Booming stock market, strong growth, fiscal surplus, strong dollar: one by one the elements of the US boom of the 1990s are saying good-bye. We have all four in sequence. One, two and three are gone. The fourth, the strong dollar, is just beginning to go.
As we write Europe's shared currency, the euro, is trading at a little over 92 U.S. cents. It is therefore 21 percent down on its value of $1.17 at the currency's launch January 1, 1999. That is quite a fall. And yet, at 92 cents, the euro is an eight-month high against the dollar. After hovering around 85 U.S. cents in mid-January, close to its all-time low, the euro has picked itself up. It is, at last, the dollar that is giving ground.
Suddenly, sentiment is negative on the dollar, more negative than on the euro which, for three years, it had been wrestling to the ground. Take some research published this week by Morgan Stanley, a U.S. investment bank. We do not entirely agree with it, but it gives some indication of the way the market is thinking about the dollar.
Morgan Stanley writes that four variables -- relative productivity, relative terms of trade, relative fiscal position and the net foreign asset position of the United States, have underpinned the strong dollar, and the dollar is "overvalued on all four counts."
Their argument seems over-complex. Relative terms of trade depends very heavily on the exchange rate so there appears to be some circularity in their reasoning. And they argue that "productivity growth ... drives capital flows," on which basis the 8.6 percent rise in US productivity in the first quarter ought to be drawing further inflows of capital and driving the dollar up.
But Morgan Stanley's interpretation is that "the long-run sustainable rate of growth of the U.S. total factor productivity is not likely to be so much higher than the rest of the world."
We would place less stress on productivity, the data for which seems less than dependable, but would agree that capital flows are the key.
Why has the dollar been so strong? We come back to the first element in the U.S. boom in the second half of the 1990s: the surge in the U.S. stock market, a surge that since the first quarter of 2000 has not proven sustainable, but which helped to push up U.S. growth and to draw huge amounts of foreign capital into the United States.
In 1995 purchases of U.S. securities other than U.S. Treasuries (stocks and corporate and municipal bonds) amounted to $96 billion. Two years later, in 1997, that inflow doubled to $198 billion, and by four years later, 1999, the annual inflow had quadrupled, to $345 billion.
But the capital inflow was also into non-financial assets. Investments were made. Land was bought. Companies were purchased.
Remember the acquisitive European companies who wanted a share of the U.S. boom? In 1995 the net foreign direct investment inflow in the United States amounted to $58 billion. Three years later, in 1998, that inflow was more than three times greater. And by 1999, when the boom was coming to its thin air peak, it was $301 billion, more than five times greater than the 1995 inflow.
In the same years, of course, U.S. investors were also sending money abroad. But here, too, the figures tell the same story: that it was the United States that grabbed the lion's share of international capital flows in the late 1990s. Whereas from 1995-97 the outflow of U.S. direct investment overseas exceeded the annual inflow, in 1998 and 1999 foreign direct investment in the United States exceeded the outflow, and more than doubled it in 1999.
Similarly, U.S. investors bought more foreign securities than foreigners bought U.S. ones in 1995 but in 1999 foreign purchases of U.S. securities was more than double that of US purchases of foreign ones.
The huge net inflow of capital to the United States contributed in many apparently positive ways to the U.S. economy. It enabled US stocks to boom and US bonds to rise in price. It helped to fund soaring US trade and current account deficits. And even as the trade deficits rose, the dollar got stronger. It is that trend that is now beginning to end. We can see the evidence in numbers for the past two years.
In the first place the portfolio capital inflow into U.S. financial assets, has leveled off -- at a very high level. In 2001 it amounted to $498 billion, almost half a trillion U.S. dollars and about 5 percent of U.S. GDP.
The rise on the 2000 figure was of just $12 million. The peak has been scaled. Now the decline begins.
Meanwhile the net foreign direct investment inflow into the United States has already tumbled. At $158 billion it is not far short of half its $301 billion peak in 1999. The importance of this is that funding for the U.S. deficit on current account (the broadest measure of trade) which amounted to $417 billion in 2001, 4 percent of U.S. GDP, now relies on inflows into U.S. stocks and bonds, neither of which have been doing well.
Corporate bonds have been hurt by rising defaults and fears of bankruptcies. U.S. Treasuries seem to lose all round: the rising fiscal deficit implies the government will need to issue more debt; the rising money supply threatens medium-term inflation; and each time a stock-market friendly number appears, Treasuries are hurt.
As for the stock market the story is familiar. The Nasdaq is roughly two-thirds down on its first quarter 2000 peak. The Dow is down by about 10 percent. A series of rallies in the past 18 months have each been eroded.
There are stubborn fears about the strength of the U.S. recovery and about corporate profitability. U.S. investors are concerned. Foreign investors in U.S. assets, those brave souls who in 2001 more than funded the US current account deficit, have a further element to worry about: the dollar.
Does it make sense now for foreign investors to pour funds into U.S. assets? We would say not, and their very reluctance to do so will be what takes the dollar down.
It is always the same. In the boom years the imbalances are ignored and the boom goes on. Even now, U.S. Treasury Secretary Paul O'Neill and under-secretary John Taylor say that they cannot understand why the International Monetary Fund is concerned with the U.S. current account deficit. But, eventually, imbalances demand correction.
The correction in the U.S. economy will come about through a fall in the dollar and weak growth in the United States. For the rest of the world that is in most respects bad news. European and Japanese exports to the United States will suffer, while U.S. exports receive a boost to competitiveness. But in a slow world economy it is not exports that are going to help the United States to the recovery investors are looking for. And a weak dollar, by adding to import prices, will tend to depress U.S. consumption and make for a weak economic recovery, or even the dreaded "double-dip" whereby the U.S. economy heads back towards recession.
A falling dollar, a fallen stock market, a rising fiscal deficit, weak growth: all the elements of that irrationally exuberant boom are going eventually to reverse themselves. It was ever so.
(Global View is a weekly column in which our economics correspondent reflects on issues of importance for the global economy. Comments to firstname.lastname@example.org.)
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