Two Deficits, Fed Turnover

Two decades ago, the United States was the world’s largest creditor; now it’s the world’s largest debtor. As Ben Bernanke assumes the post of Federal Reserve chairman, succeeding Alan Greenspan, opinion is split over how much America’s profligacy actually matters.

January 31, 2006

Current political and economic issues succinctly explained.

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Unchecked spending

Two decades ago, the United States was the world’s largest creditor; now it’s the world’s largest debtor. As Ben Bernanke assumes the post of Federal Reserve chairman, succeeding Alan Greenspan, opinion is split over how much America’s profligacy actually matters. The Economist recently suggested that Greenspan, hailed by many as a hero, is in fact leaving behind him "the biggest economic imbalances in American history." Jeffrey Frankel, professor of capital formation and growth at Harvard’s Kennedy School of Government, says that irresponsible spending is America’s "worst economic problem in the last twenty-five years, and will be the dominant problem over our next twenty-five." And yet, despite warnings, American consumers (and the federal government) just keep spending, and growth remains strong. Most experts agree that some kind of correction will ultimately be in order, but how this might come, and when, remains far less obvious.

Two deficits?

We should be worried about two deficits, not one, according to a 2005 CFR Task Force Report by Menzie D. Chinn, professor of public affairs and economics at the University of Wisconsin’s LaFollette School. The "twin deficits" to which Chinn refers are the current account deficit, which reflects how much America spends internationally (imports) versus how much it makes (exports); and the budget deficit, or the gap between government tax revenues and total government spending. Each of these deficits reached record levels in 2005. Americans are importing far more than they export, and the Federal government is spending far more than it raises each year in revenues.

Are these deficits necessarily harmful for the American economy?

Most experts agree that the account and budget deficits could be damaging to the American economy, though there is a significant variance of opinion about how damaging, and when that damage might come. "It’s unlikely that international investors will continue to agree to hold ever-larger amounts of U.S. debt," Chinn told But he hesitates to predict a time-frame. "With private investors, we certainly haven’t seen any movement yet. And with central banks, you just don’t know when they are going to switch. It’s like reading tea leaves."

Despite warnings, American consumers just keep spending

What’s less enigmatic is how damaging the effects of an international mood-swing could be. Foreign debt and a giddy real-estate market have allowed American consumers to consume more than they earn for ten years on end. Grounding could be unpleasant either way, but sharp grounding could prompt painful corrections in the American stock and real estate markets, and an eventual curtailing of American demand. It’s ominous to consider the fallout, not only in the U.S. but also in the developing world, where American demand plays an enormous role as a catalyst of both financial and political reforms.

Fortunately, most experts think a worst-case scenario is improbable. Roger Kubarych, senior fellow for international economics and finance at CFR, says it is most likely that consumer spending will decrease as part of a natural process. "In the future, U.S. consumers will save more, when it becomes clear that their retirement accounts are insufficient to support them in the style to which they have become accustomed," Kubarych says.

Nor is it a foregone conclusion that American spending patterns are irrational. "It’s not a done deal," Chinn says. "It may turn out that we’re going to be much wealthier in the future, so we can pay off all this debt we’ve accumulated." Still, Chinn recommends caution: "If I had to guess, I would say, to some extent, Americans are making poor decisions for the future."

What can Ben Bernanke do about America’s deficits?

The Federal Reserve Board has limited powers. “The Fed directly controls very little” says Benn Steil, senior fellow and director of international economics at CFR. It is responsible for setting short-term interest rates, but it cannot directly control legislative policy. This can put a chairman in an awkward position, particularly when legislative bodies make policy that is economically unwise. Still, though the Reserve Board only controls monetary policy, Bernanke will have means of influencing legislation.

Alan Greenspan assumed a role more public than that of most chairmen. N. Gregory Mankiw, professor of economics at Harvard (and chairman of the president’s Council of Economic Advisers from 2003-2005), summarized in an open letter to Bernanke that “Greenspan is a rock star, at least by the standards of the American Economic Association. So high has his profile been that I am surprised that we have not yet seen a TV drama written around the life of a central banker.” Over his tenure at the Federal Reserve, Greenspan spoke up when he felt legislative policy bristled against America’s economic interests.

But a number of economists believe that Greenspan’s outspokenness did harm as well as good. “I often agreed with what Greenspan said,” says Steil, “but he often spoke his mind about areas that were not under his control.” This is a problem, Steil says, both because it has spread the perception that the Fed chairman has more power than he actually does, and because it can lead to instability. In his letter to Bernanke, Mankiw also recommends against Bernanke seeking a high profile: “The central bank’s job is to create stability, not excitement.”

