Home > Economics - General > The other deficit: Part II

The other deficit: Part II

August 25th, 2004

In my previous post on US trade, I argued that if the current account deficit is to be stabilised at a sustainable level, the balance of trade on goods and services must return to surplus in the next decade or so. In this post, I’m going to ruIe out a soft option and argue that, while a smooth market-driven adjustment is not inconceivable, it’s unlikely.

The soft option is the idea that central banks will keep on buying US dollars indefinitely in order to keep the world trading system indefinitely, and that the US can therefore consume as much as it wants, subject only to the capacity of the Treasury to keep printing dollars. This option is not a goer for both economic and geopolitical reasons. On the economic front, there comes a point when the risk of being left with a pile of worthless paper exceeds any benefits from being able to export goods.

On the geopolitical front, there’s no point in spending hundreds of billions of dollars a year becoming a military hyperpower if you’re going in to hock to your rivals/potential adversaries for a similar amount. On current trends, the Chinese central bank will hold the better part of a trillion dollars in US government bonds in a few years time. Should there be any minor unpleasantness on the foreign policy front, nothing would be more natural than for the Chinese to stop buying a bit and diversify some of their existing holdings, say a hundred billion dollars or so, into yen and euros. At this point, Wall Street and the Treasury would demand immediate capitulation.

There are also various private sector versions of the soft option, based on the idea that foreigners desperately want to hold US assets, but none of these will stand up to the pressure of chronic trade deficits. As other countries have found out, relying on hot money to finance chronic deficits guarantees a crisis of confidence sooner or later.

If the soft option is ruled out, we’re left to consider paths by which the US can return to trade surplus. Currently the US exports about half as much as it imports. The imbalance could be reduced in a number of ways

* A (further) devaluation of the US dollar

* Reductions in US wages relative to those overseas

* Increases in US relative to foreign productivity (the relevant concept here is multifactor productivity, taking account of both capital and labour inputs)

* Reductions in US consumption relative to foreign consumption

To get back to balance or surplus in a decade, and without a crisis, no one of these would be sufficient. For example, to get to balance by devaluation alone would require a devaluation of the order of 50 per cent, which would certainly entail both an upsurge in inflation and an increase in interest rates. A lot of emphasis is (rightly) put on productivity but even on the most optimistic accounts, the gap between the US and other countries is no more than one percentage point per year, which is nowhere near enough. About 40 per cent of the marginal dollar goes on imports, so the restoration of balance through increased household saving alone would require an increase in saving equal to something like 12 per cent of GDP, and this seems most implausible.

If the adjustment were to begin almost immediately and everything went right, it could go smoothly. But the odds against this seem long. So it’s worth considering alternatives.

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  1. kyan gadac
    August 26th, 2004 at 01:39 | #1

    If the alternative is a 50% devaluation in the US$ then the question becomes what effect this will have on countries holding US$ debt. Japanese banks (amongst others) would probably capitulate. A global version of the Wall Street crash does not seem entirely far fetched. The critical issue may be the steps that the US takes to restrain the outflow of foreign capital invested in the country. Can they do anything? Will they succeed?

    I reckon the crunch will come after Kerry is elected because people will hold onto a straw when they’re drowning. Mind you while a crash seems inevitable, the recovery from the Asian crash of the 90′s was evidence that the global financial economy was pretty resilient and flexible. This time though it’s the role of the dollar in iternational transactions that will be critical. In a way, the dollar has replaced gold as a standard – simply by the absolute value of dollar trades in the global financial system.

    At some point devaluation will make the euro or (some asian equivalent) have more absolute value than the dollar at which point some new consensus will have to emerge from the chaos. A yen/yuan or rupee/yuan merger will be probably on the cards as a possible way out. Optimistically, the US will be financially humbled and learn the error of its ways and a new international consensus will emerge with three major currencies (Europe, Asia and America) being tied to each other in an orderly fashion – surely a pipe dream.

    Mind you a severe economic crash in the US will be incredibly good for global greenhouse emissions :-)

  2. Steve Edwards
    August 26th, 2004 at 03:50 | #2

    The US political economy is unsustainable. For instance, it is clear that they need to take their medicine in cuts in living standards.

