How one ticking economic timebomb is being slowly defused

Allister Heath
ONE of the greatest imbalances at the heart of the global economy is that many Western nations have been consuming too much and producing too little. There is nothing wrong with imports. Protectionism is always wrong. But over time imports need to be paid for, either by exports, or from the proceeds of external investments, or by handing over assets, such as domestic property or securities.

The problem is that the process of adjustment that would ordinarily flow from the market has been corrupted by government policy and errors. The Chinese – who have been pursuing a mercantilistic policy by under-valuing their currency and preventing their citizens from consuming and investing their money abroad freely – have converted the revenues generated from their exports into a vast foreign exchange reserve, much of it held in government bonds. Combined with America’s persistent budget deficits, even during the good times, this helped create a bizarre symbiotic relationship between the US and China, with huge effects on the global economy.

US consumers bought Chinese goods; these were paid for in dollars; these dollars were swapped into government bonds. For all intents and purposes, the US authorities were printing bonds and handing them to the Chinese in return for cheap goods. The Chinese economy got a boost, as did the US consumer, yet the whole exercise was based on credit conjured up out of thin air. Most importantly of all, the massive pile of US Treasuries accumulating in Chinese vaults helped push down the US government’s cost of borrowing, and because of Treasuries’ benchmark status, the long-run cost of borrowing for everybody. This recycling of dollars into Treasuries, and their senseless accumulation, helped create a false market in debt. It was one of the main drivers of the global property and credit bubble.

The good news is that the US current account deficit is shrinking, which means fewer Treasuries are being exported and the accumulation of global dollar reserves will therefore slow. The current account deficit hit a record high 6.5 per cent of GDP in the fourth quarter of 2005; it is now down to three per cent of GDP, figures out this week revealed, which while high remains a substantial improvement. China’s forex reserves appear to have peaked, and are now falling slowly, dropping to around $3.24 trillion at the end of the second quarter – though the decline to date remains tiny, and the reserves are still up ten times in a decade, from just $386.4bn in 2002. Beijing still has a very long way to go before it fully liberalises its currency and capital flows. But at least the Chinese are buying fewer foreign bonds, which means that yields will no longer artificially be pushed down further (though of course they are hugely lower than they would be had the multi-trillion demand from China never existed, and all of the reserves were privately held).

Unfortunately, while America’s falling current account deficit and China’s reduced appetite for forex are improving global imbalances, and reducing the chances of another bubble, quantitative easing from central banks is having the opposite effect. But that is a column for another day.

Now let me get that straight. Nick Clegg isn’t apologising for his policies – in fact, he isn’t even apologising for breaking his promise. He is apologising for having made a promise, and is promising (yes, promising) not to make promises again. If you’re confused, don’t worry – so is everybody else, including Clegg himself.
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