Understanding our Account Deficit

After a rant on the TIE message board, I realized that my message was getting lost with my tone. Economic terms really don't always explain the emotions that people feel about issues that are often affecting their livelihood.

Many folks fear change. Globalization causes very real and painful dislocations. My message on the TIE Board was NOT focused on the real changes that are causing people to feel the way they do. I was focused economic terminology and explaining how policy affects economic growth, trade, the dollar, etc.

I have edited my original post below. The purpose of reporting this is on my Blog is to try to elevate the discussion about economic policy. I am a Free Trader, but think that the US and US Policy could do a much better job maintaining and enhancing our standard of living and preparing our current and future work force for global competition.

The current US Account Balance is defined as the difference between a nation's saving and its investment. These definitions are taught in ECON class, but let’s discuss this a little. The theory goes that the US is saving too little relative to its investments, causing an “account deficit”. This is often compared to other countries (such as China or Japan) that are saving too much relative to its investments. It is simple accounting on a VERY LARGE Macro scale.

Almost every economist that knows anything about this will tell you that the trajectory of the current Account Deficit is unsustainable. The bottom line is that our foreign assets are less than our foreign liabilities, making our net investment position to currently exceed ¼ of our GDP. Sooner or later this trend has to reverse itself or the cost of servicing this negative international investment situation puts the very loans that we are talking about (US Treasuries, etc.) in jeopardy.

In other words, foreign investors are already investing in us in T-bills. They don’t want us to fail, so they will have to work with us. Part of that process is making “investments”. These investments adjust the current Account Deficit.

It has been noted by folks smarter than me that our Account Deficit can be placed into five buckets that all have impact. Some are more important than others. The two most often used by “the sky is falling” crowd are the first two and they have a minor role in my opinion. The next one is actually a positive and the last two (or fourth and fifth) buckets are the "big burritos" and what is happening.

• The Federal Government Fiscal Deficit. Sorry, but this is one of the issues. We have too much focus on consumption (Health Care, Social Security, and other consumption categories) and not enough on investments (roads, infrastructure, etc). We also pay out more than we bring in. A larger fiscal deficit boosts domestic demand, pushing up domestic interest rates relative to foreign rates; this, in turn, attracts investors and raises the value of the dollar, thereby leading to a larger current account deficit. The reverse of this (lower domestic demand) does the opposite and is like what I think is happening now (improving the account deficit). I think this is a very small issue relative to the others. Japan, for instance, has a fiscal deficit, but an account surplus – kind of disproving the relationship. To the extent that this is an issue, the theory goes that the fiscal deficit crowds out some private investment, which would be helpful to the situation.
  
• Decline in the private saving rate. We almost hear this story every day on CNBC from some pundits. The problem with this point of view is how much lower could it go? If we saved more, would the account deficit turn positive? Most economists believe that the effect is indirect by mainly affecting a change in consumption (we would buy less). High private consumption boosts GDP growth, and with everything being equal, forces the Fed to increase interest rates. Although the rise in interest rates strengthens the dollar, it leads to much lower investment spending. Therefore, a further decline in our savings rate appears to crowd out investment more than it crowds out net exports, and thus leads to little change in the Account Deficit.
  
• Productivity Growth. Higher productivity growth increases perceived rates of return on US investments, which in turn generates capital inflows that increase the value of the dollar. These higher rates of return lead to a rise in domestic investment. Expectations of higher returns boosted equity prices, household wealth, and perceived long-run income, and so consumption rose and saving rates declined which leads to a higher Account Deficit. While Productivity Growth has major benefits to the US, it does affect the Account Deficit.
  
• Changes in Foreign Demand. Foreign demand growth has not been strong enough in many foreign economies because of varying combinations of an increase in saving rates and a decline in investment. Weak foreign spending has enhanced the supply of capital available to the US, put downward pressure on U.S. interest rates, and put upward pressure on the dollar. This situation is improving. The global growth story is helping our Account Deficit, but will put downward pressure on the dollar. As foreign demand improves, the account deficit will improve and this is what is happening.
  
• Changes in Global Financial Investing. Have you looked at mutual fund inflows lately? They are going overseas. In the past, folks basically invested within their own country. This is changing and I believe is leading to big swings in the US Account Deficit. It is hard to measure but the US Government should focus on it. When our savings increasingly are being used to finance investment in other countries, the Account Deficit reflects that. Is that all bad? Of course not. Our money (our savings) is being put to work elsewhere. In theory, that savings would be repatriated if the economic conditions overseas change, thereby changing the Account Deficit. As our savings are invested overseas, foreign consumption will eventually increase as their economy grows. As foreigners are investing less in the US than the past (because their economy is hot) and US investors are doing the same, the account deficit grows.

So what does this long post mean? Anybody harping about the account Deficit (or trade deficit as the media likes to use) needs to understand what is happening. In a macro sense, there is nothing the US is “doing” that is really causing this Account Deficit other than a series of policies that are not altogether horrible.

If someone wants to change things to improve the Account Balance, then have the Government spend less (note that I did not say balance the budget through tax increases), create incentives for Americans to save more (like increase 401 or IRA savings) or encourage foreigners to save less, provide mechanisms to increase productivity through investments in technology (tax breaks, etc.) or education, encourage growth (both here and globally) while minimizing inflation, and encourage foreign investment in the US (we are doing it in their country) which means buying stuff like Citi and Morgan Stanley.