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February 04, 2005

The Budget Deficit and the Current Account

The number I have in my head is 0.3-0.4: a $1 increase in the government budget deficit increases the trade deficit by between thirty and forty cents. The links are there, but they are slippery and erratic. Greg Ip writes:

WSJ.com - Cuts in the U.S. Budget Deficit May Not Help Close Trade Gap:

The Fed study, by economists Christopher Erceg, Luca Guerrieri and Christopher Gust and recently published on the Fed's Web site, says the budget deficit does play a role in the trade deficit, but far less than some previous estimates have found. (Fed staff members don't necessarily share the views of Fed policy makers like Mr. Greenspan.)

They found an increase in the budget deficit of 1% of GDP, whether via a spending increase or income tax cut, boosts the trade deficit by less than 0.2% of GDP. The reason is that lower taxes and higher government spending cause Americans to spend more but mostly on domestic, not imported, goods and services. It also finds that the deficit raises long-term interest rates, and, as a result, the private sector invests less, reducing demand for imported capital goods.

The study says the trade deficit is far larger today than can be explained by the swing in the budget from surplus to deficit in the past five years. That means other factors may be at play, such as increasing foreign demand for U.S. assets and strong worker productivity growth in the U.S., the study suggests.

Posted by DeLong at February 4, 2005 11:45 AM

Comments

Would we expect the impact of fiscal shocks on the trade account to vary depending on the cyclical state of the domestic economy? Would a fiscal response to slack domestic output have a different (smaller) impact on the trade account than when the output gap is smaller (like now) or when the output gap is very tight? Erceg's 0.2%/1.0% ratio seems small (and they acknowledge that other researchers find a higher ratio), and it might be misleading if we would expect different ratios at different points in the cycle.

Who is that DeLong guy cited in the study?

Posted by: kharris at February 4, 2005 11:56 AM


"The study says the trade deficit is far larger today than can be explained by the swing in the budget from surplus to deficit in the past five years. That means other factors may be at play, such as increasing foreign demand for U.S. assets and strong worker productivity growth in the U.S., the study suggests."

Hmmph. I have a man-on-the-street interpretation of the data. There was a time when the big discount department stores made a big deal about displaying "Made in U.S.A." signs throughout the stores. Now, you practically have to search for items made in the U.S.

Sometimes, life is simpler without statistics. (Yeah, I might be completely wrong, but I didn't have to put much effort into it).

Posted by: Ottnott at February 4, 2005 12:01 PM


I have not read the fed paper, but if the US import elasticity is over 2, I would have trouble accepting the conclusion that the stimulous would almost all be spent on domestic goods.

Posted by: spencer at February 4, 2005 12:01 PM


http://www.nytimes.com/2005/02/04/business/04cnd-greenspan.html

Greenspan Sees U.S. Trade Gap Stabilizing and Possibly Falling
By ALAN COWELL

LONDON - Alan Greenspan, the chairman of the Federal Reserve, suggested today that the United States' record trade deficit may be poised to stabilize and even decline as a result of market pressures and promised spending restraint by the Bush administration.

Mr. Greenspan was speaking at a gathering here coinciding with a scheduled meeting of finance ministers and central bank governors from the Group of 7 leading industrialized nations.

His remarks contributed to a strengthening of the dollar today, which had fallen earlier when the United States reported weaker-than-expected employment growth in January....

Mr. Greenspan said one reason for the trade deficit to shrink was that foreign exporters selling goods in the United States might no longer be willing to keep prices down in the face of a weak dollar and accept smaller profits in order to preserve their American market share.

"We may be approaching a point, if we are not already there, at which exporters to the United States, should the dollar decline further, would no longer choose to absorb a further reduction in profit margins," he said. That would mean a reduction in the volume of imports but "leave the resulting value of imports uncertain."

Mr. Greenspan said American exporters' profit margins, bolstered by the weak dollar that makes American goods more affordable for foreign buyers, "appear to be increasing, which bodes well for future U.S. exports and the adjustment process." ...

Posted by: anne at February 4, 2005 12:06 PM


http://www.nytimes.com/2005/02/04/business/04cnd-greenspan.html

"Besides market pressures, which appear poised to stabilize and over the long run possibly to decrease the U.S. current account deficit and its attendant financing requirements, some forces in the domestic U.S. economy seem about to head in the same direction," Mr. Greenspan said.

"The voice of fiscal restraint, barely audible a year ago, has at least partially regained volume," he said, referring to promises by the Bush administration to restrain spending that has led to the huge budget deficit....

"I have argued elsewhere that the U.S. current account deficit cannot widen forever but that, fortunately, the increased flexibility of the American economy will likely facilitate any adjustment without significant consequences to aggregate economic activity," Mr. Greenspan said.

Posted by: anne at February 4, 2005 12:12 PM


The interest rate is playing a strong role in their paper (as it must) in the adjustment to the fiscal shocks. But when they want to apply their findings to the recent movements in the twin deficits -- part of their War on Delong -- shouldn't they acknowledge how muted interest rate movements have been over this period (especially at the long end, and in the upward direction)? A key channel of their model is not obviously manifesting itself.

Posted by: P O'Neill at February 4, 2005 12:32 PM


Yikes. A generation ago, I used to tell my students that the marginal propensity to import was around 15% to 20%. I also used to tell them that the fiscal policy multiplier was around 2. My really bright students used to challenge me as to where I got my hypothetical classroom examples. Was I reading your lecture notes back then? Then again, I have recently been arguing a Mundell floating exchange rate type model for the impact of fiscal policy on the current account, which makes my fixed exchange rate noodling a little off. Of course, Dan Drezner once opined that my suggestion that Bush's fiscal stimulus was not responsible for the fall in exports etc. Somehow, Dan should rethink this claim.

