This is a wonkish post, but bear with me, because it’s important. Randall Wray’s last post sparked a thought regarding trade deficits and budget deficits which I wanted to run by you. Randy said:
We see from the chart that the "normal" situation in the US is a private sector surplus, and a (growing) current account deficit. These are offset by a government budget deficit. The exception was the Clinton years, when government ran a surplus and the private sector ran unprecedented deficits.
He was pointing to this chart from Scott Fullwiler:
Here’s where my thought process goes from that. The U.S. dollar is the world’s major reserve currency. Especially in the post-Bretton Woods world, this has meant capital account surpluses as foreigners accumulate U.S. dollar reserves. These capital account surpluses translate into current account deficits. So the "normal" situation, as Randy put it, absent a depreciating dollar, is a U.S. current account deficit. Moreover, Randy writes that a private sector surplus is also normal. And I assume this is true absent some sort of malinvestment-induced capital spending or household dissaving spree. So, while Randy puts normal in quotation marks, I think there is something to this state of affairs being the baseline case for the U.S. sectoral financial balances.
This is where my prior statements on the Triffin Dilemma and the U.S. dollar’s reserve status comes to mind.
One big problem with the present set up is the Triffin Dilemma. The dollar’s role as a national currency with any domestic agenda of a balanced current account is fundamentally at odds with its role as the world’s reserve currency. Especially post-Asian crisis, the desire by many was to accumulate US dollar reserves and that means running a capital account deficit/current account surplus with the US.
The current account imbalances become problematic during downturns and lead to protectionism, as I argued in my third post at Credit Writedowns
So, here’s my logic:
- The dollar’s reserve currency status makes dollar accumulation by foreign central banks the default mode. This naturally leads to a capital account surplus and a current account or trade deficit for the U.S.
- Meanwhile, absent serious incentives for private sector dissaving, the baseline sectoral balance for the non-government domestic sector, for households and businesses in the U.S., is surplus.
- Whenever a major downturn hits, two things will happen. First, the current account deficits will become a lightening rod for protectionist sentiment. Second, the private sector will move to a net saving position inducing an increase in government deficits which will become a lightening rod for anti-deficit sentiment.
I use the term "major" downturn because my assumption is that a major downturn will induce large government deficits that will draw the attention of deficit hawks in a way that a smaller recession would not. And that means that there will invariably be a political effort to reduce that deficit irrespective of its root causes. See my post Does focusing on deficit reduction reduce deficits? for why I think this leads to a recessionary relapse. The long and short of that post is that, to the degree you want to reduce deficits, you need to either increase employment or reduce military and entitlement spending.
At the time, my conclusions were:
- Cyclical deficits are just that cyclical. Focusing on deficit reduction as a cause is likely to increase these cyclical deficits.
- Debt-to-GDP constraints are artificial and are implicit indications of fears of cronyism and government waste.
- Deficits matter only to the degree they steal real resources from productive use. This can be surmised from a rapidly rising debt-to-GDP ratio.
Right now, the Obama Administration is trying to have its cake and eat it too by avoiding too much austerity but talking a good game on budgetary restraint. For example, in the State of the Union Address, President Obama said he wants to freeze non-defense, discretionary spending as I predicted in my post on "Obama’s Economic Agenda for Re-election". However, the President has not taken on Social Security or Medicare to pre-empt deficit hawks as I had predicted, I suspect because the Democratic base is opposed to such a move.
But, if you look at my thinking on the sectoral financial balances, you can see you have a problem. The jobs are really not coming yet as this morning’s employment situation summary demonstrates. The private sector is back to its default savings. And the U.S. is still the world’s reserve currency. So the capital account surpluses continue. That necessarily means continued high government deficits – deficits that I think are politically unsustainable, meaning they will come under attack.
What are potential ways out of this?
- A reduction in the capital account surpluses. Obviously, a Chinese revaluation might help here because what would really end the capital account surpluses is a major devaluation in the dollar vis-a-vis its trading partners. Now, this is a de facto decrease in American per capita income but it will bring down capital account surpluses. Obviously, if central banks stopped accumulating dollars and switched to euros or yuan or yen, that would also help.
- A reduction in private sector surpluses. This could happen via the household or business sector. If we had a capital spending binge, then business savings would go down. If households starting seeing job growth and started to reduce savings levels due to the psychological effect’s from increased economic security, then this could reduce the private sector surplus. But given high household debt levels, this would be a bad thing.
My analysis here says that the Clinton years’ achievement was due largely to a booming economy fuelled by a capital spending binge in the telecom sector and by business generally, mixed with an unsustainable decrease in household savings. Barring a repeat of this – something I would argue is a bad thing – the only way to get around the government deficit is to depreciate the dollar. Right now, getting back to full employment should be the first priority. That would go a long way to reducing the deficit. However, one must accept that government deficits are inevitable with the world’s reserve currency; the private sector is net saving and the capital account is in surplus. Otherwise, you really need a major devaluation, a reduction of reserve currency status or a private sector binge. I vote for a reduction of reserve currency status.