    For the wage/consumption cuts to be possible, without causing a full-blown national riot, the United States will have to end mass immigration. That’s the real problem here. Real wages have been falling over time, as the labour supply has dramatically increased. Per-capita income will need to be stabilised at some stage, or there will be trouble.

    For the political/economic/military establishment to tread water they need to think about

    -abolish immigration
    -slash government spending
    -withdraw military forces from Europe (including the Balkans) and South Korea
    -undergo a staged withdrawal from Iraq (and eventually Afghanistan)
    -raise taxes on higher incomes

    And I think that is just a start. The idea that they can preside over a NATO security apparatus up to the borders of Russia, surround China, occupy the Middle East and Central Asia, and still have plenty of forces left-over for a few humanitarian interventions in Africa is somewhat ludicrous. But to combine this hegemonic system with tax cuts, high borrowing, and mass immigration is dangerous. If they don’t take some medicine now, they’ll lose the lot.

  3. Fyodor
    August 26th, 2004 at 10:46 | #3

    Steve,

    The USA faces a complex balance of payments problem and what’s your solution? Abolish immigration. Honestly, you’re becoming a caricature of yourself.

    Immigration has nothing to do with the USA’s current account deficit. The current account deficit is driven primarily by the USA’s trade deficit, i.e. imports are far greater than exports. This is largely because Americans consume more than they earn (i.e. they don’t save enough), and like buying foreign goods, which are relatively cheap due to the strength of the USD.

    Abolishing immigration will not change any of these factors.

  4. Harry Clarke
    August 26th, 2004 at 12:35 | #4

    I disagree that cutting immigration won’t help reduce deficits. There is a lot of evidence that ‘capital chases labour’ around the world. Historically evidence supports this for the US, Australia and Canada back to 1860. Big current account deficits go with big immigrations as resources are dragged in to service the larger workforce.

    Of course this does not mean that one should not enjoy the benefits of labour immigrations. Its just that the induced capital inflows will tend to transfer a lot of the induced gains-from-trade from the original population to the new arrivals.

    Let me guess that some smart-Alec PhD will eventually connect US prosperity over recent decades to its high rates of immigration. There will be a debate and eventually the connection will be deemed inconclusive on ‘causality’ grounds.

  5. Fyodor
    August 26th, 2004 at 13:09 | #5

    Harry,

    I think your last point is the most powerful. I had a think about it, and couldn’t find really strong theoretical arguments either way for the effect of relatively modest immigration on the current account.

    In the particular case of the USA today, I cannot see how the 300-odd million existing Americans will suddenly stop borrowing to consume imports just because there are fewer immigrants each year. That is, I think the problem is endogenous to the US economy, not exogenous. A bit of human traffic either way doesn’t change the fundamental position of the average US consumer.

    And on the subject of US prosperity, it’s not hard to argue that the combination of people (i.e. immigrants) + resources + capital took them a long way. Ditto Australia, Canada and New Zealand.

  6. Steve Edwards
    August 26th, 2004 at 14:03 | #6

    Did you even read my post, Fyodor?

    Actually, nowhere did I make my immigration comments with respect to the current account deficit. I suggested that living standards need to be brought down to a sustainable level, implying a recession. You are supposed to cut immigration during a recession.

    On the other hand, immigration most certainly does affect the current account at some level. Quoting what former federal Finance Minister, Peter Walsh, had to say about the issue:

    “The argument in 1988 focussed on the effect of immigration on the Current Account Deficit, a problem much more acute than its long term effect on wages. For a given level of unemployment, the immigration programme required GDP growth to be 1 per cent higher which, according to Treasury estimates blew out the import bill by 3 per cent…Social infrastructure spending driven by population growth bleeds funds away from productive investment. In short, migration adds more to demand than it does to supply, ipso facto it blows out the current account deficit…EPAC later estimated an immigration program of 140,000 a year had an adverse current account effect between four and six billion dollars” (Confessions of a Failed Finance Minister, p.186-7)

  7. still working it out
    August 26th, 2004 at 15:31 | #7

    billmon has been following this issue for quite a while. The best post I’ve ever read on the US deficit’s problem is in this post The Economic Limits of Empire. Its quite long and detailed, but he’s a great writer and makes it an entertaining and certainly very informative read.

