The other deficit

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[1], 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[2], 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[3].

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.

14 thoughts on “The other deficit

  1. John,
    What is the likely impact on the bilateral deals the USA has negotiated with other countries in the scenarios you have posited….?

  2. I have been reading Kotlikoff and Burn’s, ‘The Coming Generational Storm’ which forecasts, using generational accounting, a $72 trillion US debt (current debt $4.4 trillion), high and rising inflation and more than a doubling of US tax rates by 2030. Current lifetime average taxes are around 20% and these are forecast to need to rise to around 50%.

    Their key question: ‘When will bond traders start looking at the US menu of pain and draw the appropriate conclusions?’

    It seems to me that a lot of the intergenerational studies in Australia essentially focus on Australia when they should have at least one eye cast on what is happening in the rest-of-the-world. Nor is it simply enough to say that the US will experience tough times — scenarios in Europe and indeed in developing countries such as China need also to be considered.

    Proposals for an intergenerational fund in Australia can effectively be met by Australia maintaining long-term public sector surpluses until the intergenerational storm hits both here and overseas. This gives us a greater capacity to borrow in the future if we need to.

    Indeed while I generally agree with John Q’s argument that being fixated on keeping surpluses is dumb as a matter of principle, it seems to me that keeping our national debt low is a sensible move in the longer-term if we are to experience fiscal stresses at about the time I become old and doddery.

    One point that interests me is that, the sounder is Australia’s long-term fiscal management, the more attractive Australia will become as a place to live if the US economically implodes.

  3. John,
    surely your starting point should be the Balance of Payments.
    The BOP has three accounts. The Current Account measures trade in goods and services, and earnings on international investments. which you addressed.
    The Capital Account records capital transfers and the acquisition and disposal of non-produced, non-financial assets.
    The Financial Account shows transfers of financial and non-financial capital.

    The debits and credits in all three BOP accounts are summed and theoretically in balance. This is because every international credit should have an offsetting debit somewhere else in the BOP accounts. For example, when the U.S. runs a trade deficit – buying more goods and services abroad than foreigners buy from the U.S. – they must somehow have financed the difference. Ultimately, they must have either borrowed the money from abroad, or sold off some of their own assets to foreigners. In reality, however, there are many uncertainties in the measurement of international transactions, so it is normal for the BOP to be a little out of kilter.
    I think I will have to go with Stephen Kirchner on this one.

  4. Tipper, as you say, the balance on capital account is (apart from stat discrepancies) exactly equal and opposite to the balance on current account. This is an accounting identity like the fact that, in a company balance sheet, assets are equal to liabilities.

    But you can’t infer anything from an identity. The fact that assets=liabilities doesn’t tell you whether a company is solvent, and the national accounting identities don’t tell you whether a trend in the current account is sustainable.

  5. Max Corden had a similar aphorism specifically in the context of the current account, which argued that worrying about something that is “unsustainable” is like worrying about the growth rate of a teenager.

    Australia shows that market-determined exchange rates provide a relatively painless adjustment mechanism, eg, the 2001 depreciation. Of course, Australia also shows that the moral panic over the current account deficit then turns into a panic over the exchange rate, with few people making the obvious connection between the two.

  6. Pr Q, taking a well-earned break from savaging John Howard, strikes a reliably gloomy note about US economic prospects:

    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.

    Bulls, such as Stephen Kirschner, pooph=pooh the bears as “chicken-littles” always worried about impending crises. But the attempt to compare the US’s current fiscal crisis with the ones that obtained in the eighties is misleading, as Stephen Roach argues:

    today’s budget deficits could matter a good deal more than they did in the 1980s. That’s because America is now contemplating another multi-year fiscal stimulus with its lowest national saving rate in recorded history. In the third quarter of 2002 (latest available data), the net national saving rate — for consumers, businesses, and the government, combined — fell to a record low of 1.6% of GDP.
    By way of comparison, the net national saving rate stood at 9.0% in mid-1981 on the eve of the Reagan supply-side tax cuts, more than five times the rate prevailing today.

    And Roach has not even mentioned the 800 lb fiscal gorillas in the living room in the form of the retiring baby boom generation and the escalating costs of the war against Islamic militants.

    The global rate of interest, for a given rate of income growth, must be determined by the demand and supply for loanable funds. Assume that real global GDP continues to chug along at a growth rate of 2% pa. The level of global GDP is in the order of ~ $50 trillion.
    The Asian saving rate, since Asia started to put out about 1/3 of global GDP, has declined to ~ 15%. The EEC saves about 10% of its (1/3 of global) GDP. The US saves nothing. This implies global savings rate in the region ~ 5-10%.
    This would, over the next decade, give a pool of global credit that increase at a rate of about $5 trillion pa for the US to draw on to finance its shortfall in national savings. This demand on global credit, given a $500 billion annual trade deficit, does not seem extravagant.
    It may be that global capital markets can absorb this demand without a rise in interest rates, providing every one else stays prudent savers. This would leave global interest rates at a sustainable less-than 5% level, not high enough to break the US bank.
    But Asian growth and savings rates may not stay at the astronomic levels which have propped up the US debt-addiction. The current US blow out is being funded by Asians who are very thrifty, although less-so now.

    double-digit annual growth in credit-card receivables has been recorded in Thailand, Taiwan, India, Singapore, Hong Kong and Malaysia over the past five years.

