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Going (bust) for growth

23 February 2004

The capacity to be shocked by a naked breast on television is not the only issue separating America and Europe as the U.S. splashes out on an expensive economic recovery in an election year. Eurozone growth may be slower, but its longer term prospects look a better bet. Britain, as usual, is torn both ways.

Exchange rate movements tell a variety of stories. Black Wednesday, in 1992, when sterling plunged ignominiously out of the European exchange rate mechanism, was widely credited with losing the Conservative government its reputation for economic good management, and hence the general election five years later. Despite which the chancellor of the exchequer of the day, Norman Lamont, admitted to having sung in he bath as the exchange rate plummeted. For decades the mighty Deutschmark was synonymous with the phenomenal success of the West German economy, and no German government dared mess with it. And now the U.S. government is rubbing its hands at the sight of a rapidly declining dollar, a decline which is viewed as a key element in an election year purchase of "the best recovery money can buy".

As a crude rule of thumb, an economy gets the exchange rate it deserves. A currency is an investment like any other, so money will follow the best returns. That might mean interest rates or it might mean longer term economic prospects. Whether the investor is buying interest-bearing securities or setting up a factory in the country they still have to buy the local currency to do it, and that buying keeps the exchange rate high.

But the currency markets are exceptionally dynamic. They are looking not only at the long term, but also at the next five minutes. The exchange rate of a currency is dictated less by its intrinsic worth at a given moment that by perceptions about what it is about to be worth. It's a guessing game in which huge numbers of factors come into play.

In crude GDP terms the U.S. economy has been through a bad patch and is perking up. But the trade deficit is at record levels, and the huge federal budget deficit is climbing, too. The dollar is on the slide because the dollar economy owes a vast sum of money to the rest of the world and is still borrowing. If the rest of the world is to keep on lending, it wants more dollars for its money to make it worth the risk.

The U.S. government isn't bothered about that. It thinks that a cheap dollar will be a motor for growth that will do something about the trade deficit at the same time. It makes dollar-denominated U.S. exports cheap, so they should increase in volume. It also makes imports more expensive, so people should buy home-grown American products instead, which keeps the factories turning.

It's a nice idea, but, of course, it is not as easy as that. A big slice of U.S. trade (and trade deficit) is with China, whose currency is held to the dollar by the Chinese authorities. So a weak dollar makes China's exports even cheaper to the rest of the world, and no more expensive than they were to Americans. But if China cuts the dollar tie and floats its currency to a twenty or even thirty per cent appreciation, Chinese manufactured goods will still be much cheaper that home grown U.S. product. This is because unit costs are so low that twenty or thirty per cent increases don't make much difference.

What is more, the Chinese manufacturing behemoth imports huge quantities of components and materials to feed its output. If the local currency is allowed to appreciate these imports will get cheaper, so the net increase in cost to the overseas consumer of the manufactured item will not be so great.

The big danger in the U.S., therefore, is that the decline in the dollar will not stop the flood of imports, but just make them more expensive. This would create inflationary pressures, as people spend more to get what they want, and any increase in U.S. exports as a result of the weak currency could be offset by the increased cost of imports. For the U.S. government, however, that's a secondary risk since, in an election year, only one thing matters in the economy and that is growth. The GDP measure of economic activity indicates crudely whether people are (i) working, (ii) spending and (iii) content. If they are, they will vote for the government in power, and if they're not, they won't.

GDP measures economic activity, but it doesn't measure whether that activity is affordable. So, if you buy a meal in a restaurant, the activity of the chef and the waiter are recorded in GDP and contribute to economic growth, irrespective of whether you could really afford to pay for it. Spending generates economic activity, which increases people's feeling of wealth, but if the spending is borrowed the down turn will come when in has to be paid for in the future.

The U.S. has been over-spending consistently for fifty years. It is able to do so because other countries have invested in dollar assets, and the growth in economic activity has been sufficient to pay them back their interest. But that growth has not been uniform across the economy. It is increasingly a story of a two speed, two tier economy of rich and poor in which the rich economy is powering ahead while the poor economy is struggling with the decline in agricultural and manufacturing incomes.

Part of the credit for the boom years of the 'nineties has been given to the twelve million or so illegal workers whose low wages and vulnerable status have fuelled large profits for the industries in which they work. Meanwhile, industries with established labour practices such as steel are struggling to compete on world markets and are experiencing decline that impacts most on the level of employment. What this means is that the growth experienced by the rich part of the U.S. economy is being paid for not only by foreign investors who will need to be repaid but by a transfer of wealth from the poor part of the economy to the rich. If a company can increase its profits by laying off workers, that leaves the workers borrowing money to live while the shareholders spend their increased profits on imported goods. The poor are, therefore, quite literally borrowing money to fund the spending of the rich.

The growing gap between rich and poor in America is a long-standing phenomenon that has been fuelled recently by tax cuts for the rich and cuts in welfare for the poor. It may be just about sustainable while the economy is moving forward, but when the music stops it will be the poorest of society who are left scrabbling for the seat that is not there. In particular, if increased spending by the rich economy brings inflationary pressure the resulting increase in interest rates to choke off this inflationary spending would harm the poor and most indebted side of the economy disproportionately. How America deals with the social stresses created by this mounting imbalance is a question it has yet seriously to address.

Which brings us to Tony Blair, talking up the British model of economic growth in Europe at his pow-wow in Berlin with friends Gerhard and Jacques. The British economy has been spending more that it earns for just as long as the American, although with one or two blips at a period when North Sea oil production was at its greatest. The British economy is also two-speed, with house-owners having access to borrowing to finance their spending, while the manufacturing and exporting economy is in steady decline. As in the U.S., the gap is widening between rich and poor.

Under these circumstance it is not surprising that his Berlin chums take Tony's preachiness with more than a pinch of salt. Eurozone growth may be progressing at a tortoise pace, but it is doing so with a currency at an all time high, coming out of painful economic restructuring occasioned by the introduction of the Euro, and the unification of Germany before that, and the imminent addition of another seventy million people and ten national economies to its ranks. More importantly, the Eurozone is substantially in credit to the rest of the world, recording a trade surplus for 2003 of about seventy billion Euros, a sum approximately equal to the UK's trade deficit for the same period.

Neither Jacques nor Gerhard is immune to the electoral pleasures of economic expansion, however achieved, but their appetite for an Anglo-American style dash for spending-fuelled growth must be greatly diminished by the threat it poses to social cohesion. This notion of an interdependent society, more highly valued on the continent than in Britain or America, and evidenced by a costly investment in welfare, retirement and health provision, has already been sufficiently battered by the pressures of economic liberalism for the French and German governments not to wish to add to its problems. Slow growth, backed by a strong currency and a healthy balance of payments, is likely to offer a better long-term future than a recovery fuelled by consumer spending that will be just one more thing for the next generation to have to pay for.