from Follow the Money

Not a current account deficit. A capital account surplus.

February 14, 2006

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Nouriel has already commented on the Economic Report of the President.    He didn't exactly like its international chapter.  It didn't rub me the wrong way quite as strongly - in part because I am more inclined to think that even if there is not a global savings glut, there is something of a savings glut (or consumption dearth) in China and the world's oil exporters.   Reducing the US current account deficit will be hard if they don't reduce their surplus.

Or maybe I have too much sympathy for the economists who had to draft the international chapter.  The Bush Administration hasn't given them an easy brief to argue.    The US has a record deficit, and the Administration's basic policy to hope nothing bad happens, not to do much of anything. And, as Steven Pearlstein points out, that is likely to be the policy of the Bernanke Federal Reserve too.

A graph showing the US current account deficit relative to the deficits and surpluses of other countries would portray the US deficit as this totally gigantic chasm, a chasm that is far larger than the deficit of any other country, and totally out of proportion with biggest surplus of the biggest surplus country (Japan in 2004) as well.   So I don't know if the decision to focus on the capital account surplus rather than the current account deficit reflects Bernanke's intellectual influence, or a fear that that mirror image of chart 6-2 (on p 131), one showing current account deficits rather than capital account surpluses, would just look really, really bad.

Probably it was a bit of both. 

The drafters' problems did not end there.   Suppose you want to argue that current account deficits are caused by big capital inflows, and reflect the markets judgement about the desirability of investing in different places.   You end up with one big problem:  in 2004, relative to its GDP, China attracted more (net) private capital flows than the US did.  China pretty clearly didn't run a current account deficit.   So at least in some cases, big capital inflows (private ones) don't lead to big current account deficits.

Suppose you want to argue that the trade deficit reflects fast growth in the US.   Fair enough.  But that argument poses the same problem.  if trade deficits stem from fast US growth, then why is China, which is growing even faster than the US, financing the US?  And more generally, why is the fast growing emerging world financing the US?

Unlike the Financial Times, I didn't find the section of the economic report on China particularly strident.    If your thesis is that capital flows drive the current account, it is hard to avoid discussing how central bank intervention to defend China's peg overwhelmed large inflows of private capital.    I do think China's exchange rate policies contribute to the US deficit - as, clearly, do US fiscal policies.   The two interlink: without China's big reserve build-up, US would have had trouble financing big fiscal deficits and a residential housing boom out of its own limited savings.

I did object for to a few slights of hand - nothing that is outright wrong, just what to my mind seemed to be a rather selective presentation of the available data.

One example:  The argument that US deficits reflects higher productivity growth in Japan and in Europe.   My problem: Europe as a whole isn't financing the US, the emerging world is.  And some countries that are financing the US - China - have far higher productivity growth than the US does.    Like I said, the US is deficit is growing because the world isn't growing argument doesn't really work.   World growth was very, very strong in 2004.

Another: the omission of data showing the role foreign central banks played financing the US deficit.  Particularly in 2004, a very large share of total inflows into the US came from foreign central banks.  About $400 billion according to the US data, about $500 b according to the BIS.   It is not just that the dollar remains a reserve currency; it is that central banks added to their reserves quite rapidly.

Finally, I was a bit disappointed that ERP focused on Germany as a surplus country without really noting that the Eurozone as a whole doesn't have a surplus.   Best I can tell, Germany's surplus plays a bigger role financing current account deficits in France and Spain than the US.  And no doubt it helps finance Eastern Europe too.   But a bit of comparison would have complicated the "Germany has a surplus because it hasn't reformed" story.  France has done less reform than Germany I suspect, and it has a significant (and still growing) deficit.    There is even a reasonably case that the reforms and restructuring that have led German unit labor costs to fall  (and pushed German exports up) have contributed to higher household savings and weak demand growth, and thus to Germany's surplus.

No doubt I have biases of my own, and would present the data that is most favorable to my case.  But in these instances, I thought the authors steered clear of some hard questions.

The Economic Report of the President does recognize that reducing the US fiscal deficit could play a role in reducing the current account deficit.  But it minimizes the likely impact.  That is because President Bush is far more interested in scaling back entitlement spending (or at least talking about the need to do so) to please his base than in cutting the current fiscal deficit.

That also brings me to another point - one I have been meaning to make for a long time.

A lot of the commentary focuses on the growth of entitlement spending (see this US News and World Report article, among others).  And there is no doubt that medical spending is growing fast, and that such spending is a future problem.    But the argument that "To really control the deficit you need to control entitlements" strikes me as incomplete. 

Particularly with respect to Social Security.  After all Social Security payroll taxes were raised in advance of the baby boom - and right now, the US takes in more from the payroll tax than it pays out.    That is why the CBO shows off budget surpluses (Social Security) offsetting big on-budget deficits, helping to keep the overall consolidated deficit down over the next few years.  

The central banks of China and Japan are not the only non-economic actors lending big sums to the US Treasury; the Social Security trust fund remains by far the United States Treasury's biggest creditor. 

Today's simply deficits don't stem overwhelming from entitlements.  Sure, the US spends a decent chunk of money on entitlements, but it also raises a decent sum from the payroll tax to help pay for them.  Today's deficits stem from the fact that the Bush Administration ramped up discretionary spending (particularly defense and homeland security spending) while cutting the set of taxes that finance the non-entitlement portion of the US government. 

Reducing the deficit over the next few years doesn't require entitlement reform.  It does require finding enough revenue to pay for the Administration's current priorities.

This is not to say that combination of rapidly growing heath care expenses and an aging population will not create huge challenges.  Only to say that if you are worried about the role the budget deficit plays creating a savings shortage that contributes to the United States enormous current account deficit, reforming entitlement promises ten years down the road won't have much of an impact.   

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