from Follow the Money

Directing the perennial dollar horror story

January 10, 2006

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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(Dollar) gloom and doom sells.  Even if it isn't true.

So says Bloggin' Wall Street 

Folks who worry about the trade deficit are in denial. They cannot accept that in the new (financial globalized) economy, deficits really don't matter.  Especially if the Dow is at 11,000.

The truth (according to Bloggin Wall Street) is: 

Either the trade deficit is a sign of US strength, so it doesn't matter

Or the trade deficit is not as bad as it seems. 

The deficit must be mis-overestimated.  Or at least mis-measured.  Bloggin Wall Street:

So the problem has to be in the way we're calculating trade. We have to have more money coming in than we think we do. Otherwise, our incomes wouldn't keep growing and we wouldn't be able to keep buying more stuff. It's funny because the mathematicians and economists don't see this  .... I don't know just what the problem is, but I do recognize that it is somewhere within the growing complexity of trade and the fact that for the most part economists are having difficulty keeping up with and understanding the complexity of trade. It's the most likely place for a mathematical error to occur due to the fact that we have little control over the flow of information outside of our countries borders. What do we really know about what our companies are doing overseas?

The last argument has certain parallels with the argument of Hausmann and Sturzenegger that, correctly measured, the US isn't that indebted. 

Deficits certainly didn't matter to the market in 2005.  A growing current account deficit did not stand in the way of a dollar rally, at least against the euro and yen.  We will see if that holds true in 2006 as well.  I tend to share Stephen Roach's doubts.  I'll also set Hausmann and Sturzenegger's argment on dark matter aside - I'll take it on in excruciating detail tomorrow.

Is the trade deficit really a sign of strength, of fast growth in the US?   Trade deficits certainly can be associated with fast growth.    But they are also usually a sign of fast growth of a certain kind - whether fast growth in consumption (which leads to a fall in savings) or a surge in investment.   In the US, it is a bit of both.   Consumption has grown quite fast as household savings fell.  Investment is up too, but it is investment of a certain kind.  We really do have a .home investment bubble.  Residential investment now accounts for a higher share of US GDP than tech investment at the height of the .com bubble.   But trade surpluses are not always associated with slow growth either.  Ask China.  

It certainly is not the case that the US trade deficit is a sign of fast growth in the US and slow growth in the world.  The world is not Europe.   The world includes China, India and other fast-growing emerging economies.    It turns out the world as a whole is doing just fine.

So why worry about US deficits if they are the product of growth in the US and in the world?  My answer:  trade deficits can be a signal of future trouble.  Can be.    This is different than always are.    But there is more to worry about when the deficit gets big. 

Compare a country running a trade deficit to an individual spending more than he/ she earns, and charging the balance to his/ her credit card.   You can live quite well for a while, but eventually you hit the maximum on your credit card.

The credit card analogy is inexact.  No credit card company lends at 4 or 5% a year.   But that is the rate - more or less - that the US borrows at right now.    And most credit card companies don't let you spend 50% more than you earn, year after year. But at least up til now, Asia and the world's oil exporters have been willing to finance large US deficits on generous terms.

To me, those terms are a source of concern -- indeed, a far bigger source of concern than hitting the credit card's upper limit.  Why?  Because these terms are a bit too good to be true.  America's creditors might raise the interest rate. Or force the US to spend a bit less. Or a bit of both. 

So far, though, they haven't.

Which brings me to the second issue - is the US trade deficit mismeasured? 

No.  The data here is pretty bleep convincing.

Look at the gap between inward and outward container traffic in the West Coast ports.  2 out of the 3 inbound containers coming into the US at Long Beach (a huge port) leave the US empty ...

Or growing Chinese exports of IT goods, one of the areas where the United States has at least a comparative advantage.  Or the deteriorating balance of agricultural trade.  Or just the details of the plain old trade data that will come out tomorrow.

There is no real mystery how the US pays for its import bill either.  With debt.    We have good data on that too.   The TIC data has its problems. It doesn't do a good job of capturing who is financing the US.  But there is no reason to think it understates the total amount of debt the US sells to foreigners to finance its deficit (and US investment abroad).

