In recent months a variety of commentators have questioned the sustainability of the U.S. trade deficit. There appear to be two points of view here: The first is that the U.S. has been spending in excess of its income for too long and that the day of reckoning is fast approaching. Steven Pearlstein (April 15, 2005, Washington Post) expresses this view when he argues that U.S. fiscal deficits are stimulating U.S. export demand which provides income for the rest of the world, but foreigners are not spending enough of that income, but rather saving in the form of investment in the U.S.. As a result, U.S. interest rates remain low, which further stimulates U.S. spending. Unfortunately, Pearlstein points out, this isn’t sustainable in the long run.
The second point of view is much more sanguine. Richard Clarida (April 11, 2005, Wall Street Journal) argues that the U.S. is essentially providing a useful service to the world, since in his view, the problem is an excess of global saving over global investment resulting in extremely low real interest rates. In this situation, foreigners are placing their funds in the safe haven of U.S. financial markets. The U.S. current account deficit is not a sign of U.S. weakness, but rather the opposite. Glenn Hubbard (May 2, 2005, Wall Street Journal) provides support to Clarida, stating that world financial market imbalances are not entirely the fault of U.S. policy, but rather due to lack of efficiently functioning capital markets in other parts of the world. Robert Samuelson (April 27, 2005, Washington Post), summarizing Ben Bernanke, agrees that there is a global savings glut, but that continuing deficits are “dangerous.”
What is missing from these arguments? Economists tend to view the world in terms of equilibrium processes. A market is either in equilibrium or, absent government intervention, moving towards some new equilibrium. What seems to be missing from the above commentary is explicit discussion of the equilibrating forces. According to the traditional view of open economy macroeconomics, when a country like the U.S. imports more than it exports, it pays for that deficit either by drawing down its assets to the rest of the world, or by borrowing from them. Either way, the country’s net worth falls, and to the extent that it earns income on its net foreign assets, so does its income. These effects are reinforced by a decrease in the value of the dollar in international currency markets. Declining wealth and income should reduce U.S. spending until it is back into balance with U.S. income. Similarly, increasing foreign wealth and income should increase their spending. If this happens slowly and smoothly, without any kind of financial or economics crisis, it is described as a “soft landing.”
However, that’s not the only possible outcome. The status quo can persist as long as foreigners remain willing to accumulate our assets. A soft landing requires that we need to save more and spend less, while foreigners need to do the opposite. In both cases (status quo & soft landing) if our respective plans don’t mesh in the sense that they are complementary, financial markets will adjust possibly dramatically to make up the difference.
Suppose foreigners decide to reduce their lending to us, but we don’t reduce our spending in proportion. Then the result will be more painful, a “hard landing.” In this scenario, the reduction in credit will cause interest rates to rise, possibly precipitously. This rise will impose a reduction in U.S. spending, leading to recession. This is what some experts are concerned about.
Notice what both sides are saying: The world is saving more than it is investing. U.S. interest rates are (too) low. U.S. spending is (too) high. Foreign spending is (too) low. Will foreigners increase their spending at the same rate that U.S. folk decrease spending? That remains to be seen. For now, neither U.S. nor foreigners seem willing to change their behavior. This won’t last forever.
