The US benefits from global dominance but there are downsides for the rest of the world
In a weak world struggling with growth and a severe debt overhang, the US has become a rare beacon of growth. The past three years have brought a steady flow of generally positive economic news. Unemployment fell steadily to 4.5% months ahead of predictions, from 10% in the aftermath of the last financial crisis. Real GDP has been volatile, but the picture has largely been one of growing strength and confidence in recent quarters. Meanwhile, inflation is trending higher.
Among the hallowed ranks of policymakers, the feeling is that a punishing war of monetary attrition is finally won. US central bank policy has diverged from other central banks, many of which remain mired in the post-2008 hangover and are obsessing about how to reignite growth.
Talk has turned from recovery to normalisation. After threatening at the start of 2016 with a brief rise and then pausing, the US Federal Reserve finally raised rates in December 2016 and again in March 2017. The discussion has now turned to managing reflation, how best to shrink the balance sheet and debates over what to do with maturing securities.
Markets have grown to accept the inevitable, with assets appreciating, volatility plumbing new depths and bond vigilantes timidly suggesting once more that yields need to be higher.
Into this already euphoric mix, Donald Trump has been an accelerant. Much has been written about him and depending on one’s political ilk, he may well be the Messiah or, equally, the second coming of Damien. But regardless, since his election, his economic plans have made him the darling of Wall Street.
His ambitious plans to boost the US economy and ignite GDP include the savage cutting of US corporate taxes, repatriation of offshore cash pools held by US companies and an alleged trillion-dollar infrastructure programme.
Taxes go down. Domestic investment goes up. GDP goes up. What could possibly go wrong?
But before we break out the champagne, there is a glaring omission above, and one that threatens both the global economy and future US hegemony.
The dollar is the reserve currency of the world, making the Fed the global central bank and the real power behind the throne for countless economies. Notional central banks of emerging economies such as India, Brazil and Turkey bend pliant like reeds in the face of US monetary influence. For all of our opining about individual countries and economies, the fate of the dollar remains key to the world economy, particularly given the current lacklustre economic environment.
Any analysis or strategy that does not take this critical international dimension into account is flawed. Unfortunately, the impact of the hunger for domestic growth on the world economy and managing the fallout remains, worryingly, outside the calculations of the US, presenting real dangers.
Today, 70 years on since the US ascended to the podium, almost all global trade is in dollars and foreign countries are among the largest holders of US Treasuries. This has cemented the hegemony of the US – a tactic presciently summarised by the American journalist Ludwell Denny in his 1930 book America Conquers Britain, which examines the passing of the baton from the UK to the US: “We shall not make Britain’s mistake. Too wise to try to govern the world, we shall merely own it.”
For the US, there are clear benefits to this dominance. Beyond the geopolitical clout it bestowed, it allowed policymakers the latitude to implement quantitative easing and stimulus on the scale undertaken over the last decade, as markets acquiesced to the preservation of the economic status quo.
But the relationship is symbiotic. The provision of dollars by a generous central bank, aided by a longstanding US current-account deficit and a long-term depreciating dollar, has meant that the world has had three decades of ample dollar liquidity. The impact has been three decades of uninterrupted credit growth.
Relationships cut both ways. Monetary decisions taken in Washington now rapidly ripple through the world economy, particularly in an era of globalisation when institutions and markets are densely interconnected. Small shifts in the dollar yield curve and monetary base soon transmute into large changes in capital flows, real exchange rates, asset valuations and inflation in many other countries.
In recent years, unconventional monetary policy flooded the system with even more dollars. It may have been the right course then for the US faced with the prospect of a depression, fuelled by collapsing demand and a vicious debt-deflation cycle. But it was also overkill for many others that were treading a shallower recession-type dynamic.
This was hyper-stimulus. Quantitative easing and the ultra-low interest rate environment it created led to a hunt for yield that fed a dangerous debt addiction. A succession of asset bubbles emerged in numerous financial assets, as money became cheap and investors searched for growth in a no-growth world.
More darkly, the global mountain of debt that almost brought the banking system and world economy to their knees in 2008 grew to even more gargantuan proportions. Global debt is now over 60% higher since before the last crisis and greater by $70trn (€46trn), give or take a few thousand billions.
But, beneath, the tide has been turning. For the last six years, the dollar has steadily strengthened, accelerating in mid-2014 as US decoupling began to come through, other countries continued to pursue monetary stimulus and capital rushed towards sources of growth.
But a rising dollar also represents monetary tightening, not just for the US but for the rest of the world. That is a significant source of strain in today’s debt-saturated world.
With Trump’s stated policies, the danger now is not one of explosive growth but rather hyper-tightening and added pressure on a fragile global economy that is vulnerable to shocks.
The sting in the tail is the intended repatriation of offshore cash pools.
Unlike many other countries, the US taxes corporate income globally, although companies can defer paying tax on any offshore earnings until they decide to repatriate that income.
In recent decades, the rise of multinational and tech firms, whose businesses are agnostic when it comes to geography, has led to their staggering growth. According to Congress’s Joint Committee on Taxation, US companies have now parked $2.6trn offshore to avoid paying taxes.
Trump’s plan is simple. Enact a tax holiday or amnesty, thereby persuading US corporates to bring much of that money home and providing the US economy with a significant multi-trillion-dollar stimulus. Financial markets have fallen in love with this notion, particularly as the Fed ponders reflation. Coupled with the broader tax cuts and increased infrastructure spending, we have seen a sustained Trumpflation rally since the election victory in November, with the wheels only wobbling recently as people fretted about the timing of it all.
