Richard Cooper: Carry on spending!
The problem is not that the United States is spending too much, but that the rest of the world is spending too little, says Richard Cooper
There are three sources of concern with the global economy right now: high oil prices, the large American current account deficit, and significant budget deficits in all the world’s leading economies. How serious are these situations, and what are the alternatives?
Take oil first. Crude oil prices (Brent) increased from less than $20 a barrel in 2002 to $25 at the end of 2003 and more than $50 a barrel in October 2004. There were various reasons for this, arising from both supply and demand. China’s demand was unexpectedly strong in 2003 and early 2004. Disturbances in Iraq, Venezuela, Russia and Nigeria raised questions about stability of supply. The Organization of Petroleum Exporting Countries (OPEC), the producers’ cartel, had little spare productive capacity. Private inventories were exceptionally low. Official inventories appeared impressive, but the United States refused to release oil from its strategic petroleum reserve, even on a repurchase commitment and, indeed, perversely continued to add to the reserve while prices were rising.
If supply uncertainties persist, and if Saudi Arabia is slow in bringing on new capacity, oil prices are likely to remain high, in excess of $40 a barrel through 2005 and beyond. Of course, if this happens growth projections will not be realized.
Consumers will have to spend more on oil and, therefore, reduce spending on other goods and services, and central banks will tighten credit in order to limit the impact of higher oil prices on other prices, and of rising prices on wage formation. According to Global Insight, an economic research firm formerly known as DRI, the actual and projected increase in oil prices since early 2004 will cut the growth rate of America’s gross domestic product (GDP, a measure of national income) by 0.3 to 0.4 percentage points in 2004 and by 0.7 to 0.8 percentage points in 2005. If the price stays up, growth in subsequent years will also suffer.
There will also be large transfers from oil consumers to oil producers – at an annual rate of nearly $600 billion with oil prices at $45 rather than $25 a barrel. Much of this will be within countries, for example, from New England to Texas within the United States. But OPEC earnings will increase by an estimated $185 billion a year, with additional sums accruing to Russia, Norway, Mexico and other oil-exporting countries. These new revenues will eventually be spent. But most of them accrue in the first instance to governments, as the chief owners of oil resources, and it will take time for government expenditures to respond to the higher revenues. Consumers, in contrast, must adjust to the higher oil prices promptly. This asymmetrical response will raise world savings temporarily and will tend to slow growth in the world economy.
Oil supply
A central longer-run issue concerns how much Saudi Arabia and other Gulf producers will invest in additional productive capacity. On US Department of Energy projections, world demand for oil will rise by 33 million barrels a day between 2001 and 2020 (at a price of around $26 a barrel). How will that demand be met? Saudi Arabia could produce more oil profitably at $10 a barrel, below the profit threshold in most other countries. Saudi’s ability to turn on the taps, if it chooses, deters all-out investment in currently profitable locations, such as Canada’s tar sands or promising but expensive deep offshore locations, or even in coal liquefaction, even if prices rise much higher. The world needs a commitment from Saudi Arabia, one way or the other, about its future investment strategy, to foster a more certain environment for investment elsewhere in liquid fuels.
Philip Verlerger, an energy economist, suggests that offering Saudi Arabia and other OPEC members assured duty-free access for energy-intensive products such as aluminium and plastics in exchange for commitments to produce at maximum rates is consistent with proper reservoir management. Any such arrangement would have to be augmented by commitments with respect to investment in new production capacity.
Apart from oil, there are other key issues facing the world economy: widespread fiscal deficits and the large current deficit in the US balance of international payments. There are widespread calls for significant reductions in both. But such calls are probably misguided, at least in the short to medium run. Play the thought experiment of reducing the fiscal deficits of G7 countries (excluding Canada, which runs a surplus) by, say, two to three percentage points of GDP, mainly by reducing government spending. This objective is widely viewed as highly desirable and, indeed, for France, Germany and Italy is insisted upon by the European Commission, under the eurozone’s Stability Pact. Prominent Americans call for similar reductions in the United States, while Japan is widely viewed as having an “unsustainable” fiscal deficit.
