Magazine

The Deficit: The Sky May Not Be Falling


When the Commerce Dept. announced on Mar. 16 that the current- account deficit ballooned to a record $665.9 billion last year, the dollar took a knock, falling lower against the euro and the yen. Behind the currency's swoon: concern that the U.S. has become so dependent on foreign money to fund its current-account and budget deficits that sooner or later the dollar must crash.

Not so, say a number of top Federal Reserve officials. In a new analysis that turns conventional wisdom on its head, they argue that the swelling current account deficit is not the result of U.S. profligacy on the part of a tax-cutting President Bush and import-happy U.S. consumers. Rather, the gap -- which consists mainly of the trade deficit but also includes interest, dividends, and other financial payments -- stems largely from what Fed Governor Ben S. Bernanke calls a "global saving glut." The excess savings have their origins in both slow-growing industrial economies such as Japan and Germany and fast-growing emerging markets like China and India.

According to this theory, the glut is holding down interest rates in the U.S., freeing the federal government to run big budget deficits and allowing debt-laden consumers to spend more. If Bernanke is right, fears that foreign funds will dry up and lead to the collapse of the dollar are significantly exaggerated. What's more likely is a continuation of the dollar's gradual fall; over the past three years, the greenback has shed 15% against the currencies of America's major trading partners.

Not surprisingly, Bernanke and his peers' take on trade is not one that has won much support in foreign capitals. Instead, many European and Asian policymakers pin the blame for America's bulging current-account deficit squarely on the U.S. and its debt-driven economy.

Still, the "don't worry, be happy" approach to the trade deficit got a boost on Mar. 15, when the Treasury Dept. reported that foreign financiers bought a net $91.5 billion worth of U.S. bonds, stocks, and other financial assets in January. That was up sharply from $60.7 billion in December and was the second-highest level ever. More important, net foreign capital inflows dwarfed the $58.3 billion trade deficit that the U.S. racked up during January. And it was private investors, including hedge funds -- not foreign central banks -- who did the bulk of the buying. Many of them piled into the U.S. stock market to take advantage of its start-of-the-year rally.

THE RETIREE EFFECT

The strongest evidence for the global savings surplus comes from the rapidly aging societies of Japan and Europe. Workers there need to build up savings for retirement but face a dearth of investment opportunities in their own slow-growing economies. So they're investing money abroad, including in the U.S. That, St. Louis Fed Bank President William Poole said in a speech on Mar. 8, makes perfect sense, given the breadth of U.S. financial markets and the dynamism of the U.S. economy. After all, while the U.S. is also graying, its retiree population isn't growing nearly as quickly as either Japan's or industrial Europe's. By 2050, the U.S. will have 34 retirees for every 100 working-age people, vs. 21 now, according to U.N. projections. Japan will have about 78 for every 100 20-to-64-year-olds, and Europe, 60.

When Japanese and Europeans start retiring in droves, they'll draw down their savings and spend that money on goods and services, some of them from the U.S. "A case can be made that the current-account surpluses of these countries as well as the current-account deficits of the U.S. will be reversed in the future," Poole says.

But it's not only Europe and Japan that are piling up their savings. Many emerging-market countries are, too. Even though China, for instance, is investing billions of dollars in new factories, it's still not spending nearly as much as it is saving. The balance is invested abroad, much of it in U.S. Treasury securities. Chinese holdings of Treasuries rose to $194.5 billion in January from $156.2 billion a year earlier.

THE WAR CHEST FACTOR

China is not alone. South Korea, Taiwan, Thailand, and Brazil all increased their holdings of Treasuries over the past year. Stung by the financial market crises of the mid-to-late '90s, they have opted to build up their foreign currency war chests to insulate themselves against the vagaries of international capital market flows. Some, such as China, are also seeking to ensure economic stability and boost their exports by linking their currencies to the dollar.

So are Ber-nanke & Co. right about the reasons the current account went from balance in 1991 to 5.7% of gross domestic product last year? The argument seems to hold up for the late 1990s, when foreign money poured into the U.S. stock market and the dollar soared. Even after the bubble burst, foreign funds kept coming. Big purchases of Treasuries and mortgage-backed securities helped keep long-term interest rates low, fueling a refinancing boom that spurred a consumer binge on domestic and imported goods.

Of course, foreigners' push to invest in the U.S. isn't the only reason for the surges in the trade and current-account deficits since 2000. Big tax cuts -- and the budget deficits they bought -- also powered imports. What's more, the dollar's fall over the past three years, and especially its precipitous 40% drop vs. the euro, suggests that financing the trade deficit has not been trouble-free.

The Fed's optimists acknowledge these warnings -- but still believe that the foreign savings glut will dominate. If they're right, there's no big rush in cutting the current-account deficit. The deficit will someday fall -- not with a bang of a dollar crash but slowly, as the rest of the world gathers the rewards of the savings it invested in America.

By Rich Miller in Washington


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