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July 15, 2005

Dials Moving Into the Red Zone

At the end of 2000 I said that while the U.S. trade deficit was a worry, there was still plenty of time to deal with it. It was very important that it be resolved by the world economy "balancing up" rather than "balancing down." And I would have put the chance of a major dollar-based financial crisis at only one-in-a-thousand.

By the end of 2003 I said that the chance of a major dollar-based financial crisis was one-in-a-hundred, and it was time for keeping that probability from growing any higher to become the highest economic policy priority.

By the end of 2004 I thought that the chance of a major dollar-based financial crisis was one-in-ten.

Now I think that the chances are one-in-five. It is still possible that we may escape unscathed: the dollar could fall by nearly half without foreigners ever demanding an expected-depreciation premium in interest rates, the foreign currency-denominated value of U.S. foreign debt could melt away, and the exchange rate stage could drive an export-driven boom that brought trade into balance as higher import prices shrunk imports. We did it in the late 1980s, after all--although starting from a disequilibrium only half as large as our current one.

Brad Setser writes:

Brad Setser's Web Log: Don't worry, be happy. Trade deficits do not matter so long as US hhousehold wealth is rising: Michael Mandel thinks I am making a big mistake, albeit a very, very common one - worrying about rising US external debt rather than celebrating rising US household wealth.

Brad is making the very very common mistake of taking the value of U.S. assets--that is, our wealth--as a fixed number, so that everything that goes to foreigners is less for Americans. That is, he's treated wealth as a zero-sum game.

In fact, U.S. wealth has historically grown at a pace which far exceeds the size of the current account deficit. As the economic pie gets bigger, there's enough to feed our foreign friends while keeping an ever-growing piece for ourselves.

Since 1952 household net worth--that is, assets minus liabilities--has increased by an average of 7.4% annually, or 3.7% in real terms. That includes real estate booms and real estate busts, bull markets and bear markets. This annual percentage gain translates into a huge increase in net worth, in dollars. Household net worth today is just under $50 trillion, according to the Federal Reserve.

...If US household wealth is rising, should we worry if US external debt is also rising?... [W]hat would happen if US... long-term rates... were to rise substantially?... Too much of US household wealth depends on the interest rate for me to feel very comfortable. At some point, the United States foreign creditors are likely to want an interest rate high enough to compensate them for the risk of future dollar depreciation. A country that outsources savings will likely have to offer foreign investors a positive real return (over time) in terms of their local currency, not in dollar terms....

The US likely will have a current account deficit of close to 7% of GDP by the end of 2005, and even if that deficit started to fall, the US would still need to finance a very large current account deficit for some time. That might not be much fun if interest rates were high.

Of course, there are scenarios where the US trade deficit falls and US interest rates stay low. For example, the US consumer could give out, pushing the US economy into a recession.... But low interest rates, constant household wealth, no growth and stagnant (if not falling) household income is hardly a comforting prospect....

The US net international investment position... is likely to be more like 30% of US GDP at the end of 2005. And it is poised to keep on rising so long as the US runs large trade deficits. Exports as a share of US GDP, in contrast, are no higher now than they were in 1997, when the US had a lot less external debt. I think that matters. Remember that external debt ultimately is a claim on the United States future export revenue. New homes -- and higher prices on existing homes -- won't help pay the interest on the US external debt. A new Boeing production line would.... It is not clear that the United States capacity to generate future export revenue to pay its external debt is set to rise as fast as its external debt looks likely to rise. Call me old fashioned. I think the external debt to exports ratio still matters.

Posted by DeLong at July 15, 2005 11:43 AM