The Anatomy of Global Re-balancing
Today the ECB chose to raise the Eurozone interest rate which effectively should not come as a big surprise for anyone following the European discourse and debate as of late. However, behind this move by the European Central Bank lies a more subtle narrative concerning the global macroeconomic imbalances and how some believe that while the US is slowing and the dollar falling the ECB will continue to raise rates on the back of a sustainable recovery in the Eurozone. As such, we are seing the beginning of the unwinding of the imbalances. This at least was how many argued a week ago, among those the influential British magazine The Economist (of which I am third year happy subscriber I should add) who in their cover story and following in-depth article hailed a new era in the global economy where the dollar and the US economy corrected to the fundamentals of a huge US current account deficit and the fact that Eurozone would take over pulling growth forward. In short, what we are seeing is a prolonged and sustained fall in the dollar. Also the notable economics commentator Martin Wolf from the FT noted that the current fall in the dollar would be sustained to correct the imbalances.
In the following I will argue that we are not on the brink of global re-balancing. My argument is initially based on the simple yet crucial notion that the extent to which the Dollar can fall hinges on whether other currencies can appreciate. I will present the theoretical components for re-balancing as two steps and show why this most likely will remain to be theory and not practice. My essay will end on an open note inviting to a discussion about the fundamental drivers of global macroeconomic imbalances.
Let us begin with the facts here as we indeed have seen a rather elevated and volative trend in the Euro/Dollar lately where the Dollar lately has fallen rather substantially against the Euro. These are undeniably the facts, but we need to ask ourselves what really is triggering the recent fall in the dollar? Or more accurately, I am perfectly able to see why commentators are persisting that the Dollar must fall and in fact the greenback has been drifting gradually downwards on a broad based index the recent years. However, I am hard at work to see which currency should be fundamentally able to take up the slack which kind of brings back to the starting point and an initial point; is there in fact a natural structural floor for the dollar's downward trend?
In order to move closer to the real truth here about global rebalancing we need to approach this with some kind of an organized methodology. As such we could hypothetically imagine a rebalancing process (be it abrupt or gradual) in two steps and my argument is that we are only now flirting with the first step. Consequently, what we have on our hands at the moment is a US economy which is slowing down considerably going out of the third quarter in 2006 obviously putting a downward pressure on the dollar. Meanwhile, we have a Eurozone economy experiencing a year (2006) which is probably, on a whole, going to beat all records for growth. This is creating a situation where we have a pausing Fed and a raising ECB and this kind of divergence in monetary policy also operationalized as the interest differential is the main driver for the current widening of the Euro/Dollar.
This brings us to the first important point. I believe we need to realize that the global macroeconomic imbalances will not unwind on interest differentials between the ECB and Fed alone, I mean have people not been reading Brad Setser here? In short, we could approach this by saying that the global macroeconomic imbalances represent a structural phenomenon based on the Asian central bank's (most notably China's) and Petro exporters' de-facto dollar peg. This again means that any thing short of a major shift in reserves in a colluding move against the US dollar will not unwind the imbalances. So what might trigger such a move then?
This brings me back to my initial outline because what we are seing now is only the first step which arguably could turn into a negative (or positive?) feedback process in which the interest differential between the ECB and the Fed narrowed or perhaps even widened so much in the Euro's favor to set in motion a deliberate move against the dollar. This would then be step two in the rebalancing scenario. However, as I will argue this is all mighty fine in theory but quite unfeasible in practive. In fact, people only need to ask themselves what would happen on the back of a major reserver diversification which essentially would need to be Euro-biased? In such a case as I have pointed to before we should not be looking to the US for a crash but initially to Italy which would almost certainly come sliding out of the Eurozone perhaps with Portugal in the slipstream. In Germany where we have a current account surplus running at 6% of the GDP we would almost certainly run into a nasty recession as well. Once people think about this I believe it is pretty clear that this is not going to happen.
So as I have tended to say a lot these days this pretty much brings us back to square one and the Euro/Dollar which in the end is driven at the moment by expectations on interest differentials between the Fed and the ECB. I mean this is what this is all about ... we can all see that the US current account deficit is the single most textbook-defying phenomenon in the world today but this is because the dollar's value is locked in as a function of what we could call Bretton Woods 2. Yet, one question still remain then ... what should we expect in terms of the interest differentials between the Fed and the ECB going into 2007?
