from Follow the Money

Stephen Jen, Eternal optimist

October 9, 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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Apparently, the US fiscal deficit is set to disappear and the US current account deficit has peaked.  At least it has in Stephen Jen-land.  In his latest email Jen writes:

“US’s corporate revenues are growing rapidly and the US’ Federal budget could be in balance by 2010; the US’ C/A deficit is likely to be peaking this year”

Color me unconvinced on both points. 

I’ll take Douglas Holtz-Eakin’s forecast for the 2007 fiscal deficit over Stephen Jen’s forecast.   Holtz-Eakin in the Journal

The world doesn't end, but the deficit goes in the other direction next year," says Douglas Holtz-Eakin, a former CBO director. Interest rates are rising, adding to the government's annual interest tab. Iraq continues to be costly. The revenue surge already is beginning to fade. And a slowing economy is likely to restrain revenue growth even further. A one-percentage-point drop in economic growth for a full year increases the deficit by about $35 billion.

Holtz-Eakin was talking about 2007, not 2010 -- but I doubt he would forecast the 2010 deficit at zero either. Corporate tax revenues won’t keep growing at their current rate unless profits continue to increase as a share of GDP from already high levels.  Receipts from corporate profit taxes are now 2.7% of GDP – their highest level since Jimmy Carter.  I rather suspect that those receipts are not likely to continue to increase at close to 30% y/y (they were up 27% in FY 2006).    

And I really would like to see the details of Jen’s forecast for the 2007 US current account deficit.    

From what I gather, Jen thinks:  

  • The US won’t slip into a recession – as the slump in residential housing won’t spill over into a major slump in US consumer spending.  US growth will slow, but not stop – the classic soft landing.  So US non-oil import growth continues, one assumes.
  • The dollar will rally v. the euro as structural dollar bears give up.  That cannot be all that good for US exports – even if Jen thinks Asia will appreciate modestly against the dollar.  A modest yen appreciation won't provide Toyota with a strong incentive to increase the US content of its (growing) US sales.
  • US interest rates will remain roughly at their current levels.  So interest rates on US external debt should continue to rise, increasing the income deficit.

The only way I can see the US current account deficit falling in those circumstances is if oil continues to fall from its current levels.   If oil stabilizes at $60, I would argue the current account deficit will continue to rise.  Remember, the harsh math of the US current account.

  • The US imports about 55% more than it exports, so exports have to grow 55% faster than imports just to keep the trade balance constant.  5% import growth and 8% export growth more or less just keeps the deficit stable.   And US imports have not grown at 5% (in nominal terms) since the last recession.
  • The average interest rate that the US pays on its external debt was only about 4.2% in the first half of the year.  As the interest rate on the United States’ roughly $8 trillion in (gross) external debt  renormalize at around 5%, the US income balance will take a $60b hit.   And the $900b or so deficits imply a $45b a year hit from new borrowing.  Yuck.   
  • Some of the sting of rising interest rates on US external debt has been offset by rising interest receipts on US lending, but I think a close reading of the data suggests that US lending already has largely reset at higher interest rates, while US external borrowing is still in the process of being reset.  In the first half, the average interest rate on US lending was already 5% --it doesn’t have much further to rise -- unlike the average interest rate on US external borrowing.  Remember, the US lends at short-maturities and borrows at a longer maturity, so the average interest rate rises/ falls faster on US lending than on US borrowing. 

All that makes an outright fall in the US current account deficit rather difficult.  

Real improvement in 2007 is particularly difficult if, as I expect, the income deficit is likely to go from say $25b this year to over $100b next year. 

Absent a sharp recession, my sense is that the only thing that could realistically bring the trade deficit down enough to offset the rise in interest payments is a big fall in oil prices.  Going from $70 to $60 won’t cut it.  If oil stays at $60 through 2007, the US oil import bill in 2007 wont be much lower than the 2006 oil import bill -- and both will be larger than the 2005 US oil import bill.

Jen’s forecast for soft landing in the US does suggest some moderation in US import growth.   But I would argue that Jen’s broader forecast also implies that the pace of US export growth is likely to slow.   

Jen, after all, expects the dollar to rebound against the euro.  That won't help US exports.   And in case, Boeing’s exports are pretty much capped out until the 787 line starts up.  Production has maxed out, and pretty much every Boeing off the line is being exported.    

Remember, from 2004 through 2006, the US has enjoyed the strongest three years of export growth since 1987-89 --  presumably a result of the dollar’s depreciation from 2002-04 and strong global growth.  

Combine a maxed out Boeing, a stable dollar and slowing global growth … and it seems to me that export growth is likely to slow from its current pace.  And given the harsh math created by the big gap between US imports and US exports, it is really hard to bring the trade deficit down quickly if US export growth slows.   Absent a US recession that is.

What would bring the 2007 current account balance down in nominal terms if US non-oil imports continue to increase in line with US GDP? Well, a $20 a barrel fall in the price of oil from its 2006 average would help a lot.  A $20 fall should reduce the US trade deficit by about $100b.   That would offset the expected deterioration in the income balance.

I would be interested in seeing the internals – the export growth/ import growth/ oil price/ interest rate on US external debt/ interest rate on US external lending and so on – that support Jen’s overall forecast that the US current account deficit is close to its peak.  

There is some evidence that the trade deficit – in real terms -- has stabilized as a share of US GDP.  But I haven't seen much evidence that the US current account deficit has stabilized.  Sure, it has fallen a bit from its peak in q4 2005.  But the deterioration in q4 2005 was quite sharp, so some bounce back in q1 wasn't a total surprise.   The latest monthly trade number wasn't encouraging.

And some strange dynamics in the income balance -- US external lending has repriced faster than US borrowing -- have limited the recent deterioration in the income balance.  But that just stores up a bigger adjustment in the income balance.

There is a scenario where the trade deficit falls faster than the income balance deterioratesin 2007.  In that scenario, the US slows significantly, oil prices fall, the Fed starts lowering rates and the dollar slides further.     

But that is Roubini-land, not Jen-land. 

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