The other deficit: Part II

by John Q on August 25, 2004

In my previous post on US trade, I argued that if the current account deficit is to be stabilised at a sustainable level, the balance of trade on goods and services must return to surplus in the next decade or so. In this post, I’m going to ruIe out a soft option and argue that, while a smooth market-driven adjustment is not inconceivable, it’s unlikely.

The soft option is the idea that central banks will keep on buying US dollars indefinitely in order to keep the world trading system indefinitely, and that the US can therefore consume as much as it wants, subject only to the capacity of the Treasury to keep printing dollars. This option is not a goer for both economic and geopolitical reasons. On the economic front, there comes a point when the risk of being left with a pile of worthless paper exceeds any benefits from being able to export goods.

On the geopolitical front, there’s no point in spending hundreds of billions of dollars a year becoming a military hyperpower if you’re going in to hock to your rivals/potential adversaries for a similar amount. On current trends, the Chinese central bank will hold the better part of a trillion dollars in US government bonds in a few years time. Should there be any minor unpleasantness on the foreign policy front, nothing would be more natural than for the Chinese to stop buying a bit and diversify some of their existing holdings, say a hundred billion dollars or so, into yen and euros. At this point, Wall Street and the Treasury would demand immediate capitulation.

There are also various private sector versions of the soft option, based on the idea that foreigners desperately want to hold US assets, but none of these will stand up to the pressure of chronic trade deficits. As other countries have found out, relying on hot money to finance chronic deficits guarantees a crisis of confidence sooner or later.

If the soft option is ruled out, we’re left to consider paths by which the US can return to trade surplus. Currently the US exports about half as much as it imports. The imbalance could be reduced in a number of ways

* A (further) devaluation of the US dollar

* Reductions in US wages relative to those overseas

* Increases in US relative to foreign productivity (the relevant concept here is multifactor productivity, taking account of both capital and labour inputs)

* Reductions in US consumption relative to foreign consumption

To get back to balance or surplus in a decade, and without a crisis, no one of these would be sufficient. For example, to get to balance by devaluation alone would require a devaluation of the order of 50 per cent, which would certainly entail both an upsurge in inflation and an increase in interest rates. A lot of emphasis is (rightly) put on productivity but even on the most optimistic accounts, the gap between the US and other countries is no more than one percentage point per year, which is nowhere near enough. About 40 per cent of the marginal dollar goes on imports, so the restoration of balance through increased household saving alone would require an increase in saving equal to something like 12 per cent of GDP, and this seems most implausible.

If the adjustment were to begin almost immediately and everything went right, it could go smoothly. But the odds against this seem long. So it’s worth considering alternatives.



Jason 08.25.04 at 1:43 pm

“Owe a hundred dollars and the bank owns you, owe a million dollars and you own the bank.”

Only loosely related, but I like the quote (it was used in talking of the relationship between the US and Japan).


Y '81 08.25.04 at 1:57 pm

Following up on what Jason said, if the Chinese central bank owns a trillion dollars in bonds, it will be difficult for them to crash the market for those bonds. It won’t even seem like a credible threat. The US would have more credibility in threatening to repudiate the bonds, thereby bringing the Chinese government to heel.

If the theory is that developed Western nations are uniquely weak in the inability to ruin themselves financially for military glory, consult any history of World War I for a refutation.


kevin donoghue 08.25.04 at 1:58 pm

The final sentence suggests that Part III is in preparation? In the meantime a few points on this one:

Before you rule out the soft option entirely, consider a slightly less soft variant: even if the US cannot get away with selling paper to the rest of us indefinitely, it can sell equities and real estate if the price is right. A weaker dollar doesn’t just help to balance the current account, it can also make funding a persistent imbalance that much easier.

Still on the soft option: if “capitulating” to the Chinese means saying sorry when a Chinese pilot gets killed buzzing a US spy-plane, or leaning on Taiwan to avoid provocation, surely that’s nothing new? Does it greatly bother Americans?

