Anantha Nageswaran of Libran Asset Management in Singapore has submitted a set of (lengthy) comments that respond, in some sense, to many of the points I and others have raised on this blog. Check them out.
Dr Nageswaran argues that we here are a bit too pessimistic about the US. Oil may act as an automatic stabilizer for the US economy - rising to cool excess demand, but falling if US demand falters. A fall in housing-driven US consumption might lead to a fall in oil - and with housing bubbles in Europe too, it is not obvious that the dollar would lose out if there is a global housing correction. Or - to insert the views of Dooley, Garber and Folkerts-Landau - the US is simply too important an engine of demand for the United States' biggest creditors to ever pull the plus. A strong dollar is so important to China that China will continue to prop the dollar, and US demand, up. And if China wants to lend us the money needed to buy their goods and expand our housing stock, we should do it, even if it makes the US domestic economy look unbalanced to some.
I have not commented extensively on the US current account deficit recently, largely because there has not been much new to say. But this seems a good time to reiterate my base case for why we in the US - and everyone in the world too - should worry about the US trade and current account deficit. That afterall is the basis of most of my concerns about the trajectory of the US economy.
The US current account deficit is now, to state the obvious, quite large. It was around 6.5% of US GDP in the first half of 2005, and I expect it will head towards 7% by the end of the year and will come in at over $800 billion. Lewis Alexander of Citibank forecasts a deficit of more than 7% of US GDP in 2006.
That is very large in relation to the United States' small - 10% of GDP -- export base. I think the United States' small export base and its leveraged economy, which makes the US vulnerable to a rise in interest rates, offsets the (very real) advantages of borrowing in your own currency, and having substantial foreign assets whose value rises if the dollar falls.
Unlike in the 1980s, the US is now a significant net debtor. US net external debt will likely hit 30% of US GDP by the end of the year. In 2006, interest payments on the United States' external debt will start to add significantly to the current account deficit. Looking ahead, rising interest payments on a rising external debt imply that the trade and transfers deficit of the US has to fall just to keep the current account deficit from rising.
Even if the trade and transfers deficit stabilizes at around 7% of US GDP, the US current account deficit will keep on rising as a result of rising (net) interest payments on the US debt. A current account deficit of over 7.5% of GDP in 2007 and close to 8% of GDP in 2008 is quite possible even if the trade deficit (as a share of GDP) stabilizes at roughly year-end levels.
A 7% of GDP plus annual current account deficit starts to add up. Ignoring GDP growth and valuation gains, it would add over 20% (3*7%) to the US net external debt position; factoring in GDP growth, the US net external debt position if nothing changes would hit 45% of US GDP (maybe 400-450% of US exports) by the end of 2008 - and be on a sharply rising path.
That surge in external debt, generally speaking, is financing the construction of homes (and the renovation of old homes), consumption (cash-out refinancings ...) and government deficits - not investment that will lead to an obvious increase in the United States' export capacity, or an increase in its capacity to produce goods that will substitute for imports.
I am not comfortable with the easy assumption that this can all be sustained, or that if it cannot be sustained, the US will be able to adjust smoothly with just a small (or not so small) fall in the dollar.
I think there is some risk the US won't be able to maintain its current trajectory through 2006, and think there is a very significant risk something will change before 2008. Remember, just putting the US on a path where the US trade deficit stops rising - the scenario laid out above -- implies significant adjustment. Exports need to start growing 60% faster than imports to keep the deficit rising. With continued trend import and export growth, the US current account deficit would be closer to 9% of GDP in 2008, not 8% of GDP.
I think most (though clearly not all) analysts think that US trade deficits of the current size cannot be sustained indefinitely, and at some point, correcting the deficit likely implies a further fall in the dollar.
I suspect I part company with the "consensus" in four ways:
1. I think the risk that market pressures will emerge to force the US to adjust over the next three and a half years are high, not low. I am not convinced China can absorb $300 billion plus (possibly a big plus) in reserves annually for the next three years without experience more domestic financial strain than we have seen so far. That kind of annual reserve accumulation would push China's reserves to GDP ratio up to something like 70% of China's GDP by 2008. That level of reserves truly is unprecedented for one of the world's largest economies.
2. I am not convinced - despite the evidence from the experience of other industrial countries - that the adjustment process will be smooth. The best economists at the Fed cannot find evidence that falls in the currencies of industrial countries systematically lead to higher interest rates. If anything, most periods of current account adjustment seem to be associated with lower rates. But in most of those cases, rates were high during the period when the current account deficit expanded. Remember the US in the early 1980s - high US interest rates pulled in foreign capital. Or Italy in the early 90s, when rates where high to defend the Lira's parity in the ERM.
The US now is in the unusual position of starting (should it ever start) a period of adjustment with low rates. That may make it hard for US rates to fall further from their current already low levels in the context of a falling dollar, or, to be more precise, in the context of expectations of future falls in the dollar. Low rates and a falling dollar implies that the US has exceptionally generous external creditors - creditors who are either taken surprise by dollar depreciation or who are quite happy to expect to lose money.
3. I am not convinced that the transition from a housing-centric economy to a export-driven economy will be easy. And the economy really is very housing-centric. From Merrill via Scott Reeves and the Big Picture:
We find that the red-hot housing sector alone, which typically represents just 5% of the total economy, accounted for an astounding 50% of the overall growth in the U.S. economy by the first half of this year, and more than half of the private payroll jobs created since fall 2001 were in housing related sectors," Merrill Lynch (nyse: MER - news - people ) economists Kathleen Bostjancic and David Rosenberg said in a economic commentary.
We argue this represents an unhealthy and disproportionate share of economic growth. The over-reliance on residential investment leaves the economy very vulnerable if housing demand and prices cool--prices do not need to even fall, just a slowing in the pace of home price appreciation would have a noticeable negative impact on economic growth--not unlike the fallout following the frenzied tech over-investment in the late 1990s.
There may be a large mismatch between the capital stock the US ends up with after a housing boom and the capital stock the US needs to become an export powerhouse.
4. Finally, and this probably puts me most of out the consensus, I am not convinced that the US economy will continue to become more service heavy and manufacturing light. That means I don't think all manufacturing will migrate toward countries with low-wages. Rather, I suspect in 15 years, the US economy will look a bit like the Eurozone's economy. The US will have to run a surplus on trade in manufactured goods to pay for US raw material imports, and specifically, to pay for US oil imports.
Shocking, I know. But remember, stabilizing the US external debt to GDP ratio basically requires eliminating the US trade deficit (though not the US current account deficit). In other words, I don't think the past offers a good guide to the future.
It is possible that the US could export enough services to outsource even more manufacturing and still shrink the trade deficit. But I would not bet on it. Dan Gross has argued that the biggest US services exporter - Hollywood - is the next Detroit.
The weakness in my argument, at least as I see it? So long as the financing is available, nothing necessarily will force the US to adjust. And nothing that precludes the possibility that the world's central banks and private investors will give the US a very long rope indeed.