The U.S. economy continues to amaze. Despite record trade and budget deficits, a shrinking manufacturing sector, and a costly war against terror, economic growth continuous to be robust and inflation appears to be relatively benign in the United States, at least according to the official figures. Some observers conclude that there is no need to worry. On the contrary: instead of being a sign of weakness, the twin deficits reflect the relative strength of the US economy.1 The problem child of the global imbalances would not be the US, but the relative underperformance of the economies that have trade surpluses.
According to the "no worry"-position, the trade deficit is not an indicator of economic weakness but reflects the attractiveness of the US for foreign investors. Within the context of the balance of payments, so the argument goes, the inflow of foreign capital represents a surplus in the capital account, and this surplus, in turn, implies a deficit in the current account. Therefore the attractiveness of the US for foreign investors would be the reason for the American trade deficit.2
The problem with such a perspective is the presumption that the motive behind the international capital flows to the US is the search for higher returns. This would be the case if the funds came from private sources. However, over the past years it has been mainly foreign central banks that have invested in the US, and these central banks have invested their funds mainly in US government debt certificates.
The target of these financial inflows from abroad is not the productive base of the US economy (which would be the case with foreign direct investment), but under the auspices of the central banks the funds have gone almost exclusively into the hands of the US government. One can hardly say that the reason for that would be the search for a place of high efficiency. Consequently, in terms of financial results, these foreign central banks have had poor or negative returns on their holdings, particularly when alternative instruments of foreign exchange reserves diversification such as gold or even the euro are taken into account.
What's behind the massive capital flows to the United States is not capitalist calculation, but the role of foreign central banks, which are held to slow down the appreciation of their own currencies against the US dollar. The repressed adaptation of the exchange rates favors the export industries these countries. The US manufacturing industry is shrinking, while that of the trade surplus countries is expanding.
In contrast to a full gold standard, a swift correction of the trade imbalance need not happen under the current exchange rate system. The reason for that is not the system of flexible exchange rates, but the existence of an international monetary system that is managed by governments and central banks. Some countries formally fix or "peg" their currency to the dollar or to a basket or currencies, while other countries practice "dirty floating". The global imbalances receive no swift correction, because the monetary authorities do not want a correction.
Over the past couple of years, foreign central banks, particularly in Asia, have accumulated drastically their foreign exchange reserves holdings (see table 1).
Foreign exchange reserves accumulation by selected Asian central banks 2002-04 (in billions of US dollars)
|2002||2003||2004||Memo: Amount |
Due to the additional reserve accumulation in dollars by Asian central banks, the ongoing diversification into euros that many others central banks have undertaken, did not reduce the long-term share of the US dollar in international reserve holdings of around 65 per cent. Currently, foreign central banks hold approximately 2.5 trillion of their official foreign exchange reserves in US dollars.
Keeping their exchange rates suppressed, Asian countries could manage a huge turnaround in their current account position from a deficit of 10.3 billion dollars as the annual average in 1990-96 to a surplus that averaged 120.7 billion dollars in 2000-03 and amounted to 184.9 billion dollars in 2004.3
Most regions of the world have now current account surpluses; their counterpart is the growing current account deficit of the United States (see table 2).
Current Account Balances of Selected Countries and Regions 2001-04 (in billions of US dollars)
|Other emerging Asia||74||96||124||124|
Source: Bank for International Settlements, 75th Annual Report, Basel, 27 June 2005, Table II.4, p. 21
Seen within the macroeconomic accounting framework, the US current account deficit is linked to insufficient national savings. The discrepancy between investment and savings for the US economy has widened from -2.4 percent of gross domestic product as the average during the 1990-99 period to -6 percent in 2003 and 2004.4 A large part of the internal savings shortage results from the public deficit (as it represents negative government savings), as it is not compensated by the size of private savings when the private investment demand is taken into consideration.5
Domestically, the US trade deficit has insufficient national savings at its root. That, in turn, is the result of two other factors: Low private savings result from high consumption relative to income; and the negative public savings are the consequence of high government expenditures relative to government income.
Trade deficits don't matter as long as that there is someone who finances the debtor. The looming problem, however, is the impact that these financial flows have on the capital structures of the economies involved. Persistent imbalances bring about changes in the composition of a country's production structure. Depending on the duration and size of the imbalance, profound transformations of the capital structures occur. The economy of the country with the trade deficit is losing its manufacturing base while the country with the export surplus is overextending its manufacturing industries. This, in itself would not be a problem if the deficits were sustainable; but when the trade deficit comes along with debt accumulation, there is a limit to this process.
When the creditworthiness of the debtor country reaches its limit, a re-adaptation of the production structures has to take place that must happen likewise in the creditor country. This problem is being largely ignored by conventional macroeconomics. In their view, the re-adaptation, which is required after the debt limit has been reached, would be merely a flow problem that could be achieved through the exchange rate mechanism.
