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How long can this go on ?

November 11th, 2005

The record US trade deficit of $66 billion naturally raises the question “How long can this go on?”, and not in a rhetorical sense. To be more precise, the question is “How long before the US trade deficit starts declining” and my best estimate is “No more than two years”.

The reasoning is simple. Given two more years of growth in the deficit, the annual current account deficit will be around 1 trillion dollars (about 8 per cent of GDP) and accumulated net debt will be pushing 40 per cent of GDP[1]. At this point, the effects of compound interest start to bite, as interest on the accumulated debt adds to the income deficit. If trade deficits continue to grow, or even remain stable, the current account deficit explodes. This can’t continue.

If a trend can’t continue, it won’t. Therefore the US trade deficit must begin to decline, and soon. Flow-on effects to Australia are likely.

To be continued …

The figures were affected by Hurricanes Katrina and Rita. As discussed by the BEA, the hurricanes disrupted oil trade, reducing crude oil production and also crude oil imports and increasing imports of refined products. The net effect was to increase the trade deficit, though, as Brad Setser notes, this doesn’t entirely explain the observed increase.

On the other hand, receipts of insurance payouts and foreign aid mean that the hurricanes will tend to reduce the income deficit.

fn1. I think the historical figures understate the net position of the US. Although the US is supposed to be a large net debtor, the income account is roughly in balance, which would suggest that, valued in terms of their capacity to generate income flows, US assets abroad are about equal to foreign liabilities. My guess is that equity assets accumulated in the past, when the US was a net foreign investor, are undervalued. However, after making this adjustment, the analysis above still goes through.

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  1. Terje Petersen
    November 11th, 2005 at 09:37 | #1

    With a floating currency then can just inflate the debts away by dropping the value of the US dollar towards zero. There is no discipline in government created money. Slosh, slosh, slosh.

  2. wilful
    November 11th, 2005 at 11:20 | #2

    And the speculated flow on effects to Australia would be….?

  3. Ernestine Gross
    November 11th, 2005 at 11:48 | #3

    Terje,

    The numbers provided in John Quiggin’s post do not allow a distinction between private and government trade and they do not allow a distinction between private and government debt.

    The value of the US dollar relative to that of most other currencies is ‘floating’ because it is determined in a ‘free market’.

    So, what exactly is your complaint?

  4. Terje Petersen
    November 11th, 2005 at 12:03 | #4

    QUOTE: The value of the US dollar relative to that of most other currencies is ‘floating’ because it is determined in a ‘free market’.

    RESPONSE: When there is only one supplier and all other suppliers are prohibited by law then it is not generally regarded as a ‘free market’, or at least it should not generally be regarded as such. Demand is free, supply is strictly regulated in accord with US government monetary policy, legal tender laws and the prohibition on counterfeiting.

    Its a little like walking into a country that has a single telecommunications provider, where that provider is government owned and where competition is prohibited by regulation and then claiming that its a free market system just because citizen can subcribe for a telephone service.

    A free market implies open access to producers as well as consumers. The US government has an absolute monopoly on the production of the US dollar. It is not a free market product.

    A fixed exchange rate regime (ie not floating), a gold standard (ie fixed to gold) or a managed interest rate regime (ie what we have) are all regulated fiat monetary systems. None of them are free or even approximate freedom. We can argue the merits of one over the other but none can claim to be a free system.

    QUOTE: The numbers provided in John Quiggin’s post do not allow a distinction between private and government trade and they do not allow a distinction between private and government debt.

    RESPONSE: An entirely valid point and one that I will happily accept.

  5. Uncle Milton
    November 11th, 2005 at 12:42 | #5

    Terje has half a point, which is that the United States,as the supplier of the world’s major reserve currency, has more freedom to supply seemingly unlimited mounts of money to the rest of the world than do countries like Australia.

    Of course, this is not an original observation, having been made forcefully by Charles de Gaulle in the 60s.

    But there are limits to the ability of even the United States to do this. What those limits are, nobody knows.

  6. Ian Gould
    November 11th, 2005 at 12:54 | #6

    Milton, even more worryingly we have no idea of the abiltiy of the countries financing the US government debt to continue to do so.