Granted no one of your four bulleted solutions works by itself; but if a fiscal contraction leads to relatively lower interest rates and, hence or otherwise, a dollar devaluation, that should reduce US wages in a common currency relative to those overseas. Consumption should be curtailed too, or is Keynes deader than I thought?


Doug Turnbull 08.25.04 at 2:13 pm

Seems like an additional option which didn’t make your list is the complement to falling US wages. Namely, that wages elsewhere could rise. And given the choices, it sounds like that one is far and away the best for all concerned.

I’m not sure if there’s much we can do to pursue that end, but if there is, it ought to be one of our highest economic priorities.


theCoach 08.25.04 at 2:43 pm

I am assuming it is remote, but what are the chances that China is playing a more devious game? It would seem to me that China is dependent on exports in the near term, but as a communist country they would be more capable of a massive shift to domestic production if they felt the need to unpeg. Perhaps I am just showing my ignorance of international economics, buit don’t the Chinese have some options here as well that wew should consider on the pessimistic side of the equation?


bob mcmanus 08.25.04 at 2:47 pm

When does Krugman get his Nobel? I know the Nobel in Economics is usually given for technical achievements. But his columns of 2002 in which he realized that the Bush administration was revolutionary, and deliberately sending the nation into fiscal crisis, should about now be getting some recognition.


Scott Martens 08.25.04 at 2:56 pm

Jason, the quote is – I think – oringially from the film Rosalie goes Shopping, made by my wife’s favourite German director and I believe former Fassbinder protegé Percy Adlon, and starring her favourite German actress Marianne Sägebrecht. They are better known in English for Baghdad Café, which was another Adlon film starring Sägebrecht. The line that ends the film is “When you’re $100,000 in debt, it’s your problem. When you’re $1,000,000 in debt… it’s the bank’s.”

I have to admit having the same hesitations about the thesis that the US is in the corner. China holds enormous US dollar reserves, which lose their value as soon as they try to spend them. China is a country with a trade balance of roughly zero – it exports enormous amounts to the US and imports just as much from Japan, other Asian states and Europe. As much as its economy depends on buying dollars with exports to the US, and spending them in the rest of the world, I have to ask what China could possibly see in undermining the value of the dollar? The whole export-driven paradigm depends on China buying dollars indefinitely from a US that is perpetually willing to run a deficit.

What makes this different from some form of financial mutually assured destruction? If China drops the bomb and ruins the US economy, they ruin their own ability to import. And remember, Chinese imports mean the food they eat, essential commodities like oil and paper, and other things they can’t substitute and can’t live without.

In 2000, I figured Bush was just dumb enough to do the American equaivalent: pass trade sanctions against China, forcing them to sell their dollars and have the same effect. But now, why can’t this persist for years to come?

Eventually, I suppose, China will either cease to need its US trade so much, and start unloading unproductive dollars. Or some unrelated crisis may undermine the dollar and force them into a sell-off. Or some other kind of crisis could happen. But it doesn’t seem to me that that’s likely to happen anytime soon.


kevin donoghue 08.25.04 at 3:49 pm

Regarding Jason’s quotation:

“If you owe your bank a hundred pounds, you have a problem. But if you owe your bank a million pounds, it has.” – John Maynard Keynes

“If you owe your bank a billion pounds everybody has a problem.” – The Economist


dave 08.25.04 at 4:33 pm

One thing we must keep in mind, though, is that world demand has been, and will continue to be, driven by American consumption (however unsustainable) for the foreseable future. Consequently, many of these nations (China in particular) have an interest in financing these debts and keeping the money flowing.

The most desirable solution, as I see it, would be if China, India, or some other emerging economy were to develop a robust, American style consumer society. China is already on that path, and if the experience of South Korea can be used as a rough indicator, in 10 to 15 years from now they’ll have nasty credit card debts like the rest of us.

All of this would probably coincince with a devaluation of the U.S. dollar and a decrease (though not convergence) of the wage gap between U.S. and European countries and other, newly developed ones (ala factor-price equalization).

