October 8, 2003
During the 1980s, economists were complaining about the "twin deficits" of government borrowing relative to GDP and high trade deficits as a share of domestic production. As the government deficit vanished during the boom of the next decade, "twin deficits" were only mentioned in assessing currency risk of developing countries. The "twin deficits" are back, but discussion remains muted. Why?
Let us look at the currency risk that can be caused by these government and trade deficits.
Developing countries do not have enough domestic savings to finance large government deficits. Thus, international lenders must help finance those budget shortfalls. Similar international sources must provide credit to importers because exports are not sufficient to create enough international capital to finance those imports.
If trade deficits and government deficits are rising together, the international borrowing needs of a developing country balloon. Very high interest rates are needed to continue attracting the world's savings. While an ensuing recession might deflate imports and lower the trade deficit without currency devaluations, most countries choose currency adjustments over employment losses.
Therefore, most foreign exchange desks monitor the "twin deficits" to determine the likelihood of currency devaluation.
Of course, the United States now is running high and growing "twin deficits." Trade deficits are more than 4 percent of GDP while federal revenue shortfalls are approaching 5 percent of GDP. In the past, a rule of thumb has been that twin deficits in excess of 3 percent of GDP were excessive and needed to be reduced.
Unlike developing countries, the United States has substantial domestic savings capacity. Those government deficits might be financed internally under certain economic conditions.
Furthermore, the trade deficit might be the result of international savers seeking U.S. assets. After 9/11, uneasiness around the world caused many investors to seek the most liquid markets they could find. They wanted ready access to their purchasing power if unusual conditions developed.
U.S. markets provide more liquidity than anywhere else in the world. Therefore, those international savers needed to buy dollars to have the purchasing power to be in our markets. This led to a surge in the dollar's value.
Unfortunately, the side effects of that dollar surge included reduced competitiveness of American producers. A significant portion of the 2.6 million manufacturing jobs lost since 2000 has been caused by this strong dollar impact. As imports displaced domestic production, the trade deficit soared.
If the trade deficit is the result of international savings flowing into the U.S., as it was after 9/11, then that deficit is self-financing. Therefore, no currency risk exists.
Certainly, there is very little upward pressure on U.S. interest rates at this time. Indeed, ten year government bonds have reduced their yields back below 4 percent. Strong gains in corporate cash flow that are not yet being converted into inventory rebuilding and capital expansion have provided surprising sources of funds to finance the ballooning federal deficit.
Some households also have paid down debt (a form of savings) from funds provided by lower tax burdens. This also has relieved interest rate pressures generated by the government deficit.
Nevertheless, there is increasing evidence that foreign exchange investors believe the "twin deficits" are becoming a problem for the U.S. The dollar's weakness against most major currencies might suggest that even this government prefers devaluation to rising unemployment.
To be sure, the Bush administration declares that it maintains a strong dollar policy. But this has continued to be said even as the euro has jumped from 84 cents to $1.16 per U.S. dollar. A dollar used to buy 125 yen. Now it only purchases 110 yen. Even in Canada the U.S. dollar has fallen from an ability to purchase 1.6 Canadian dollars to buying less than 1.35 Canadian dollars.
Either we are inept in our strong dollar policy, or that really is not our policy. While no one rules out ineptness, international investors increasingly believe we are behaving like developing countries with a growing "twin deficit" and are welcoming a dollar devaluation.