I was looking at the latest US trade figures from the Bureau of Economic Analysis and thought, rather unoriginally, that this is an unsustainable trend. Despite the decline in the value of the US dollar against most major currencies, the US balance of trade in goods and services hit a record deficit of $55 billion (annualised, this would be about 6 per cent of Gross Domestic Product) in June. The deficit has grown fairly steadily, and this trend shows no obvious signs of reversal, at least unless oil prices fall sharply.
This naturally, and still rather unoriginally, led me to the aphorism, attributed to Herbert Stein “If a trend can’t be sustained forever it won’t be”. Sustained large deficits on goods and services eventually imply unbounded growth in indebtedness, and exploding current account deficits, as compound interest works its magic. So, if the current account deficit is to be stabilised relative to GDP, trade in goods and services must sooner or later return to balance or (if the real interest rate is higher than the rate of economic growth) surplus
But forever is a long time. Before worrying about trends that can’t be sustained forever, it is worth thinking about how long they can be sustained, and what the adjustment process will be.
I set up a simple spreadsheet model and started with some reasonably optimistic numbers. Suppose the deficit on goods and services levels out at 5 per cent of GDP, stays at that level until 2007, and then declines steadily over the next decade years, with the balance stabilising at a surplus of 1.5 per cent of GDP. Over this period, net external obligations increase steadily, and so do the associated income payments. The equilibrium position has net obligations equal to around 80 per cent of GDP (about $8 trillion at current levels). Assuming an interest rate of around 7 per cent, the current account deficit stabilises at 4.5 per cent of GDP.
Would this be a sustainable outcome? Stephen Kirchner points to Australia to suggest that it is. After a big run of goods and services deficits in the 1980s, Australia’s position broadly stabilised in the 1990s, with net obligations around 60 per cent of GDP (still rising, but slowly), and a CAD of 4-5 per cent.
There are several problems with Kirchner’s claim. First, it’s not clear that complacency about Australia is justified. We weren’t affected by financial panic during the Asian crisis, but that doesn’t rule out the possibility that high debt levels will produce a panic sooner or later.
Second, as Peter Gallagher observes, the US is much bigger than Australia. It’s not clear that global capital markets can call forth enough savings to finance deficits on this scale, at least not without an increase in interest rates. Any significant increase in interest rates would create huge problems for debtor countries like Australia and the US.
But the biggest problem for me is that I can’t see how the stabilisation scenario I’ve described is going to be realised without some sort of crisis. Without radical changes in the US economy, a large deficit on oil imports can be taken as a given. And there are large classes of consumer goods for which domestic production has pretty much ceased. If balance is to be reached in a decade, there has to be a big turnaround in the pattern of trade somewhere, and it’s hard to see where. There is no sector in which the US is currently running a large surplus (there’s a small surplus on services, but even here, the trend is flat or negative). Even with the recent depreciation, and much-touted productivity growth, there’s no sign that US producers are gaining market share in any part of the traded goods sector. The big decline in manufacturing employment since the late 1990s is hard to square with the idea that short-term deficits are justified by long-term growth prospects.
Finally, the scenario requires a lot of faith on the part of foreign lenders, who face a big risk of expropriation through inflation or repudiation. At a minimum, you’d expect them to try to shift their lending to the US out of loans denominated in $US and into more secure currencies. (The $A-denominated share of Australian debt is 33 per cent and falling). This in turn would weaken the position of the US as a financial centre.
If a smooth, market-driven adjustment to a sustainable position is unlikely, what are the alternatives? Stay tuned for my next post, in which I will look at this question, and some of the proposals that have already been floated.
fn1. The exception is China. But Chinese inflation, which is accelerating, has the same real effect as a depreciation of the dollar against the Chinese yuan
fn2. The current account deficit is the sum of the deficit on goods and services (the trade deficit) and the deficit on income payments (the income deficit). At present, the US has a large trade deficit, but only a small income deficit.
fn3. Details in this report from the Parliamentary Library (PDF file). On the way to this balance, we went through a very nasty recession, largely driven by government policies aimed at bringing down the deficit. Although these policies were rightly criticised, and most economists now oppose using contractionary policy to target the CAD, it’s not clear that a market-driven adjustment would have been painless.