Why democrats can sleep at night

International Economy, The, Fall, 2004

Republicans, giddy and gloating, are understandably proud of the outcome of the November election. Democrats living between Boston and the District of Columbia are on a 24-hour suicide watch. Yet lest the GOP euphoria get out of hand, consider the fact that the next four years could be challenging in ways never imagined. No, I'm not talking just about enacting the President's domestic agenda, filling court vacancies, or democratizing Iraq. The far greater challenge may come in mastering the global economic Rubik's Cube in a world dramatically more financially integrated than even when the President's father was in office. No surprise event, sudden imbalance, or price shock occurs anymore in a vacuum. Worse, a lot of the reliable solutions may no longer suffice. Even the experts themselves often are in dispute.

Begin with the price of oil. Some optimistic experts suggest a return to the high $20 level, but even more make a case for why oil could jump to $60 and stay there. Philip Verleger, an important expert at the Institute for International Economics, thinks so (p. 22) but ominously goes further: "The situation ... today bears a remarkable similarity to the one observed in the late 1960s."

While $60 oil ain't beanbag from a U.S. standpoint, it would be devastating for China, probably collapsing its banking system. And why is that important to America and thus the world? The U.S. budget deficit is large and its current account imbalance, according to the Federal Reserve, will soon approach 6.5 percent of GDP. David Hale (p. 16) argues that the newest source of funding for this imbalance--in other words, the funding that helps keep U.S. interest rates low--is commodity-producing countries that have benefitted from the impact of China's economic boom on their export prices. In any event, the future of the U.S. dollar and exchange rate stability throughout the G7 could depend on the longevity of the Chinese boom.

Again, some experts see China booming for as far as the eye can see. Yet a growing number are beginning to predict trouble ahead, starting with the failure of Chinese consumption in recent years to underpin overall growth. Is a Chinese investment-led bubble about to burst, producing an economy soon in the midst of a boom-bust cycle? Japanese analysts, including Tadashi Nakamae (p. 10), are already writing that the Chinese economy today is reminiscent of the fragile Japanese economy in 1973. Pippa Malmgren (p. 20) writes about the latest industry in China--getting the money of elites out, often in suitcases. What do they know that we don't know?

And as for those bloated U.S. current account deficits, why are interest rates still so low, which runs counter to all traditional economic thinking? More specifically, why did the long-term bond market rally each time as the Fed began raising short-term rates the past six months, something that hasn't happened since the 1960s? The Fed offers positive spin--that the market is simply convinced of the central bank's inflation-fighting credibility. IMF experts suggest that because of aging U.S. demographics, pension funds are merely engaged in a long-term shift from equities to bonds.

The most troubling explanation comes from the Japanese. Some analysts such as Richard Koo (p. 28) argue the U.S. experience since the information technology bubble burst in 2001 bears a remarkable resemblance to Japan's frustrating experience in the 1990s. U.S. interest rates remain low and monetary policy relatively ineffective, they say, because corporate demand for debt has come to a standstill. Koo calls this the "corporate debt rejection syndrome." Addressing U.S. budget deficits, he argues that in light of America's cautious corporate sector now in surplus, thank God for the public borrowing. Such thinking of course runs counter to the global consensus view, which is why it is so troubling.

Not worried yet? Consider the scenario offered by Roger Kubarych (p. 32) of a coming U.S. private pension crisis which could wreck the auto industry. Or try this on for size: Remember the scare of a decade ago over the dangers of financial derivatives? Measured at the end of the first quarter of 2004, according to Christopher Whalen (p. 51), derivatives held by U.S. commercial banks rose to $76.5 trillion--a stiff 21.2 percent jump in the past year alone!

Then there's what the American Enterprise Institute's Michael Ledeen (p. 76) describes in crisis management as "the old reliable: human stupidity." One foolhardy move by an important government or a mega corporation, or global hackers suddenly successful in gumming up the financial system, and George W. Bush could really have his hands full. Fiddling with the Rubik's Cube, the effects could quickly fan out worldwide.

This is why Republicans need to balance their post-election gloating and glee with a dash of humility. It's a dangerous world out there. Bad things happen and it's in the interest of a lot of people globally to see George Bush fall flat on his face.