What can't be sustained, won't be
The US recorded a trade deficit of $725.8 billion or 5.8 per cent of GDP in 2006. That’s roughly equal to Australia’s entire GDP. With short-run interest rates having risen, the income component of the current account deficit is bound to start growing rapidly soon. If the trade deficit doesn’t turn around this will generate an unsustainable explosion in debt and deficits.
What can’t be sustained won’t be, so it’s safe to predict that the trend shown will be reversed sometime soon. What’s harder to predict is the mechanism by which this will happen.
The optimistic theory was that strong US productivity growth, aided by the moderate depreciation of the early 2000s would lead to a revival of the US export sector. This seems to have worked for Boeing, but nowhere much else, and both the depreciation and the productivity boom have now run their course. And the loss of traded-sector jobs (mostly manufacturing) that took place in the recession hasn’t been reversed, suggesting that US businesses don’t anticipate any big growth in this area.
A really big depreciation would be another possibility, but nothing like this is priced into US interest rates at present. It seems likely that the US dollar is being held up by foreign central banks. This process must unwind some time, and its impossible to tell whether the process will be orderly or chaotic. Even so, it’s hard to imagine a depreciation large enough to restore balance in time.
The third possibility is a reduction in US demand. It doesn’t seem likely that this will come from the public sector: there’s no hint in the latest Bush budget that chronic deficits are a problem. So a big decline in household consumption is needed to restore balance, and also to repair household balance sheets, which look bad now and will look worse if housing prices fall.
Such an increase could result from a general recognition by households of the need to save more, but it seems more likely to result from an increase in long-term interest rates. Again, we come back to the observation that no such increase is being priced in by the market.
Australia is, of course, in a very similar position. Suggestions that our deficit problems would right themselves when the drought ended or when coal exports started moving have proved false. Our adjustment process will almost certainly be tied up with that of the US.