Saturday, November 27, 2004

When is a deficit not a deficit?

Deficits deficits and more deficits! Deficits are bad, right? So who cares what kind they are -- fiscal, monetary, or current account -- all are bad bad bad (and the fault of BusHitler to boot).

I must confess, I don't care about any kind of deficits. I care about marginal tax rates, inflation, and real interest rates, and that's about it.

Let's talk about current account deficits. The US is running a large current account deficit, which means that it is importing more goods than it exports (conversely, exporting more debt than it imports). It's interesting to note that the US hardly imports or exports anything -- 90% of all economic activity is domestic, and the 10% that is foreign is mostly split between Canada and Mexico. But the US economy is so enormous that even the tiny sliver that interacts with the non-Canada/Mexico rest of the world matters.

Reader JC sends in a link where Paul Musgrave is worrying about the value of the dollar -- namely, it is falling against the Euro and he lives in Europe but saves in America. You will note that Paul's natural reaction (move money from the US to the Europe) will reduce the value of the $ and increase that of the Euro, while simultaneously reducing the American current account deficit. It is the decisions of people like Paul that are leading to the value of the $ falling in worldwide currency markets.

One interesting thing about currency markets is that they are zero sum--in other words, a perfectly hedged basket of currencies would always and forever be worth exactly the same amount. This is different to pretty much every market where you would expect a basket to move up (or down) over time.

The reason, and this is well understood, for the dollar's large fall against the Euro is that Asian central banks are buying dollars to prop up their export markets (a transfer, I might add, from their domestic savers to their domestic exporters). Stephen Roach, Morgan Stanley's chief economist, has a good piece on this in the NYTimes (of all places):
Suddenly all eyes are on a weakening dollar. In recent days, the American currency has fallen against the euro, the yen and most other currencies around the world. The renminbi is a notable exception; China has kept its currency firmly pegged to the dollar for a decade.

The fall of the dollar is not a surprise. It is the logical outgrowth of an unbalanced world economy, and America's gaping current account deficit - the difference between foreign trade and investment in the United States and American trade and investment abroad - is just the most visible manifestation of these imbalances. The deficit ran at a record annual rate of $665 billion, or 5.7 percent of gross domestic product, in the second quarter of 2004.

[China, Japan, and Europe gripe about America]. Yet global imbalances are a shared responsibility. America is guilty of excess consumption, whereas the rest of the world suffers from insufficient consumption. Consumer demand in the United States grew at an average of 3.9 percent (in real terms) from 1995 to 2003, nearly double the 2.2 percent average elsewhere in the industrial world.

Meanwhile, Americans fail to save enough - whereas the rest of the world saves too much. American consumers have borrowed against the future by squandering their savings. The personal savings rate was just 0.2 percent of disposable personal income in September - down from 7.7 percent as recently as 1992. Moreover, large federal budget deficits mean the government's savings rate is negative.

America's consumption binge has its mirror image in excess savings elsewhere in the world - especially in Asia and Europe. For now, America draws freely on this reservoir, absorbing about 80 percent of the world's surplus savings. Just as the United States has moved production and labor offshore in recent years, it is now outsourcing its savings.

This is a dangerous arrangement. The day could come when foreign investors demand better terms for financing America's spending spree (and savings shortfall). That is the day the dollar will collapse, interest rates will soar and the stock market will plunge. In such a crisis, a United States recession would be a near certainty. And the rest of an America-centric world would be quick to follow.

First, there would be a gradual rise in interest rates in the United States - compensating foreign investors for financing the biggest debtor in the world. That would suppress growth in those sectors of the American economy that are most sensitive to interest rates, like housing, consumer durables like cars and appliances, and business capital spending. The result: a higher domestic savings rate and a reduced need for foreign capital - a classic current-account adjustment.

What's certain is that a lopsided world needs to be put back into balance. The dollar is the world's most widely used currency, but its fall affects more than just foreign-exchange rates. A weakening dollar is an encouraging sign that the world's relative price structure - essentially the value of one economy versus another - is becoming more sensible. If the world can manage the dollar's decline wisely, there is more reason for hope than despair.
There's something about currency value, like national airlines, that rises above the mere Economic and becomes something more, some totemic symbol of national virility. An economy managed with a view towards totemic virility symbols (in other words, an economy managed by politicians) will make bad decisions and impoverish their people.

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