Of course, there are problems with the measurement of the trade balance.  US imports from Colombia, Peru and Bolivia and a few other places are probably understated.    I would not be surprised if both US service imports and US service exports are be undercounted.   The flow of goods through ports is far easier to count than outsourced IT services.

But I suspect the argument that most captures the hearts of the "don't worry, the US economy is great (so long as you make more than the median income, the rest are in the more risk, no reward part of the economy) crowd" is a bit different.  The US balance of payments data just misses the immense profits successful American firms earn abroad.    

I agree, at least in part.   The US probably earns a bit more abroad than shows up in the US current account data.  

But I doubt that is the biggest source of error in the US current account. 

Why?  Foreigners have a lot of investment here in the US too.  They earn money here, just as Americans earn money abroad.  And based on the US current account data, foreign investment has been a real dog.   FDI in the US earned a bit under 4% in 2004.    That's better than the 2% or so it got from 2000-2003 but nothing great.  Look at Figure 6 in the latest from Wynne Godley and Levy Institute. 

The errors associated with calculating the overseas earnings of firms work both ways ... 

The sums basically add up.  The US is buying lots of stuff that's made outside the US, and paying for those goods (and services) with debt, not with the profits on US investment abroad.  Indeed, the US is running a historically unprecedented trade deficit for major, advanced economy. 

See another member of the dollar doomsday cult, UCLA (and IADB) economist Sebastian Edwards.   Very few industrial countries have sustained trade deficits larger than 5% of GDP for over five years.   New Zealand and Ireland have.  But no large country has.  And, according to Edwards,  "Historically, periods of high current account imbalances have tended to be short-lived and followed by periods of current account adjustments."

Unfair to compare the US to other advanced (formerly) industrial economies?  A current account deficit of 6.5% or so (probalby more like 7% now) is large even by the standards of emerging economies.  6.5% puts the US in the 75% percentile of emerging economies v. the 90% percentile of industrialized economies (see table 3 in Edwards). And if you scale this data to export revenues, the US is even more of an outlier.  Countries that run 6.5% of GDP current account deficits are far more common than countries that run 6.5% of GDP current deficits that only export about 10% of their GDP. 

Some say deficits don't matter, because rising US (external) debt has been matched by rises in US household wealth.  I disagree. External debt needs to be compared to external assets.  Houses don't generate export revenues.  That is why serious economists worry about taking on external debt to build suburbs (and to finance fiscal deficits) more than taking on external debt to develop oil fields.

But there is better argument out there.  

Over the past few years, rising US external debt has been matched to a surprising degree by rising US external assets.    The value of US assets abroad has soared as the dollar fell from 2002-2004.  The value of US assets abroad kept rising in 2005, as foreign markets did better than US markets, even in dollar terms.  See this graph; data is in US dollar trillion.

image

What's wrong with borrowing from abroad against the rising value of US foreign assets?   After all, borrowing against rising domestic asset prices has been the foundation of the US domestic economy for some time.

Unfortunately, for the game to go on, US external wealth needs to keep on rising faster than US liabilities. And there isn't a good case that is going to happen.    The US has to take on ever more liabilities to finance its ever rising trade deficit - and would have to take on even more if our creditors upped the interest rate on our credit card.   But the only way the US can generate a comparable surge in the value of US assets abroad is if the dollar falls by even more against the euro than it did between the end of 2001 and 2005 (over 30%, even taking into account the dollar's 2005 rally) and that kind of fall in the dollar (and surge in the euro) doesn't lead European equity markets to tank.   Think of the euro at $1.55-1.60, and other European currencies at a comparable level.  And think of that happening without a fall in European equity markets.  

Actually, just repeating the valuation gains of the recent past wouldn't work.  The US needs bigger valuation gains to offset bigger deficits.  The kind of valuation gains that come if the dollar really tanks against those places where the US has large investments.

It is pretty hard to offset annual deficits of close to $1 trillion. 

I may be premature in raising the warning flag, but nothing more. 

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