  8. Fyodor
    August 26th, 2004 at 16:49 | #8

    Steve,

    If you didn’t “make my immigration comments with respect to the current account deficit”, why did you bother making them? It’s only the subject of this thread, after all.

    The subject of JQ’s post is the US current-acccount deficit. You responded with:

    “The US political economy is unsustainable. For instance, it is clear that they need to take their medicine in cuts in living standards.

    For the wage/consumption cuts to be possible, without causing a full-blown national riot, the United States will have to end mass immigration. That’s the real problem here. Real wages have been falling over time, as the labour supply has dramatically increased. Per-capita income will need to be stabilised at some stage, or there will be trouble.”

    Some rejoinders:

    1) It’s not at all clear that a cut in living standards is required to correct the US current account deficit. As JQ pointed out, there are a couple of options/scenarios.

    2)You assume “wage/consumption cuts” are required, and that these can only accommodated (politically, I assume) with a cut in immigration. Why? The USA currently has an historically low level of unemployment, and rising unemployment historically has not caused a “national riot” over immigration.

    3) You imply that the increase in the US labour supply was wholly attributable to immigration, without noting the demographic surge of the Baby Boomers and the increased participation of women in the workforce in recent decades.

    As for Peter Walsh’s quote, I’d be careful before quoting him as an authority on economics, though I gather you’re fond of the guy. Perhaps there’s an economist out there who’s done the work?

  9. Steve Edwards
    August 26th, 2004 at 18:35 | #9

    Fyodor, the mass immigrationist, writes:

    “1) It’s not at all clear that a cut in living standards is required to correct the US current account deficit. As JQ pointed out, there are a couple of options/scenarios.

    2)You assume “wage/consumption cuts” are required, and that these can only accommodated (politically, I assume) with a cut in immigration. Why? The USA currently has an historically low level of unemployment, and rising unemployment historically has not caused a “national riot” over immigration.

    3) You imply that the increase in the US labour supply was wholly attributable to immigration, without noting the demographic surge of the Baby Boomers and the increased participation of women in the workforce in recent decades.”

    Let us return to JQ’s medicine:

    -A (further) devaluation of the US dollar
    -Reductions in US wages relative to those overseas
    -Increases in US relative to foreign productivity (the relevant concept here is multifactor productivity, taking account of both capital and labour inputs)
    -Reductions in US consumption relative to foreign consumption

    There is only one factor here that does not involve a reduction in the global purchasing power of Americans, and that is the increase in productivity. But it’s not clear how that will come about without an increase in savings/investment rates. In order to free up the capital for higher productivity, they will either have to cut consumption elsewhere in the economy, or borrow yet more money abroad.

    In any case, virtually all of what JQ amounts to belt-tightening.

  10. August 26th, 2004 at 18:35 | #10

    To resolve the trade deficit problem, you have first to analyse correctly the circumstances in which it has come about and persisted.
    Those circumstances – including the economic policies – of the United States and Australia are fundamentally the same. Their origin is the attempt to “fight inflation” by raising interest rates and “damping down” the economy, beginning in July 1969.
    Essentially the same policies are being applied today. When inflation becomes or is thought to become a threat, the immediate response of central banks is to raise interest rates. In fact, a hike in interest rates increases production costs and cuts supply in relation to demand – demand sustained by welfare and, for example, consumer-credit policies.
    Historically the result was severe stagflation for many years, followed by supply from outside the economies that had applied the fallacious anti-inflationary policies. Put in specific terms, supply to countries like the United States and Australia came from countries like the Asian Tigers and, more recently, especially from China.
    The basic anti-inflationary policies thus did not “beat” inflation – except asset-price inflation – but only shifted it from domestic price increases to external trade and payments deficits.
    Since these basic anti-inflationary policies have not been changed – they persist today – this shift persisted, the external deficits became chronic and, of course, aggregate external indebtedness increased over the years.
    The indebtedness of the United States is now massive and increasing at a rate, at the moment, of some $US600 billion or more a year. The indebtedness of Australia is of course large too although, for a variety of reasons including the differences in the status of the currencies, it is not in the same league as that of the United States.
    The problem of the deficits – and the problems of stability and sustainable growth generally – will not be resolved until there is fundamental reform in the policies for the macro-economic management of our major economies. It may well be – and now seems highly probable – that a major crash of the kind of the late twenties and thirties will be needed to bring the policymakers – and, indeed, the mainstream professional economists and central bankers – to their senses.