    Several of the Asian countries that are buying large quantiites of t-bills (and accumulating heavy budget deficits in so doing) are the exact same countries that got badly burnt back in the 1990s when they last tried to manipulate the currency markets.

  7. Ernestine Gross
    November 11th, 2005 at 13:34 | #7

    Terje,

    Just to confirm understanding, you accepting my point on the aggregates destroys your ‘slosh, slosh, slosh’ response to John Quiggin’s post. All other words are therefore redundant.

  8. observa
    November 11th, 2005 at 14:54 | #8

    “A free market implies open access to producers as well as consumers.”

    And you don’t have open access to other producer currencies in the world as a consumer? Pssst, I’ll give you an Aussie dollar for each of your monopoly yankee dollars you poor oppressed thing. That’s the freedom loving sorta bloke I am. You got any more oppressed friends like you?

  9. Ernestine Gross
    November 11th, 2005 at 15:50 | #9

    Uncle Milton,

    The conversation seems to be a bit off-track. However, your post invites a comment.

    You say that it wasn’t Terje Peterson who made the original observation about the role of the US dollar as a reserve currency but it was Charles De Gaulle in the 1960s.

    Assuming Charles de Gaulle made the observation, then he made one that was relevant at the time because in the 1960s the US dollar did have the role of a major reserve currency. The ‘half point’ you ascribe to Terje Peterson in this regard in 2005 is simply anachronistic with respect to the monetary system to which Australia belongs.

    I wouldn’t have a clue how you arrived at the ‘half point’ for Terje Petersen from his post . But this is something for you and Terje Petersen to sort out.

  10. wilful
    November 11th, 2005 at 16:02 | #10

    Wasn’t one of the speculated plethora of reasons for the war on Iraq the idea that Saddam Hussein would start selling oil in euro, triggering a change and reducing the reserve value of the greenback, thereby making US monetary slightly more restricted by the market?

  11. Andrew Reynolds
    November 11th, 2005 at 16:44 | #11

    Terje,
    You are right in that the US could opt to inflate away its debt (slosh, slosh, slosh) – but this would be a very short sighted option. It would result in the loss of confidence in the currency as a store of value. Central banks and others would be less willing to hold it as a reserve and would switch to Euros, Sterling and others, getting rid of the free ride that the US has had as a result of being the global reserve currency. The reason why the last bout of inflation did not have this effect was because almost everyone was experiencing inflation at the same time. That is not occurring now.
    Fiat money does have some discipline behind it – a wise (or at least reasonably intelligent) government knows that once confidence in it is lost it takes along time (and a change of government) to get it back. That is why many governments have given control over monetary policy to a group outside the control of the politicians.

  12. Terje Petersen
    November 11th, 2005 at 17:16 | #12

    QUOTE: Just to confirm understanding, you accepting my point on the aggregates destroys your ‘slosh, slosh, slosh’ response to John Quiggin’s post.

    RESPONSE: No. Me accepting your point does not destroy my original response. However I accept that my original response was not entirely relevant. ie My point was VALID, but perhaps not RELEVANT but certainly not DESTROYED by my acceptance of your point.

    QUOTE:Terje has half a point, which is that the United States,as the supplier of the world’s major reserve currency, has more freedom to supply seemingly unlimited mounts of money to the rest of the world than do countries like Australia.

    RESPONSE:The USA has a favourable position in world trade because historically it represented such a large proportion of global production, and as an institutional hang over from Brenton Woods it emerged as the dominant currency for international trade. However whilst it is in a powerful position it does not have “more freedom”.

    QUOTE:And you don’t have open access to other producer currencies in the world as a consumer? Pssst, I’ll give you an Aussie dollar for each of your monopoly yankee dollars you poor oppressed thing.

    RESPONSE:In the international arena (ie cross border trade) we are certainly free to choose between the various international fiat currencies or even private currencies (eg e-gold etc) for the purposes of business. However when it comes to intra-national trade (ie trade within one country) then the system is a very long way from free. Tax laws generate demand for the national currency. Legal tender laws mandate acceptance of the national currency. Laws against counterfeiting ensure that there is a single producer of national currency. In Australia things like the Bank Notes act of 1910 ensure that that any rival producer of currency is put out of business.

