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May 11, 2005

The U.S. Current Account Deficit: How Big Is Sustainable?

Today's trade report for March (and revision to the February data) was obviously some welcome news.  From MarketWatch:

The U.S. trade deficit narrowed unexpectedly in March on a surge of exports of capital and consumer goods and farm products, the Commerce Department said Wednesday.

The deficit narrowed by 9.2% in March to $55 billion. This is the lowest trade deficit since last September and the largest monthly decline since December 2001. The narrowing of the trade gap was unexpected. The consensus forecast of Wall Street economists was for the deficit to widen to $61.2 billion...

The trade gap in February was revised down to $60.6 billion compared with the initial estimate of $61 billion.

The timing was great for the latest Chicago Fed Letter, penned by staff economist by Michael Kouparitsas, titled "Is the U.S. current account sustainable?".  Michael starts by noting that, when talking about the current account deficit you may as well be talking about the trade deficit.  In fact, you may as well be talking about the deficit in manufactured goods:

Current_account   

With that in mind, here is the definition of sustainability:

When economists want to assess sustainability of the current account, they begin by calculating the net exports to GDP ratio that would be required to maintain the current net foreign assets to GDP ratio, NFA*. I refer to this as the critical net exports to GDP ratio, NX*. Net exports to GDP ratios above NX* will increase the nation’s net foreign assets to GDP ratio above NFA*, while net exports to GDP ratios below NX* will decrease it.

NFA refers to the U.S. net foreign asset position: The value of assets owned by U.S. residents held abroad (A) minus the value of U.S. liabilities to the rest of the world (D) is called the U.S. net foreign asset position (NFA). If its net foreign asset position is positive (NFA > 0), the U.S. is a net creditor to the rest of the world. Conversely, if NFA is negative (NFA < 0), then the U.S. is a net debtor because its outstanding liabilities to the rest of the world exceed its claims on the rest of the world.

The connection between the current account deficit and our net foreign asset position is pretty straightforward.  The important thing to recognize is that foreigners do not provide us with more goods than we provide to them out of the goodness of their hearts. They do so because they expect to be paid back sometime in the future, and they collect promises to do so in the form of financial assets – like Treasury securities -- that pay off in dollars. A current account deficit therefore means that U.S. citizens are increasing their indebtedness to foreigners. 

The article contains a detailed explanation of the Kouparitsas' calculations, but here is the punch line:

Regardless of the method used to calculate it, the size of the net exports deficit that would allow the U.S. to maintain its current level of international indebtedness as a percentage of GDP is well below that of the current net export deficit. My estimates suggest that the U.S. net export deficit must fall by 3% to 3.5% of GDP to maintain the current net foreign asset to GDP ratio. However, I also note that if the U.S. continues to enjoy relatively high rates of return on its foreign assets, the resulting net foreign income surplus would allow it to run relatively large net export deficits without much change in the net foreign asset to GDP ratio.

It's an excellent and timely article -- I highly recommend it.

UPDATE: You will certainly want to check out pgl's critique at Angry Bear, as well as Brad Setser's in the comments section.  (Brad also has his own post on the trade news.)   
Kash has a post of his own at AB (all of the above being noted by Calculated Risk).  Michael Mandel has his say too (although pgl tries to straighten him out as well).

Elsewhere: The Prudent Investor smells a rat.

UPDATE, THE SEQUEL: William Polley decides, quite sensibly, that the confidence interval around his trade-deficit point estimate has increased.

UPDATE, THE THIRD: The Capital Spectator parses the report.

UPDATE, THE FOURTH:  General Glut smells something fishy, which I guess is something like smelling a rat.