  11. Steve Edwards
    August 26th, 2004 at 19:16 | #11

    Fyodor writes:

    “2)You assume “wage/consumption cuts” are required, and that these can only accommodated (politically, I assume) with a cut in immigration. Why? The USA currently has an historically low level of unemployment, and rising unemployment historically has not caused a “national riot” over immigration.

    3) You imply that the increase in the US labour supply was wholly attributable to immigration, without noting the demographic surge of the Baby Boomers and the increased participation of women in the workforce in recent decades.”

    This is all completely off the mark. The US does not have an historically low level of unemployment.

    There is yet to be, to my knowledge a riot over immigration specifically (even though there has been no shortage of race rioting over other matters). On the other hand, a democratic society cannot survive a long-term decline in living standards without major upheavals and instability. Given what we know about the income effects of mass immigration, we can safely say that inducing a recession and then compounding the misery by needlessly inflating the labour supply will create an enormous amount of pain. What really gets me is that it is entirely avoidable.

    Fyodor suggests: “You imply that the increase in the US labour supply was wholly attributable to immigration, without noting the demographic surge of the Baby Boomers and the increased participation of women in the workforce in recent decades.”

    No I don’t. I do, however, note that mass immigration is causing more punishment than otherwise would be the case. Cut or rationalise immigration – raise living standards.

    “As for Peter Walsh’s quote, I’d be careful before quoting him as an authority on economics, though I gather you’re fond of the guy. Perhaps there’s an economist out there who’s done the work?”

    Some economists did do the work, of course. Read the Walsh quote again. These economists include the Department of Treasury and the Economic Planning Advisory Council.

  12. Fyodor
    August 27th, 2004 at 09:03 | #12

    Steve,

    The links to the Department of Treasury and EPAC don’t show the research you’re talking about. Given it’s your source, I’d prefer it if you wasted your time rather than mine looking for the research.

    Specifically on the USA, you’ve yet to demonstrate that:

    1) the USA’s immigration intake is a material factor in its current account deficit; and

    2) “abolishing immigration”, as you put it, will reduce the deficit.

    You say that the Americans have to reduce immigration to improve their living standards? What absolute bulldust. The richest, most powerful nation on Earth was built precisely on immigration, and you think it REDUCED living standards? Simply astonishing.

    Contrary to your assertion, I’m no more a “mass-immigrationist” than you are a xenophobe.

  13. August 27th, 2004 at 11:15 | #13

    Fyodor – immigration did cut US living standards in the short term. It was just the serendipity that the USA had opportunities that were opened up by immigration that made it work as a capital inflow (which it wouldn’t have done without other forms of capital inflow as well). But you might want to look up the whole nativist argument of the early 19th century to get a fuller picture; it wasn’t just about total levels but also about how those were distributed among existing groups.

  14. Steve Edwards
    August 27th, 2004 at 13:32 | #14

    Sorry, Fyodor, but I’m right and you’re wrong. Your evasions are very artful, but they aren’t going to work. Walsh got economic advice from Treasury and EPAC and the current account effects. I have linked to example after example after example of proven data on the effects of immigration on the United States on this thread and others.

    I’ve not suggested that I have data on the immigration effect on the US current account, although the former Aust Finance Minister got advice from two government bodies. On the other hand, the composition of immigration into the United States is lower-skilled with higher transaction costs than Australia. This coupled with the tendency for immigrants in America to send remittances home, suggests that the effect is probably similar. To repeat, I have found plenty of evidence of the effects of immigration on per-capita incomes in the United States.

    The best you can rebut with are fact-free evasions.

  15. Steve Edwards
    August 27th, 2004 at 13:36 | #15

    Second last sentence should have ended, “and even though I haven’t got specific US current account effects, it is well known what the effects are in Australia”

  16. Fyodor
    August 27th, 2004 at 13:47 | #16

    P.M. Lawrence,

    Um…which short-term are you talking about? The short-term from the foundation of the first colonies in the early 1600s to around about now? I’m also not sure what you mean by immigration as a form of capital inflow. From my recollection, many of the immigrants to the USA (e.g. the “poor, tired and hungry”) arrived with bugger-all capital, apart from the value of their own labour. Pace Steve Edwards, they subsequently made an enormous contribution to the country.

