December 23, 2004
The Difference Between the Current Account Deficit and the Trade Deficit
For the U.S., this difference has been unimportant for the past two decades. It is about to become important. Brad Setser writes:
Brad Setser's Web Log: One more point on Martin Wolf: It is a simple point, but an important one. Wolf says the United States would be fine if it reduced its current account deficit from 6% of GDP to 3% of GDP. External debt to GDP then stabilizes at 50% of GDP. All true.
But remember that cutting the current deficit in half likely requires cutting the trade deficit by much, much more. Right now, net interest payments on US external debt are close to zero. That is largely due to a combination of good investments (The US accumulated a lot of European assets when it was running current account surpluses in the 50s and 60s, and these assets generally provide the US with a decent return) and good luck: foreigners hold lots of US debt, and US interest rates are very low.
But over time, as debt levels rise and US interest rates rise, the income balance will turn negative. If the US pays just 4% interest on a (net) external debt to GDP ratio of 50%, interest payments would be 2% of GDP. A 3% of GDP current account deficit therefore is consistent with a trade deficit of 1% of GDP -- compared to about 6% of GDP now.
This oversimplifies. If the US continues to earn a higher rate of return more on its offshore assets than it pay on its external liabilities, its "income" from borrowing abroad to invest abroad (what I call financial intermediation) will offset some of the interest payments on its net debt. A net external debt of 50% of GDP might imply external assets of 50% of GDP and external debts of 100% of GDP. Suppose the US pays 4% on all its liablities, and earns 5% on its assets. US net interest payments would be 1.5% of GDP in this scenario. Then a trade deficit of 1.5% of GDP is consistent with a current account deficit of 3% of GDP.
My point is simple: cutting the current account deficit in half over time will require cutting the trade deficit by more than half. Realistically, the trade deficit (technically, the balance on trade and transfers) will need to fall by between 4.5 and 5% of GDP ...
There is no guarantee that the US will be able to bring its current deficit down to 3% in an orderly way. Emerging markets typically do not adjust smoothly. Rather, once capital inflows dry up, they swing from current account deficits to current account surpluses. They rarely end up in the sweet spot -- that is, they typically are not able to run the small ongoing current account deficits that can be consistent with a stable debt to GDP ratio.
Posted by DeLong at December 23, 2004 08:54 AM
Who is keeping long bond yields low? If it is self-interested Asian central banks, one can imagine the status quo continuing for some time. If it is hedge funds plying the carry trade, the status quo is very, very vulnerable.
Below are some scary thoughts from Bloomberg.
...What happened to the higher expected yields that weren't? One frequent answer is massive Asian central bank buying of Treasuries from countries that intervene in the foreign-exchange market to prevent their currencies from rising (Japan) or that acquire dollars from exporters who can't convert them in the open market (China).
While China grabs all the headlines, as of October Japan held $715 billion of U.S. Treasuries, a 40 percent increase from a year earlier. (The Treasury statistics on foreign holdings include both official and privatei nvestors.) China, whose trade surplus with the U.S. ballooned to $131 billion in the first 10 months of the year, increased itsh oldings by 16 percent to $174.6 billion.
...The hole in that argument is that foreign central banks traditionally park their dollars in the short end of the yield curve, according to Jim Bianco, president of Bianco Research in Chicago.
``Don't make the mistake of confusing bonds with GDP futures,'' Bianco says. ``Financing rates are more important to bonds than the inflation rate.''
Easy money since the Sept. 11,2 001, terrorist attacks has encouraged ``a new breed of leveraged investor, with most of the hedge-fund growth coming in fixed-income arbitrage or relative value funds,'' Bianco says, based on data from Hedge Fund Research in Chicago.
The growth in hedge funds is also evident from the explosion of trading in U.S. stocks and bonds from the tax-haven countries of the Caribbean, where total turnover is up 100 percent in the past year, according to Bianco.
If cheap money has been the inducement for hedge funds to load up on 10-year notes, then higher real rates should be the trade's undoing. With core CPI up almost as much as the funds rate this year, there's been no change in the real cost of financing bond purchases so far.
Cheap money has been an incentive for more than leveraged trading. ``It was a big employment incentive, too,'' Bianco says. ``For hedge funds.''
Posted by: steve at December 23, 2004 10:03 AM
Brad: The US accumulated a lot of European assets when it was running current account surpluses in the 50s and 60s, and these assets generally provide the US with a decent return
This is *very* interesting. What are those? Private or public? When acquired? How? Managed how?
