US Deficits and Possibilities for Global Instability

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US Deficits and Possibilities for Global
Instability
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In the News

• Dollar Falls On Fears of U.S. Deficits
• A Field Guide to the Falling Dollar
• The Other US Deficit
• What Happens if the Dollar Crashes?

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Was This An Issue During the Presidential Debates?

• Yes and no
• What was discussed was the budget deficit
• Also indirectly the topic of free trade,
  outsourcing, etc. was considered
• It turns out that these issues are all
  inter-related

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Whys the Budget Deficit Such a Big Deal Anyway?

• A deficit must eventually be paid for by future
  generations!
• But if this was all there was to it the issue
  would simply center on whether the exigencies of
  today justify shifting higher tax burdens onto
  future generations
• But nothing is ever that simple!

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Part of a Bigger Problem

• The US budget deficit is part of a bigger problem
  related to the overall deficit of the US with the
  rest of the world
• This deficit is called the current account
  deficit
• Most would agree that such a deficit is
  unsustainable, but the extent and timing of its
  adjustment are uncertain and there are certainly
  good reasons to be concerned

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Larry Summers on the Current Account

• In a recent speech, the former Secretary of the
  Treasury and current President of Harvard, Larry
  Summers stated
• I am reluctantly convinced that the most serious
  problem we have faced in the last 50 years is
  that of low national saving, resulting dependence
  on foreign capital, and fiscal sustainability,
  which has far-reaching implications for the US
  and the global economy
• The last time Summers made similar such
  predictions, 3 months later Asia crashed into the
  deepest financial crisis in its history

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Topic of Todays Discussion

• The topic of todays discussion is the US current
  account deficit
• We will explain first what the deficit is
• Then well discuss its root causes. In
  particular we will talk about the role of the
  budget deficit
• Finally we will ask why the deficit is concerning
  and whether the potential for disaster is real or
  if its overblown

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Whats a Current Account Deficit

• The current account deficit is a countrys total
  (current-period) deficit to the world?
• Its the difference between how much a country
  earns and how much it spends

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A Current Account Deficit is Not a Trade Deficit

• If a country is spending more than it produces it
  must be running a trade deficit (this is simply
  the difference between exports and imports)
• But a country also receives interest-income from
  abroad on its net foreign assets positionnet
  factor income from abroad

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A Current Account Deficit is Not a Trade Deficit

• A countrys total deficit with the rest of the
  world is therefore the sum of its
• Trade Deficit
• and net factor income from abroad

Net factor income
Current account
Trade deficit
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But There Are Other Ways of Viewing a Current
Account Deficit

• One way we can view a current account deficit (or
  surplus) is as the difference between a countrys
  savings and investment
• The next few slides will provide an argument as
  to why this is the case

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Domestic Absorption

• What does the US spend its income on?
• Consumption of goods and services by households
  (C)
• Investment on new equipment etc. by firms (I)
• Expenditures by the government (G)
• Hence the total expenditures are simply the sum
  of consumption, investment and government
  spending
• This is called domestic absorption (CIG)

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Current Account Income Domestic Absorption

• Recall that a the current account deficit is the
  difference between a countrys income (Y) and a
  countrys spending
• Therefore the current account deficit is simply
• CA Income domestic absorption
• CA Y - (CIG)

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Income Approach

• But where does your income go?
• Presumably some of it goes toward consumption
  (C), some of it is saved (S) and some of it is
  used to pay taxes (T)
• This logic can be extended to the US as a whole.
  The total income in the US can be divided into
  three components
• US Incomeconsumption savings taxes
• US income(CST)

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Current Account Savings Investment

• Recall that a the current account deficit is the
  difference between a countrys income (Y) and a
  countrys spending. That is
• CA Y - (CIG)
• But income (Y) is just CST
• Hence the current account is
• CA (CST)(CIG)
• (ST-G)-I
• This is how
• much you save

This is how much the government saves
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Current Account National Savings Investment

• The sum of your (private) savings and the
  governments savings is called national savings
  (SN)
• Strictly therefore the current account is defined
  as the difference between national savings and
  investment. That is
• CA SN-I

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So What Causes a Current Account Deficit?