    The US financial trend, given a more spendthrift East, is not sustainable since most of the US’s borrowing is to finance a rise in, interest-incurring, political and cultural consumption (wars, retail therapy) not, income-earning, business investment.
    My guess is that, somewhere down the track, there will be a “fiscal crisis of the US state” (another Marxist trick borrowed by the neo-cons!). This will lead to some sort of harsh IMF-endorsed structural adjustement plan, cuts in benefits and rises in taxes, a risk-premium hike in US interest rates, a collapse in security, liquidity, equity and property values and a nasty recession.
    But this bear has been shouting himself hoarse in the face over this scenario for the past five years and still the US economy roars onwards and upwards.

  7. It’s tricky, the US economy. Instinctively, my reaction to this question follows Stephen Kirchner’s argument, i.e. the USD will depreciate to adjust for the USA’s current account deficit. However, this is unlikely to be as (relatively) painless as the adjustment suffered by the AUD in the 1990s and early noughties.

    When the AUD depreciated from 1997-2001, the RBA faced a backdrop of global disinflation and falling interest rates. The AUD’s depreciation thus did not trigger inflation via the increased (AUD) prices of imported good and services, and the RBA was able to reduce interest rates through this period, thereby softening the blow.

    Fast-forward to 2004/5, and the USA faces a much less benign environment: inflationary pressure is already building in its economy at a time when the government and consumer sectors are dissaving. If the Fed is serious about containing inflation, it will have to continue raising interest rates from their currently abnormally low levels, and this will counteract the stimulatory effect of USD depreciation.

    The USA could well enter a period of stagflation (relatively high inflation AND high interest rates) as it burns off surplus demand in the economy. The period of adjustment – if and when it happens – is likely to be more painful for the USA than it was for Australia.

  8. There’s something called “quasistable”, that comes up when using composition of probablity generating functions to estimate how things will settle in the long run. Usually, long run behaviour involves “in the long run we are all dead”, i.e. everything collapses to a flat nothing. However, there’s a mathematical trick a bit like renormalising that eliminates consideration of that total collapse and sees how the long run probabilities converge once you leave out that worst case outcome. It usually converges to something stable, only since it is a fake/fudge the solution is called “quasistable”.

  9. I hate to sound like an alarmist fool but…China, Japan and India have all protected their economies from inflation by converting the profits from their exports to the US back into US$. This has enabled 10% growth rates in China and India and has protected the Japanese from economic collapse. This works because it keeps the US$ overvalued which enables it to be a currency of choice.

    It’s a bit like a drug in prison being used as a currency – it works because there are addicts (US consumers and war machines) always willing to buy even if they have to sell grandma or their old growth.

    Of course, it doesn’t work forever,and since the greenbacks is a counterfeit’s favourite… who knows what it’s real value is. It’s collapse will be sudden and unexpected as the creditor nations start to bail out. Wild fluctuations in the exhcange rate will ramp up the costs of trade along with oil prices. The stagflation of the 80’s will look like a summer shower in comparision tothis storm.

    Of course, we also don’t know when the Saudi Arabia oil fields are going to run out. We do know that this too will be sudden and unexpected.

    It seems to me that the US economy is bound to collapse the same way as the old USSR economy. What they both share in common is large command style corporations/bureaucracies that have little ability to adjust to changing circumstances and both economies have been underrmined by the collapse of their ecological and economic infrastructure.

    IMO it has nothing to do with inter-generational equity. That is a nonsense euphemism designed to distract from the consequences of unsustainable growth and an unwillingness to acknowledge the seriousness of the situation.

  10. Kyan, IMO the heavy deficits that US is now incurring does have a lot to do with intergenerational inequity if current policies imply a much greater tax and debt burden on people around in 20 years time. That’s not so far away.

    My own comment was to suggest that targeting public sector surpluses makes most sense than running deficits if you need to borrow a lot in the future. This amounts to very much the same thing as an intergenerational fund.

    I was also suggesting US problems in this regard have implications for Australia.

  11. Sorry Harry, it was a broad swipe at the term – I do agree with your points regarding conservative management of public service debt as a prudent course of action. The question is – when confronted with the sort of statistics that you quote regarding the US – will the collapse of the US economy allow the global financial system (with it’s tradeable currencies) to continue or will it bring it down as well. Given the significance of the US$ it’s hard not to conclude that the collapse will be catastrophic.

    It’s possible(but unlikely) that President Kerry will find a peaceful resolution in Iraq and hence the collapse of the US$ will not be complicated by a losing war. But even a peaceful resolution will be difficult.

    My bet is that the US will suddenly decide that global debt forgiveness is a good idea but nobody will be listening to them by then.

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