Inflation: A View from Abroad

Includes: UDN, UUP
by: Joseph Trevisani

The view from a jetliner at 30,000 feet can be clarifying. So the view of the American economy and its prospects from abroad can be instructive.

From overseas the latest Washington political gaffe or media outrage doesn't even make it to translation. No one in Saudi Arabia, where I have been for a week, asked me if I thought the Democrats or Republicans were responsible for the AIG bonuses. Perhaps it was simple courtesy, but more likely it was not considered important enough to discuss. That people with government power serve people with financial power is not seen as worthy of comment, except maybe with a shrug, 'that's the way things work'. But that is not to say people are unaware of the politics and actions of the United States. It is just that their concerns are sharpest for the policy questions that affect them the most. The view from overseas, like that from an airplane, only catches the major formations, the economic policies that have the consequences to reach across oceans.

Three topics came up again and again in the questions I was asked: is the US banking system stable? Will the American government succeed in reviving the economy? Will US fiscal and monetary policies devalue the dollar?

Saudi Arabia's banks and financial system were relatively untouched by the hurricane that struck Western finance last fall. The Kingdom's banks had not bought debilitating amounts of asset-backed and mortgage-backed securities during the boom. Naturally conservative, the banks are now in a position to help the government when it supports the economy rather than require their own bailout.

But no bank exists in isolation. When panic strikes the world financial system everyone suffers. The United States is still the largest component of world finance. None of the world's banks can be secure, even in their own country, if US banks, especially the money center banks, are staggering. Although many, perhaps most, banks around the world would survive a US bank collapse, the risks would be enormous. The negative effects on economic growth might linger for a decade. After the events of last fall, the dependence of the world financial system on confidence has never been more evident. The determination of the Federal government to insure that the US banking system continues to function has never been more important.

In the run up to the financial crisis last summer, the fashionable discourse was whether various areas of the world economy, primarily the EU and China, were 'decoupled' from events in the United States. Could these large economic blocs continue to prosper without the US? No one is asking that question now.

The world economy will have a very difficult time recovering if the US is not leading the way. It is not the details of the Obama administration's stimulus plans that interested my questioners in Saudi Arabia, but a more basic consideration, will they work? In the US, a common idea is that by 2010 the economy is likely to be recovering on its own regardless of the stimulus bill. But the view from abroad is much simpler, returning growth is the point, not the method by which it is achieved. If the economy is growing in 2010, even poorly, the Obama administration will get the credit.

Probably the greatest concern of the people I spoke with was for the inflationary potential of the US government's fiscal policies and the Federal Reserves' new quantitative easing policy. An often expressed idea was that the government was creating debt on one hand and buying it with the other; a sleight of hand that did not impress my interlocutors.

US government debt is about to skyrocket. The easiest way to reduce the debt burden on future generations is to inflate it away. I encountered a good deal of skepticism of the idea that when the time is appropriate, the Fed will withdraw the excess liquidity from the economy. The suspicion is that when the Fed and the US government have to choose between no growth and low inflation and higher growth and higher inflation, they will choose the second every time.

The Saudi Riyal is pegged to the dollar and Saudis have just witnessed the inflationary effect of a weak dollar on their economy. If the peg remains, US inflation is a direct import to the Kingdom's CPI. In addition, oil is priced in dollars. Though it is improbable that an inflationary dollar would prompt another massive speculative bubble, the damage that a high oil price would do to the world’s economy in its weakened state would be substantial. A weak dollar will also revive pressure for the alternative pricing of oil in Euros.

Lastly, the Saudi government is one of the world’s largest holders of US government debt. US Treasuries are a low return, low risk instrument. With inflation that all changes. Not only does the value of those low returns diminish under inflation but the returned principle is also devalued. The prospect of inflation is probably the greatest threat to the continued investment of foreign governments in US sovereign debt.

If the dollar has remained the central currency in the world’s economic system it is because there is no genuine alternative. Governments that might prefer, in their ideal world, to strip the US of the economic advantages provided by the dollar have to resort to speculation about the arcane qualities of the IMF's Special Drawing Rights (SDR) just because there is no credible alternative.

To the Saudis and the world it will not matter why the US banking system remains stable, only that it does. The world will not care what happened to US capitalism if large banks are nationalized but only that the US and the world financial system functions. Likewise for the US economy. No one overseas will look askance if it is government spending and not tax cuts that revives the economy. But if deficit spending and quantitative easing destroys the value of the US dollar, the US currency will lose its reserve status and no one will care that it was for the best intentions.

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