• To start with write down the different
  definitions of the current account
• CA Trade deficit Net factor income
• CA National savings Investment

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The Trade Deficit?

• A large part of the CA deficit can be
  attributable to a large trade deficit
• What has caused this trade deficit and how can we
  reduce it?
• One of the reasons why the trade deficit is so
  why is because demand in the US is so high and it
  is growing faster than the demand in the rest of
  the world

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Might Tariffs Work?

• One solution would be to impose tariffs, or
  encourage other countries to lower their tariffs
• But if the trade deficit is generated by an
  imbalance in demand growth between the US and the
  rest of the world, it seems unlikely that such a
  solution will work
• May be instead what needs to happen is a
  modestslowing of US growth andsome acceleration
  of demand in the rest of the world, Edwin M.
  Truman former Assistant Secretary of the U.S.
  Treasury for International Affairs
• That is the emphasis shouldnt just fall on
  relative prices of imports vs. export, but also
  on other factors that affect the demand for these
  goods

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The Savings Gap

• Another way of thinking about the current account
  is as the difference between savings and
  investment
• So a current account deficit could arise because
  of
• an increase in savings
• a fall in savings
• This fall in savings can in turn be attributable
  to
• a fall in government savings (higher budget
  deficits)
• a fall in private savings (higher consumption)

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So What Has Driven the US Current Account Deficit?

• The US started running current account deficits
  in 1982
• It is fair to say that these deficits were
  initially caused by the sharp increase in the US
  budget deficit
• In the 90s however the US government turned the
  deficits into surpluses but the current account
  deficits continued
• It seems fair to say that these deficits were
  caused by
• (a) a sharp increase in investment
• (b) a decline in private savings

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US Current Account Deficit and Budget Deficit

• Until about 1992 the current account deficit is
  highly correlated with the budget deficit

Budget deficit
Current account deficit
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Budget Deficits Are Again to Blame

• More recently investment in the US has declined
  but the deficit has continued to worsen. Why?
• This time it seems the government is again to
  blame
• The large US-government budget deficits have
  sharply worsened the current account deficit

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So Who Finances Our Deficits?

• There is a simple answer to this question.
• Foreigners!
• Foreign central banks
• Private foreign investors

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But What Happens When Foreigners Are Being
Uncooperative?

• Who pays for the deficit then?
• We do
• Basically we run down our holdings of assets that
  are referred to as reserves
• The resulting change in reserves is sometimes
  referred to (in the financial press) as the
  balance of payments

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Example
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So Can We Run a Balance of Payments Deficit
Forever?

• Clearly no. We will eventually run out of
  reserves
• What happens then
• (1) Investment will have to fall or savings will
  have to rise, since we will no longer be able to
  run a current account deficit
• (2) The value of the dollar will decline sharply

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Why Will the Dollar Decline?

• The value of the dollar is determined by the
  supply and demand for dollars
• When foreigners buy our goods they demand
  dollars, when we buy their goods we sell our
  dollars for their currency
• When foreigners lend us money they demand
  dollars, when we lend them money we sell our
  dollars and buy their currency
• A CA deficit means we are buying more foreign
  goods than they are buying American, this tends
  to cause the value of the dollar to fall
• But when foreigners are lending us money, they
  are effectively buying US assets, and demanding
  dollars and this helps prop up the value of the
  dollar

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Why Should the Rest of the World Care?

• Clearly if the current account deficit is not
  sustainable this entails corrections in terms of
  investment and consumption in the US and a sharp
  recession!
• Why should foreigners care? They care because
• the US economy is an engine for growth
• This will imply a global recession
• if the dollar declines the value of foreigners'
  investments fall
• This will imply a global slow down in consumption

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The World Wont Abandon Us, Will They?

• So by not financing our deficits the rest of the
  world is shooting itself in the foot, as well as
  the US
• Clearly no one wants that, so why are we
  concerned?