But those same cash pools represent an invaluable source of liquidity for the global economy. At its most basic level, the rest of the world needs dollars to engage in global trade. Without a ready supply, trade may stagnate or even decline, something few would want to add to the heady mix of protectionism already in the ascendant today.
Much of the debt issued by emerging markets in recent years was dollar denominated and, more widely, to match the offshore cash, there is an offshore pile of dollar-denominated debt of about $10trn. This debt pile requires dollars to service and eventually repay. A strengthening dollar makes that harder as more local currency is needed continually to service the same amount, eroding the credit quality of the borrowers.
KEY MACRO RISKS
Geopolitical and socio-political
Probability: ← →
Impact: Medium to high
Brexit has come to the fore once more, as the UK triggered Article 50 and the sabre rattling has begun in earnest. It has already been a bad-tempered start, and the real danger is one of emotion overcoming sense. In the background, influencing attitudes and strategies, sits an uncertain calendar. Italy looks to be rapidly falling out of love with the euro and the German elections represent another test for the lure of populism in the most ardent supporter of the EU. Regardless of victors, the dialogue has moved decisively towards an emerging new populist protectionism. Donald Trump continues to be entertaining, sowing volatility, but has become mired in politics as his agenda stalls. More damaging, his government remains dangerously understaffed, presenting real challenges for the finer analysis and detail that policy requires. The danger of a mallet approach, particularly as he looks to reignite a waning popularity (and perhaps ratings), is larger today.
Financial markets have paused in recent weeks, as they fret about the timing of all the promised policy manna and seek a clear path through the uncertainty. The dollar remains a key risk, as discussed here already, but we see this playing out slowly for now. Fragility is increasing and the potential catalysts multiplying, but there is an excess of capital in the world looking for return and the technical flows have a strong momentum that will take time to brake. Additionally, central bank largesse, notwithstanding the US, still has a way to go before it declines. Internal political battles are likely to prove a frustration to markets. The US is more hung up on Obamacare than fiscal easing. The UK is more focused on securing borders than passporting for financial markets. China is focusing more on social stability than financial repair. Talk has been growing of whether we are entering a period of reflation and whether it is the time to move out of debt. That is probably misplaced. The recent move by the Fed to postpone a rate rise and talk of transient weakness reflects an anxiety.
Probability: ← →
Impact: Medium to high
Inflation is starting to pick up in different flavours and talk has moved on from central banks. But if monetary accommodativeness comes to a halt, fiscal easing is still a while off. The tussle over Obamacare robbed Congress of valuable time but the political capital invested and the partisan nature of US politics means that it remains a higher priority than tax cuts and corporate reform. While people are still hopeful of widespread tax reforms, they may find that the pace is not as fast as hoped for and, indeed, it may be late in the year, or even next year, before we see meaningful movement. But sentiment is up. Most countries feel that growth is slowly picking up and where there is weakness, it is perceived as transient. But the narrative is far from certain yet. We have seen the first signs of a protectionist agenda from the Trump administration in the recent moves against Canada, and the levels of distrust are already affecting other relationships. Mexico, for so long reliant on US agriculture, is now looking to forge links with other suppliers such as Argentina and Brazil.
Probability: ← →
Migration remains a constant backdrop to the political and social debate. It has again come to the fore in the recent jostling before Brexit negotiations formally opened and in the French elections. The German election later this year will provide another key insight. The future of the internet – the poster child of globalisation – is coming under greater scrutiny. Today, only 8.5% of internet users sit in the US and the nature of the internet is fast changing as the boundaries of geopolitics move online. What was a US phenomenon is facing a struggle over its culture, social norms, attitudes to privacy, governance and so on. On one hand, there are security and terrorism concerns as with the UK and US, and on the other hand, there are worries about enforcing state influence, as with Turkey and China. In the middle sits an emergent digital populism as privacy becomes an important battleground under both sets of pressures. The result is a fragmentation, whose trajectory and implications are yet to be determined.
Throw in a repatriation and the risk is that you introduce a further sharp restriction in the supply of dollars globally. This would cause the dollar to rally hard, and the cost of accessing dollars for global borrowers would rise sharply. For the rest of the world, this is a far greater monetary tightening than anything their own central banks might have in mind.
In the end, this is only bad for economic growth and financial markets. A credit crunch in emerging markets could soon spiral out of control, while a rapidly strengthening dollar would also sharply increase input costs for individuals and companies, notably energy, straining those balance sheets.
This is not a strong position from which to fight contagion. Given the levels of asset prices, there is also the risk of turning sentiment as trust erodes.
What may seem an obvious win for the Trump administration may only make life difficult for the rest of us and eventually for the US. As we wade through murky uncertainty, understanding and monitoring these currents is critical. Increased volatility and discordant outcomes will lead to potentially dramatic tightening for many countries, eroding internal consumption and corporate profits, and harming growth. As economies are not closed systems, but have social and geo-political dimensions, the spillover could be messy.
The US would do well to remember that globalisation works both ways. As capital flows out of emerging markets, it will find new homes and bubbles.
It may be the US currency but it is everyone’s problem.
Bob Swarup is principal at Camdor Global Advisors, a macroeconomic investment and risk advisory firm.
He can be contacted at firstname.lastname@example.org