    Additionally, as I understand it, the US nativists’ gripes of the 19th century were more to do with the ethnic and religious backgrounds of the new immigrants, not the economic impact. Sound familiar?

  17. Fyodor
    August 27th, 2004 at 13:58 | #17

    Steve,

    That’s a truly devastating line of argument: “I’m right and you’re wrong.” I can’t wait for your next rhetorical master-stroke.

    I’m not evading anything. Produce the “facts” you’ve cited. That’s all I asked for.

  18. Steve Edwards
    August 27th, 2004 at 17:09 | #18

    Fyodor seems to have a short memory. So short, that not only is he trying to ignore losing this exact same debate two weeks ago, he is pretending that I haven’t linked to any facts already in this thread.

    Of course, if you are a globalist ideologue, this behaviour is not surprising. Globalists do not like to be told the truth regarding the effects of immigration on wages and income, as that would require them to revise their borderless agenda.

    Theoretically, the effects of (particularly low-skilled) immigration on income can be predicted not only in a standard labour market model, but in the model of economic growth developed by Nobel Prize winner Robert Solow. The effects are clear – income depends on capital invested per worker (long term growth requires technological change) – increase the number of workers and you decrease capital-per-worker. Furthermore, the Solow-Swan model specifically builds population growth into the capital depreciation function, such that higher population growth lowers per-capita incomes.

    So here we have Nobel Prize winner Robert Solow, former Finance Minister Peter Walsh, the standard labour market model, proven US economic Data, the Department of Treasury, EPAC and me, versus Fyodor the fact-free link-free globalist. The same globalist believes that the US is at a historical low in unemployment

    Justin Raimondo has pointedly remarked of Christopher Hitchens:

    I always distrust a web writer who fails to utilize links, and Hitchens (who never uses them) embodies two bad traits linking tends to minimize: laziness and dishonesty. I hasten to add that these flaws are by no means confined to writers: the point is that linking is an attempt to validate, in some sense, what would otherwise appear to be an arbitrary assertion. But since Hitchens doesn’t really want to prove anything, except to show, once again, that he is merely a bundle of prejudices, it’s no wonder his Slate pieces are link-less – and, certainly in this case, clueless.

    I must concur with Mr Raimondo.

  19. Fyodor
    August 27th, 2004 at 17:53 | #19

    Steve,

    I’ll repeat the request I made earlier:

    “The links to the Department of Treasury and EPAC don’t show the research you’re talking about. Given it’s your source, I’d prefer it if you wasted your time rather than mine looking for the research.

    Specifically on the USA, you’ve yet to demonstrate that:

    1) the USA’s immigration intake is a material factor in its current account deficit; and

    2) “abolishing immigration”, as you put it, will reduce the deficit.

    You say that the Americans have to reduce immigration to improve their living standards? What absolute bulldust. The richest, most powerful nation on Earth was built precisely on immigration, and you think it REDUCED living standards? Simply astonishing.”

    Specifically, you have not answered points one or two, and you still haven’t produced the research that Peter Walsh refers to.

    FYI, the Solow-Swan model you’ve referenced is a closed-economy model which doesn’t explicitly model immigration, trade or capital flows. Not only is it irrelevant to the current account deficit, it was also lazy and dishonest of you to employ it as evidence. Get YOUR facts straight before you start throwing stones.

  20. Steve Edwards
    August 27th, 2004 at 18:24 | #20

    Still evading the facts are we?

    My source is the former Federal Finance Minister for the EPAC and Treasury estimates – I made that very clear. The best you could come up with in response was “oh, we must be careful about Peter Walsh”. Right. So he made up the figures? I’m sorry, but that is just not good enough.

    The following demonstrates you have neither read my post, nor have even checked any of the links:

    “Specifically on the USA, you’ve yet to demonstrate that:

    1) the USA’s immigration intake is a material factor in its current account deficit; and

    2) “abolishing immigration”, as you put it, will reduce the deficit.”

