from Follow the Money

The Joint Economic Committee

October 25, 2005

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United States

Budget, Debt, and Deficits


Last Thursday, I had the opportunity to testify before the Joint Economic Committee on the US current account deficit, as part of the panel that followed Dr. Bernanke's testimony.

I strongly suspect that I will never testify in the same hearing as Bernanke again.  If you have not heard, he just got a big promotion.

I am sure you all will be shocked to discover that I do not think trade deficits of the current magnitude are sustainable, and that the United States' need for perhaps $900 billion net capital inflows is a risk to next year's economic outlook.   I am pretty sure that I did not say anything that would surprise regular readers of this blog - or, for that matter, anything that Mr. Geithner did not say better last Wednesday. 

Among other things, I did update my "what happens to the US net external debt" in a gradual adjustment scenario graphs for my testimony.  It turns out that if the US trade deficit starts to fall by about 0.4-0.5% of US GDP in 2006, the US external debt would stabilize at around 60% of US GDP.  Actually, it would be a bit lower, since that kind of fall in the trade deficit likely implies a fall in the dollar, and thus a rise in the value of US assets abroad.   My simple graphs did not take into account valuation gains. 

The scenario where the US trade deficit gradually falls to zero requires something like 9-10% export growth and 5% import growth over the next ten years.  It is in many ways an optimistic scenario, one where the deficit comes down gradually without any sharp interruptions in financial flows.  It now seems likely that the adjustment won't start in 2006, which implies either that the US net external debt stabilizes at a higher level or a sharper and more painful adjustment path.

One small point about these scenarios.   In the future, it is likely that net interest payments will make up a larger and larger share of the US current account deficit.  Debtors, after all, generally do have to pay interest on their debts.   The US net external debt is the difference between gross US external debts (and foreign investment in the US) and gross US assets (including US investment abroad).  Consequently, assumptions about the future rate of return (from interest and dividends) that foreigners will receive on their investments in the US and the rate of return that the US will receive on investments abroad can have a big impact on these forecasts. 

Back in 2004, Nouriel and I assumed that the overall interest rate that the US had to pay on its external liabilities would likely converge with the overall interest rate that the US earned on its external assets.  Bill Cline has argued that this assumption is too pessimistic (See Chapter 3 of his book).  That doesn't bother me much - I would worry If was not somewhat more pessimistic than Bill Cline.   The real news here is that even an optimist like Cline thinks the US is on an unsustainable path.

Cline argues that the US historically has earned more on its direct investment abroad than foreigners gave earned on their investment in the US.  That certainly is the case - read the IMF WEO, or Philip Lane and Gian Maria Milesi-Ferretti!  But if that continues to be true, doesn't it cut against the argument that the US should be able to finance large ongoing deficits with ease because it is such a great place to invest?