US paying for being a good neighbour

By Alan Deans

New York view

The world owes the United States a huge vote of thanks. Uncle Sam stepped into the breach last year when South Korea, Russia and Brazil showed that there was little holding up their fragile economies other than bloated political egos.

A panic was thus stamped out that had threatened to spread quickly around the globe.

The trouble is that the US is starting to pay the price. It is too early to say how deeply the impact will be felt, but some fear that a sizeable slowdown is in the offing.

Turn the clock back to last winter. Korea, a leading Asian economy and one that is closely tied to the US, caught the Asian economic flu.

Russia followed not long after when it defaulted on debts. Hedge funds that had taken highly leveraged gambles on Russian bonds started selling their large exposures in Brazil in a scramble for liquidity.

Suddenly, it seemed that the world was a house of cards.

The greenback became one of the few havens as investors rushed into the US treasury market. For a time no one wanted to know about anything else, causing a sharp sell-off in municipal and corporate bond markets and in stock prices.

The Federal Reserve Bank acted quickly to ease the ensuing credit crunch by cutting interest rates - three times, no less. It was an action that, on its own, the US economy did not need.

Technological innovation - read here, the internet - was pumping up a speculative bubble and helping to spur productivity, both big factors in enriching Americans and causing a dangerous spending spree that has devastated household savings.

The strong dollar, in turn, created a welcome new market for Asian and South American goods. Hyundai cars that were not wanted in the rest of Asia were shipped to California, where buyers snapped them up. So, too, were cheap clothing, sporting goods, computer equipment, steel and anything else you care to name.

Now that is changing. Asia and South America are recovering. Currencies such as the yen are rebounding, so money is being withdrawn from US treasuries to places where investors can get a higher return.

American interest rates are rising, and the greenback is falling. So the cycle goes.

The impact is showing up in the trade figures, where this week the US recorded its highest monthly deficit since 1992. Exports in July of $US79 billion and imports of $US104.2 billion left a goods and services deficiency of $US25.2 billion. Increased deficits were posted to countries including Japan, China, Canada, Korea and Western Europe.

The lower dollar will help to reverse this trend, but there will be a lag. The latest figures from the Department of Commerce are nearly two months old, and the supply pipeline is still working through inventories shipped to the US when the trade equation was more favourable.

Yet investors are reacting by pushing the greenback lower, particularly against the rampant yen.

They are nervous, because they know that money will keep flowing to foreign shores unless the currency holds up. The Clinton Administration, to its credit, has said that it will not artificially protect the dollar and some pundits are suggesting that it could soon trade below the 100-yen level.

None of this is going to cause the US recession that some doomsayers foresee. Rather, it is a healthy reaction to a huge stimulation in domestic demand deliberately engineered by the Fed to bail out everyone else.

First, it will give pause to the Fed's recent trend of raising its official interest-rate targets. That should help to bring some stability back into markets.

Second, it will start to boost export receipts and funds generated from foreign revenues of US multinationals. That will give an impetus to corporate profits, and provide support for stock prices.

Third, it will result in US investors and households becoming more cautious. Economic growth rates should moderate in the short term, and the retail spending and house construction sprees should slow down.

Investors will realise that pumped-up internet stocks are not a sure way to make money. They will be forced to diversify into bonds, foreign markets, financial services companies and commodity producers as improved world demand kicks in.

But some months of confusion lie ahead. Fundamental changes such as these never occur as quickly as people want. It could even be that the trade balance and the greenback will worsen markedly before getting back on an even course.

There will, however, be a soft landing. The Fed has not used the US economy as a buffer during the past year simply to have it flounder on the rocks as others regain their prosperity.

Next year will see concerns about Y2K overcome, and the presidential race will see purse-strings loosened across the country.

* Alan Deans is New York correspondent for the Australian Financial Review.