Safehaven | The US Trade Deficit is Unsustainable

June 01, 2005

The US Trade Deficit is Unsustainable
by Bud Conrad

Introduction
The US has been borrowing from willing foreigners to maintain its lifestyle, even as we have become uncompetitive in world manufacturing markets. This article examines how big the US trade deficit is with the world, and what this may mean for investment. First I just show the size of the deficit, and then I show how dependent the US housing market and US government deficit spending is on re-investment by foreigners. I then examine the details of the situation building on a speech given by Ex Secretary of the Treasury and now President of Harvard Dr. Larry Summers. This analysis shows how dangerous the US trade balance is to the stability of the US and world economic systems.

The Trade Deficit of the US is at unsustainable levels
The trade deficit is just the difference in how much we buy versus how much we sell of goods and services to foreigners. Economists like to use a more precise measure of the net amount of money that flows across a country's border, so they add in the net returns on investments as well. The investment flows are much smaller than the trade differences. The combination of the investment returns and the trade deficit is called the current account (CA). I will show current account data below but it can be thought of as very similar to the trade deficit. How big is the current account deficit? The chart below shows the history since 1959;

The US is importing $700B more of goods and services than it is selling abroad. The shape of this change is not one of a cycle that gets pushed to one side and then swings back to the other. It is more like a cliff. Our situation is unprecedented. No G7 country has ever had as big a deficit. Axel Merk, who runs a foreign currency fund, (http://www.merkinvestments.com/) points out that the US CA deficit could reach $900 B in 2006. He references the Bank of International Settlements for this estimate. To see if this is reasonable, I calculate what would happen if crude oil went to $100/ bbl: We import ¾ of our 20M bbl per day usage. That calculates to (20 X ¾ 365 =) 5 billion barrels per year. At $100/ bbl this bill would be $500 B. All other cars, computers and clothes would be in addition. If the dollar's purchasing price dropped as the quantities of goods stayed the same, the deficit would also rise. A $900B deficit is possible.

The situation is even worse when looking not at what happened each year, but looking at the accumulated deficit of the US. This accumulated deficit over time that measures how big the US indebtedness has become. The even more dramatic chart below shows that we have accumulated a $4 trillion debt.

This astounding amount is 40% of GDP and shows no signs of slowing. To put this $4 trillion in perspective, the comparable base of what the whole country is worth is only $48.5 trillion. This total value of the nation is the sum of all real estate, all equities and such personal possessions as cars and furniture. So we are approaching having given away 10% of our net worth as collateral for importing the oil, cars and computers we use for our life style.

The chart below shows how big the flows to and from individual nations. The US stands out with the biggest deficit by far.

The problem of big debt is like it is for an individual who has too much debt: they have to pay the growing interest to service the debt. A rough calculation of how big that interest is on the outstanding debt is shown below by multiplying the amount outstanding by the interest rate of the 5 year note in the chart below:

All these pictures show that the deficit is big and growing.

The Trade Deficit links to the US housing bubble and government deficit
The most basic view of the economy is diagramed below. Households earn the wages they spend on the goods and services from the businesses:

The following chart adds that consumers spend a portion purchasing foreign goods. The foreigners then recycle the dollars they collect from this trade into the US government debt by buying Treasuries and into Agency debt of Government Sponsored Enterprises like Fannie Mae, which then provide money for housing.

Foreigners have funded our housing boom and provided enough credit that the growing Federal deficits have not driven interest rates up. Much is simplified out of the above explanation, but the value is that we can see the biggest and most important money flows.

The US credit market matches the amount borrowed and lent. The accumulated foreign contribution of $4 trillion of lending (investment) has provided the credit for the borrowing by the US government whose debt held by the public is now similar in size to the accumulated foreign loans to the US. The chart below shows the size of Federal government debt and the foreign accumulated current account debt to point out that foreigners are funding credit at comparable levels:

A comparison of Mortgage Debt and Current Account shows similar growth rates:

If foreigners were to look for other investments, such as gold, or to cash in the investment by buying assets like stocks or real estate, there would be a big increase in the amount of dollars in the US borders, and a big increase in US prices. The implication of impending inflation is that investors would see the risk, and expect higher interest rates to cover their loss to inflation.

An ex-Secretary of Treasury views the deficit as dangerous
Larry Summers (see web for a bio - http://www.president.harvard.edu/biography/) spoke at a meeting of the Stanford Institute of Economic Policy Research on the problems of the US current account (CA) Deficit. He is analytic and convincing. In summary, he painted a very bleak picture as to how serious the situation is. He used the Mutual Assured Damage analogy of the cold war, as a model for countries holding our debt but not wanting to lose by cashing it in and forcing its value down. He even suggested that foreign debt holders might get the rip-them-off strategy of letting the dollar drop so much that our debts to them evaporate. He implied that there could be a serious calamity in financial markets. He concluded with "I don't know the answer" to fixing the problem. I asked him to explain why interest rates were so low in the face of the situation. He said the 10 year should be at 5.5% at least. He had no economic rationale for the low rate, but proffered that maybe investors who had been betting on the rate rise had decided to "throw in the towel" much like NASDAQ shorts did at 3,000 on the way up to 5000. Their buying back short positions they may be contributing to the low rate.