Savings good?
Would the world be better off if such reductions were made? My answer is negative for the short and medium run, and with an appropriately high discount rate the same negative answer applies even if the long run is included.
What would be the consequence of such reductions? Many rich countries – Japan, Germany, France, Italy – have excess national savings despite ageing populations – in part perhaps because of anxieties about old age and unviable national pension schemes. Investment, the real way to meet requirements for future income, falls short of savings in all these countries. Advocates of cutting budget deficits argue that reducing the access of governments to bond markets will lower long-term interest rates, thereby stimulating investment. But businesses will not invest if they expect that there will be no demand for their additional output, even with low interest rates. It strains credulity to believe that demand for new housing, the sector most sensitive to long-term interest rates, would boom with a decline in interest rates in view of the ageing and prospective low new household formation in these countries.
The increase in oil prices will reduce budget deficits for a few years, but they will be the deficits of OPEC and other oil-exporting countries, not the deficits that are usually decried. Nonetheless, the net effect will be to increase world savings temporarily.
The lack of private demand is compensated for, in part, by public sector demand, that is, budget deficits, and in part by export demand – the latter mainly from the United States, directly or indirectly. Reducing the budget deficits by two to three percentage points of GDP would reduce total output, and productive investment, in all these countries. Since investment now is our legacy to the future, the reduced capital stock would leave the next generation worse off, not better off as is usually assumed because of a presumed decline in public debt.
A weaker dollar
That brings us to the second thought experiment. Suppose the huge US current account deficit – over $600 billion – were reduced to a more moderate $200 billion to $300 billion, or even eliminated altogether, as some would wish. If such a reduction were brought about by more robust growth in the rest of the world, particularly in Europe and Japan, that would be widely welcomed; but that is unlikely in the next several years, again because of excess savings.
The only other way we know to reduce the deficit is to make American products more competitive, for example, through a depreciation of the dollar. From 2000 to late last year, the dollar has already depreciated significantly: by 25% against the euro; 19% against the British pound; 16% against the Canadian dollar, and 4% against the Japanese yen and by even more from the peak rates. But the dollar could depreciate further, especially against the currencies of east and south-east Asia, as Morris Goldstein of the Institute for International Economics has urged. Would the world be better off?
Again, my answer is negative. Basically, for the same reasons sketched above: there is excess saving in the rest of the world, or at least in those parts of the world that are prosperous or prospering. Even China runs an export surplus and until recently ran a budget deficit, despite a vigorous construction boom that many observers consider unsustainable, in the sense that not all the new space can be rented or sold profitably. Private saving is even higher than China’s high investment, admittedly in part because of China’s underdeveloped domestic capital market.
The world outside the United States generates more than $6 trillion a year in savings, and this is growing from year to year. Most of the savings, of course, are invested at home in each country. America’s large current account deficit implies, however, that the rest of the world is also investing some of its savings in the United States – around 10% on a net basis, more if allowance is made for the fact that Americans are also investing in other countries.
The US economy accounts for more than a quarter of the world economy and around half of its marketable financial assets. Furthermore, it provides higher real returns on capital investment than do Europe and Japan, and returns that are more secure and reliable than those offered by emerging markets. Property rights are protected and dispute settlement is impartial among commercial parties, even when the government is one of the parties. The willingness of Americans to invest more than they are saving provides some counterweight to excess saving in the rest of the world. An attempt to reduce the US trade deficit through aggressive dollar depreciation would have a profoundly deflationary impact on the rest of the world that, on balance, relies on an export surplus (or, looked at another way, net foreign investment) to compensate for excess domestic saving.
Thus we need to beware the ancient Chinese curse: may your wishes be granted!
Richard Cooper
Richard N Cooper is Maurits C Boas Professor of International Economics at Harvard University. He is vice-chairman of the Global Development Network, and a member of the Trilateral Commission, the Council on Foreign Relations, the Executive Panel of the US Chief of Naval Operations, the Aspen Strategy Group, and the Brookings Panel on Economic Activity.