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Roubini & Setser on "The US as a Net Debtor"

  • "The US as a Net Debtor" | Part 1
  • "The US as a Net Debtor" | Part 2
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    Roubini & Setser on "The US as a Net Debtor" | Part 1

    November 29, 2004

    Nouriel Roubini & Brad Setser, "The US as a Net Debtor: The Sustainability of the US External Imbalances" (PDF; courtesy of Brad Delong)

    For a long time economists have debated the implications of large debt, whether internal (from a long series of large government deficits) or external (from a chronic trade deficit). What has been lacking has been a rigorous method of estimating when the dam would break, or when the cell wall would rupture.

    So it seemed to me that it was an extremely urgent matter for macroeconomists to develop a rigorous, concrete method of establishing specifically what the tipping point was for these sorts of crises. I didn't know it at the time, but I wanted a method of applying national income and product accounting (NIPA) to the problem of asset evaluation, so that the actual effect of fiscal deficits/trade deficits on interest rates, employment, inflation, and future trade, would be knowable. The method employed of late is the concept of the country's net interational investment position (NIIP) as a sort of budget constraint (Taylor, 2004, PDF; HC), which includes external debt. When a country such as the USA runs a trade deficit, that deficit is likely to be rolled over into debt (US Treasury bonds, commercial paper, private debt, etc.) or equity (shares in US firms, holdings of real estate in the USA). Those holdings in the hands of non-Americans generate a steady stream of income-factor payments-that are added to the trade deficit and unilateral transfers (like foreign aid) to result in a current account deficit. In recent years, the huge deterioration of the US NIIP has led to the steep increase in net factor payments abroad, whereas in the past net factor payments from past US capital exports meant that the current account deficit was smaller than the trade deficit.

    The trade deficit of the USA has a role in predicting the future current account deficit, since the former must be financed in some interest-bearing form, thereby increasing net factor payments to non-US nationals. Suppose the USA were to suddenly reduce imports and increase exports by an amount so large that trade were suddenly balanced. The country would still run a current account deficit because of past current account deficits and their cumulative effect on net factor payments. Another issue to consider is the role of investment valuation abroad; frequently the value of US investments abroad increases faster than investments held in the USA. This, rather than "seignorage," is a tremendous boon to American affluence, since it causes the NIIP to increase much more slowly than the cummulation of current account deficits would lead one to suppose.

    However, in order to stabilize net external debt as a fraction of GDP, the US needs to reduce its trade deficit by an amount equal to 5 percent of GDP (about $550 billion; Roubini & Setser, p.5). If this were to happen, external debt would still be growing, but it would be growing at a "sustainable" rate. This statistic-the amount by which a country's trade deficit must shrink in order to stabilize its external debt-to-GDP ratio, is called the "resource gap." Stabilization can be achieved through three ways: (1), a decline in the real effective exchange rate of the US dollar against trading partners; (2) the adoption of an industrial policy that deliberately favors exports and discourages imports1; or (3), some secular increase in demand for US products, accompanied by a secular decline in US demand for foreign products.2

    Since neither Democrats nor Republicans have called for a coherent industrial policy, and since (3) is absurdly improbable, economists like Obstfeld & Rogoff (2004; PDF) and Roubini & Setser (above) have rightly assumed that (1) is the path to adjustment. O&R calculated that a devaluation of 40% is required for adjustment (on a trade-weighted basis, I believe this is a historically unprecedented amount. In contrast, Roubini and Setser speculate on multiple scenarios of adjustment to determine the most plausible levels of sustainable aggregate demand in the US economy.

    [JRM corrected the following paragraph in response to a comment by Prof. Setser. Originally I said that R&S had argued in favor of the twin deficits hypothesis]

    Neither Roubini & Setser nor Obstfeld & Rogoff argue in favor of the twin deficits hypothesis-a controversial idea that argues for a causal correlation between the large trade deficits and large federal deficits.3 On the other hand, they do not exclude the possibility that the twin deficits scenario applies to the USA at this time, either. They imply that the USA could "choose" among scenarios by reducing the internal deficit.

    (Part 2)


    NOTE: 1 The USA negotiated a trade pact-the Uruguay Round of the General Agreement on Trade & Tariffs (GATT) that created the WTO. Despite the immense potential negotiating power of Washington, the Uruguay GATT included some features that were highly inconvenient to the USA; so, for example, the USA was proscribed from nearly all methods it has employed in the past to promote exports and manage import volume, while EU member states were unaffected [* *]. Only the most egregious EU policies have been subject to WTO arbitration, such as outright bans on US products for unproven health risks.

