US ECONOMY: Downwards lurch

DECEMBER 10 1998 Lex

The US current account deficit took another lurch downwards yesterday. It is now running at over $60bn a quarter, or about 2.8 per cent of gross domestic product.

In theory, the need to finance such a massive gap with foreign capital puts upward pressure on US interest rates and downward pressure on the dollar. In fact, the dollar strengthened on the news.

For the past few years, the US has been in the happy position that the world has wanted to buy its assets to take advantage of the country's strong growth and open economy.

How long can this continue? The deficit will grow even larger next year, topping 3 per cent of GDP. The economy is slowing, while political rumblings over impeachment continue.

All that suggests US assets could start to look less attractive to overseas investors. In that case, the currency would have to fall to restore their appeal. But there is a caveat. The state of the trade gap is well known.

Since the US first began to run a sustained deficit in 1982, the cumulative current account gap has been some $1,700bn.

Yet in real terms, the trade-weighted dollar has held its ground over that period. That said, there may come a time when investors conclude that enough is enough.

Moreover, with the euro looking like being a strong currency, it could be difficult for the US to continue to pull off the trick of financing its rising deficit without the help of a weaker dollar.

The boomerang theory
By Paul E. Erdman, CBS MarketWatch, Dec 8, 1998

The economic outlook for Europe is looking less and less good. Britain is on the edge of recession. Contrary to all expectations, unemployment rose last month in Germany. Bundesbank President Hans Tietmeyer admits that last week's the coordinated interest rate cut by the euro-11 countries will do little to bring down Europe's 11 percent unemployment rate.

"The rate cut," he said," cannot solve the severe structural problems in most of the euro countries.''

By contrast, our economy keeps humming along, with unemployment at its lowest levels in decades. Such disparities can give rise to envy. Which I believe is the starting point for a new theory that is making its rounds in academic circles in Europe. It postulates that although Greenspan's aggressive cutting of interest rates might be good for the United States and the world in the short turn, it will boomerang on us in the long run, and lead to recession here.

It starts with the fact that we Americans are living way beyond our means. This is reflected in our huge current account deficit, which may approach $300 billion next year, or 3 percent of GDP.

By definition ( i.e. In bookkeeping terms) this "trade" deficit must be compensated for by an equal amount of capital inflows. So far, no argument. But now it gets tricky. Until this year, the United States was also running huge budget deficits. So the necessary borrowing from abroad went to help finance that deficit through foreign central bank purchases of US Treasurys.

Now, the theory goes, since we are in surplus, that borrowing will have to be borne by the private sector. But with a slowing economy next year, lower profits growth, and lower interest rates, returns on investments in the United States, be they in the stock market, bond market, or bank deposits are sinking across the board here -- induced in part by the Fed's rate-cutting activities.

Eventually this will boomerang. Foreign investors will balk at putting new money here. So in order to attract the $300 billion necessary to "finance" our trade deficit, dollar Interest rates will now have to rise, and rise sharply. This will dump the United States into recession.

Very nice logic. But I detect a distinct element of wishful thinking. The Germans term it Schadenfreude.

Regardless of interest rate disparities, where would you rather store your money? Japan, Germany, or here?

Case closed.

Economist and author Paul E. Erdman is a columnist for CBS MarketWatch.

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