from Follow the Money

Katrina and the current account deficit

September 12, 2005

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At least a half percent off US GDP growth for the remainder of this year (Goldman says more), $150 billion in new federal spending (much of that in fiscal 2006), higher gasoline prices now and next year and - perhaps - somewhat lower US policy rates ...

Those all seem to be the consensus estimates of the impact of Katrina.

(continues)

Why could Katrina imply higher gasoline prices next year?  After all, by then, all the refining capacity knocked out by Katrina should be back on line.

Simple.  The US has down on its stocks of crude and perhaps, more importantly, our allies in Europe have drawn on the stocks of already refined gasoline.  Refining capacity is more constrained than the supply of crude.  That will help to keep current prices down.  But at some point, both the US and Europe will want to rebuild their stocks - and that incremental demand will put additional pressure on prices.  See Calculated Risk.

Unless, of course, as some suspect, Katrina is providing an excuse for the major economies to intervene in the spot crude market - if the US and Europe run down their reserves now and don't rebuild them later, the impact on the market obviously would be a bit different.   The FT reported on Friday:

"In spite of the surplus of crude, the US and Europe have released more than a million barrels a day from emergency reserves, reinforcing suspicions that they are using the crisis triggered by the hurricane to damp oil prices."

Who knows? The spot market certainly seems to be a bit calmer right now.  But that may be because high oil prices are finally slowing the growth in demand for crude, not because of the release of stockpiled oil.

$150 billion (not all in FY 2006) in new Federal spending implies an equal amount of new borrowing, particularly if the Administration decides to play to the "base" in 2006 and Congress goes along with plans to cut taxes.   There are no shortages of expenses the Federal government will need to cover - Louisiana and Mississippi are sure to look to the federal government to help them pay their bonds, and to make up for shortages in local tax revenues (see today's WSJ, page A3.

I am not sure the deficit in FY 2006 will hit $500 billion, as David Broder suggests.   But it sure seems likely to top $400 billion  by a large margin.

It is worth recalling Tim Geithner's January argument for taking preemptive action to better align US government revenues and expenditure:

It is important that the United States work to build more confidence that it will act on the fiscal front to achieve a better balance between our commitments and our resources, both with respect to the medium term and the longer term. Given the inherent uncertainty surrounding long-term growth forecasts, the formidable rise in costs associated with providing for an aging population with longer life expectancy, and a potentially protracted elevation in national security costs, it makes sense to build a stronger financial position into our fiscal future. The present fiscal trajectory entails an uncomfortable scale of borrowing and little insurance against possible adverse outcomes in an uncertain world.

It so happened that a nasty natural shock hit the US well before any market shock. 

But right now the Federal government's balance sheet is being used to help "insure" the broader economy against a fall off in demand, even though an entire city has been displaced and half a million people will be out of work.  That means that the US has even less insurance against the risk that the markets (or foreign central banks) may - at some point - be less willing to finance large fiscal deficits.

I suspect the net result of Katrina will also be a slightly higher US current account deficit.

There will be some fall off in oil imports in late August and early September.  But energy imports will then pick-up.  Substituting imported gasoline for imported crude will tend to increase, not reduce, the US current account deficit - barring a fall off in spending on non-oil imports. 

The federal government's disaster spending (and any pause by the Fed) will support consumer spending, but US income (production) will go down as the labor force (temporarily) falls.  If all goes according to plan, US consumption won't fall, even though US production necessarily will.  That suggests a larger current account deficit.

Put slightly differently, more federal borrowing not offset by rise in household or corporate saving (remember, more household savings means less consumption) implies more borrowing from abroad, and thus a larger current account deficit.  Bond bear turned into a (wavering) bond bull Stephen Roach notes that the US government's plan for minimizing the impact of Katrina is basically borrow more, and since the US doesn't save, that means borrowing more from abroad. 

America's problem is that it no longer saves.  ...  That means it has had to run massive external deficits in order to import this foreign capital.  A current account deficit that hit a record 6.4% of US GDP in early 2005, and that will easily pierce the 7% threshold in the months ahead, underscores how far the US has had to stretch offshore in order to make ends meet.  This is the essence of the shoestring economy -- a United States that is lacking the saving cushion needed to fund future growth and ward off the impacts of more immediate shocks.

...  Asset-dependent consumers were running a negative personal saving rate to the tune of -0.6% of disposable personal income in July 2005.  ....  the energy shock of 2005 is likely to take the personal saving rate even further into negative territory as US households defend their lifestyles in the face of rising expenses for transportation, electricity, and heating.  The American consumer is on the leading edge of the shoestring economy.

The government sector is in a similar position.  While a cyclical rebound in the economy has led to a temporary improvement in the federal budget position, the combination of Katrina-related assistance and energy-driven impacts on economic growth -- to say nothing of the ongoing expenses of US occupations in Iraq and Afghanistan -- point to a renewed widening of government budget deficits.  So far, the Bush Administration has hit Congress with $62 billion in supplemental spending requests in the immediate aftermath of Katrina.  The risk is that these disaster-relief appropriations are only a down-payment on the final tab, which eventually will span the gamut -- from infrastructure repair and reconstruction of housing and commercial areas to massive environmental clean-up efforts.  In the politically-charged post-Katrina environment, any semblance of fiscal discipline has vanished into thin air.  Next year's federal budget deficit is currently projected at -2.4% of GDP; a conservative estimate of a post-Katrina budget could easily push that figure into the -3.25% to -3.5% range -- virtually identical to peak cyclical shortfalls hit in 2003-04.  ... That will put the shoestring economy under even greater pressure.

Nor can business sector saving be counted on as a buffer to the same degree it has been in recent years.  .... it seems reasonable to look for a significant reduction of the business saving rate well into 2006.  In a climate of government and household sector dis-saving, that only underscores the further downward pressures likely on overall net national saving. 

The macro conclusions are inescapable: A saving-short US economy that runs a massive current account deficit is effectively living beyond its means.  It not only relies on foreign saving to fund domestic growth, but it also lacks the capacity to invest in public goods that may be needed to safeguard its future.  Lacking in domestic saving, the shoestring economy is also biased toward chronic under-investment in infrastructure -- leaving itself vulnerable to "breakage." 

The markets seem willing to indulge the US.  So long as America's foreign creditors are forgiving, higher interest rates won't add to the Katrina shock - or force the US to cut back.   The US - as always - will just borrow more to sustain its current consumption.

One caveat.  I suspect that the Katrina consensus probably includes one additional element - the odds that the "borrow ever more to spend ever more" US consumer will stop borrowing and start saving a bit more went up.    But no one really knows by how much ...

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