Will the U.S. Trade Deficit Inevitably Lead to Monetary Crisis?

As C. Fred Bergsten, director of the Institute for International Economics,

sees it, the United States is next in line for a monetary meltdown.

"The clock is ticking. It’s going to hit. It could be in three months or three years," says Bergsten, who was at Wharton last month delivering the annual Robert and Anita Summers lecture in international economics.

Bergsten began by reviewing the causes of the various financial crises which have wreaked havoc in Europe, Mexico, East Asia, Russia and Brazil over the past two decades. He then predicted that an "American dollar" crisis will be next.

The problem, he says, lies with the current $400 billion trade deficit — 4% of the gross domestic product – and a net foreign debt that’s $4 trillion and growing. Bergsten believes that should U.S. inflation and interest rates rise, the dollar will drop sharply in value — not by 50% as it did in the 1980s, but very possibly by 20% to 25%.

This "softer landing" would come about, he said, because the other G7 nations [Britain, Germany, Italy, France, Canada and Japan] can be counted on to intervene to slow the dollar’s fall. "A free rise in their own currency [which would make their goods more expensive on the world market] is not wanted by others," said Bergsten. "It would undermine their own recovery."

Asked to propose a strategy that would reduce the risk of this crisis, Bergsten suggests that the U.S. "keeps money in the bank, pays down the debt, keeps our powder dry and keeps the ability to respond to unforeseen difficulties."

What he definitely would not do, he said, is adopt the tax cuts proposed by Congressional Republicans. Not only would that deplete the surplus and thus make it harder to respond quickly to a downturn, but giving tax cuts in a roaring economy would only help bring on a crisis.

When the economy fell into recession in the 1980s, the Federal Reserve cut interest rates three times in a row to revive it and that could be necessary again, he said. "When the evil day comes, we need the ability to prime the pump."

Bergsten countered his bearish outlook for the U.S. with a decidedly bullish

perspective on the world economy in general. When he began his career in international economics in 1964, he said, the annual per capita income in Korea was $60. Today, it’s $10,000. "So the world economic system must be doing something right."

The bottom line, he argued, is that despite the difficulties of recent decades, "hundreds of millions of people have been lifted out of poverty, a result unparalleled in human history." And the economies in most of the countries that experienced financial crises are now coming back.

"Eighteen months ago," said Bergsten, "Russia defaulted on its debt and Brazil was close to it. Long-Term Capital Management (the hedge fund) had gone under. Japan was in the tank for the sixth consecutive year. The outlook for the world economy couldn’t have been shakier. But today it’s a totally different ballgame. Japan is still in recession, but coming back. Europe has had 3% growth. Domestic demand growth in the U.S. is 5% for the third consecutive year. The output level in East Asia is now higher than it was when the crisis hit. Even Indonesia and Russia, the worst performers, have seen positive growth this year."

That has been so, Bergsten contended, partly because the U.S. economy has been "a growth engine for the world" and partly because the much-criticized International Monetary Fund and World Bank helped in their recovery.

"The main problem facing the world economy today," he said, "is complacency …the threat that countries which still need to work out problems in their economic structure will settle for the status quo." What we have learned from the 1980s and 1990s is that "the world economic system is crisis-prone and we still have too little ability to predict and prevent [these crises]."

Although the causes of some of the more recent crises differ from country to country, Bergsten did blame a number of macro-economic factors, including excessive deficits, currency over-evaluation and overspending (although, as the countries of East Asia have proven, you can have a crisis even if you are not guilty of any of the above).

In the East Asian crisis, Bergsten said the major culprit was "poorly functioning, flawed, faulty, even corrupt domestic banking systems." Eighty percent of the member countries of the IMF had a banking crisis in the ’80s or ’90s, including the U.S., he noted.

Bergsten ran through a litany of bad banking practices: Lax lending standards, poor monitoring of credit risks, excessive lending into "bubble" situations, heavy lending to the government or to relatives of high government officials, weak financial reporting, huge understatement of non-performing loans, inadequate accounting, inadequate bank capital, capital requirements far too low in terms of local conditions, no supervision, an absence of regulatory authority and no monitoring by investors.

This last, said Bergsten, was probably because of what’s called "moral hazard." Investors simply supposed that the banks would not be allowed to fail so they didn’t monitor them.

Still another factor, he said, was "liberalized international capital. Many emerging nations took on capital before they were ready to do. You have to follow a careful sequence before opening your doors to international capital and East Asia did it before it had the regulatory system in place to deal with it. This was accompanied by huge currency and maturity mismatches – borrowing abroad to lend locally, borrowing short term to do long-term – which were exacerbated by faulty exchange rate systems. The debt built up and then the evil day came when the money flowed out with a vengeance, bankrupting the already stressed banking systems."

In the wake of the crises, said Bergsten, there has been no shortage of remedies proposed, including holding a new Bretton Woods conference, merging the IMF and World Bank, abolishing the IMF and sharply limiting global capital flow. None of these have been implemented and it’s just as well, he said.

The challenge to economic policy makers is to find the right balance between the need for reform and going too far. Bergsten made it clear that he believes critics of the IMF and World Bank who would curtail their role and dramatically limit which countries they could aid are "going too far."

He thinks other more modest reforms now underway show more promise. One, called the G20 Initiative, brings together the key emerging nations as well as the major industrial economies in an effort to manage the global financial system.

Another, called the Financial Stability Forum, unites government treasurers, central bankers, regulators, banking system supervisors and private market operators in an effort to develop a "best practices" code for such things as accounting, trading stocks and data dissemination.

A third concerns the IMF itself. "In the past," Bergsten explained, "the IMF has consulted with member countries on their economic policy but the results have been kept secret. Now, because of pressure from Congress and elsewhere, those results will be made public. There is an IMF web site containing information on what the IMF believes to be the economic outlook for each country."

Bergsten said that more reforms are needed. Ways must be found to avoid the problem of excessive capital flow. A system must be developed in which the private sector shares the burden of working out a crisis with the public sector "to diminish the incentive of private investors to pile in without doing due diligence."

While the reforms now taking place have not been dramatic, Bergsten said, he believes that "taken together, they will substantively reduce the risk of crisis" … though not, presumably, in time to avoid the one he sees heading this way.

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