The trade deficit has lost power to grab headlines. Every month, the BEA announces the figure, the markets react to the number for a few days, then everybody goes back to their regularly scheduled program until next month. In addition, the primary mechanism that brings the trade deficit into the public spotlight – a deterioration of the dollar’s value – hasn’t happened since the first of the year. Starting in January, dollar has rallied versus other currencies because US interest rates are high relative to other countries.
So, everything must be OK, right? Wrong. The trade deficit will probably set another record this year with little sign of correction in the near future. It still endangers the US economy in a fundamental way, threatening our economic security.
Last week, NY Fed President Timothy F. Geithner spoke to the Asia Society’s CEO forum. He used the speech to discuss the trade deficit and why it is so important to deal with it now before it deals with us later. His comments outline the problem’s causes and implications for US policy.
What caused the problem?
In the United States, public savings and household savings fell, while investment spending stayed reasonably strong and housing investment very strong, even during the latest recession.
The second feature of this dynamic has been an increase in the willingness of the rest of the world to invest its savings in the United States.
An economy must have a savings base to expand. Savers place their excess funds into various financial intermediaries – banks, the stock market etc…. These financial intermediaries then lend the money to business who in turn use the money to invest in new productive capital to expand their respective businesses.
The problem is the US savings rate has declined for the last 20+ years, and now stands at 0. Yes, you read that correctly. We have a 0 savings rate. This doesn’t mean what you probably think it means. For economists, “savings” is what is left over after monthly consumption expenditures. So, for the last 20 years, Americans have slowly decreased the amount of money they set aside after they are paid wages, pay taxes and purchase items. At the macro level, Americans now set aside nothing. They immediately spend everything they make.
So, domestic funds for the national financial intermediaries has been decreasing. But, the US economy is still expanding. Where does the money come from?
Overseas. Foreign investors take their excess money and invest it in the US because they perceive the US as the best and safest place to invest. The Republicans have now framed this issue as a sign of American strength – we’re so great, people want to invest their excess cash in the US!!!! The US is strong!!! No need to worry about the trade deficit!!!!
Well, we need to worry about the deficit. Why? Well, according to the same speech, here are some of the reasons:
It matters because of the size of the U.S. imbalance. Our current account deficit is now running at a rate of above 6 percent of GDP, a level without precedent for a major economy.
Just to give you an idea, 5% is considered really bad by most economists. 6% is, well, really, really bad. Usually this would spell disaster for a currency. In fact, it did for the dollar last year when the dollar was ready to fall through important levels. However, the US also has the highest interest rates in the first world, which is currently bolstering the dollar in the forex markets. In fact, it’s pretty much the only thing holding the dollar up right now.
It matters because of the trajectory of the U.S. imbalance. On reasonable assumptions about its likely near term path, this deficit will produce a very large net deterioration in our net external liabilities relative to national income, with progressively larger net transfers of income to the rest of the world
Simply put, if the trade deficit continues on its current course, the US will have to pay more and more money to overseas investors. This money going overseas will continue to increase relative to US national income, meaning more and more of our GDP will go overseas instead of into domestic business.
It should concern us because of how the imbalance has been financed. A substantial portion of the capital inflows that finance our current account deficit has come from foreign central banks–which have been accumulating dollar reserves to preserve exchange rate arrangements that are unlikely to be sustainable and are already in the process of change. The impact of a reduction in the scale of official accumulation of dollar assets could be fully offset by increases in purchases by private investors. But even in the context of a continued high degree of confidence in the relative return on claims on the United States, it is hard to know with confidence how the preferences of private savers might respond to the process of gradual evolution in their nation’s exchange rate regimes now underway.
Right now, foreign central banks are the big purchasers of US debt. If that starts to drop off, foreign private investors could pick-up the slack. However, if foreign central banks are no longer investing in the US, why should their citizens? Wouldn’t a drop-off by foreign central banks mean the US was no longer a great place to invest? If their governments won’t invest, why should their citizens?
This pattern should concern us because it is not simply the result of the savings and investment decisions of the private sector. The fact that we are using a substantial part of the savings we are borrowing from the rest of the world to finance an unsustainable level of public borrowing leaves us more vulnerable than if those savings were being used for productive private investment. Large structural fiscal deficits limit the size of the sustainable external imbalance for any country, even the United States, and they necessarily increase concern about the terms on which we are likely to finance the present imbalance.
