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|The risk of rebuilding New Orleans in a deluge of debt
By Clyde Prestowitz
Published: September 29 2005
In the wake of President George W. Bush's recent speech in New Orleans, I have been wondering if anyone has asked the Chinese how they feel about his decision to spend "whatever it costs" to rebuild the city. After all, they are the ones who will have to pay for it.
The cost of rebuilding is estimated at more than $200bn (€167bn) but the White House insists it will not increase taxes. That means the entire cost will be added to the $350bn federal budget deficit, driving it close to $600bn. This deficit is financed by selling US Treasury bonds to investors looking for a fair and safe return on their savings.
You might think these investors would be mostly Americans. But they are not because the historic 7-8 per cent US household savings rate is now below zero and the federal budget deficit outweighs the savings of US companies and state and local governments. So the nation's overall savings rate is negative and the deficit is funded by foreigners. In fact, more than 75 per cent is financed by foreign central banks, among which the People's Bank of China will soon pass the Bank of Japan as the biggest lender. Thus, the financing of additional federal borrowing for reconstruction of the Gulf coast must depend heavily on it.
The entire US economy is on life support from the PBoC and the BoJ. In 2004, according to the Bank for International Settlements, central banks funded 75 per cent of the US current account deficit. This year, the PBoC alone is likely to cover nearly 40 per cent of it. It is true that US gross domestic product growth is top among the developed countries and that US unemployment, inflation and interest rates are all low, while home equity and household wealth is rising. That is what Mr Bush means when he says the US economy is the "envy of the world".
The problem is that the negative savings rate means Americans are consuming more than they produce and importing more than they export. The resulting trade deficit will be close to $800bn this year. To cover this gap, the US must have a net inflow of capital from abroad of more than $2bn per day and that must come mostly from China and the other Asian countries whose trade surpluses mirror the US deficit. Any slowing of this flow could cause a decline in the dollar, a rise in interest rates, a slowdown in growth, a rise in unemployment and declining home equity and household wealth - in a word, a recession, if not a depression.
Until now, the PBoC and other Asian central banks have been willing to keep recycling dollars. One reason is that they subsidise their exports by pegging or managing the value of their own currencies to keep them undervalued versus the dollar. Chinese exports have been growing at a rate of 30 per cent per year for several years and are on track to account for nearly 50 per cent of Chinese GDP in 2005. With such a large proportion of its domestic economy dependent on exporting goods to the US, China dares not risk either a slowdown in US consumption or a steep fall in the dollar exchange rate. So the PBoC has been recycling its export earnings into US Treasuries to keep both US consumption and the dollar strong. These banks now hold so many dollars ($800bn for the PBoC and close to $850bn for the BoJ), that any fall in its value would cause large capital losses on their own balance sheets.
There has been increasing concern about the sustainability of the system. Various analysts have pointed out that the US is already absorbing more than 80 per cent of the global savings available for international investment and that continuing US consumption-led growth implies eventually running out of the foreign savings to finance it. Others have noted that there are limits on the ability of the PBoC and other central banks to keep absorbing dollar denominated reserves without causing inflationary pressures in their own economies. Still others point out that fear of a capital loss if they sell dollars may eventually be outweighed by the fear of a capital loss resulting from the inflationary affect of unbridled US deficits. In view of all this, Paul Volcker, the former Federal Reserve chief, has predicted a 75 per cent chance of a global financial crisis within five years.
Breaking the budget and flooding the world with yet more Treasuries to reconstruct New Orleans could trigger the crisis which in turn could cut off the lending that is essential, not only for reconstruction of the south but for the day-to-day operation of the whole American economy. That is why it is important to know if Hu Jintao, the Chinese president, likes jazz.
The writer is author of Three Billion New Capitalists: The Great Shift of Wealth and Power to the East. He is president and founder of the Economic Strategy Institute and was counsellor to the secretary of commerce in the Reagan Administration
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