Really though, the most desirable outcome is increased consumer consumption in other countries so that world growth won’t be so heavily reliant on U.S. consumption.


hi 08.25.04 at 4:44 pm

Maybe US wages can go down when we stop carrying water for Europe like we have done for 50 years. I would like state health insurance and 6 weeks of vacation too.


Jim Harrison 08.25.04 at 5:59 pm

Aren’t U.S. wages already going down?


abb1 08.25.04 at 6:12 pm

Aren’t all these four option basically the same, don’t they all amount to devaluation of the US dollar?

Devaluation of the US dollar is how you reduce US wages relative to those overseas.

Devaluation of the US dollar is how you increase US productivity relative to foreign productivity.

Devaluation of the US dollar is how you reduce US consumption of the foreign goods (which is the only consumption that matters here).

The dollar is too high.

For example, to get to balance by devaluation alone would require a devaluation of the order of 50 per cent, which would certainly entail both an upsurge in inflation and an increase in interest rates.

EUR/USD 2002: 1.12
EUR/USD 2004: 0.79
Not quite a 50% drop, but pretty close. And not much inflation, unless you count oil and housing. And lowest interest rates in what? 40-50 years?

Well, obviously, if the dollar dropped 50% against yuan within a couple of weeks, we’d certainly see some serious inflation – but if it happens gradually, over 3-4-5 years? May not necessarly be so cataclysmic…


beowulf 08.25.04 at 8:58 pm


What are your thoughts of Warren Buffet’s plan to eliminate the trade deficit (involving the creation of an import certificate market)?


glory 08.25.04 at 9:00 pm

hey! america’s dangerous deficit by martin wolf came out today, too :D

The argument that deficits are unimportant goes back to Adam Smith’s assault on mercantilism in The Wealth of Nations. The aim of economic activity is consumption, he insisted, not the accumulation of treasure. Trade deficits permit a country to consume more than it produces. This then is a good thing.

More technically, with a lower cost of capital than it would have without the capital inflow, the US can enjoy higher living standards. The standard of living of the rest of the world will also be higher, provided the returns on its investments in the US are greater, at the margin, than the returns on spending at home. The export of capital to the US from the rest of the world is, therefore, a win-win proposition.

This argument is correct, so far as it goes. But it does not go quite far enough. There are three different reasons why one might still be concerned about deficits: US savings may fall too low; the rest of the world may be wasting its capital; and reversals of capital inflows may destabilise the world economy.

Lawrence Summers, president of Harvard and former US treasury secretary, emphasised the first of these points in his Niarchos lecture to the Washington-based Institute for International Economics*. US savings have reached all-time lows, he noted, as a share of gross and net national product (see chart). Net national savings (that is, after allowance for depreciation) are running at about 2 per cent of net national product. In effect, foreigners are now funding close to three-quarters of US net investment.


The second point is quite different. The rest of the world is offering the US more than one-tenth of its gross savings. A transfer of savings on this scale to the world’s richest country from what are often much poorer countries looks perverse. It suggests gross inefficiencies in capital markets, domestic policies or both.

The third point is the risk of destabilising reversals of capital flows. One danger does not exist. Since the dollar is the world’s key currency and principal reserve asset, US financial liabilities are either denominated in the national currency or are claims on real assets whose prices are flexible. The US cannot suffer from the currency mismatches that have proved so devastating to other countries. That is why the US is the world’s borrower of last resort.

Yet the fact that the US offers no hedge against depreciation of the currency exacerbates risks to creditors. They may also conclude that the US would need a sizeable depreciation in the real exchange rate if it had to live with significantly lower capital inflows. It may well need a sizeable depreciation merely to stabilise the current account deficit, as a share of gross domestic product, given the prospective deterioration in net investment income. US exports would now need to rise by 50 per cent if they were to equal imports (see chart). If the relative prices of exports were to fall as well (that is, the terms of trade were to deteriorate), the increase in the volume of exports needed to balance trade would be still larger.