    A free market in currency would mean that anybody could produce currency (ie no Bank Notes act of 1910), accepting a given currency for payment would be a voluntary matter (ie no legal tender laws), and doing your book-keeping in an alternate “unit of account” would not bias your treatment by the tax office or other government departments.

    I am not necessarily suggesting that a free market in currency is a priority. However I do disagree strongly with the assertion made by Ernestine that ‘floating’ currencies are a product of a ‘free market’. In fiat currency terms a ‘floating’ system is just one where the regulator of production has chosen some other target to determine production rates besides the exchange rate. The fact that they ‘manage’ interest rates should tell us straight off that the market is far from being free of government or regulatory interference.

    Given the core nature of currency in the field of economics (ie try draw a supply and demand curve without a price axis) it is disappointing that such misunderstanding abounds.

  13. Ernestine Gross
    November 11th, 2005 at 17:23 | #13

    Andrew Reynolds,

    What exactly is the problem to which you say Terje has provided the (slosh, slosh, slosh) solution with which you partly agree?

  14. Terje Petersen
    November 11th, 2005 at 17:25 | #14

    QUOTE: You are right in that the US could opt to inflate away its debt (slosh, slosh, slosh) – but this would be a very short sighted option. It would result in the loss of confidence in the currency as a store of value. Central banks and others would be less willing to hold it as a reserve and would switch to Euros, Sterling and others, getting rid of the free ride that the US has had as a result of being the global reserve currency.

    RESPONSE: Yes you are right. However the interests of a nation and the interests of its government do not always align. And when they do people are not always wise. So fiat money goes slosh, slosh, slosh and rocks the boat.

    QUOTE: The reason why the last bout of inflation did not have this effect was because almost everyone was experiencing inflation at the same time. That is not occurring now.

    RESPONSE: The reason why everybody experience inflation was initially because nearly everybody had a fixed exchange rate with the US dollar in the late 1960s. When the US dollar started inflating (ie when they left the gold standard and started devaluing the US dollar) everybody else followed the value of the dollar down. Not by rational choise but rather due to institutional behaviour. Once the follow of this was discovered people ‘floated’ their currencies and sought a better way. It took them a long time to find a better way. Nations like Switzerland that stayed on gold avoided the intial problems but were forced to choose between destroying their domestic industries as their comparative advantage in banking began to overwhelm everything else. Eventually they decided that inflation was more tolerable politically.

    QUOTE: Fiat money does have some discipline behind it – a wise (or at least reasonably intelligent) government knows that once confidence in it is lost it takes along time (and a change of government) to get it back. That is why many governments have given control over monetary policy to a group outside the control of the politicians.

    RESPONSE: Sure. It is also why traditionally systems like the gold standard were adopted. Such systems remove some subjectivity and introduce more objectivity. However fiat currencies do not have a good history. Over the long term governments are not that intelligent.

  15. RD
    November 11th, 2005 at 17:41 | #15

    About the income-position divergence dealt with in the footnote: There are some measurement issues about valuing direct investment, but it is probably not the major factor. I think the most important reason is that the US assets are have a high proportion of foreign equity, while the US liabilities are disproportionately in the form of debt securities. The return on equity tends to be higher than interest rates, particularly those on government bonds.

  16. Jonno
    November 11th, 2005 at 18:54 | #16

    Is it coincidence that Slosh rhymes with Bush?

  17. Terje Petersen
    November 12th, 2005 at 17:20 | #17

    Slosh rhymes with Bosh not Bush.
    :)

  18. stephen bartos
    November 12th, 2005 at 20:28 | #18

    I made a similar point to John’s in a gathering of regional banking and other financial types recently and the response was – “but where else would we go?”. That is, among this audience at least, the view was that the US is still the best bet in terms of long term growth prospects and that they were willing to continue to bankroll US borrowers, because the risks elsewhere were higher. I seem to recall from distant economic history classes that the US ran a large CAD for most of the 19th century, and built a booming economy on the back of it: there were corrections, and there does seem to be a good chance that there will be a relatively orderly correction soon with the US (but if there is a sudden run on the bank, hold on to your hat!).

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