    This means the USA can either unilaterally withdraw from the WTO in order to demand a new treaty-as demanded by US Democratic presidential contender Dennis Kucinich (an idea this website condemned in the strongest possible terms, BTW); or it can do what I recommend-which is, adopt European methods such as the value-added tax (VAT-exempt from the GATT) and parastatal ownership of oligopoloid firms. The most recent WTO rulings against the USA were for measures that contributed little or nothing to a coherent industrial policy anyway.

    2 This is somewhat far-fetched; the closest we've come was during the 1980's, when the telecommunications-information technology boom created a large pool of capital goods that were irreplaceable and US-made. Conservative commentators trying to dampen alarm over the burgeoning current account deficit insist that intellectual property exports like movies and recorded music, or GM technology, will offset the pandemic loss of manufacturing jobs. The idea is that American firms will hold so many patents that the US will have a monopoly on production of items for which the world has an insatiable demand. I, on the other hand, suspect that the reverse is probably true: American firms have been coasting on monopoloid rents so long that they are far worse at developing products that non-US nations "must have" than vice versa. Besides, the intellectual property protection pendulum has swung so far in our favor that it is bound to swing back.

    3 For the record, the USA has run very large deficits in both trade & current account, while the federal deficit has fluctuated; conversely, readers should understand that the current account deficit of the 1990's was probably caused by a boom in personal spending. In other words, if the Clinton Administration had not been accompanied by a wealth effect and speculative bubble, and if the health plan had been passed in 1994, then the declining federal deficit would have translated into a decline in the current account deficit


    Roubini & Setser on "The US as a Net Debtor" | Part 2

    December 12, 2004

    (Part 1; Roubini & Setser, "The US as a Net Debtor," PDF)

    In part one, I mentioned in passing the Twin Deficits Hypothesis, something that is apparently quite controversial. This is understandable; on the one hand, from a basic national income & product accounting (NIPA) perspective, it's almost tautological to say the current account and the government budget deficits are twins, since the current account deficit may be defined as the shortfall between domestic savings and domestic investment. If the government is running a deficit, then contrives to run a surplus, it logically follows that the saving rate has increased; the funds heretofore tied up in government dissaving will hereafter be available to replace foreign funds. Historically, this tautology does not hold:

    (graph from p.23 of Roubini & Setser; I modified it-JRM)

    As is obvious from the chart, for most of the last thirty years the internal and external deficits have been out of synch; no one expects them to be exactly the same, but one might suppose they would tend to move in the same direction. They don't. This led Edward M Gramlich to declare, "Budget and trade deficits - linked, both worrisome in the long run, but not twins" (PDF). Moreover, my initial reflex was to explain, "Well, listen folks, the private saving rate plunged when the federal budget deficit declined; the two movements essentially offset each other," which is true in the most recent episode (beginning in the Clinton years) but not for the other three, when investment also fell in close sympathy with private saving and government dissaving. So, to address this, I wrote a paper which I later redacted and posted here. Here I explain graphically how the ISLM dynamic responds to the movement of the IS curve to the right (in response to the internal deficit) leading to a new equilibrium. As the currency regime has changed over the years, the tendency has been for the ISLM equilibrium to respond differently. Unfortunately, my paper did not undertake to explain the impact that internal deficits in major trading partners would have.

    Readers may notice, if they review the links, that I attempted-as my professor urged the class-to include an aggregate demand/aggregate supply graph with the ISLM graphs. This was intended to help map out the effects of inflation in the ISLM model. The short answer is that the deficits are indeed twins, insofar as they have the same origin. For the USA, the role of the currency regime was different than it was in the case of, say, Japan or France-so neither mode and both modes of the Mundell-Fleming Model apply to our ISLM equilibria. However, the overall result was that, when the USA moved to an internal deficit, we also moved to a structural current account deficit, which might not be immediately obvious because of the artificial barriers to the US dollar's real exchange rate correction.

    The ISLM analysis of this situation as been ignored, I believe; I'm not sure why, but I suspect the reason is that there's little hope of actually getting a meaningful predictive effect because true general equilibrium analysis is very sensitive to slight adjustments; so, for example, if I set up an open economy macro equilibrium model of a few major trading blocs, I'm going to be dealing with some very complex issues relating to mapping out the positions of the IS and LM curves for different currencies under different conditions. And at the moment, there aren't very many economists publishing ISLM analyses of anything.

    In my opinion, this is an error; and while I think that Roubini and Setser's analysis is sound, I don't think it tells us anything about the impact of other internal deficits or the likely transition to sustainable trade patterns. That lacking, it doesn't really tell us very much that we did not already know; but I think it suggests where the frontier of research lies.

