ERNEST H. PREEG: The deficit trap
Financial Times, August 5, 1999
Ernest H. Preeg is a senior fellow at the Hudson Institute in Washington
The US current account deficit could reach a record $350bn this year, the 18th deficit in a row. The accumulation of deficits means the US is likely to be a net debtor to the tune of $2,000bn early in the next decade, despite having been a $350m net creditor in 1980.
The country's foreign debt is equivalent to 20 per cent of gross domestic product, and could reach 30 per cent by 2005. Yet many - perhaps most - observers think this is nothing to worry about, and could even be beneficial to the US. I disagree.
Much hinges on whether growing foreign indebtedness is used to increase the level of US productive investment or to boost immediate consumption. The non-worriers believe that all or most of the deficit reflects additional investment. But I believe that about 80 per cent goes into consumption.
The classic statement in support of incremental new investment was made by economist Herbert Stein in The Wall Street Journal 10 years ago: "The US has a trade deficit because people in the rest of the world invest their savings here . . . As a result of the capital flow . . . the stock of productive capital in the US is . . . higher than it would otherwise have been . . . This inflow of capital has been mainly of benefit to American workers who as a result of it work with a larger capital stock and have higher productivity and real incomes."
In February 1999, the annual report of President Bill Clinton's Council of Economic Advisers came to a similar conclusion: "Since 1993 . . . current account deficits have been driven by increases in investment, with foreign financing taking the form of both direct and portfolio investment."
Unfortunately, these assessments are flawed. It is true that, by definition, an increase in the trade deficit goes hand in hand with an increase in foreign investment in US assets. The dollars accumulated from the trade deficit have to be invested somewhere, including in bank accounts and US Treasury bonds.
But the question is not whether foreign investment increases. Instead, we must examine whether this foreign investment translates into a higher level of aggregate investment in the US economy, or allows Americans to switch from domestic investment to domestic consumption. The reality is that the switching effect probably dominates.
The Asian financial crisis of 1997 to 1998 caused an increase in the US trade deficit to the order of $100bn. US exports fell as Asian economies declined, and US imports grew as a result of lower, more competitive Asian exchange rates. The resulting $100bn deterioration in the trade account inevitably corresponded with $100bn of additional foreign investment in the US.
The impact of the additional foreign investment on aggregate US investment and consumption is not self-evident in cases like this. Various forces can operate to bring about macro-economic adjustment. The decline in the US export sector and cheaper imports from a strengthened dollar may together shift the balance toward greater personal consumption. A lower interest rate from the damping effect of the growing trade deficit on inflation would tend to stimulate both investment and consumption. Stock market prices pushed higher by overseas investors might increase consumption through the "wealth effect".
There is no available analysis that shows clearly whether investment or consumption is stimulated more by such forces. The safest conclusion is that the proportional effects are more or less neutral. However, there is evidence to show that the trade deficit has a greater effect on consumption than investment within the US.
In absolute terms, US personal consumption is more than four times larger than gross private investment - $5,800bn against $1,400bn in 1998. Hence, I conclude that about 80 per cent of the increase of the trade deficit is likely to be translated into additional private consumption, and only 20 cent into incremental investment.
Non-worriers about the trade deficit make one other spurious argument in support of incremental investment during the 1990s. They point out that the investment share of US gross domestic product has increased by 2 per cent from 1993 to 1998, while the consumption share has declined by 1 per cent. The additional foreign investment recorded during these years is given credit for much of this rise in investment share.
But there is no justification for treating foreign investment as the cause. The US economy has indeed experienced extraordinary investment-led growth in the 1990s, but it is far more likely to have been driven by new technology application and industrial restructuring within the US economy than by the growing trade deficit.
If there had been no Asian financial crisis and the trade deficit had not risen by $100bn, there would still have been investment-driven growth in the US economy. However, the increase in the investment share of GDP would have been somewhat smaller, and the drop in the consumption share would have been a little larger.
This is the principal reason why I worry about continuing large US trade deficits. Interest and dividend payments on accumulating net foreign debt are already about $100bn per year, and this figure could more than double by 2005. These debt servicing payments would be made by the children and grandchildren of Americans now on a consumption binge, thanks to almost 20 years of unprecedented foreign borrowing.
Moreover, this concern about a generational income transfer raises an additional worrying prospect. The deficit on current course is simply not sustainable. The longer it prevails, the more likely it is that there will be a costly and disruptive adjustment for both the US and the global economies.
It makes more sense to take the appropriate steps to reduce the deficit now rather than later. Regrettably, as long as the assessment of Mr Stein and Mr Clinton's council of advisers that the trade deficit is nothing to worry about prevails, any official steps will be hesitant at best.