Aware of this, private creditors may wonder whether the prospective returns on US assets cover the risks of a rising exposure. Just as happened in emerging markets, fear of withdrawal of money by others could precipitate a self-reinforcing run on the currency. Without the massive foreign currency intervention by foreign governments in recent years that would probably have happened already.

So do the deficits matter? The world does need the US to run a large current account deficit to balance excess savings elsewhere. Moreover, the country may be able to run a sizeable deficit – perhaps one as large as today’s – forever. In the short run, the huge fiscal deficit has also been a great help. Without it, sustaining US demand after the implosion of the stock-market bubble would have required dramatic monetary loosening, possibly zero interest rates. That might have had destabilising effects on the dollar’s value against other floating currencies.

Yet there are also good reasons to be concerned, not just over the scale of the US current account deficit but also over its persistent tendency to rise as a share of GDP. Americans should be concerned about the impact on them of rising external deficits that are financing consumption more than investment. The rest of the world should worry about its failure to use its own savings more productively. It should also think about the potential for much greater US protectionism. Both sides should worry about the potential for destabilising reversals in capital flows.

The steady rise in US deficits has proved better than the plausible alternative of a world slump. But the fact that the alternative to the unacceptable is the unsustainable should worry any prudent observer of the world economy.

i’d emphasize the rest of the world’s “failure to use its own savings more productively,” on which note a PIMCO discussion on developments in asia’s domestic fixed income markets i find interesting. but yeah, sorta like abb1 sez, i suspect any eventual adjustment (catastrophic or no) has to come either thru the exchange rate, the price level or interest rates, or some combination thereof. and as dave suggests, if asian currencies appreciate (to PPP?), you’d think their propensity to consume (versus save) would as well, but i think that still begs the question that wolf poses: who’d then buy US assets? which kinda brings us back to square one… asia’s central banks. also btw, while china does hold “enormous US dollar reserves,” (esp as a % of its economy) japan holds almost twice china’s $440bn. oh and yeah, that quote’s keynes’ :D



a different chris 08.25.04 at 10:28 pm

>And remember, Chinese imports mean the food they eat, essential commodities like oil and paper, and other things they can’t substitute and can’t live without.

Hmmm, let’s think about two plausible outcomes that China must consider when the subject of embarking on a militarist path towards world hegemony comes up in whatever Chinese government thinktank that is tasked with thinking about stuff like that:

1- It would send millions of young Chinese men and women in their prime to bloody, miserable deaths.

2- The US would nuke them.

I suspect the way Bejing weighs these two factors is approximately 0% for number 1 and 100% for number two.

Your numbers may be different, but I’d be hard to convince that China is nowadays run by a bunch of Ted Kennedy clones. If they think at a certain point that they can bring the US – and therefore the world – to heel, and all it costs them is some middle and lower class economic suffering, I don’t see them hesitating.

Heck, they can have their own version of Greg Mankiw assure them that “it isn’t as bad as the Great Leap Forward.”


glory 08.25.04 at 11:18 pm

hey! here‘s one by edwin truman :D

  1. Is the US current account deficit sustainable? No, but the extent and timing of its adjustment are uncertain.
  2. How will the adjustment take place? Through a combination of substantial changes in exchange rates; a modest, largely endogenous slowing of US growth; and, it is to be hoped, some acceleration of domestic demand in the rest of the world.
  3. What are the implications for the euro area? It is likely to have to absorb more than its proportionate share of the adjustment.
  4. What are the implications for US and euro area fiscal policies? It is urgent for the US to address its fiscal imbalance. The case for compensating fiscal action in the euro area is less compelling. In any case, the European Central Bank (ECB) will bear a major responsibility for sustaining European growth and stimulating domestic demand.
  5. Is there a role for policy coordination to help manage the adjustment process? Yes, starting with information exchange and shared analyses.

dave heasman 08.27.04 at 9:32 am

“In any case, the European Central Bank (ECB) will bear a major responsibility for sustaining European growth and stimulating domestic demand.”

Well, we can kiss that little bugger goodbye then.

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