Consumed by America

Indian Express, 29 November 2010

Over the past two years, the need for rebalancing the world economy has often been discussed at forums like the G20. But it was not made explicit what it involved. At the recent G20 meeting, there was little consensus on the issue, as it became clear that rebalancing can only be achieved through a depreciation of the US dollar. While rebalancing of the world economy may be good for all countries in the long run, in the short run there will be winners and losers. This could make rebalancing a truly difficult objective to genuinely agree upon.

The best option for a stable world economy seems to be for US households to consume and save as other households do all over the world. But if US households start saving, they will consume less. While all this looks good in principle, the practical problem is that when they consume less, they also import less. When US imports decline, countries exporting to the US stand to lose. In the immediate future, those who see their currencies appreciate the most, may lose the most. If China does not allow its currency to move, the burden of rebalancing falls on other countries. Not surprisingly, no one wants to take on the brunt of the adjustment.

India is in a relatively different position. India does not see only short term losses in its share of world consumer goods exports as the only relevant story. Services, for example, are a large share of India's export basket. There it is clear that US firms should do well for Indian exports to grow. The importance of an expanding US market, with healthy firms that produce and invest, is a necessity for the growth of Indian exports. India cannot afford to be myopic like other emerging economies who directly compete for export markets in manufactured products with China.

Recent data for the US economy suggests that the impact of the fiscal stimulus has been limited so far, and what is there, may soon wear off. High import intensity of US consumer demand has helped translate higher demand into larger imports, rather than domestic output and employment. Both QE2, and the pressure on China to make Chinese exports more expensive, are directed at trying to give domestic US production a push.

As details about implementation of the USD 862 billion US recovery package of 2009 unfold, there is much debate among economists about the size and efficacy of government spending to pull the economy out of a recession.

First, the multiplier, or the impact of the fiscal stimulus on total output, is being hotly debated. There is little agreement on the exact magnitude of the impact, but most economists agree that the second and third round effects of government spending on aggregate demand, are quite small.

Next, the quantum of the stimulus itself was perhaps not as large as originally envisoned. Expenditure that is directly in the hands of the federal government is more under its control, but spending to be done by local and state governments is not. After money was alloted to these governments under the recovery package, local and state governments did not spend as much as originally envisaged. They largely continued to spend as much as they would have spent otherwise, and used this opportunity to get additional funds from the federal government and borrow less.

Third, to the extent that there was an increase in demand, it led to an increase in imports, more than an increase in domestic production. US imports have risen rapidly since April.

In July-September, for example, US demand was 286 billion dollars higher than in the first three months of the year, while the inventory change was 71 billion higher. Thus, total demand increased by 358 billion. Yet, most of this higher demand went into higher imports—which increased by 232 billion. The marginal import ratio, which measures the extent of additional demand that goes into imports, was as high as 65 percent.

As a consequence, while in July-September 2010 demand grew at 4 percent, much of it leaked out through higher imports, and US GDP growth was a mere 2 percent. Retail sales are picking up, but output is sluggish. This partly explains why the second and third round effects of the stimulus are weak. A strong multiplier effect requires that an increase in government demand, leads to an increase in demand from industry, which produces more. As a consequence, labour demand and wage income go up. This futher pushes consumer demand, encourages investment, and so on. If an increase in demand results in higher imports, there will be a weak multiplier effect.

Further, the expenditure of the federal government has risen more due to transfer payments. For example, the total unemployment benefit expenditure automatically increases when unemployment rises. (Higher infrastructure spending was only a small part of the US fiscal stimulus.) As long as unemployment rises, the expenditure on unemployment benefits can increase, but once unemployment stabilizes, regardless of how high it is, the expenditure will stop growing. Transfer payments have now risen to an all time high of 21 percent of US disposable income, and unlikely to rise much beyond this.

In other words, not only was the US fiscal stimulus small, its effect was to raise import demand more than domestic output. Consequently, it has not led to a significant increase in employment, so it has not kicked off much of a second and third round effect, or led to an increase in employment and wage income in the US. And, now this stimulus is likely to taper off.

It is difficult to say whether US monetary easing will lead to a significant weakening of the dollar, considering how hard countries are trying to prevent it. The US consumer could continue to buy cheap imported goods. If the dollar does not depreciate, the world could face the prospect of a long and painful recession.

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