Posted by: a at December 23, 2004 10:05 AM
So, if I understand, hedge funds are borrowing short and lending long. Japan, China, India and Brazil are buying America shorter term debt, while hedge funds are buying long term debt. As long as interest rates rise modestly there is no problem, since there is still a profit to be made borrowing short to lend long. But, as in 1994, if rates rise more rapidly and the cost of borrowing cuts away profits from holding long term securities, hedge funds will start selling debt.
Posted by: anne at December 23, 2004 10:14 AM
On a current account surplus, the river is filled with fish, who are swimming upstream to live, and not to die.
Posted by: cloquet at December 23, 2004 10:36 AM
Yes, you have described the carry trade. One important ingredient is leverage - you borrow many times more capital than you actually have, at the low short-term rate, and buy long bonds. If the interest differential is, say 2%, but you use 10x leverage, you can make a 20% return on the original capital. But if rates rise and prices of long bonds decline, your losses are also multiplied 10x. There is an old joke on Wall St. about practicing the carry trade until you yourself are carried away on a stretcher.
This means the meltdown on the long end of the yield curve could be quite quick and ugly.
There are even some closed end funds (I think Blackrock, for example) that practice a "light" version of the carry trade - they use more modest leverage, but it's the same thing. These actually had a good year last year. Acting like a wimpy academic rather than a trader I avoided them, convinced they would definitely blow up in the rising rate environment.
Posted by: steve at December 23, 2004 10:43 AM
Sigh -- and I remember the days when we were told not to worry about the trade deficit because our net investment income would pay for it.
Posted by: Ken Jarboe at December 23, 2004 01:26 PM
One of the things about the current administration's economic policy that strikes me as completely bizzare is the complete disregard for consequences.
The economy is very complex and most people don't even pretend to understand all the complex interactions that are involved. it is not called the dismal science without good reason. But this usually means that the people running the country approach problems with a certain degree of caution.
This gang of incompetents seem to take the view that if they can't be bothered to understand something they can do whatever they please without consequences.
In the space of four short years Bush has all but dismantled NATO. Lech Walensa, the founder of Solidarity, the man who Ronald Reagan beleived won the cold war is saying that the US has abandoned its claim to moral leadership.
What the Bushies do not seem to understand is that political parties who make catastrophic blunders can become extinct in the course of a single administration. The British Tory party has already conceeded that it will lose the next UK general election, the third in a row to Tony Blair. The question it is asking now is whether the party has any hope of possibly winning the next or if that is also a foregone conclusion.
The US economy is facing the possibility of a total fiscal meltdown. If that happens the Republicans will have nobody to blame but themselves. Even Fox news may abandon them, Murdoch abandonded the UK tories when he realized they would be out of office for a decade at least.
If the Republicans push this strategy to its conclusion they may find themselves asking not whether they can keep their hands on the Whitehouse or even whether they can avoid conceeding a filibuster proof majority in the Senate. They may find instead that they are limited to hoping that their majority will be large enough to stop the Democrats from impeaching Thomas.
Posted by: Phill at December 23, 2004 01:30 PM
"One of the things about the current administration's economic policy that strikes me as completely bizzare is the complete disregard for consequences."
I think they understand the consequences, they just believe the rest of the world does too. If you were a holder of massive American debt, looking at the relative size of American military and at the Republicans who control it, would you want to send America into depression?
Posted by: bob mcmanus at December 23, 2004 02:34 PM
a: US assets in europe are overwhelmingly privately owned, and mostly equities. US firms built up a big presence in most European countries after WW2 (some before) -- Ford produces lots of cars in the UK, GM lots of cars in Germany, IBM has a big european operation, as do some consumer brands. Remember that in the 60s the French were worried the bretton woods system (with its strong dollar no longer fully backed by gold) was financing the US takeover of europe "on the cheap" --
Since the early 80s, the US no longer runs a global current account surplus, so its net liabilities have been rising -- but even in this context, US firms investing in Europe and European firms investing the US built up large and offsetting positions.
anne: China clearly is not putting the bulk of its funds at the short-end of the treasury curve, or if it is doing so, it is opting to do so in a very disguised way. there is a huge gap between its reserve accumulation this year and its reported treasury purchases. But Steve's point is no doubt right -- heavy central bank demand at the short-end and leveraged players funding themselves short to invest long have combined to keep rates low. Steve -- gotta go check out your blog! Inteeesting stuff on relative value hedge funds from bloomberg (i.e. the new generation of LTCMs?)
Posted by: theotherbrad at December 23, 2004 04:04 PM
"Come wolf, come swimmer. Come raven, come eagle."
Posted by: cloquet at December 23, 2004 05:37 PM