May 11, 2005 in Data Releases, Trade Deficit | Permalink

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Listed below are links to blogs that reference The U.S. Current Account Deficit: How Big Is Sustainable?:

» More on trade deficits from Economics Unbound
David Altig has a nice piece about the sustainability of the trade deficit. He fails to note, however, that the deficits are sustainable as long as U.S. wealth, net of debts to foreigners, continues to grow--which it has been doing... [Read More]

Tracked on May 11, 2005 6:11:20 PM

» Trade deficit: good or bad? from Half Sigma
David Altig says the trade deficit is bad. “[F]oreigners do not provide us with more goods than we provide to them out of the goodness of their hearts. They do so because they expect to be paid back sometime [Read More]

Tracked on May 13, 2005 1:19:36 PM

Comments

excellent article indeed. There seems to be an editing error in box 1 where GDP and GNP are confused, or did I miss something entirely?

Posted by: godement | May 11, 2005 at 10:55 AM

I rather like some of the contrarian thinking on the trade deficit over at Cafe Hayek.

http://cafehayek.typepad.com/hayek/2005/05/investor_nation.html

Additionally, I do find the dynamics of this subject to be complicated. Apple's iPod is manufactured overseas (i assume this shows as an import), but once here is sold at a profit (that goes to Apple) - and creates value through additional iTunes purchases and a nice accesory market. That dynamic seems like a net positive to me.

Posted by: Mcwop | May 11, 2005 at 11:00 AM

This reminds me of Michael Darby's Pleasant Monetarist Arithmetic as it derives what would appear to be a strange result - that being a nation in debt can run non-interest deficits forever. He does so by making the assumption that the interest rate on debt is no greater than the steady state growth rate AND the return to financial assets is greater than the cost of debt. Both assumptions strike me as very odd for a steady state model.

Posted by: pgl | May 11, 2005 at 01:46 PM

Wow -- You all at the Fed really do like putting out don't worry, be happy, big deficits are sustainable kinds of pieces (see the Economist two weeks ago) -- or at least articles that have that kind of spin. usually 6% of GDP (or more, depending on whether the current monthly trade number is a blip) elicits a bit more concern. I have not worked through all the math in the appendix -- the methodology differs ever so slightly from the methodology that I have used in the past by breaking out returns on US and foreign assets. But i have a pretty good sense of what is going on. Before going into my critique, let me first note upfront that some of the "trade deficit is not sustainable" crowd have also calculated that a deficit of around 1% of GDP in the trade and transfers balance is potentially sustainable if (and it is a big if) real growth continues to exceed the real interest rate on US net foreign assets (we calculated a net interest number rather than seperate assets and liabilities, but it should work out to be the same). However, rather than saying everything is fine if the deficit falls by just 3% of GDP, we looked at the 04 deficit in trade and transfers (5.9% of GDP) and SAID, oh my god, the needed adjustment even in good scenario is 5% OF GDP, and if that happens slowly and gradually, the US net debt stabilizes at above 50% of GDP. Same numbers, different spin.

critique follows

Posted by: brad setser | May 11, 2005 at 04:14 PM

Critique.

1: Why aren't you using the 04 trade deficit numbers and estimated 04 NIIP (try 2.9 trillion, market value, may be a bit less). Bernanke has used $400 b plus in estimated valuation gains for 04 in a public setting. using the 03 deficit numbers understates the size of the adjustment needed to get nx back to levels most of us would agree are sustainable.

2: I don't buy using long-term returns to estimate future returns. let's leave aside the question of valuation/ equity premum, etc. Baseline assumption: net usually debtors have to pay a bit more, so as net debt to GDP rises, int. rates rise a bit. data from the days of the us as a net creditor may not be so applicable going forward. admittedly this has not happened yet. But the low realized return on foreign FDI in the US (if it is not a fiction created by tax accounting) does seem to have reduced FDI inflows into the US ... why should anyone invest in US unless you think you will get a higher return going forward?

3: recent returns on us assets and liabilities seem well, well below the long term average. moreover, the current payments on US net debt are v. low b/c of current us interest rates. even if long rates stay constant, they should rise a bit along with the rising short-rate. Overall returns of foreign investment in usa by calculations fell from 3.6% in 00 to 2.4% in 03 -- and probably rose a bit in 04 -- that is driven largely by steep falls in the returns on treasuries (realized) and on portfolio debt and bank deposits (realized). you need some view on how those rates are likely to evolve as US net debt rises ...

