Stephen King: EM Forster and the American paradox

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The Independent Online

"Only connect" is a recommendation familiar to anyone who's read EM Forster's Howard's End.

The novel deals with the mix between the commercial and the cultural through the trials and tribulations of the Shlegels (intellectuals), Wilcoxes (the Edwardian equivalent of private equity investors) and Basts (with ideas supposedly above their station). "Only connect" could also, though, be a recommendation for any budding economist. When financial markets are all over the place – as they have been over the past few months – connections become ever more important.

The problem lies with the apparent paradoxes that prevent connections from being successfully made.

The US trade deficit has been shrinking for some time. Policymakers have been worried about so-called global imbalances for many years, so on the face of it the shrinking deficit seems like good news. Yet far from rallying, the dollar continues to tumble.

Newspapers are full of talk about a coming US recession, but the data mostly continue to impress. Jobs continue to be created in the US economy even though the housing market has been in freefall for two years. The economy posted a 3.9 per cent annualised gain in the third quarter, the biggest quarterly increase since the beginning of 2006.

Although the Monetary Policy Committee refused to pull the trigger last week, investors mostly expect the next move in the UK's bank rate to be down. Yet sterling continues to surge ahead against the dollar. It's also holding its own against the euro, even though Jean-Claude Trichet indicated last week that the European Central Bank has no intention of cutting its key interest rates.

Meanwhile, oil prices threatened to pass through $100 per barrel last week, despite the doom in the banking sector and fears of a US recession. The relentless upward path for oil prices, alongside gold, metals and food prices, tells us both that the dollar is very weak (raw materials are typically priced in dollars) and that the global economy is still buoyant, despite ongoing fears of a credit crunch.

Making sense of these apparent paradoxes is not easy. Other things equal, an improving US trade deficit should lead to a stronger dollar. The credit crunch should be delivering weaker US economic activity. Faced with falling house prices, sterling should be under downward pressure as the Bank of England braces itself for an interest rate cut. And oil prices really ought to be a bit lower.

So why have we ended up with such strange results?

Let's deal with the dollar first. After all those years of worry about widening global imbalances, it really is a bit of a surprise that the dollar is so weak given the narrowing deficit. The obvious reason is that the Federal Reserve is cutting interest rates whereas other central banks have steadfastly refused to do so.

Beyond this, though, other factors are at work. In the four years to 2006 – before the recent improvement – the US current account deficit has increased by around $400bn. The vast bulk of this increase was funded through the sale of increasing amounts of asset-backed securities, many of which were ultimately linked to the US housing market and its various sub-prime customers. These asset-backed securities are now treated as not much more than toxic waste.

Put another way, the rest of the world has pulled the plug on funding the US current account deficit. If the dollar is to rise, the deficit has to shrink faster than the fall-off in demand for asset-backed securities, other things equal. So far, that's manifestly not happening. The current account deficit may be improving, but it is not improving fast enough to prevent the dollar from falling.

The strength of US economic data is an encouraging sign, but may say little about the months ahead. When there's a financial shock – whether it be a stock market decline or a banking crisis – the economic data tell you only what has already happened, not what is about to happen. At times of stress, looking at the economic data alone is a bit like looking only in the rear view mirror when driving a car.

A better bet – although by no means reliable – is to look carefully at survey evidence, notably those surveys that directly tell you something about the problem at hand.

Last week, the Federal Reserve published its latest Senior Loan Officers' Survey. Admittedly, this doesn't sound like riveting reading, but the messages contained within are more than interesting. Not surprisingly, US banks have suddenly revealed a conservative streak. Over the past three months, it has become a lot more difficult to get a mortgage on reasonable terms. Commercial realestate companies no longer have easy access to credit. And while commercial and industrial companies aren't being turned away, banks are, nevertheless, demanding much higher interest payments from their corporate customers.

Sterling's rise against the dollar is not so difficult to explain in a broader European context. Sterling has been closely tied to the euro for a number of years, so sterling's strength is really more a story about dollar weakness. The Canadian and Australian dollars are also remarkably strong, and many emerging market currencies are struggling to break free from their policymakers' shackles. However, to assume that sterling will continue to rise may be a mistake. After all, the UK has a housing market which looks a bit like America's circa 2005, which is all a bit worrying.

As for higher oil prices, they're very much a reflection of ongoing economic strength in the emerging world. The latest country to issue an "overheating warning" is China. Last week, the People's Bank of China declared in its third-quarter economic update that the economy was growing too vigorously. Inflation, meanwhile, was rising uncomfortably quickly. This, in turn, means that the rest of us may have to pay more and more for access to the world's raw materials.

So how might we connect all these things together? The answer, I think, lies with the excess liquidity that became a hallmark of economic progress in the first half of the decade. Excess liquidity came from a number of different sources – low US interest rates after the stock market collapse, substantial increases in emerging market central bank foreign exchange reserves, financial innovations associated with structured products and securitisation. This excess liquidity, previously invested in an overheated US housing market, is now fast disappearing, in the form of a US housing collapse, falling bank share prices and the growing threat of recession. In coming months, the connections will become clearer. Sadly, as they do so, we will all be increasingly affected, whether we're Shlegels, Wilcoxes or Basts.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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