Often, for whatever reason or reasons, two things get coupled together in what seems like little more than an effort to obfuscate clarity. The present topic of interest is the so-called "twin deficits". The twin deficits are the Federal budget deficit and the balance of trade deficit.
We seek here to answer the following questions:
- why does each of these deficits exist?
- what can be done about the budget deficit?
- what can be done about the trade deficit?
- are the two causally connected?
- what are the implications of the fact that the
two are so large at the same time?
- is inflation an inevitable consequence of these?
The Federal Budget Deficit
I think that an underlying truth is that the Federal government has been enamored for quite a while with spending more money than it takes in. It's a bad habit like smoking. People who smoke know that there are consequences. The consequences are, generally, deferred in time. The pleasure - or whatever the high is that come from nicotine - is now.
The current state of the budget deficit is the result of at least 3 things that have happened recently.
- the dot-com/telecom booms created a lot of jobs, a lot of wealth, a lot of capital gains and, consequently, a lot of income for the Federal (and state and local governments). When the dot-com and telecom bubbles busted tax receipts fell. The economy has recovered but the latent effects of counting on that surplus are still being felt. For several years it was state budgets which were hardest hit. Unlike the Feds they do not have the ability to create money or approve a $750 billing deficit cap hike.
- 9/11, Afghanistan and Iraq happened and the Federal government spent a heck of a lot of money on things having to do with homeland security and the military
- Bush decided that a way to cure the mild recession was a tax cut
The Federal budget deficit exists largely by our choosing and partly as a result of unsound fiscal policy. I do not think that it is not possible for the administration and Congress to balance the Federal budget with sound fiscal policy. I wrote about this in the piece which suggest a new agency to manage fiscal policy - mainly taxes. That piece was coauthored by Jurgen Brauer and may be viewed here Rate Watch #499.
There are only three paths through which the budget deficit can be addressed:
1) higher tax rates
2) substantial economic growth leading to higher revenues at the present tax rates or
3) less spending.
The solution may be a combination of these elements.
If the government is going to spend more than it is taking in there are only two possibilities for making up the difference:
1) it can create more money or
2) it can borrow the money. It has been doing a lot of both of these over the past couple of years. M2 is $6,370.8 billion dollars as of 11/15/2004. It was $5,284.6 the day before 9/11/2001.
The general policy of the Fed has been to increase money supply (M2) at a rate approximating GDP growth. For the vast part the deficit is made up by increased borrowing. Like a big cash-out mortgage on the old USA.
The Treasury Department can also sell securities (notes, bills and bonds) on the open market and, in essence, borrow money to pay its present
spending habit and pay it back with interest. And this is where things get interesting.
The pain of borrowing money and paying it back later should be measure by the difference between the interest rate and the rate of inflation. Interest rates on Treasuries with maturities less that 3 years were all in 2004 less than 3%. CPI is less that 3% so that, in terms of real dollars, carrying that debt
was costing us nothing. Pay it now or pay it later it is the same bill.
One problem that the U.S has is the low savings rate. Since we save so little, most of the borrowing that the Treasury Department does comes from abroad.
It must be noted that, in recent years, the Fed had decided to issue less long-term debt and more short term debt. Only recently has the Fed started issuing 30-year binds again.
Some make the case that there is a nexus between the Federal budget deficit and the trade deficit. I think that the answer is that theoretically there should be but
there, in fact, is not.
The fact that the money supply has been increased so aggressively in the past three years could have led to inflation. This is the concept that "too many dollars chasing the same amount of goods" causes the prices of those goods to rise.
That did not happen. Inflation has been tame. Instead, two other things happened: 1) the dollar dropped in value 2) the "global economy" has been actualized. The fact that so many goods are available (mainly from China) means that this larger number of dollars is chasing a supply of goods which, for all practical purposes, can expand to provide whatever is demanded. The traditional rules about supply and demand are not operational when a nation with a population of over 1 billion and an ever-mounting amount of hard currency achieved from exports becomes a player.
The Trade Deficit
The Trade Deficit is, from my perspective, like the weather - there is little that can be done about it. The simple fact is that since the cost of labor is so small in
China, India, Mexico and Central America vast quantities of "stuff" will be made there because
1) the consumer seeks low prices
2) gigantic retailers have cut the supply chain to a very small size
3) transportation costs are so low. Containerized shipping, inexpensive international telecommunication, commercial air travel, the Internet and computer software managing the mating of supply and demand have served to make the world a very small place.
