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Why Deficits Matter (Condensed Version)

Author: Benn Steil, Senior Fellow and Director of International Economics
September 2006
Council on Foreign Relations

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How quaint it now seems that we began this new millennium just few short years ago with a growing debate in Washington over how to manage projected budget surpluses. And how worrying it is that there is now no debate in Washington over how to manage our projected budget – and now current account – deficits.

Whereas the budget deficit fell to 2.6 percent of gross domestic product (GDP) in 2005 after a year of exceptional tax receipts, war costs, uncontrolled “entitlement” spending, and expected moderation in the federal tax take are certain to set us back on a relentless upward path. But fiscal rectitude is simply not on the agenda in Washington. The recent $39 billion in projected spending cuts adopted by Congress for programs such as Medicare and student loans amounted to great dramatic theater, but a mere 7/100ths of 1 percent of GDP.

As a nation, we are also now consuming 6-7 percent more than we produce. This gap requires us to import about $2 billion a day.

Currently, the administration has no deficits policy beyond sending out the Treasury secretary every now and then to cajole the Chinese into allowing greater currency “flexibility,” which the whole world feted them for not doing during the Asia crisis. These are therefore merely thinly veiled calls for a weaker dollar, no different from the devaluation cries heard routinely around the world from export interests.

But outsourcing deficit management to the currency market is junk economics and irresponsible geopolitics. Even if China revalues by the large levels demanded in the Schumer-Graham bill, the yawning American trade gap will remain. Recent econometric analysis of the trade and currency data show the responsiveness of U.S. imports to movements in the dollar to be vastly lower than politicians assume. Thus, particularly because imports currently exceed exports by such a large amount, the higher dollar price of imported goods will make the trade deficit larger, at least until exports start growing rapidly. And that may take a very long while.

But do deficits really matter? That argument is now all but settled for countries whose currencies are unwanted in the global marketplace – that is, for all developing countries. Budget and current account deficits engender fears among locals as well as foreign investors that hard currency may be hard to come by when it is needed most. Financial crises follow scary deficit projections as sure as winter follows fall. But that is not a problem for the United States, which mints hard currency. Or is it?

Of all the reasons to be concerned about the so-called “twin deficits,” the long-term effect on the dollar as a global store of value and medium of exchange is by far the most serious.

As the administration and Congress continue to push forward with unbridled spending and tax-cut plans that raise the trajectory of future budget deficits, foreign investors are certain at some point to turn their backs on the ever-expanding stock of U.S. treasuries, and turn instead to investments in other countries’ assets. Central banks, such as Sweden’s Rijksbank, are already known to be doing this with their reserves. When the extraordinary level of official financial flows to the United States do dry up, American policymakers will be confronted with some very unpleasant choices. Especially if oil prices, now around $70 a barrel, continue to rise, the trade deficit will become even more insensitive to changes in the dollar’s value. As a result, the dollar may have to fall by commensurately still larger amounts to shrink the trade deficit.

Consider what a bad scenario for the dollar will actually look like. There is a discomforting contrast to be drawn between the economy today and in 1985, when many were already proclaiming the U.S. current account deficit “unsustainable.” Twenty years ago, when the U.S. current account deficit stood at 2.8 percent of GDP, foreign governments owned 8.4 percent of U.S. government debt outstanding. At the end of 2004, with the current account deficit at 5.2 percent of GDP, foreign governments owned a much higher 27.6 percent of the total debt outstanding. This is a cause for concern, as it represents a much greater concentration of holdings among a group that is prone to herding.

The dollar has thus far been bailed out by a heady combination of EU constitutional chaos and French and German political angst, on the one hand, and petrodollar parking in U.S. assets on the other. Resurgent gold, recently at a quarter-century high of over $700 an ounce, was the main haven for dollar bears in 2005, but with the euro zone set to expand by a dozen or more nations in as many years going forward, it is clear that the still fledgling euro’s international allure has enormous upside potential.

Now consider the fact that precedent is not encouraging for the dollar. Witness the fate of gold as a central bank reserve holding in the 1980s and ‘90s. Over the course of the 1980s, when the gold price fell from $615 to $381 an ounce, central banks added a net 344 tons of gold to their reserves. Yet over the 1990s, as gold fell further to $279, central banks sold a net 3,148 tons. In one year alone, 1992, central bank sales amounted to nearly a quarter of the annual gold supply, depressing the price by an estimated 8.27 percent. Central bank net gold sales continued at annual rate of 500 tons in the early years of this decade.

The dollar has since fully supplanted gold as the foundation of the world’s monetary system; a feat unprecedented in world history for a completely uncollateralized fiat currency. But should the dollar continue an extended decline, under pressure from unprecedentedly high trade deficits, there is every reason to believe that central banks will seek greater diversification in their reserves, most likely into euros. As central banks bailed out of gold in the 1990s, their herding out of dollars will accelerate the dollar’s decline. 

If the Bush administration persists in projecting an image of insouciance over the dollar’s long-term fate, this will undermine the currency’s hard-earned role as the world’s preeminent standard of value. It will also reduce America’s influence over the setting of global norms in international commerce. Such a decline would halt the further march of dollarization in Latin America (where Ecuador and El Salvador recently ditched their currencies, and with them the very possibility of capital account crises): a march that is every bit in America’s long-term economic and security interests.

So, what should be done? The beginning of wisdom is to acknowledge that a Chinese flex-currency will not be our savior. But the fact that both the administration and Congress continue to bank on this false hope prevents the nation from pursuing more difficult but far more reliable solutions.

First among these measures—and the one meaningful action the administration and Congress can undertake in short order—is to forge a serious and workable plan to reduce the federal budget deficit over the next five years, and the trajectory of future deficits going further forward. This, of course, is easier said than done. Political forces arrayed against spending cuts and tax increases remain very strong.

Only about 2.5 percent of the current account deficit can be accounted for by the swing in the fiscal stance since 2000. Yet budget deficit reduction is the only lever available to cut America’s dependence on imported capital that is both economically sensible and under the U.S. government’s direct control. Many commentators have pointed to America’s low and declining private savings rate as an important target, but decades of government tax incentives to boost private savings have yielded little more than windfalls to those wealthy enough to be able to shuffle their existing savings toward whatever tax carrots are dangled before them.

The policy burden is necessarily on America to reverse its growing fiscal imbalance. America’s standing in the world very directly hinges on what others believe the country can give to them or withhold from them. Washington can prevent a dollar-driven decline of U.S. global power by demonstrating that it has the political leadership and will to make the hard decisions necessary to sustain American economic strength. This must be grounded in restored budgetary responsibility.  America is, at this moment, effectively an economic diabetic. Its insulin is fiscal rectitude. It will not cure the trade gap on its own, but it will allow the world to live with it by preserving the dollar as the bedrock of world commerce and finance.

Benn Steil is senior fellow and director of international economics.  This article is based on a longer one, co-authored with Menzie Chinn, which appeared in the Summer edition of The International Economy.

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