Roubini/ Setser assumption was foreign returns in US (in $ terms) converged with US returns abroad (in $ terms) as US debt levels rose ... we could jazz up our model to include equities and some overall rise in US net equity (with higher return) every year b/c of sustained net equity outflows from the US ($200 b a year recently). But sustained net equity outflows hardly seems consistent with continued strong US growth. And even with that adjustment, which would generate a slightly lower estimated return on us liabilities v. us assets and thus a lower realized real int. rate on the US net debt position, so long as you think the returns on US debt cannot stay at the current level, the income balance will turn increasingly negative barring an enormous surge in US FDI returns (and that likely would require a surge in growth in europe ... which would make it hard for usa to attract financing for its deficits at current rates ...).

4: I about when into seizures when i read the valuation adjusted current account deficit in 2003 was only 1.7% of GDP, close to sustainable levels. I don't doubt for a second the impact of valuation gains in 03/04 -- but picking 2003 as your example warps the analysis. valuation losses were $118 b in 00, $345 in 01 ($ rising v. Euro), and then we got gains of $236 b in 02 and $432 b in 03 and something similar per Bernanke in 04 ($ falling v. Euro). Bottom line -- unless the $ falls every year against the euro by 10% or more, you won't see similar valuation adjustments in the future. US assets in asia are comparatively small. Focusing on 03 is INTENSELY misleading without some analysis of whether those kinds of valuation gains (and losses for US creditors) are sustainable.

And to be honest, finding the currency composition of US external assets and figuring out the conditions needed to generate comparable valuation gains going forward is not that hard to do -- i can give you all a few references (hint: Helene Rey, 04, has a decent estimate)

Posted by: brad setser | May 11, 2005 at 04:35 PM

Loved your critique - in particular point #2. It is the core of what I just posted over at Angrybear.

Posted by: pgl | May 11, 2005 at 04:49 PM

pgl -- no shock,i liked your post.

and to my friends at the fed -- i like the idea of decomposing us NFA position into assets and liabilities and equity and debt and breaking out seperate return assumptions and then working that back into the external debt sustainability equation.

but if you want to engage with the critics, you cannot focus on 03 when US interest payments were very low relative to gross US liabilities and US assets had unusually large valuation gains for very explanable reasons ($/ euro move) that are unlikely to repeat themselves. or at least recognize that you are picking the year that is most favorable to your case ... and explain why 03 is likely to repeat.

Posted by: brad setser | May 11, 2005 at 07:03 PM

pgl and Brad --

It seems to me a reasonable steady state is one that implies dynamic efficiency, so the relevant condition is that the rate of return to risky capital exceeds the growth rate of the economy. The real return on relatively safe government debt is almost always less than the growth rate of the economy. (This point was made some years ago by Larry Summers and co-authors.)

As for not being convinced that the last two decades are not useful guides to future interest rates, fine, but I'm not much convinced by the mere assertion that it should be otherwise. For one thing, real interest rates have not been especially low over that period. For another, we have been a net debtor, let's see, FOREVER! (OK, let's make that thirty years.) Sure we are in uncharted territory here, but as you know there are quite a few of us (I don't think we're all in the Fed) that believe at least some of this is because international savers don't have a lot of good options at the moment.

As for the NFA issue, I don't think Michael's point is that the revaluations will persist indefinitely. But if they happen and are not reversed -- which he claims (and I'd listen to contrary arguments on that) -- it changes the inherited debt, which factors in.

As always, I am as amazed at your pessimism as you are by my optimism. That said, I offer yet again my gratitude for the ever insightful critiques.