In fact, if anyone is threatened by the ability of the Chinese to provide a myriad of consumer goods it may be the EU that should be more concerned than the U.S. If the Chinese can manufacture a car that is perceived to be more like a BMW or Honda than a Hyundai there are going to be some auto plant closings in the EU
and Japan. China has the example of Hyundai to learn from. This car was perceived to be a low quality joke here in the U.S. and despite the vast improvement in quality is still not respected here.
The trade deficit is an inevitable effect of the disparity in labor costs. It is not going away any time soon but what are the consequences? In the long term the answer is not evident. In the short term what happens is that the Chinese wind up holding U.S Treasury debt. The Chinese are helping, in no small way, to finance the undertakings of the United States government. What would Chairman Mao think if someone told him that the Chinese are enabling the U.S. to simultaneously
lower taxes here and fight a preemptive war in Iraq? Strange times.
The Chinese are becoming our de facto economic ally. Their interests and ours are becoming coincident. They provide stuff. We consume in and send them debt - a promise to pay back that money in the future. Unless I am missing a big piece of the puzzle, that encourages peaceful coexistence.
The consequence is that manufacturing jobs are lost here. There is little that can be done to stem this. We need to make sure that a greater portion of our population
is trained for the service-sector jobs that now make up 80% of the economy.
One important point is that the Chinese currency is pegged to the dollar so the effect of a declining dollar has had no impact on the price of Chinese goods.
It is interesting to note what can happen when the dollars that wind up abroad are "repatriated". If you are a foreign company with a ton of dollars you have
an initial choice to make: do you go to your Central bank and exchange them for your local currency or do you purchase U.S. Treasuries on the open market?
If the dollars are exchanged for local currency the decision now is passed to that central bank. They can either create more of their own currency to provide
for the demand of the dollar-exchangers or they can go to the Foreign Exchange market and trade the dollars for their currency. Theoretically, the creation
of local currencies to exchange for dollars can create inflation in those countries if trade barriers exist and that large supply of Chinese goods is not allowed in.
Conclusions
The twin deficits are not related. The budget deficit can and should be fixed. Either tax increases are in order or Congress and the administration need to get the Federal Reserve more involved in fiscal policy.
The trade deficit is an effect of America's wealth and the low price of labor elsewhere. The hope should be that we are helping economies all over the world to advance
from poverty.
Should we worry about the twin deficits? We should be concerned about them. We should encourage fiscal policy to reduce the budget deficit. The trade deficit will be a problem if it causes continued erosion of the dollar or a demand for higher Treasury yields.
The fall of the dollar has been deliberate and orderly. If the dollar continues its fall and interest rates rise considerably there is some concern that the housing market
could be hurt. Higher rates would translate into fewer sales and defaults. This might result from people who had adjustable rate loans and did not strategize for a high
rate scenario. Serious levels of defaults could threaten the banking system. This is not likely to happen but being concerned about things not likely to happen sometimes
keeps them from happening.
The dollar is still the most respected currency in the world and may be seen as a bargain at present Forex prices.
Dick Lepre
I do not believe the notions of raising taxes will increase government receipts and lowering taxes will lower government receipts. Dick mentions these ideas as if they are givens. We cut the capital gains tax rates and the government revenues from capital gains has dramatically increased. Same goes for the Bush tax cuts he refers to. We do not have a lack of government revenue problem. Tax revenues are higher than any point in history and continue to increase even when we cut tax rates. The problem, as I see it, is Washington's insatiable desire to increase non-discretionary spending (Medicare drug benefit, Medicaid, Social Security, etc.) Raising tax rates will not bring more revenue to the government and will not fix the fiscal problem we are in. Imagine Bill Gates or Warren Buffet in a cash flow cruch (I know, you really have to stretch here). Would we advise they need to increase their incomes to cover rampent spending sprees? No, they don't need to earn more. It makes a whole lot more sense to tell them they need to spend less.
Posted by: Dcomp | April 03, 2006 at 12:51 PM
I agree that this problem is complex. What my proposal (http://www.loanmine.com/rw499.html) does is to let Congress do the spending but to create a Fed-like entity to set tax rates. This entity would be chartered to do what is best for the long-term interests of the economy. That might be to lower taxes. That might be to raise taxes. I am in no way suggesting that tax increases are always the way to offset deficits. I am most certainly suggesting that I have no confidence that politicians can make this decision. The hope is that such an entity can have the same success with fiscal policy which the Fed has with monetary policy.
Posted by: Dick Lepre | April 04, 2006 at 12:31 PM