The federal deficit – (again) created by those fiscally responsible Republicans — is soaking up foreign central banks investments in the US instead of going to US industry (like out deteriorating manufacturing and information technology sector). As a result, the US isn’t investing in productive assets that could help grow the US out of the trade imbalance. Looking at the trade figures, imports are still growing at a faster rate than exports.
And most importantly, perhaps, these imbalances matter because at some point they will have to reverse. Market forces will at some point induce an adjustment. And that inevitable process of adjustment will bring with it the risk of large movements in relative prices, greater volatility in asset prices and slower growth in the United States and in the rest of the world.
The magnitude of this risk is difficult to measure with any confidence. Past episodes of external adjustment offer some reassurance, but the present circumstances seem sufficiently different from historical precedent that history may not be a particularly useful guide.
This situation can’t last forever. And as market forces take over and start to correct the situation, the US could experience some serious pain:
The risks associated with this adjustment process may be magnified by changes in the household balance sheet in the United States. The average household in the United States today has a higher level of debt to income and is somewhat more exposed to interest rate risk than in the past. The sustained rise in housing prices and the scale of borrowing against housing assets raises the possibility that a rise in risk premia could have a greater impact on household spending that would have been true in the past
Paul Volcker puts it far more succinctly:
I don’t know of any country that has managed to consume and invest 6 percent more than it produces for long. The United States is absorbing about 80 percent of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of dollars.
Now that the new Fed chairman has been announced (Bernanke), how likely is it that he will take any of the necessary steps to reduce the trade deficit? Apparently he doesn’t think the housing bubble is much of a problem.
I have no faith in anyone tha Bush nominates.
However, I will start to do some research on Bernanke to see what his record says.
I have little faith in anyone they nominate as well, but was wondering if the choice is likely to provide people who are actively reducing their debt a little more time before the fecal matter really hits the fan…
Wingers who even acknowledge this fact will attribute it to a loss of moral character. People who fail to save are simply making poor choices, I’m told by those I spar with at a local blog.
Poor choices, like buying food and heat.
Too true, it’s hard to save when real wages keep falling and more and more people can’t afford the essentials, let alone any extra purchases.
I mentioned this in a diary comment yesterday, but someone really needs to tell these idiot right-wingers that if they really want to help out their big business cronies, the government should send out a quarterly income assistance check to low-income families. If you send a poor family 200 bucks every three months and track the spending, I GUARANTEE that it will all be spent at Wal-Mart or the local supermarket. Rather than directly give the cash to those bastards in the form of a tax cut, I’d like to see people fight for corporate welfare that at least helps someone on the way into one of the Walton heir’s pockets.
radio documentary on our local community station recently that analyzed why Colorado is so eager, statistically much more so than other states, to place children in foster care.
The basic cycle is like this: Dad leaves or is killed. Mom’s got two kids, and one on the way. The older boy gets in trouble with the law or misses school, and mom is unaware or unable to deal with it since she’s just leaving for her second shift at Wal-Mart.
A case worker steps in and more often than not in our state, recommends the kids be taken away from mom and placed in foster care. Their unsettled lives are now made even worse, and the cost to the state is apparently well in excess of $80-100,000 per kid, per year.
What if we took $80,000 and simply gave it to mom, enabling her at the very least to quit her night job? Might that not have a better outcome for everyone involved AND save Colorado money?
Yep. But that’s socialism, you communist, pinko.
It’s a “life voucher.” She can spend her money better than the government can. It’s teaching her to fish, not giving her fish sticks…etc., etc.
Not that I have any problem with Socialism. I consider some form of highly managed capitalism to be the only realistic approach to economic activity. I just think the people who would freak at my proposal would freak out anyway. They’re just greedy and assume that anyone getting any sort of public help necessarily takes something away from them.
Like that shooting incident in “Bowling for Columbine” where the mom had to ride the bus to work several hours a day and had to leave her son with a family member who had a gun in the house.