    You are debating an imaginary person. Although one of my links did claim that immigration affected Federal fiscal policy, I did not argue anything with respect to the US current account deficit.

    “You say that the Americans have to reduce immigration to improve their living standards? What absolute bulldust. The richest, most powerful nation on Earth was built precisely on immigration, and you think it REDUCED living standards? Simply astonishing.”

    Wrong. You have not even attempted to disprove the case I have made – nor have you provided any evidence to the contrary. You have therefore conceded defeat. Whether or not a country has been “built” on immigration is irrelevant. You haven’t even bothered to read my argument. Ceteris parabis an increase in the labour supply decreases capital invested per labour unit.

    “FYI, the Solow-Swan model you’ve referenced is a closed-economy model which doesn’t explicitly model immigration, trade or capital flows. Not only is it irrelevant to the current account deficit, it was also lazy and dishonest of you to employ it as evidence. Get YOUR facts straight before you start throwing stones.”

    No, YOU get YOUR facts straight. I wasn’t deploying the model with regards to the current account deficit. The model DOES integrate immigration into the capital:labour function. This is perfectly obvious. It essentially shows the relationship between savings, investment, depreciation (population is built into the depreciation function) and economic growth.

    Fyodor – you are by far and away the most dishonest commenter I have ever come across. Nobody I have ever seen has operated with worse faith than you. You have no evidence, no facts, and you have lost this argument fair and square. I beat you hands down last time, and you should probably cut your losses before you look really bad this time.

  21. Steve Edwards
    August 27th, 2004 at 18:35 | #21

    Let me see if I can get the full litany here.

    Fyodor believes the following; or is trying to dishonestly make a case for the following; or will not admit the following are untrue because it does not serve present tactical purposes:

    -There is no relationship between labour supply and wages

    -The capital:labour ratio has no implications for living standards; else decreasing the ratio may improve living standards

    -There are no social equity implications for accepting mass low-skilled immigration

    -Diverting capital to social infrastructure to service higher immigration has no implication for the current account deficit in Australia.

    But of course. Only a “xenophobe” would believe otherwise.

  22. James Farrell
    August 27th, 2004 at 18:38 | #22

    Steve:

    If you have access to JSTOR, there is a good primer on the state of theoretical and empirical knowledge in The Impact of Immigrants on Host Country Wages, Employment and Growth by Friedberg and Hunt in The Journal of Economic Perspectives, Vol. 9, No. 2.

    The Solow model is of little use in examining this kind of question. The simplest version treats labour as homogeneous. In a richer version, involving different kinds of skills and human capital, the results would depend on the substitutability and complementarity of different kinds of labour and human capital. More importantly, it leaves out international capital flows. The fact that immigration might encourage larger capital flows actually supports your original argument about immigrants and the current account, but it undermines the one about immigrants and wages.

  23. John Quiggin
    August 27th, 2004 at 18:40 | #23

    I think we might call a halt on this thread. I’ll try to address some of the issues in a later post.

  24. Steve Edwards
  25. Steve Edwards
    August 27th, 2004 at 18:59 | #25

    James – I did not deploy the Solow model to support my point about the current account deficit – it was Fyodor that claimed this, incorrectly.

    I have found data on the impact of immigration on wages in the United States. My point, however, is not to take an axe to immigration period (I would be a hypocrite if I did). The real issue is the content of an immigration programme. A business migration scheme will increase the demand for labour in the host country. A skilled migration scheme will increase inputs to higher-valued industries, and lower prices for related goods/services.

    This much is clear.

    However, the United States is receiving an enormous number of unskilled immigrants that bring minimal capital with them, and few skills. As a result, the welfare of Americans is likely to be adversely affected, to say nothing of the income distribution effects.

    And finally, the words “ceteris parabis” must be heeded at all costs. I use the term as often as possible.

  26. gordon
    August 28th, 2004 at 13:02 | #26

    Let’s not forget also the environmental hazards of excessive population. Sustainable Population Australia (formerly Australians for an Ecologically Sustainable Population) has its population policy statement at http://www.population.org.au/pressrm/pub/SPA_Population_Policy.pdf.
    It looks good to me!

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