In the global economic circus, the pre-Budget report is no more than a vaguely interesting sideshow. The really big entertainments are to be found elsewhere. And the Chancellor knows it. In his speech on Thursday, he stated that: "All policy makers will keep a close eye on continuing risks from global trade imbalances, exchange rate movements and an uneven world recovery." He's right to worry because, the very next day, those risks came to the fore once again.
The US economy may be growing, but it doesn't seem to be able to generate much in the way of new jobs. Although there are countless arguments about the best measure of US employment, the truth is that, on Friday, the payrolls report was a lot softer than expected. November's increase amounted to a paltry 112,000, more or less half market expectations and a lot weaker than October's gain of 303,000 (which, in turn, had been revised down from an earlier estimate of 337,000.) President Bush's first term in office truly has been a dismal time for US job creation, the worst record, in fact, since the 1930s.
How did the markets take this rather bad news? The knee-jerk reaction was to sell the dollar and to buy US Treasuries. The dollar continued its recent rapid descent against the euro, heading down to $1.345, its lowest level since the euro first arrived in 1999. The dollar also got rather closer to the magic $2.00 level against sterling. The bond markets rallied, based on hopes that the Fed wouldn't be quite so aggressive in raising short-term interest rates in the months ahead and, perhaps, because the payrolls report showed an unexpected easing in wage inflation pressures.
The main problem with all of this, though, is that the markets themselves don't seem to be sure about what they would like to see. Strong US jobs growth has been the missing link in the US recovery to date. Yet strong jobs growth implies higher household incomes. Those rising incomes, in turn, point to more spending, more imports and, hence, a bigger and bigger balance of payments deficit.
Only a few weeks ago, though, Alan Greenspan warned of the dangers associated with a continually widening US current account deficit, saying that the US couldn't continually increase its liabilities to foreigners. And, for this to stop, a minimum requirement would seem to be weaker US domestic demand growth, thereby limiting America's apparently insatiable demand for imports from the rest of the world. So, on this basis, weaker jobs growth might seem to be a rather encouraging sign. Fewer jobs means lower demand which, in turn, means lower imports and, hence, a smaller current account deficit.
Yet it is difficult to see US policymakers immediately embracing this view. They might recognise that, eventually, the US current account deficit has to be brought under control but, ideally, they don't want it to be brought under control through a lack of domestic demand and, hence, a lack of jobs. John Snow, the US Treasury Secretary, repeatedly says that the US current account deficit is a global problem, not a specifically US responsibility, implying that he'd rather see stronger demand elsewhere than weaker demand in the US itself.
But what if this stronger demand elsewhere doesn't materialise? Does that mean that the US has to restrict domestic demand? Not necessarily, unless either the markets or foreign policymakers force a change on US policymakers. After all, the balance of payments deficit has been getting bigger now for so many years and, until recently, there's not really been any serious risk of a funding crisis. But it might be wise to start thinking seriously about this option.
There are only so many ways of dealing with the US current account deficit over the medium term. Either foreign demand has to rise (the Snow option), US domestic demand has to slow (the frugal European Central Bank view) or the dollar has to fall (increasingly, perhaps, the markets' view). And, as I argued in this column two weeks ago, the longer the problem is allowed to fester, the worse the situation gets. So long as the US remains in heavy balance of payments deficit, the bigger its foreign liabilities become. To keep its foreign creditors happy, it will increasingly have to send interest income and profits to those foreign creditors, driving the deficit up to even higher levels. This is a highly unstable situation, reminiscent of the worst emerging market crises.
If policymakers aren't prepared to change, the market will eventually find its own solution. The problem, though, is that the market solution may not be quite what policymakers would like to see. The three alternatives - US demand slowdown, foreign demand recovery, weaker dollar - are often seen as mutually exclusive. They most definitely are not. How far does the dollar have to fall to bring the current account deficit back down to something that's more sustainable over the medium term? Maybe to $1.60 against the euro, or ¥80. And these numbers will be right only if the foreign exchange market adjustment is immediate. The longer the process of adjustment is delayed, the further the dollar would have to fall.
But if the markets know this, they're not going to be particularly enthusiastic about owning any US assets that offer no obvious hedge against dollar weakness. Before Friday's very soft payrolls, the US bond market had been selling off in a rather worrying fashion. Yields had jumped by around 0.4 per cent from the earlier low point, seemingly driven not by worries about tighter monetary policy but, rather, by concerns about the weakness of the dollar.
A period of dollar weakness no doubt would help US exporters but there's no guarantee that the domestic US economy would be left immune. To fund the US current account deficit, the US needs to persuade the rest of the world to buy more and more US assets. But if the US economy now suffers from the depreciation rates associated more with a Vauxhall Omega than a BMW 3 series, it's difficult to see why demand for US assets is going to remain as robust as it once was.
This, in turn, suggests that part of the mechanism to correct the US balance of payments deficit will have to come from a squeeze on US demand. The question for policymakers is who, exactly, should be doing the squeezing. Falls in asset prices leading to negative wealth effects and a higher cost of capital are hardly going to be good news and certainly won't fall equitably across US citizens. A better bet, surely, would be for the US Administration to take responsibility for the problem, tightening fiscal policy and, hence, reducing domestic demand growth in a controlled fashion.
Of course, tightening fiscal policy doesn't always win votes. But, unless it happens soon, the US could end up in a lot more trouble. Far better to act now than to wait, because waiting will only make the scale of the problem a lot worse. The price might be ongoing weakness in the US labour market over the months and quarters ahead, but surely a period of only modest jobs growth is a price that's worth paying to avoid the meltdown scenario that a market-imposed solution might eventually lead to.
Stephen King is managing director of economics at HSBCReuse content