Published: December 3 2004
The US balance of payments deficit is now 5.5 per cent of gross domestic product, nearly double the previous trough in 1986. The dollar's exchange rate against other major currencies has fallen about 30 per cent since 2002 and this will mitigate the deteriorating trend. But against other trading partners, including China, the dollar has not fallen at all and the enormous accumulation of foreign liabilities generated by the deficits, in combination with a continuing rise in US interest rates, is set to raise progressively the net outflow of interest payments.
So long as GDP continues to grow at a satisfactory rate, this outflow will increase the overall balance of payments deficit to perhaps 7 per cent in two years time and 8.5 per cent in 2008. Those who write about the current account deficit generally address the dangers specific to external affairs, the need to import huge amounts of capital and so on.
Meanwhile, the US government's budget deficit has reached 4.2 per cent of GDP. Those who comment on the budget, including the 10 Nobel laureates who recently published an open letter, see this rise as a manifestation of "fiscal irresponsibility", to be put right by a dose of fiscal restriction.
Absent from the public debate is any clear perception that the budget and balance of payments deficits are organically related to one another and to the evolution of the US economy as a whole. Yet it is well known that the budget deficit is identically equal to the balance of payments deficit plus private net saving (the balance between private income and total expenditure). It is this equivalence which provides a missing link.
Since 1952, the ratio of private net saving to GDP averaged 1.8 per cent. Fluctuations in the ratio, fairly modest for most of the time, were clearly associated inversely with movements in the flow of net borrowing (which kept the fluctuations within bounds) and, more recently, with exceptional movements in asset prices. It seems more likely that the ratio, now minus 1.3 per cent, will eventually rise towards its historic mean rather than remain negative indefinitely or fall.
This is because private indebtedness, net lending to the private sector and asset values are all still relatively high while personal saving has shrunk almost to zero. But even if private net saving were to remain at its present level, an important conclusion follows. The rising balance of payments deficit implies that the budget deficit must get progressively worse from now on if stagnation is to be avoided.
Our conditional forecast of an 8.5 per cent balance of payments deficit in four years time translates into a 7.2 per cent budget deficit. If the net saving ratio were to recover to 1.8 per cent (a more neutral assumption) the budget deficit would have to be 10.3 per cent! These grotesque numbers have been mechanically derived, but they have an economic rationale: the projected balance of payments deficits would bleed the circular income flow so much that, if deep recession is to be avoided, budget deficits of this enormous size would be needed to fill the gap.
Yet everyone agrees that the budget deficit must be substantially reduced. This may seem to be a reasonable objective because there have often been deficits as high as 4.2 per cent which have been reduced successfully. But there has never been a balance of payments deficit approaching 5.5 per cent, and this has transformed the game.
If the balance of payments deficit continues to rise and if private saving does not deteriorate further, either fiscal policy will have to be progressively relaxed so the budget balance deteriorates even more, or the economy will face chronic stagnation, with dire consequences for the rest of the world.
The dilemma can be resolved only if the US's net export demand (exports relative to import penetration) is dramatically and discontinuously improved. But the obstacles are formidable. It has become vacuous simply to advocate more devaluation. A large and complex realignment of exchange rates is required involving, in particular, a renminbi revaluation. And since a sustained increase in US net exports would impart a deflationary impulse abroad, fiscal and monetary policies across the world must be reoriented.
But these changes will not happen automatically as a result of market forces. China and some other Asian countries see the maintenance of the status quo as in their interest, and there is no obvious way to make them stop accumulating dollar reserves. And there is no sign that these and other countries, particularly the eurozone, recognise any obligation to generate more expansion domestically.
The detailed logistics of how to engineer the world-scale reforms needed are beyond our scope here, but we do not doubt that a co-operative solution is possible once the problems are properly understood. The crunch may be at hand
Both writers are scholars at the Cambridge Endowment for Research in Finance