The current account deficit is now unsustainable at 6% of GDP. Since imports are bigger than exports, if they grow at a similar rate, the deficit will grow. The accumulation of debt means that we have to pay increasing interest on the debt making the balance worse. Historically, as the US GDP grows 1%, the current account deficit has grown 2%. But foreigners grow their CA by only 1% for a 1% of GDP growth. The conclusion is that the CA will get worse.

The 6 measures to identify if the CA is a problem:

Is it too big? At 6% of GDP it is bigger than the level that brought Argentina into collapse. Mexico got to 8% before its last collapse. The US absorbs 75% of the world's export surplus. A G7 country has never had such a big deficit before. The conclusion is that 6% is already too big.
Is it rising? Yes, by the measures mentioned above.
What is the comparative rate of National Investment compared to the National Saving rate? If a country is making investment for future production and has a strong savings rate, it is in a stronger position. The US has the opposite with big government deficit, and little savings.
Does the composition of the deficit indicate weakness? If a country is running a CA deficit by importing the means of manufacturing for example, it can be expected that the Investment will improve output, and thus be more sustainable than if the imports are for consumption. A measure of composition is whether the goods are traded goods, or not. The composition of the CA for the US is for consumer products, and therefor more dangerous.
Where are wealthy locals moving their money? The US is expanding its buying of foreign stocks. We are making foreign direct investment outside the country. The net flow out of investment adds to the view that these US decision-makers do not find good value in US.
Is the capital flow to the US from private investors, who tend to be more concerned about returns than politics; or more from central banks, who may have other reasons then just profits? The US was getting about 2/3 of its investment from Central Banks, and this could be a weak position.

By all 6 measures the CA deficit is judged to be a serious risk to the US economy.

There are 3 counter arguments that the situation may not be serious:

We are the Reserve Currency. The large liquid market for US Treasuries has given us leverage and speed. It looks like local stability, but if there is a big shift, the speed could lead to explosive results, as there is a tendency for a move to bring others in that keep it going farther. The Global capital market my not give that much edge to the dollar.
"We will rip the foreigners off". We will depreciate the dollar enough that they will be left with less than they paid for. In fact, this has been happening. The foreign debt to GDP (nominal) ratio hasn't expanding much. The weaker dollar means that the purchasing power of the accumulated foreign debt is not growing so rapidly. The argument has short-term merit, but the obvious flaw is that foreigners can see what is happening and may not allow it to continue. An expectation of a weaker dollar would drive the dollar down even more.
Bretton Woods II Co-dependency. The term refers to the regime of using the dollar, which is no longer based on gold, to manage the world economic system. The cold war term of Mutually Assured Damage can be applied to the very big holders of our debt. The foreign country that accepts US dollars in trade transactions and re invests them in US Treasuries may not be so concerned about a dollar drift lower, if they believe that keeping the dollar strong will benefit their own economy. We have the odd policy of asking China to raise the value of their currency, leaving them holding claims on us of decreasing value.

There will be Substantial Adjustments ahead:

The most similar historical time was the mid 1980s when the CA peaked at 3.5% of GDP. The fall of the dollar after 1985 caused the CA to come back in line.
The 1987 crash might have had some input from these unstable antecedents.
Japan had several parallels in its situation in the late 1980s with seeming unending growth. China today looks like Japan of the 70s and 80s.

He trade imbalance is a substantial problem not only in the US, but globally. US purchases of world goods are necessary for other countries economic growth. If the US fixes its CA deficit, then the rest of the world will have excess capacity. So the US fix is a problem for the world.

The relationships of the US savings rate, CA, and investment rate, leave us only limited options. The US investment (borrowing, including the government) has to be funded out of US households saving, or from foreigners as investment of their trade-won dollars. For all these things to work, as the US cuts its CA deficit, foreign countries must stimulate their own demand to provide markets for their output. There is no simple path here. With US consumers not saving much at all, the funding of credits must come from foreigners. Asian consumers have been held back by lack of long term mortgage lending and retail constraints. Commensurately, currency adjustment of the weaker dollar should occur against Asian currencies more than European. The economic link of the CA deficits and the budget deficit, is that a smaller fiscal deficit would help improve the CA deficit.

Summers concluding comment was to say "I don't know the answer". This is not a low level, off-hand group; and for Summers to come to such a dire evaluation, it is important reason to be cautious about the economy and the value of the dollar for the future.

My Conclusion
I think the US trade deficit will lead to a weaker dollar. That means alternatives to the US dollar denominated assets must be an important part of a portfolio. The US avoided a serious recession in 2001 by letting the consumer expand his spending by borrowing. We now have more debt than ever, not only internationally as described above, but also for government, and for mortgages. If foreigners were to consider other options for holding these dollars, there could be a glut of dollars in the world that would drive the exchange rate downward and prices in the US upward. If inflation rises, US interest rates could rise, and many parts of the economy could turn down, like housing, stocks and consumer spending. Because of the size of the amounts involved, and the speed of today's currency and interest rate markets, the shift could move very fast in a downward spiral.

Bud Conrad

Mr. Conrad holds a Bachelor of Engineering degree from Yale and an MBA from Harvard. He has held positions with IBM, CDC, Amdahl, and Tandem. Currently, he serves as a local board member of the National Association of Business Economics and teaches graduate courses in investing at Golden Gate University. Bud Conrad has been a futures investor for 25 years and a full-time investor for a decade.