    OTHER web logS COMMENTING ON THIS PAPER: Credit needs to go to Brad DeLong's original post, with discussion thread; needless to say, when he said, "indispensable," I had my marching orders. (The Zig Zag) cites Alan Reynolds (a columnist at the Cato Institute), who argues that many countries like Japan, Germany, and France run internal deficits as large or larger than those of the USA, but run current account surpluses. I'm sorry, Mr. Reynolds, but there is a reason why we have something called "macroeconomics" and "microeconomics." In the USA, the tax structure, the nature of public spending, and other policy constraints ensure that the savings rate is very low. This part of the story is "microeconomic." In the other developed nations, microeconomic policy seeks to maintain higher levels of saving and higher exports. As for interest rates-Americans pay lower interest rates because the US dollar remains the foundation of international systems of reserves. We do not have a pure floating currency regime amongst the developed nations-national governments frequently intervene to protect exchange rates and their export markets. This means that an element of higher interest rates in smaller economies reflects less liquid markets for their domestic currencies, greater exchange rate risk for export industries, and less institutional resources committed to their defense. If the Canadian dollar skids, that's not a disaster for Japan or China; if the USD does, then it is.

    Sean-Paul Kelly (Agonist) links to Stephen Roach's article (Morgan Stanley), although like most it merely discusses the conclusion that the USA is headed towards external debt of 50% GDP. Mr. Roach is slightly misleading when he writes

    Reflecting an unprecedented shortfall of domestic saving - a net national saving rate that fell to 0.4% in early 2003 and since has rebounded to just 1.9% in mid-2004 - the US has turned to imported saving in order to finance economic growth. And since it must run external deficits to attract that capital, it should not be surprising that the US current account deficit hit a record 5.7% of GDP in 2Q04.
    That's not really so; the USA could run a current account surplus and a capital account surplus at the same time; we're presently running a deficit in both accounts, for a total balance of payments deficit of $750 billion (a point he mentions in the fourth paragraph, so I think he understands the point I made above).

    Asian central banks currently hold about $2.2 trillion, or 80% of the world's official foreign exchange reserves. As of year-end 2003, BIS data reveal that dollar-denominated assets made up about 70% of these reserves [...] Given the likelihood of persistent US current-account deficits, there is every reason to believe that Asian [...] reserves [of USD...] will have to rise sharply [...] Needless to say, should the dollar ever fall in the face of such a massive overhang of dollar holdings, portfolio losses - the functional equivalent of an enormous welfare decline of foreign creditors - would be staggering [...]

    A new-paradigm crowd now argues that these trends are a manifestation of a new world order. They refer to it as a new de facto Bretton Woods II Agreement - or a new "dollar bloc" zone that includes the dollar-pegged countries of China, Hong Kong, and Malaysia, along with "soft-pegged" economies such as Japan, Korea, and Taiwan. The argument is...that it is in Asia's best interest to keep funding America's current account imbalance....

    Mr. Roach proceeds to explain the problems with this concept, which to me should seem really obvious; namely, that the Japanese and Chinese central banks are throwing good money after bad, and worse, refusing to prepare for US insolvency; if they insist on relying on huge trade surpluses as the only strategy for maintaining moderate unemployment, then they're as silly as us Yanks. There are actually dumber public works projects than keeping 20% of your country's labor force employed making stuff for the wealthiest citizens of the richest country on earth, but I'm too busy to post about pure stupidity.

    Gil (MacroMouse) brings to my attention Robert Skidelsky's "US Current Account Deficit and Future of the World Monetary System." The article is mainly a political polemic; Skidelsky, who is trying to make a case for an anti-US conservative British nationalism, resorts to the usual conceit that the USA is a cohesive monolithic entity rather than a region where sectional interests clash. Lamentably, he makes an error opposite to the one made by the "libertarian" Cato Institute, viz., that there really is a direct correspondence between internal and external deficits (there is not; the "twin deficits theory," as I explained above, involves a complex relationship between the two that involves movements of the IS and and the LM curves, both of which are going to be affected by other factors.) What Skidelsky does not want to say is that the real reason public deficit-plagued France, Germany, and Japan don't have current account deficits is microeconomic: they have industrial policies and a VAT that ensures favorable trade balances with either the USA or 3rd world countries. Ostensibly this is a case for an international fixed currency agreement, but it features the old "bell-the-cat" dilemma: if the USA is both monolithic and malignant, it will simply reject the international peg unless it comports with our diabolical ends. If some Jonah converts the Ninevites (here, Yanks) to a responsible currency regime like pegs, then it would be far easier to convert those same Ninevites to fiscal probity-which we'd have to do anyway.

    Kash (Angry Bear) doesn't, to my knowledge, comment on this paper, but please see his "Greenspan on the US's External Imbalances." Bourse Review (PDF) discusses the paper briefly (p.1b-2a).