The United States’ deficit is unsustainable

By: Ryan Pitylak

University of Texas-Austin

11/14/2005

Introduction

The question of whether America will see economic turmoil in the near future depends largely on future consumption, savings, and government spending decisions.  If the American deficit is brought under control, then the position of foreigners is not as important.  Otherwise, the American deficit can continue as long as investors or central banks are willing to put their surplus savings into America.  For the near future, this seems to be what will happen.  Gradually, foreigners may reduce the level of savings that they commit to America, which would put strain on the America economy.  If America lowers its desired deficit position in tandem with foreigners’ decreased willingness to purchase American bonds, then a hard landing could be avoided.  The debt-to-GDP ratio will be a determining factor, which will become a problem in the long-run if the deficit continues.  For these reasons, the deficit must lower in the future, but there is no immediate need for this.

Global Savings Disparity?

The International Monetary Fund’s World Economic Outlook showed that the global economy should grow by a healthy 4.3% this year.  In recent economic history, this level of growth has been associated with high interest rates, but long term interest rates in the United States are at their lowest levels since the 1960’s.  America is spending $700 billion a year, 6% of GDP, more than it is producing.  This 6% external deficit is twice what it was in 1999.   (Economist [2005g])

“Americans now save less than 1% of their disposable income, compared with a Euro-area average of 10%” (Economist [2005h]).  America’s national savings is 18% of GDP (Economist [2005h]). China’s national savings is almost 50%, Japan’s national savings is just below 30%, and the rest of Asia excluding China and Japan has a combined national savings level above 30% (Economist [2005e]).  Asian countries need to put their excess savings somewhere because they are not putting it all into domestic investments. 

America’s currency has been depreciating, which has decreased the value of the investments made by foreign central banks.  America is considered a safe place to put money compared with much of the world because it has strong productivity levels (Economist [2005h]).  Europe, a likely location to invest funds, has not seen many of the recent surplus capital because of potential stability issues.  Italy, for example, has publicly said that they may leave the European Union; comments such as this do not inspire confidence in foreign investors.  Also, “Europe’s budget position went from a surplus of 0.1% of GDP in 2000 to a deficit of 2.7% of GDP in 2004” (Economist [2005h]).  The main difference between the deficit in America and Europe is that Europe’s deficit has been because of economic weakness.

Hard Landing?

Several factors determine whether or not a country will be lent money by foreigners, such as their willingness to lend, and other macroeconomic goals such as exchange rate fixing.  Willingness to lend to a particular country is a function of how much money is available to be lent, how much money they want to lend, the rate of return, and the available locations to safely put those funds. 

Money can come from several sources, but recently the American deficit has been financed by central banks.  Central banks have been making big marginal investments.  When combining primary and secondary bond market purchases, the Bank for International Settlements calculated that central banks purchased 80% of the American bonds issued in 2003 (Economist [2005b]). 

Recently, countries have been concerned about stopping their currency from rising.  Central banks have been purchasing American bonds to maintain this macroeconomic condition.  This desired condition may be overwhelmed if central banks worry that the dollar will depreciate.  According to Economist [2005b], “China is finding itself increasingly alone as a buyer of dollars as other central banks grow wary of a currency that must at some point depreciate.”  The expectation is that excessive currency intervention will eventually cause inflation. 

Some optimists argue that the current account deficit is being pushed by foreigners’ desire to invest in the productive strength of the America economy.  This argument is weak for two reasons: 1) foreigners have not been investing in American factories, as they were in the late 1990s; and 2) foreign direct investment has been low. In reality, foreigners are investing in government bonds.  This means that foreigners are purposefully lending their money so that Americans can increase consumption. (Economist [2005b])

If countries stop investing in America, the sustainability of the deficit will not be feasible unless investment is substituted from elsewhere.  If foreigners stop financing the America deficit, and the deficit is not corrected, then the result will be a hard landing, which will result in higher interest rates, falling assets prices, and a falling dollar (Economist [2005c]).  A hard landing would cause the American economy to fall into a recession.

Foreign private investors, foreign central banks, and foreign direct investment are the main sources of available capital.  Foreign private investment lowers when central bank investment increases, which appears to be the reason why foreign private investment has been so low in America before this year.  Higher interest rates in the United States in 2005, and higher expected interest rates in the United States, are attracting both foreign and domestic private investment.  This year, it appears that central bank purchases have diminished greatly, and the dollar still strengthened.  This strengthened position may reverse as higher interest rates will continue to put pressure on the housing market in the Unite States.  Also, higher energy prices, after Hurricane Katrina, are expected to put downward pressure on interest rates, which may cause lower investment.  There is also a fear of rising inflation.  Combined, all of these conflicting forces give uncertainty to whether or not a hard landing will be avoided.

America’s Deficit

One problem for America is that the accumulated debt that has been used for increased consumption, and for non-productive investments such as housing.  Negative savings is acceptable if the capital is being used to increase productivity.  With the capital being used for non-productive investments and consumption, the cost of repaying the capital is more burdensome.  This is because the capital was not used to increase productivity, which would have made the repayment of capital easier because extra capital would have been available in the future as a result of those productive investments. 

According to the Ricardian Equivalence theorem, people will expect higher future taxes from increased current government spending.  That would translate into higher current savings if the theorem

housing prices in the future would translate into lower household wealth.  Also, consumer debt levels have reached a twenty year high of 13.4% (Economist [2005f]).  Figure 2 shows why consumers may

foreign assets and liabilities.  America has a distinct advantage with respect to its net external debt position because 70% of its investments abroad are not in dollars.  Therefore, the value of non-dollarized investments increases when the dollar depreciates.  Also, America issues bonds in dollars, so when the dollar depreciates, America’s debt falls relative to other currencies.  To summarize this effect, Helene Rey found that the “valuation effect is worth about 5% of GDP for every 10% drop in the dollar” (Economist [2005b]).  Nevertheless, the deficit is causing the debt-to-GDP ratio to rise, and this is not a plausible scenario for the long-term.  (Economist [2005b])

Conclusion

America will be able to sustain its deficit, in the medium-term, as long as foreigners are willing to support the excess consumption.  Cheap capital will continue to need a place to be saved while worldwide national savings are so high.  Central banks have started to spend less on American bonds, but this slack has been picked up by private foreign investment.  Eventually, America will need to stop spending so much money on consumption, and start to spend more money on productive investment, or stop spending so much money.  The adjustment away from the current deficit position is an inevitable necessity in the long-run.

References

Economist [2005a], “Anatomy of thrift: What causes people to save and invest?,” New York, NY

Economist [2005b], “Forever free: Can America go on borrowing abroad indefinitely?,” New York, NY

Economist [2005c], “Hard-landing heresy: If the dollar dives, what will happen to America’s interest rates,” New York, NY

Economist [2005d], “Reversal of fortune: Why oil exporters and East Asians are reluctant to spend,” New York, NY

Economist [2005e], “The frugal giant: China’s enormous saving surplus may rise further before it falls,” New York, NY

Economist [2005f], “The price of privilege: Too much foreign money is bad for America’s economy,” New York, NY

Economist [2005g], “The great thrift shift: America is spending while the rest of the world is saving.  But for how long? ,” New York, NY

Economist [2005h], “The hare and the tortoise: Why have the world’s savings gone to America rather than to Europe? ,” New York, NY

Economist [2005i], “The Viagra economy: Japan is getting older but its economy is looking perkier.  Will that mean fewer savings to send abroad? ,” New York, NY