Posted by: pgl at February 4, 2005 01:05 PM


If Bush were running a deficit because he was spending the extra money on domestic infrastructure, I could buy the 20% figure. However, this is not why we have a deficit. So they can write a paper about how only 20% of deficit spending SHOULD go to increasing the trade deficit. But Bush fiscal policy is not what any sane government SHOULD do in an economic downturn.

Why do we have increased spending? Bush has increased spending by about $500 Billion between 2000 and 2004. About 180 Billion of that is discretionary, mostly military (160 Billion) and Homeland security. Much of the military spending is foreign. The military runs on fuel. The fuel costs have skyrocketed with the Afghan and Iraq wars. Usage has gone up and so has the price per barrel. Uniforms are mostly made in China and elsewher. Some production of Humvees and armor is domestic, but most of the electronics (a big cost) is imported even if designed in the US. Discretionary domestic spending is up by only about $100 Billion over 4 years. Much of that goes to Homeland Defense. One might argue that much of this spending is domestic (salaries) but part of the salary increase is replacing airport security personnel with Federal agents and other replacement spending.

The other $320 Billion in increased spending is mandatory and mostly goes to SS, Medicaid, Medicare increases. Much of the health care dollar is spent domestically, especially on services. However, medical supplies, like clothing and everything else are produced offshore. Of course, one has to subtract the SS surplus to balance.

On the tax cut side, much of the tax reduction $200 billion drop from 2000 to 2004 is in individual income tax mostly for the very wealthy. Corporate income taxes took a big drop between 2000 and 03, but are less than 20 Billion different from 2000 to 2004. In contrast, social insurance taxes (mostly paid by the less affluent) INCREASED by $80 billion. So we have seen a real tax shift from the wealthy to the poor.

A generic analysis of deficit spending on foreign trade deficit does not address the rather unique changes in revenue and spending that have created the current budget deficit. If they were to look at the specific changes in spending and who was getting the tax cuts (wealthy who spend more on foreign goods) then they would not come up with a 20% number.

Posted by: bakho at February 4, 2005 01:35 PM


Has Greenspan quit reading the papers? Doesn't the Bush administration plan to increase the long-term budget deficit by trillions to deal with Social Security? Doesn't it plan to deal with the alternative minimum tax, reducing revenues? Doesn't it plan on spending billions in Iraq and Iran?

Posted by: masaccio at February 4, 2005 01:37 PM


Re Anne's Greenspan post. He makes an argument about import prices completely at variance with standard models.

What happens to import prices is close to irrelevant to the behavior of the U.S. current account deficit. If import prices go up in dollar terms, import quantities will of course go down. Most estimates of the import price elasticity place it at about -1. Thus, a 10% rise in dollar import prices would be matched by a 10 percent reduction in import quantities, leaving nominal imports unchanged. The current account balance is, after all, a nominal concept.

It's on the export side that you should see nominal adjustment. Even if U.S. exporters hold dollar prices flat, dollar weakness makes them cheaper in foreign currency terms. Both real and nominal export rise. In general, a dollar depreciation should lead to higher dollar export prices, but not in proportion with the depreciation. That way, one gets higher dollar but lower foreign currency export prices. The resulting rise in export volumes is lower, but the rise in nominal exports is about the same: again, most estimates of the foreign price elasticity hover around one.

Posted by: Matt at February 4, 2005 02:12 PM


Matt

I too was struck by this, and am thinking carefully. Greenspan may be arguing we are likely to see a different adjustment process. Interesting...


"I have argued elsewhere that the U.S. current account deficit cannot widen forever but that, fortunately, the increased flexibility of the American economy will likely facilitate any adjustment without significant consequences to aggregate economic activity," Mr. Greenspan said.

Posted by: anne at February 4, 2005 03:17 PM


"I have appointed him and he disappoointed me". That is what G.H.Bush said about Mr. Greenspan after loosing the polls with Bill Clinton. So, may be George W. Bush learnt the lesson from his own father and.....has got Mr. Greenspan gripped just there where it hurts... Why not to consider that in present times the status of the FED chairman has changed? May be - for reasons we do not know - he is now in Mr. Bush´s pockets and he can not speak freely anymore. That fits very well in the blatant "illogic logic" of his recent words and speeches. Remember he is leaving in january 2006: may be - is a possibility - he is counting the days to leave FED chairmanship as soon as possible. And then, well....Mr. Bush will have to recruit Houdini to replace him....

Posted by: WALTER at February 7, 2005 09:43 PM


I'm no economist. But considering that the largest and fastest growing trade deficit by far is with China, which pegs its currency to the dollar, how can a weakening dollar really make that big of a difference? And since Europe and Japan are the ones who are being hurt by the weak dollar, how can we expect robust growth in their demand to bring us out of this? We need robust growth in consumer demand in China to ease the import pressure. We seem to be in this strange dance of dependence with China that is ever escalating the stakes and reducing the likelyhood of a "soft landing." Meanwhile all the rest of the World can do is watch to see how it unfolds.

So it seems most importantly we need to get our own fiscal house in order, which Bush does not seem capable of.

Posted by: JW at February 16, 2005 07:32 AM


Posted by: at March 14, 2005 11:26 PM


Posted by: at March 14, 2005 11:26 PM


Posted by: at March 14, 2005 11:26 PM