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They Might Just Do That

• The problem can be viewed as stemming from a
  couple of different sources
• (1) As things are going the current account
  deficit it seems will only get worse. The problem
  is not transient it is long-term!
• (2) The world may be buying more dollars than it
  really wants increasing the risk of a sudden
  sell-off

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The Problem is Long-Term

• First it is worth defending that the current
  account difficulties are here to stay
• As Larry Summers has noted the clear change in
  national saving, which has declined precipitously
  in recent years, comes from the increase in the
  federal budget deficitrealistic long-term fiscal
  projections that reflect, in a reasonable way, a
  business-as-usual economic strategy for the
  United Statessuggest that the budget deficit
  over the next 10 years is just comparable,
  relative to GDP, to the budget deficit in 2003
  that drove the trends just described
• The projections Summers is referring to are those
  of of Bill Gale and Peter Orszag at the Brookings
  Institution

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Dollar Exposure

• Second it is worth considering why the rest of
  the world may no longer be willing to hold
  dollars
• The problem is that if the value of the dollar
  declines foreign investors lose
• If investors hold a lot of dollar assets in their
  portfolios they might want to reduce their
  exposure to this risk
• Is this the case?
• Perhaps. Perhaps because a large part of US debt
  is held by a few large playersnamely the Central
  Banks of China, Japan, and India

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Central Banks Versus Private Investors

• Private investors buying US assets (and therefore
  financing our deficit) will tend to hold
  diversified portfolios. The risk of a dollar
  decline is their, but the exposure to that risk
  is small
• Assets of foreign central banks on the other hand
  are largely denominated in dollars. A decline in
  the dollar would therefore entail a sharp
  reduction in the value of their portfolios
• Their exposure to a decline in the value of the
  dollar is very significant

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So Why Do Central Banks Hold Dollars Anyway?

• This is because many countries currencies are
  undervalued. There is a tendency always for these
  countries currencies to increase in value and
  central banks must be ready to sell off their
  currencies and purchase dollars in order to keep
  the exchange rate at the current pegs
• The reason is part of an export-led growth
  strategy that entails a need to keep their
  exports competitive

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But Now It Appears Central Banks Want to Reduce
Their Exposure

• China and India are no longer committed to
  open-ended dollar buying, Stephen S. Roach,
  chief economist at Morgan Stanley
• The Chinesehave already begun buying more
  euro-denominated assets, New York Times
• The US dollar went down to a record low of 1.33
  to the euro at the end of last week amid signs
  that foreign central banks, which have invested
  heavily in US treasuries and other forms of debt,
  are looking to shift some of their resources out
  of US financial markets, Nick Beams
• It is clear that central banks do want to reduce
  their assets of US dollars!
• But at the same time they cannot abruptly sell
  off dollars and spark a sharp fall in the dollar

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Recent Falls in the Dollar

• Recent falls in the dollar reflect
• (1) a weak investment climate in the United
  States (private investors are not necessarily
  looking to invest in the US)
• (2) Central banks reluctance to absorb dollars
• The latest fall in the dollars value was touched
  off by a report in the Shanghai publication China
  Business News that China had reduced its holding
  of US treasuries
• The slide was halted when a member of the
  monetary policy committee of the central bank,
  issued a statement saying that his remarks had
  been misrepresented by the newspaper

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Nervous Eyes

• Given the massive losses that central banks
  could incur, all the players keep a nervous eye
  on each other. They all want the inflow of funds
  to continue in order to maintain the value of
  their assets. But at the same time, they are all
  looking to reduce their own dollar holdings in
  order to lower their risk exposure. Consequently
  in these conditions, even a relatively minor
  movement out of the US market by one of the major
  players could provoke a rush to the exit,
  setting off a collapse of the dollar. Nick Beam

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Who Is to Blame?

• Can we blame the current administration
• Yes but only partly
• There is little doubt that the fiscal imbalances
  have made the situation worse. These fiscal
  imbalances are allowed because of the dollars
  key role as a reserve currency
• But the problem is more involved
• The deficit exists in part because of tremendous
  growth in US demand relative to foreign demand

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A Lack of Growth in the Rest of the World

• A lack of growth in Europe and the rest of the
  world, increases the desire of foreigners to
  invest in the US
• Their exports (to the US) grow rapidly (and the
  US economy props up these economies), while US
  exports to the rest of the world are stifled by
  slow growth abroad
• Fiscal imbalances aside, it is clear that what is
  needed is (1) slower growth in the US and (2) an
  acceleration of growth abroad