from Follow the Money

Once again, trade deficits do matter — and they really do have to be financed

August 8, 2005

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Brad DeLong and the folks over at Angry Bear have already beat up on this rather ridiculous Donald Luskin argument that the US does not take on debt when it runs a trade deficit.  

I hardly need to pile on.  I'll just note that if you go to either the Treasury web page, or the Bureau of Economic Analysis data over at Commerce, it is pretty hard to avoid the conclusion that the US is financing its external deficit by selling debt.   That is not necessarily the case.  In the late 1990s, the US financed its deficit in large part by selling equity.   But right now, US firms are investing more outside the US than foreign firms are investing in the US and US interest in foreign stocks exceeds foreign interest in American stocks.  Both the trade deficit and the equity outflow are being financed by the sale of US debt.

Facts are stubborn things.

If I were going to defend US deficits, I would not rest my case on the argument that there is no "debt" involved or, for that matter, on the argument that this external debt does not matter so long as domestic US assets (read homes) are rising in value.

There are more clever arguments out there - and none better than Bernanke's argument that the US is really doing the rest of the world a favor by putting the world's excess savings to work financing US fiscal deficits and a surge in new home construction in the US.  

Because of its flexible labor force and advanced financial system,  the US - far more than any country - can take advantage of low global interest rates by shifting resources out of the production of tradable goods and specializing (at least for a while) in real estate, auto sales and health care. 

In other words, the US has a comparative advantage at the creation of debt, and is doing the world a favor by issuing enough of it to give the rest of the world a place to park their excess savings.  You see, we in the US are just nimbly exploiting the market opportunity created by the surge in desired reserve accumulation outside the United States ...

Who cares if foreign investors are unlikely - judging from past performance - to get much of a return on their investment in the US.  The US must be better than any of the alternatives, or the funds would not be flowing into the US.  Or more precisely, if the US was not an attractive place for investment (particularly investment in residential housing ... ), any inflow from abroad would be matched by an outflow from US investors into foreign assets.  At least that is what Dooley, Garber and Folkerts-Landau claim. 


The Luskin's rant was triggered by this Washington Post oped

Obviously, I kind of agree with it.  But with one qualification.

I don't think a "small" devaluation of the dollar would increase the value of US assets abroad by anywhere near enough to wipe out the United States' existing (net) external debt.  To quote the Post:

A modest decline in the greenback would boost the dollar value of America's overseas portfolio enough to wipe out foreigners' "net ownership" of the United States.

Most US assets abroad are in Europe and Canada - not in Asia or in Latin emerging economies.  To raise the value of US assets abroad, the dollar really needs to continue its (2002-2004) fall against the euro, the pound and the Canadian dollar.   The most likely next move in the dollar - against Asia and a range of emerging economies - won't generate as much "valuation" bang for the falling buck.  In broad terms, a 50% fall v. the euro (from 0.9 to 1.35) and other European currencies generated about a trillion dollars in valuation gains.  Another 50% fall would generate roughly another $1.5 trillion in valuation gains, by my very rough back of the envelope calculations. 

That puts the euro at close to two -- not a modest fall in my book.

And it still would not generate enough valuation gains to wipe out US debt.  

Plus, if foreigners anticipated such a sharp fall, why wouldn't they pull their funds out of the US?   And, why, for that matter wouldn't US investors shift their funds abroad to take advantage of the currency shift? 

Another point -- one that i thought was missing from Eduardo Porter's New York Times article on Sunday.   Unless the US can keep on running up its external debt indefinitely, at some point, the US will have to switch resources back into the production of tradable goods and services, like it or not.  Bernanke admits as much.  I certainly don't think that transition will be easy, or costless.  So in a sense I agree with Porter, and with Mark Thoma.    There will be losers as well as winners as the US economy shifts resources around after a major adjustment in the dollar, and, at least in the short-run, the losers could exceed the winners. 

However, in a broader sense I disagree with the suggestion that the US has more to lose than to gain from a (bigger) revaluation of the RMB.

Why? I strongly suspect that the costs of the necessary transition away from a consumption and real-estate centric economy will increase if the transition is delayed - and the US starts off with bigger external deficits and more debt.   Better to begin to adjust with a current account deficit of 7% of GDP and a net external debt of 30% of GDP than with a current account deficit of 9% of GDP and a net external debt of 50% of GDP.

And I would argue that the same is true of China.  It will be better off transitioning away from its export-led model now than in a couple of years. 

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