In terms of the US, the situation is devilshly dificult to read at the moment. We are certainly slowing down which has been apparent for some time but will the US grind to a halt in the fourth quarter or or will we be able to stroll along at about 2% GDP growth? Roubini's position is well known here but I am not sure I am buying it completely and I rather tend to lean more towards what Dave Altig is doing, that is to be more balanced. Markets are clearly betting on somewhat of a crash and even against the Fed's effort to talk up inflation fears, so we might be in for a tough quarter here but I really won't say anything decisive at this point. Turning towards the Eurozone on the other hand the optimism is almost glowing and the recent raise by the ECB was almost certain this week which also goes along way to explain the currency moves in my opinion. Stephen Jen from Morgan Stanley also recently argued that this is as much a Euro story as it is a Dollar story. However, will this be a lingering story? Will the ECB continue to raise and will the US economy continue to slump? The answer to these questions brings us into to another major caveat in the current discourse of re-balancing ... the idea of de-coupling. As such, the continuation of the current trend where the ECB raises to accomodate an ever more perky Eurozone economy hinges in part on an assumption that the Eurozone will not be affected by a US slowdown. Immediately, it should consequently be clear that the relationship between cause and effect here is more subtle than what people initially might expect. If the US economy really hits rock bottom we would expect an even further fall in the Dollar against the Euro ... or would we? I am not so sure since the Eurozone economy clearly is dependant on the US as a customer as well. The ECB can clearly not continue on a quest to normalize interest rates regardless of what is happening in the US. In fact, as I have persistently argued there is a fair chance that the Eurozone and most notably Germany and Italy will have a very tough first quarter in 2007 which essentially means that we should not expect a major sudden slide in the Dollar. Furthermore, the hikes in the interest rates themselves will dent the growth in the Eurozone and coupled with the fiscal situation in Italy and Germany and the US slowdown there are several of reasons as to why we should not expect the ECB to be able to raise much going into 2007.
So there are lessons to be drawn here ...
1. The recent move in the Dollar in favor of the Euro has been driven by the expectations on narrowing interest differentials between the ECB and the Fed. Going into 2007 I do not predict this tendancy to persist primarily because I am not optimistic about growth prospects in the Eurozone. See also Credit Suisse's take here. Remember also that if you sincerely believe that the US economy will crash and subsequently are arguing as well that this will exacerbate the Dollar slide vs the Euro you are assuming a process of de-coupling. In short, the cause and effect analysis here limits the extent to which we can expect the Eurozone (and the ECB) to thunder along regardless of what happens in the rest of the world.
2. The major re-balancing act has not at this point been triggered and even if markets began to move and unwind Bretton Woods 2 it would have devestating consequences for growth in the Eurozone. At this point such a move quite simply is not feasible. As such, I would predict (following Brad Setser) that the structural nature of Bretton Woods 2 persists or in other words that pre-dominantly Asian CBs will continue to support the Dollar.
3. However, a more pressing question remains in my opinion. What is in fact the fundamental driver of the global macroeconomic imbalances? This is the fundamental question to answer here and it is essentially only when we get this one single question right that we can get to grips with this. Consequently, I believe that much more weight should be attributed to the fundamental structural nature of global macroeconomic imbalances as a function of demographic divergences. By applying this as an explanation we have a very strong basis for explaining why the Eurozone for example not all of a sudden can take on the correction and also why we need to leave an otherwise very strong economy such as Japan completely outside the equation.
This is consequently my view on the potential of global re-balancing at this stage. I am, however, leaving one question open, namely the question concerning the anatomy of the global macroeconomic imbalances themselves. I mean, are we talking demographics or Asian CB's and Petroexporter's dollar peg? A way to approach this would be to ask the simple yet so crucial question ... If we believe there are structural mechanisms at work here not only preventing the dollar from falling to correct the US CA deficit and hence the imbalances but also preventing the Eurozone and indeed Japan from contributing to re-balancing through a more consumption and import driven growth path; what are then these structural mechanisms?
As I have suggested above I am leaning towards the demographics as an explanation and I will try to flesh out my analysis at a later point.