You know, I don’t understand how social conservatives haven’t seized on that very issue. How could we ever have that Ward and June Cleaver style family these days without paying women to stay home with their children? My wife and I haven’t even thought about kids yet because we can’t afford to have one of us out of work to look after the kids. We do pretty well with both of us working, but the loss of one of those incomes would be tough.
Why child-rearing is not considered by our society to be a vital economic activity is beyond me. Especially since teaching gets dumped on almost as much. But they’re up there in the top ten most valuable economic activities, as both are a vital part of ensuring that the system continues and remains stable.
I have real doubts about the veracity of the $80K+ figure. Foster parents aren’t getting that kind of money. Medicaid for a kid in foster care costs on the order of $2,000 a year, so it isn’t going there. Full time prison supervision costs less than $30K per year.
Drop a zero, and at $8K-$10K I think you are closer to the mark. Now, this doesn’t necessarily mean that the basic idea – using the money to help mom take care of her kids instead of someone else isn’t potentially good policy (although there are plenty of kids who absolutely need to be removed from their parents), but I simply do not believe the dollar figures.
Bonddad, I read all your diaries here and and DKos and I’ve always wondered when you think the adjustment/crash will hit? Every economist I read seems to agree that there is this underlying problem with the economy, but people have been saying that for several years. How long can this bubble go without bursting?
Does it really have to reverse? And, even if it does, is that a bad thing?
Basically, the trade deficit compares imports and exports, narrowly defined. But, of course, no individual import or export is entered into without what both sides consider to be a fair exchange. If imports don’t match exports, the trade deficit must be either a result of investments in the United States, or consumption of services not within the narrow definition of imports or exports.
For example, if I pay a Chinese business $100,000 in U.S. dollars for a shipping container full of plastic silverware, and that Chinese businessman sends his child to Colorado where the child spends the money to get an education at Denver University for four years, the trade statistics record this as a $100,000, but there is nothing terribly frightening about trading goods for services. It happens every day.
The reason, as I understand it, that the trade balance is so closely watched, is because we have good data. Customs records are easy to maintain, a wholistic measure is not.
Now, support that instead of sending his kid to DU, this Chinese businessman buys $100,000 of Treasury bonds, which seems to be precisely what is going on, for the most part, in this relationship. Now, we have a shipping container full of plastic spoons and forks now, and he has a piece of paper which entitled him to $100,000 and a low rate of interest (barely above inflation really) at some point in the future (realistically, given the depth of the bond market, any time he wants).
Now, if he had $100 billion, instead of $100 thousand, he could make quite a stir in the bond market if he wanted to cash out all at once. But, since the bond market is not infinitely deep and elastic he wouldn’t want to do that. It would reduce the value of his investment. But, if instead he wants to take money out slowly over time, how is that any more destructive than the baby boomers slowly cashing out their conservative retirement invesetments?
Indeed, assuming that the opportunity to buy services in two countries, and the investment prospects in two countries are not equal, and they hardly ever are, especially in countries as different as China and the United States, why should we ever expect a trade balance to exist at all?
Do Wyoming and Colorado have a trade deficit running one way or the other? I strongly suspect that they do. Do we care? Do we even bother to keep statistics about it? We certainly don’t report on it in the papers every month.
Now, you can say, but Wyoming and Colorado are in a single currency zone, while China and the United States are not. This is true. Moreover, you can further say that one of the reasons that China buys all those treasury bonds, and it is really the Chinese Central Bank and not some business person doing so, is for the purpose of manipulating an artificially imposed exchange rate that is deliberately favored to develop a Chinese export industry. Good which would have been produced in the U.S. or Mexico had the exchange rate been a market rate, might instead be produced in China.
This has the potential to be worrisome. It sounds a bit like a Walmart going into a market and offering below cost prices for a few years in order to put the competition out of business and then jack up prices. Kill the U.S. manufacturing industry and build the Chinese one, and the trade deficit can be reduced later when China dominates the manufacturing sector and raises its prices. But, I have doubts that China is really capable of carrying out such a strategic plan. Isn’t it equally possible that the Chinese are basically giving away Chinese products to the U.S. through an artificially low exchange rate, simply because they are riding a manufacturing bubble that they can’t sustain otherwise and because there would be political hell to pay if it did? If so, it could be the China has more to fear than we do.