December 6, 2004
Why the Current Account Deficit Matters
It's uncanny how cheerful the economic outlook seems to analysts whose ideas are unbaked by any apparent knowledge about the economy. Among the fatuous bits of applesauce dropped from the table of CNBC's monthly employment report Breakfast of Champions was the idea that the inevitable adjustment to the U.S. current account deficit will be good for U.S. growth.
At the center of that argument is the idea that the U.S. can simply grow its way out of the deficit by exporting more, creating growth in the U.S. economy, which will be stimulative to foreign growth, which will therefore support demand for our exports. The argument is so circular that it's impossible to know where to start.
In general, when you hear a suspicious economic argument, there's usually a way to clear it up if you think in terms of equilibrium.
First, it is a radical misdiagnosis to believe that the U.S. current account deficit is primarily due to a shortfall in exports. The fact is that the deficit arises from a profound shortfall of U.S. savings.
Take a look. The share of GDP absorbed by U.S. consumption and investment has never been larger.
Personal consumption + gross domestic investment as a percentage of GDP:
Combine this aggressive absorption of U.S. output with huge federal spending outlays and a massive fiscal deficit, and it's no surprise that the U.S. now absorbs about 80% of the world's excess savings simply to maintain its current level of activity.
Savings are vital to economic growth
Let's revisit the savings-investment identity. I do this with some reservation because even though it's an accounting identity, it always prompts a certain amount of mail suggesting that monetary policy or some other factor can produce investment without the need for savings. Trust me. In equilibrium, the following must be true:
Gross Domestic Investment = Private Saving + Government Saving + Foreign Saving
Stare at that. It says that all real investment in factories, housing, capital spending, and so forth has to be financed by private savings (personal saving plus business saving), government saving, or an import of foreign saving. That “foreign saving” is the flipside of what we know as the current account. A current account deficit means that we are importing foreign savings in order to finance investment here in the U.S., while a current account surplus means that we have more than enough savings, and are actually exporting those savings to other countries.
Investment booms in the U.S. are nearly always financed by driving the current account into deficit. Typically, at the end of a recession, the U.S. actually has more domestic savings than it needs to finance its own domestic investment. In fact, except for the current instance, every expansion in the U.S. economy has started from a current account surplus, where we were actually exporting some of our savings abroad. As the economy turns up, the U.S. stops exporting savings and begins to import them, creating a current account deficit. At the end of an investment boom, the current account typically shows a large deficit. That deficit goes away as the economy weakens and, importantly, U.S. gross domestic investment declines.
[Geeks note: private saving is defined as after tax income minus consumption: Y – C – T, government saving is an oxymoron and defined as the excess of taxes over government spending: T – G, foreign saving is just the inverse of the current account deficit: M – X, and the identity follows from the definition of GDP: Y = C + I + G + X – M.]
But doesn't the current account deficit basically measure the trade gap?
On its face, the current account deficit does seem nothing more than a measure of the gap between imports and exports. But it is identically a measure of the extent to which U.S. savings fall short in financing U.S. investment.
See, if the U.S. imports $100 of goods and services, you can be sure that we have to export $100 of stuff in return. If only $60 of that stuff is goods and services, it must be true that the other $40 of stuff is U.S. securities. When we look at imports and exports, we see $100 of imports and $60 of exports, and say “OK, we've got a $40 current account deficit.” But looking at it in terms of saving and investment, we can also interpret the current account deficit by saying that the U.S. is importing $40 of foreign savings (by selling securities). And by the savings-investment identity, we know that this $40 import of foreign savings is (and must be) the extent to which U.S. savings fall short in financing U.S. investment.
So a huge current account deficit doesn't just say that we are importing more than we are exporting. It also says that we are saving less than we are investing.
Take a look. The following chart shows U.S. gross domestic investment (blue) and U.S. gross domestic saving (green) since 1993. The gap between these two measures the growing U.S. current account deficit. Notice that although U.S. gross domestic investment has now surpassed its 2000 peak, U.S. gross domestic saving is still near the same level it was in 1996.
Stated another way, the entire expansion in U.S. gross domestic investment since the mid-1990's has been financed not by domestic saving, but by an import of foreign capital. There's your trouble.
The fact is that there is only one way in which the U.S. has ever resolved a significant current account deficit, and that has been for the U.S. to suffer a significant retrenchment in gross domestic investment. Even if we don't experience a deep recession, one thing is clear: U.S. gross domestic investment (some combination of housing investment and capital spending) is likely to show very disappointing growth in the years ahead.
To underscore this point, notice that there is a strong negative relationship between changes in the current account and changes in U.S. gross domestic investment. This is exactly what we would expect. Large increases in gross domestic investment are associated with large deteriorations in the current account. Large shortfalls in gross domestic investment are associated with narrowing deficits or increasing surpluses on current account.
Very simply, growing current account deficits are the way that the U.S. finances investment booms. At present, however, the current account deficit has grown so large that a further expansion in U.S. domestic investment is very unlikely, at least not one of much vigor.
At best, U.S. gross domestic investment is likely to grow slowly over the coming years, perhaps with further expansion in capital spending financed by an offsetting decline in housing investment. That way, U.S. savings would gradually grow enough to reduce our reliance on foreign capital inflows. In that sort of outcome, consumption and investment would gradually fall as a share of GDP (see the chart at top), while growth in gross domestic saving would catch up with the slowly growing amount of gross domestic investment (see middle chart).
At worst, the current account deficit will ultimately be adjusted through an investment-led downturn in the U.S. economy. That risk explodes, of course, if the flow of foreign savings into the U.S. slows abruptly. The primary sources of funding for the U.S. current account deficit are China and Japan, who have accumulated U.S. securities as a method of supporting the value of the U.S. dollar. So long as these governments remain willing to continually accumulate U.S. securities, the situation could remain stable for a while. Still, there's a lot of risk to that bet.
A final note regarding the November jobs report, Alan Abelson's comments from Barron's tidily sum up the situation: “Undaunted by having wildly overestimated the final number, the more imaginative Street soothsayers suddenly discovered that the best way to figure the real job number was to average the latest two months; October, of course, was a monster month for employment, virtually the only one this year. When December's report comes in, we've not a scintilla of doubt, they'll decide that to get a truly accurate job picture, you have to add the last two months.”
Little change to market conditions or our market exposures last week. The Market Climate for stocks remained characterized by unusually unfavorable valuations and still moderately favorable market action, holding the Strategic Growth Fund to a largely hedged but still modestly constructive investment position. Market internals continue to be important factors to monitor (see the past two weeks comments). In bonds, the Market Climate remained characterized by modestly unfavorable valuations and modestly favorable market action, holding us to a limited duration of about 2.5 years in the Strategic Total Return Fund, primarily in TIPS.
Best wishes for a happy and bright Hanukkah celebration.
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