interest rates at it next meeting, with more to come.

The other half of the answer is more complex. It is that the US fiscal deficit is not as much of a problem as is widely perceived. It can be fixed. However, correcting the current account deficit may prove even more intractable than it seems to be at the moment. So while sorting out US budgetary finances is a necessary task that will have to be done at some stage, to do so would be an insufficient condition for sorting out the country's external finances.

This is important. For several years now all of us have worried about America's twin deficits and they are indeed linked. Because US domestic savings are so low, the fiscal deficit has been largely financed by inflows of foreign funds - which of course have also financed the external deficit too. So a lot of us have argued that were the US to correct the fiscal deficit, that would also tend to correct the external one.

But the longer the US growth run has continued, the less significant the link seems to be. The fiscal deficit is no longer widening, or at least not to any significant extent, yet the external deficit is heading towards 8 per cent of GDP (first graph). Parallel to that, the country's net asset position has also deteriorated, as the US piles up foreign holdings of its assets (next graph). That is an inevitable consequence of running a deficit on that scale but of course it makes it harder to correct because these foreign debts have to be serviced and therefore make the current account even worse.

This leads one to a rather uncomfortable conclusion. The fiscal deficit is fixable but the current account one is not. Or at least the latter is so large that material correction will take a decade or more. Arguably the US does not have to balance its books because for structural reasons it can run a modest external deficit, say something akin to the UK at 2.5 per cent of GDP. But getting from 8 per cent to 2-3 per cent is an enormous gulf and it is hard to see quite how this can be brought down without grave disruption.

Yet those of us who expected some sort of correction to have started by now have been proved wrong. And the longer we have been wrong, the greater the scale of the problem.

This line of argument was well presented by the economic team at HSBC a year ago in a paper entitled The Ticking Time Bomb. Well, now the same team is wondering whether this is right. There is a line of thought that argues that the figures are wrong and the deficit cannot be as large as posted but HSBC rejects that. It argues instead that the structural problem of the US deficit is as much a structural problem of emerging market surpluses.

As noted above, markets have two sides. The surpluses being piled by the emerging markets and by Japan (next graph) demonstrate that they have an excess of savings that have, in effect, nowhere else to go. This is understandable in the case of the Middle East (next graph) because the oil surpluses are hard to deploy effectively at home. But it is less so in rapidly growing China or indeed the two developed economies with large surpluses, Germany and Japan. There must surely be some investments worth making in Germany. So why does this happen?

At first sight it might seem odd that any rich, developed country should suck in funds from poorer developing ones. That is supposed to be the wrong way round. Actually there is a simple explanation. The HSBC team argues that the US has a market advantage over much of the rest of the world, and certainly much of the developing world, as a place for savings. It is politically stable; there is rule of law; there are property rights; and there is a capital market structure that enables assets to be allocated efficiently.

Some other developed countries offer this too: that is why so much of the City of London is being bought by foreigners. But the US offers scale. Meanwhile neither Germany nor Japan offers good investment returns and the large developing countries, most obviously China, have opaque markets and sometimes capricious regulatory authorities.

So what will give? The problem for the US - indeed, a problem for the whole world - is whether it will be happy to have its assets controlled abroad. If it is just a question of bits of paper - bonds and bills - maybe that is acceptable. But once foreign interests start trying to buy Californian oil companies (China) or US ports (Dubai), the US cuts up rough. Arguably it is the fear that they will be excluded from buying real US assets, as opposed to paper ones, that has triggered the recent fall in the dollar. So the limits to the financing of the US current account may be political rather than economic.

This will be a difficult ride for Mr Paulson. On the one hand he has to maintain reasonable confidence in the dollar. On the other he would probably like it a bit lower against the euro and certainly a lot lower against Asian currencies. But the current gap is so large that dollar adjustments cannot be enough to cut it.

So the bad news is the US current account is more unbalanced than that of any large economy in history. The good news is that there will be a competent person in charge of the US Treasury.