Twin Deficits at the Flashpoint
by Stephen Roach
June’s enormous US trade deficit should be a wake-up call to America and the rest of the world. It is a direct manifestation of a lopsided global economy that remains biased toward unprecedented external imbalances. As long as the US continues to live well beyond its means and as long as the rest of the world fails to live up to its means, this seemingly chronic condition will only get worse. The imperatives of global rebalancing are reaching a flashpoint.
America’s record $55.8 billion trade deficit in June was a shocker. Annualized, it is equivalent to a $670 billion shortfall, or 5.75% of nominal GDP. Nor can this deterioration be explained away by surging oil prices. Excluding petroleum products, the trade deficit for goods still widened by $2.7 billion in June -- an enormous swing by any standards. The plain fact of the matter is that America has never come close to running such an outsize external deficit before. By way of comparison, the last time the US had a “foreign trade problem” was in the latter half of the 1980s; back then, the trade deficit (as measured on a national income accounts basis) peaked out at 3.2% of GDP in the second quarter of 1987. Needless to say, that was not the most tranquil of times in financial markets. As America’s external imbalance widened in mid-1987, the dollar came under sharp downward pressure and US interest rates were pushed higher. Those were the classic manifestations of a current account adjustment that many (myself included) believe were at the heart of the stock market crash of October 1987. Today’s external imbalances dwarf those of 17 years ago.
It’s easy to point the finger at others in diagnosing the problem. In the political season, the blame game always intensifies. US Treasury Secretary John Snow blames it on new weakness in the global economy. The Democrats tie America’s trade and jobs problems to the pressures of outsourcing and unfair foreign competition. As usual, there are some elements of truth in both explanations. The global economy does, in fact, appear to be sputtering. Goods exports plunged by 5.9% in June (in real terms), the largest monthly decline on record. While month-to-month fluctuations can never be taken too seriously, I don’t think it’s a coincidence that such a sharp decline in overseas shipments of American made goods occurred as slowdowns became increasingly evident in China and Japan and sluggishness persisted in Europe. On the other side of the trade ledger, renewed sluggishness on the US job front and a 1.8% surge in non-petroleum imports in June (sequential monthly rate) certainly speak to the unrelenting pressures of foreign penetration into US markets.
Yet this finger pointing misses the basic problem -- that of a saving-short US economy that is locked into the destructive spiral of ever-widening twin deficits. Lost in all the shuffle was the latest monthly update on that “other deficit” -- a $69.2 billion shortfall in the July federal budget deficit reported last week by the US Treasury. Not only was that about $7 billion worse than expected, but it puts America easily on track to break the $400 billion threshold on the budget deficit for the first time ever. While America’s budget deficit has been larger as a share of GDP -- the estimated 3.6% gap in the current fiscal year falls well short of the 6% peak hit in 1983 -- the sheer volume of financing is obviously of critical importance for the capital markets. Nor has the US ever experienced such a massive turnaround in its budget position -- with the deficit for the current fiscal year representing a swing of 7% of GDP relative to the 2.4% budget surplus recorded in 2000.
Moreover, there’s another key aspect of this problem: Unlike the deficits of the 1980s, America is lacking in any backstop in private saving. Net of depreciation, the private saving rate of households and businesses, combined, stood at just 4.5% of national income in 2003; that’s only a little more than half the 8.3% average recorded in the latter half of the 1980s -- the last time the US had a deficit problem. In addition, the personal saving rate fell back to just 1.2% in June 2004 -- underscoring the asset-dependent US consumer’s seemingly chronic aversion to income-based saving. This deficiency of private saving means that outsize government budget deficits are now putting a greater strain on the US economy and financial markets than was the case during the latter half of the 1980s.
This lack of saving, in my view, is America’s most vexing problem. Adding in government deficits, the net national saving rate -- the combined saving of households, businesses, and the government sector adjusted for deprecation -- has averaged only about 3% since 2000. By way of comparison, the net national saving rate averaged nearly 10% in the 1960s and 1970s before falling to 5.9% in the 1980s and 4.8% in the 1990s. Lacking in domestic saving, the United States has no other choice than to import foreign saving from abroad -- and run massive current-account and trade deficits to attract that capital. To the extent that the extraordinary deterioration in the federal budget has been the main culprit in pushing down America’s domestic saving rate in recent years, the two deficits are joined at the hip. Without a cushion of private saving, a long-term structural budget deficit problem -- precisely the outcome the US now faces, according to the non-partisan Congressional Budget Office -- spells unrelenting pressures from America’s twin deficits for as far as the eye can see.
This is not a message that plays well in Washington. Believe me, I know that -- having testified many times in front of the US Congress on one of these deficits or another. Politicians, in their never-ending search for both the scapegoat and the quick fix, are hardly predisposed to looking in the mirror and accept any blame for the recent deterioration in national saving and the current-account and trade deficits it spawns. Pete Peterson makes that same point eloquently in his latest book, Running on Empty (Farrar, Straus and Giroux, 2004). The subtitle of this tome says it all: Both the “Democratic and Republican Parties are Bankrupting Our Future.” I couldn’t agree more -- especially with the ever-ticking demographic clock calling out for an increase in national saving at precisely the time when America is going the other way. Yet deficit reduction never sells on the campaign circuit, regardless of the mounting perils of a saving-short economy. Campaign 2004 is no different in that respect. Senator Kerry and President Bush are arguing more over the types of additional tax cuts America needs rather than debating the imperatives and tactics of deficit reduction.
Maybe June’s trade deficit is a wake-up call. If so, it will be up to financial markets to send that message. That was the verdict in October 1987 and it may well be the case again. Financial markets have long served the painful but useful purpose of venting imbalances in the real economy. No two such episodes are alike, however. Just because the tensions of America’s twin deficits in 1987 were vented in equity markets doesn’t mean the same such phenomenon will necessarily occur in 2004. Other asset markets could just as easily give way -- the dollar, the bond market, credit markets, or even property. Nor is the recent slide in the US equity market inconsistent with the outcome that might be expected in a more full-blown current account adjustment.
The point is that a chronic twin-deficit problem in a saving-short US economy requires ever greater volumes of capital inflows into dollar-denominated assets in order to finance ongoing growth in the domestic economy. As the current-account gap -- the broadest measure of international transactions -- rises toward 6% of GDP, America will need to import in excess of $2 billion in foreign capital each and every business day of the year. Up until now, that financing has occurred on terms that are very favorable to the United States -- there has been only a limited decline in the broad dollar index and virtually no increase in real long-term interest rates. In the end, however, a chronic shortfall of national saving cannot be financed indefinitely without consequences. Barring a sudden improvement in the national saving outlook, underlying asset values in the United States must be written down to match the ensuing reduction in this saving-short economy’s intrinsic growth potential. That’s where pressures on asset prices come into play.
Never before has the world’s dominant economic power lived this far beyond its means. Most believe that America is special -- that it deserves special dispensation from current account, debt, and saving adjustments. Just as history is littered with the remnants of other such new paradigms, I continue to believe that the United States will have to pay a steep price for its imbalances. As America’s twin deficits move inexorably toward the flashpoint, there is a growing risk that its external financing terms could take a sudden turn for the worse. The dollar, US equities, and credit markets strike me as most vulnerable to such a development. Twin Deficits at the Flashpoint