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August 25, 2004
Martin Wolf: America�s dangerous deficit
An important article from Wolf.
Martin Wolf: America’s dangerous deficit
By Martin Wolf
Published: August 24 2004 20:20 | Last updated: August 24 2004 20:20
http://news.ft.com/cms/s/a9f5cecc-f5fe-11d8-b814-00000e2511c8.html
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To highlight a few key points:
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.
Wolf notes, that this is right up to a point. But we need to go further.
He notes, 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.
important points.
I would say that in fact all three reasons are in fact real.
A key figure to note"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.
Three quarters of net investment.
Wolf notes "the return on foreign savings does not belong to Americans, even if the sums are invested in the US. Americans own only the return on their own exiguous savings. These low savings impose a constraint on future increases in their standards of living."
It is important to keep in mind, further that This would not have been the case if the rising capital inflow had raised the overall rate of investment. But the counterpart of the higher capital inflows has been higher public and private consumption and so lower savings, not a sustained rise in net (or gross) investment.
Why have US savings fallen so low? Two trends are at work: first, a long-run decline in the share of private savings in gross and net national income; and second, big swings in government savings, most recently into huge deficit. Since the current account deficit exceeds the fiscal deficit, the US is currently enjoying both guns and butter.
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.
Posted by The Lounsbury at August 25, 2004 02:29 PM
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Aug-Dec 2004
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