S. Venkitaramanan

The ongoing debate in US economic policy emphasises the fact that the lessons economists draw from their text-books have to be modified a great deal when it comes to practical application. Our own economists, who are generous with reformist solutions for India's problems, may need to look carefully at the conundrums that have emerged in US economic policy.

THE dictionary meaning of "conundrum" is "anything that puzzles". Another meaning is that it is a specific type of riddle, which has its solution in a pun. The US Fed chief, Mr Alan Greenspan, had apparently the first meaning in mind when he mentioned that the situation in which short-term rates in the US were rising but the long-term rates remained low, was a conundrum.

The fact that such a distinguished policy-maker as Mr Greenspan is despairing of logic in economic outcomes gives comfort to lesser mortals, who essay forecasts in macroeconomics and often falter.

Asian central banks' investments in US securities explain the low interest of long-term debt. US interest rates at the shorter end are determined by executive fiat by the Fed, which decides on the Fed funds rate — the rate at which banks can access short-term funds from the Federal Reserve and, hence, the market.

The disconnect between the short-term and long-term rates in the US has been a feature of the US money markets. But Mr Greenspan was right to raise a query and not wait for an answer.

A more worrying — scary — conundrum is that posed by what some observers see as the strengthening of the US dollar in recent months against the euro and the yen. This is contrary to received wisdom, which declares that with the high current account deficit of the US, the dollar has only one way to go — down.

Mr Greenspan himself had predicted that the dollar would fall nearly 20 per cent in a period of three years. The Bank of International Settlements, in its recent report, had also dealt with the possibility of a depreciation of the dollar with its adverse consequences. But, as if to disprove all these dollar bears comes news of the foreign exchange markets propping up the dollar against the euro and the yen.

Prof Jeffrey E. Garten, Dean of the Yale School of Management, Yale University, has written a powerful piece dealing with this subject under the heading "The almighty dollar is back" in the issue of Newsweek dated June 27. He points out how the dollar has risen 12 per cent against the euro and 7 per cent against the yen since January 2005.

He calls this change "the start of something big". The reasons for this apparent shift are to be sought in the TINA doctrine "There is no alternative". Asian savings looking for avenues for investment do not choose Asian currencies as they are trying to escape the poorer condition of the financial markets in China and the rest of Asia — so believes the dollar bull.

The search for security and safety drives the Asian central banks to the US dollar-based securities and hence pushes up the dollar in terms of other currencies. They prefer the dollar, because the European markets are not as well-developed as the US'. One has to consider at the same time that the US is notoriously deficit and is seeking foreign resources to fund its growing imports.

The rush for US dollar-based securities is the result of Asian central banks accumulating dollars as a result of their intervention in their forex markets, buying up the available dollars to cheapen their own currencies. The resulting hoard of US dollar is then available for investing in US long-term (and short-term) papers and necessarily makes for lower interest rates in the US, incidentally helping to finance US Government deficit as well as the current account gap.

The strengthening of the dollar in the face of the current account deficit is definitely a conundrum, but with a reasonably satisfactory explanation. The fact that US commentators have been tearing their hair over the return of the almighty dollar shows that a strong dollar can imply a scary scenario for the US economy.

The stronger the dollar, the greater the American import bill as the US will find foreign goods cheaper. Foreigners will, in turn, find it easier to export to the US. The result will be a worsening of the US trade deficit. The US will need to be more in debt to the rest of the world for more foreign funds each year.

The absence of alternative safe avenues of investment will, however, force the Asian economies to send their accumulated dollars to be invested in the US — which may result in a higher exchange rate for the dollar, notwithstanding the deficit.

Surely, this paradoxical situation opens up a number of disturbing possibilities. A strong dollar reopens the prospect of the American challenge, which had frightened Europe in the 1960s. With the strong dollar, US businesses can easily acquire corporate and other assets in the rest of the world.

By the same token, the leverage which foreign institutional investors from the US will have in Indian and other Asian stock markets will increase.

It is inevitable that the Asian economies' attempts to keep their currencies lower in value could directly contribute to making the US dollar relatively strong.

By definition, this means strengthening the dollar. Mercantilism of this kind practised by Asian economies can be ultimately self-defeating. The US will find protectionist pressures rising and non-tariff barriers of various kinds will raise their ugly heads.

One disturbing fact, however, is that US economic policy-makers at a senior level are not too concerned about the current account deficit even at its present level. This is itself a conundrum.

We recently saw the spectacle of two or three Governors of US Federal Reserve publicly trashing the common perception that something was seriously wrong with the US' current account running currently at $600 billion or more a year.

Some of America's Central Bank Governors seem to have come to the conclusion that while the deficit is big — at 6.5 per cent of the GDP — it is not America's fault and most likely it will be closed without much trouble. One of the Governors, Roger Ferguson, has even said that the implications of the current account deficit adjustments for US economic growth and inflation will most likely be benign. The most sanguine view belongs to the Fed Governor, Mr Ben Bernanke, who was recently nominated as Head of the US President, Mr George W. Bush's Council of Economic Advisers.

Among the points that he makes, the most important is that it is wrong to say the current account gap is made in America or that American policy changes, such as tightening the budget would do much to fix it by themselves.

Second, he argues that there is little reason to believe that America is heading for a hard landing. This is contrary to Mr Greenspan's own prediction of a depreciation of the dollar, although that may not mean a hard landing.

The Economist points out in its issue of April 30, that the American central bankers who express these complacent views are right to point out the global nature of America's imbalances. The source of these imbalances is the higher savings of Asia. Further, foreigners have been keener to finance America's external borrowings at low interest rates than to invest at home.

The American federal bankers go even further in their complacency. They say that there is little quantitative evidence that fiscal deficits or a reduction in private savings caused the current account deficit. They cite academic studies to show that fiscal expansion has only a minor effect on trade deficit.

The conundrum gets even more complicated. If even sophisticated economists such as the Fed Bank Governors question the link between US budget deficit and current account imbalance — in effect, blame it on the rest of the world — where are we to look for solutions? True, fiscal deficit and current account deficit are two aspects of an economy.

But the same conservative school emphasises the strong link between the twin deficits when offering advice to others. There is obviously one economics text-book for the rich countries and another for the developing nations.

The ongoing debate in US economic policy emphasises the fact that the lessons economists draw from their text-books have to be modified a great deal when it comes to practical application.

Our own economists, who are generous with reformist solutions for India's problems, may need to look carefully at the conundrums that have emerged in US economic policy.

One lesson is that certitude in matters of economic reform may not often be fully justified. What is practical and pragmatic may well be the correct path, in spite of what economics text-books tell policy-makers.

I make bold to suggest that our reformers may dare to show some revisionist courage on the lines that their colleagues in US Fed have shown in dealing with the complex challenges faced by the US' current imbalances.

Procrustean beds, such as fiscal constrictions, are the offshoots of conventional text-book wisdom. Maybe there is some merit in drawing courage from US revision and taking a re-look at our standard prescriptions for economic decision-making.

We need to question the basic assumptions that underlie recent legislation, especially that concerning fiscal responsibility, when, for instance, it comes to incurring fiscal deficit for infrastructure investment.

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