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Myth of the twin US deficits Samuel Brittan Financial Times 11/11/05 According to Will Rogers, the American humorist: "It's not what we don’t know that hurts us, it's what we know that ain't so." A striking illustration is the preoccupation with the twin US deficits; budget and current balance of payments. The conventional wisdom is that these are mirror images of each other. The payments deficit reflects an excess of investment above domestic saving and the budget deficit is one main source of negative saving. Alas, nothing is sadder than when a plausible theory is falsified by awkward evidence. The case for both a budget and a dollar correction has been powerfully stated by William Cline of the Washington Institute for International Economics*. But he is meticulous in providing data that enable one to take a different view. He has a chart showing that, in the 1990s, the conventional relationship was turned upside down. The budget moved into surplus during the Clinton period from 1992 to 2000. But the current account deteriorated and has continued to do so, irrespective of the twists and turns of the fiscal balance. Why this should have happened is no mystery. As Dr Cline observes, there was first an investment boom in the late 1990s associated with "the new economy". Second, there was a sharp decline in household saving, due in large part to the boom in residential property prices which, as in the UK, triggered a bout of consumer spending. Thus, even if the budget deficit were cut in half by the end of President George W.Bush's term of office in 2008 it still does not follow that the payments deficit will fall correspondingly or even at all. Any number of offsetting changes in the US national accounts could occur. In testimony before the Joint Economic Committee, Alan Greenspan, the US Federal Reserve Board chairman, was eloquent about the dangers of the budget deficit, but did not mention the balance of payments. His main fear was the long term one that the US administration was accumulating obligations for health and retirement programmes that it would not have the revenue to cover. There is an alternative analysis of the US payments deficit. Richard Cooper, a former member of the Carter administration, argues that there is outside the US an excess of savings over potential investment opportunities**. This is reflected in the so-called puzzle of low real long-term interest rates. Prof Cooper believes that these alone are not enough to balance the world economy and that the real balancing force consists of non-US export surpluses. None of this means that the US payments deficit can or should be allowed to rise indefinitely along the path projected by Dr Cline in the absence of policy adjustments to 7½ per cent of gross domestic product by 2010 and 14 per cent by 2024. His own remedy is a combination of dollar depreciation and a modest acceleration of overseas growth, for instance in Europe, which he believes would reduce the 2010 US payments deficit to a sustainable 3 per cent. He advocates an "Asian Plaza" that would co-ordinate exchange rates realignment "to accompany a large one-step revaluation of the Chinese renminbi". Like Mr Greenspan, I remain extremely sceptical of estimates of equilibrium exchange rates. The UK, for instance, has survived very well for at least the past 10 years with an exchange rate considered too high by many mainstream economists and manufacturing firms. There is a more positive aspect too. If governments really carried out policies that were sensible on domestic grounds, exchange rates would fall into place. If the US embarked on a credible policy of deficit reduction, if the eurozone was to be a little less doctrinaire in its monetary policies and the east Asian countries were to give more attention to the welfare of their own citizens, the pattern of exchange rates would take care of itself. A reduction in US domestic demand does not, however, depend only on fiscal adjustment. Mr Greenspan told the last Jackson Hole meeting that the US housing boom "will inevitably simmer down, home price increases will slow and even decrease. As a consequence, home equity extraction will cease and with it some of the strength in personal consumption expenditure. The surprisingly high correlation between increases in home equity extraction and the current account deficit suggests that an end to the housing boom could induce a significant rise in the personal savings rate, a decline in imports and a corresponding improvement in the current account deficit." My own guess is that the slow motion US monetary tightening will come to an end and even be reversed once it is clear that the rise in asset prices is well and truly over. This in turn would nudge the dollar in the required direction without any heroics or unlikely international concordats. * The United States as a Debtor Nation ** Is the US current account deficit sustainable? CS IFO Forum
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