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.