If Bernanke chooses to keep quiet on legislative matters, his monetary policy, in itself, can do only so much to influence the American deficits. Raising interest rates would tend to encourage saving, and could also help bring the lofty real estate market under control. This would almost certainly effect a tightening of American pockets. But experts are uncertain whether such an approach is ideal, especially given that Greenspan has already significantly raised rates. “[Bernanke] may like to slow the housing boom,” says Kubarych, “but my suspicion is that both the consumer and the housing market are going to simmer down on their own. After all, Fed funds are up by nearly 3 ½ percentage points in little more than a year and a half. Bernanke will come in with a much less energized economy.”

What are the foreign policy implications of America’s deficits?

  1. The need to retain foreign investment: Edwin M. Truman, senior fellow at the Institute for International Economics, says that for the U.S. to support its deficits, it will be absolutely necessary to keep money flowing into the country. To do this, America must effectively market its exports, everything from stocks and bonds to airplanes and automobiles. "It’s the issue of confidence," Truman says. "Eighty percent of total holdings of U.S. assets are held by the private sector. It is individuals you have to convince, not only to hold on to their [American] claims, but to add to their claims."

    A mass exodus from U.S. commodities is unlikely. As Kubarych points out, "the rationales for foreign purchases of U.S. assets are unchanged: safety, liquidity, yield, political benefits, trade benefits." But given current spending imbalances, a more subtle shift could also prove damaging. According to the Economist, Chinese officials recently hinted that they are interested in diversifying their foreign exchange reserves. (China has historically financed U.S. debt by accumulating dollar assets, in an effort to hold down the value of the Yuan and bolster Chinese exports. Analysts estimate that three quarters of China’s reserves—which this year are expected to reach $1 trillion, surpassing Japan as the world’s largest—are held in dollars.) But according to Steil, "Asian countries are very concerned about a rapid rise [in the value of their currencies]," and one of the best means they have for keeping these values down is stockpiling U.S. dollars. So the chances of large-scale dollar-dumping are limited, at least in the short-run. In the long-run, however, America will still need to confront the fundamental imbalances which feed its deficits.

  2. The need to reduce spending, at home and abroad: Convincing the rest of the world to buy American goods is only half the equation. America also needs to reduce its own spending, both internationally and domestically, if it is to control its twin deficits. Mankiw gives a stark assessment of America’s domestic spending concerns in a recent Wall Street Journal editorial: "The federal budget is on an unsustainable path. I know that when the baby-boom generation retires and becomes eligible for Social Security and Medicare, all hell is going to break loose. I know that the choices aren’t pretty-either large cuts in promised benefits or taxes vastly higher than anything ever experienced in U.S. history."

    Internationally, America faces similarly hard choices. In his report for CFR, Chinn suggests that beyond reducing the federal budget, the two most significant steps America could take to achieve sustainable account balances are reducing the quantity of oil imports and coordinating a revaluation of East Asian currencies.

    The prospects for accomplishing either goal are murky. Kubarych thinks the idea of reducing oil imports is particularly far-fetched: "We are going to see no efforts whatsoever to reduce oil imports. Prices are crushing a lot of nice people. You want to see them go up further? Voters don’t, so forget it."

    But prompting a significant shift in Asian currencies may be no less tricky. The argument that a revaluation would benefit Asian countries in the short-term is tenuous, given their broad dependence on the ability to cheaply export goods. But the chances of substantially upping American exports without such a shift are dauntingly thin. "Ultimately there’s no doubt in my mind that if the U.S. current account deficit is to be reduced, then that will involve a significant revaluation of Asian currencies," says Truman.

    Fed turnover, if anything, tends to exacerbate preexisting problems. The stock markets crashed in 1987, just months after Greenspan took office. Despite the U.S. economy’s happy last few years—and maybe in part because of them—Ben Bernanke will have little margin for error his new post. The Fed’s primary objectives to keep inflation low and employment high may even conflict with hopes of dampening spending and reducing the deficits. In any case, the primary burden of policy change must fall to the legislature. But whether change comes sooner or later, and whatever role Bernanke takes rallying it, a cooling-off may well be inevitable. "Something will have to happen, anyhow," says Truman. "If the current account is to be narrowed, then demand has to be curtailed relative to supply. It’s just a matter of how you get there."