This view ignores that capital structures cannot be re-arranged at short notice. In the debtor country a reduction of domestic consumption is required in order to generate the funds for investment in areas that produce tradable goods at competitive prices. Given that it is often government that has been the main receiver of the foreign capital, the debtor economy will scarcely be prepared to achieve the required turn-around in a short time and instead will remain depressed for years or even decades.
Sometimes the "no worry"-position refers to the argument that "persistent trade deficits" occur between one region and another within one economy without problems. Here, however, a clear definition is warranted what is meant by "trade deficit". Does the trade deficit only include goods or does it also include services and investment income, as the overall trade balance would represent? It is only by the export of services that a region with a trade deficit in goods can maintain its standard of living. Another case would be the rentier, who finances his "trade deficit" in goods by his receipts in the form of investment income.
This kind of exchange does not take place between the United States and, let's say, Japan. The US does not export services to and receives investment income from Japan in a size that would pay for the US import of manufactured goods from Japan. On the contrary: the US owes investment income to Japan in addition to the payments for the import of manufactured goods that come from Japan. The deal that the US is making with the rest of the world is not the exchange of services and investment income for goods, but the exchange of assets and future investment income debits against current goods.
As long as a country with a savings surplus is willing to provide loans in exchange for foreign assets, the game can go on. The assets, which the US pledges in return for goods from abroad, are government bonds dominated in US dollars. In contrast to real assets, this monetary asset can be produced without limit by the United States. However, the producer of such a good is confronted with the basic economic law of supply and demand.
The law of compound interest rules debt accumulation. An increasing debt burden may seem manageable for quite some time but it inexorably moves towards a phase when the debt accumulation speeds up and turns into a catastrophic expansion due to the effect of compound interest. International capital flow imbalances have the property that they develop slowly and may continue for an extended period of time, while their contraction phase is compressed in time and happens in the form of a catastrophic collapse. Such a contraction is not confined to the financial transactions but impacts directly and massively on the production structures of the economies involved in this process.
In the phase of credit expansion, the trade deficit country may even experience a stronger currency, because capital inflows are larger than the current account deficit. This relation changes with the continuance of the debt expansion. The payment of interest is registered in the investment income account that forms part of the current account in the balance of payments. This way, there is an automatism at work that leads to an expansion of the deficit in the current account relative to the capital and financial account.
Debt accumulation and the perception of creditworthiness
One can imagine two curves (figure 1) in order to visualize this process: One is the debt curve, which is propelled by the compound interest rate effect. This curve is directed upwards and has the form of an exponential growth curve. The second curve represents the willingness to lend, which is directed downwards, and which also has an exponential form. At the beginning of the debt cycle there is a wide discrepancy between de facto accumulated debt and the level at which the limit to creditworthiness is being perceived. Accordingly, the margin to lend, which is based on the perceived level of creditworthiness, is still wide. With an ongoing debt accumulation, the curves become exponentially steeper ushering the process into the contraction phase of the debt cycle.
The graph is presented in order to demonstrate that the collapse tends to come in a seemingly abrupt fashion. In other words: while the margin of creditworthiness seems quite comfortable for a considerable period of time, it is only a small step from being still highly creditworthy (a to b) to enter into bankruptcy (b to c). Once the debt levels move beyond the threshold of creditworthiness, the collapse destroys the value of the pledged assets. In the final consequence, the borrower's currency and its pledged assets, i.e. its government bonds, will become junk.
2 The balance of payments has actually four major subsets. The first one is the current account (CA), which includes the trade in goods, services, investment income and unilateral transfers. The second sub-balance is the capital and financial account (CFA). Due to difficulties in measurement, there is a third account of net errors and omissions (NEO). Finally, there is the change of reserves account (dR). As a formula the balance of payments equation can be written as: BP = CA + CFA + NEO + dR = 0. One must note that an increase in reserves represents a debit while a decrease of reserves is registered as credit. This way, when there is a net deficit in the sum of the other sub-accounts, the balance of payments is brought into equilibrium by the credit in the change of reserves account, which actually results from a decrease in reserves. On the other hand, for a country, which has a surplus in its current account that is not compensated by equivalent capital exports, the foreign exchange reserves do increase. In the balance of payments accounting framework this is registered as a debit, because these reserves exist by definition in foreign currencies and insofar are to be seen as a "capital export" by the central bank. Furthermore it should be noted that an increase of foreign exchange reserves in US dollars by a foreign central bank would be registered in the US balance of payments as a credit in the capital and financial account.
3 Bank for International Settlements (BIS): 75th Annual Report, Basel 2005, Table III.2, p. 35
4 own calculations based on BIS, 2005, Table II.5, p. 24
5 The basic formula here is NX = S - I. When national savings S (public and private) are less than investment (I), the overall trade balance (NX) -- as a proxy for the current account -- implies the existence of a deficit. If S < I, then (EX - IM) will be negative.