Posted by: Dave Altig | May 11, 2005 at 09:04 PM


by "international savers" do you mean central banks? Ok, that is less true this year than in 03/04, but the share of the global current account surplus that shows up in central bank balance sheets is kind of impressive. I am working on a rebuttal to that argument; i better put it up soon. we don't know if China would be as large a net source of spare savings as it is now (in the face of very high levels of investment) if the PBoC were not buying $300 b of fx. Global savings is flowing into china, not out of it -- the same push factors bernanke sites in the US could have generated a current account deficit there if allowed to operate, i assume.

in any case, the 03 real return on Treasuries was negative in $ terms (Milati-Ferretti and Lane, 05, forthcoming last i checked) have good data on this,not just below the US growth rate. And I don't quite see why we should assume going forward that the "return rate on risky (equity) capital" on foreign investment in the US is well below the growth rate of US the economy (look at recent realized returns on FDI in the US; they are insanely low) in dollar terms, let alone "home" currency terms, while the return rate of risky (US) equity capital abroad will be well above foreign growth rates (10% plus returns on investment that is mostly in europe? we must know something the european do not). Yet that implicitly seems to be what is built into a future will be like the past projection.

Now it is true that equity constitutes a higher share of US assets abroad than of foreign assets in the US. But foreigners also hold more claims on the US than the US holds claims abroad. Net equity was about flat (slightly negative in 01/ slightly positive in 02) before the surge in valuation in 03, and it will get bigger in 04 (probably close to 1.2/1.3 trillion -- gotta love the $/ euro; by the way, net equity at current exchange rates would be back below 1 trillion -- 1.28 is a lot lower than 1.35 ... ). but net debt is going to be in the $4.2 trillion range at the end of 04. so for the numbers to work, the returns on gross US equity holdings abroad in $ terms have to be substantially higher than the $ returns on foreign equity holdings in the US. If that is the case, why should foreigners be willing to hold on to US equity assets (lower returns/ currency risk)/ let alone add to them?

I worked on argentina at one time in my life. They loved to argue: a) external debt doesn't matter with a currency board, nor does ext debt to exports and b) the had lots of external assets so their net position was not as bad as the gross liability position looked. Even according to the Chicago fed analysis, the trade deficit needs to decline by about 3% of GDP. Presumably that implies a dollar decline. Presumably foreign investors can anticipate such a decline and will demand compensation as well. Yet the baseline assumption in all these forecasts is that foreigners will continue to accept low returns on us assets year after year in dollar terms, not to mention their home currency terms, and keep adding to their dollar portfolio. To me, that doesn't seem 100% plausible -- even if has happened in 03 and 04.

finally, my previous comment was typed in haste and i clearly did not proof read it --I'll happily send you corrections if you can post them in now that you are highlighting it, or feel free to clean up the obvious type-os ...

Posted by: brad setser | May 11, 2005 at 11:11 PM

Hi Brad --

I don't think anyone is disputing that the "global savings glut" is intrinsically wrapped up in the policies of developing country governments. The difference of opinion -- which can't be adjudicated by evidence at the moment -- is what policies are most at issue, and how fast they are likely to unwind. My guess is that a revaluation or managed float of renminbi won't, of itself, be sufficient to eliminate our capital inflows. I think you agree,but believe that would be the first step in a chain of events that will bring the whole business crashing down. That's where we depart.

I just don't buy any comparison to Argentina. I don't dispute the possibility of dollar depreciation as part of the adjustment process. From the beginning of 1985 to the middle of 1988 the dollar depreciated by about 30%. We are about 14% below the peak in the beginning of 2002 at this point. Unless it happens all at once, is another 15% (this is just a hypothetical number, of course) all that scary?

On the '03 figures you object to, it's still my impression that they affect the initial conditions in the calculations, but not the assumed rates of return going forward, which are based on a longer and (as I argued before) probably not particularly low average. However, I could be wrong. The sensible thing to do is just to ask Michael if he would like to respond, which I will do.

I'd be glad to make any edits you'd like on your previous comments -- just send them along. I know this is like a broken record, but I really do appreciate your views on these things. I never fail to learn a lot. Heck, maybe someday you'll even convince me.

Posted by: Dave Altig | May 12, 2005 at 06:24 AM

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