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June 09, 2007

Like Ben Said

Calculated Risk makes an interesting observation:

The trade deficit, ex-petroleum, appears to have peaked at about the same time as Mortgage Equity Withdrawal in the U.S.

"Interestingly, the change in U.S. home mortgage debt over the past half-century correlates significantly with our current account deficit. To be sure, correlation is not causation, and there have been many influences on both mortgage debt and the current account."
Alan Greenspan, Feb, 2005

... Declining MEW is one of the reasons I forecast the trade deficit to decline in '07. And a declining trade deficit also has possible implications for U.S. interest rates; as the trade deficit declines, rates may rise in the U.S. because foreign CBs will have less to invest in the U.S.. This is why I forecast rates to rise in '07.

I think that CR has the causation running from the housing market to the trade deficit, but as always there is another interpretation.  I take you back to one of my favorite Fed speeches of all time, from the current Fed chairman:

What then accounts for the rapid increase in the U.S. current account deficit? My own preferred explanation focuses on what I see as the emergence of a global saving glut in the past eight to ten years...

The current account positions of the industrial countries adjusted endogenously to these changes in financial market conditions. I will focus here on the case of the United States, which bore the bulk of the adjustment...

After the stock-market decline that began in March 2000, new capital investment and thus the demand for financing waned around the world. Yet desired global saving remained strong. The textbook analysis suggests that, with desired saving outstripping desired investment, the real rate of interest should fall to equilibrate the market for global saving. Indeed, real interest rates have been relatively low in recent years, not only in the United States but also abroad. From a narrow U.S. perspective, these low long-term rates are puzzling; from a global perspective, they may be less so.

The weakening of new capital investment after the drop in equity prices did not much change the net effect of the global saving glut on the U.S. current account. The transmission mechanism changed, however, as low real interest rates rather than high stock prices became a principal cause of lower U.S. saving. In particular, during the past few years, the key asset-price effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported record levels of home construction and strong gains in housing prices. Indeed, increases in home values, together with a stock-market recovery that began in 2003, have recently returned the wealth-to-income ratio of U.S. households to 5.4, not far from its peak value of 6.2 in 1999 and above its long-run (1960-2003) average of 4.8. The expansion of U.S. housing wealth, much of it easily accessible to households through cash-out refinancing and home equity lines of credit, has kept the U.S. national saving rate low--and indeed, together with the significant worsening of the federal budget outlook, helped to drive it lower...

The direct implication, of course, was that the reversal of U.S. current account deficits would likely be associated with higher real interest rates, a weakening of foreign-capital financed investment, and higher saving in the U.S. (of which a slowdown in mortgage equity withdrawals could be a part). It is worht noting that Chairman Bernanke was decidedly less than sanguine about the consequences of such adjustments:

... in the long run, productivity gains are more likely to be driven by nonresidential investment, such as business purchases of new machines. The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be.

Whether or not Mr. Bernanke believes that we find ourselves in the process of meeting those burdens I cannot say.  But those who buy the global saving glut story -- as I do -- have acknowledged all along that the day of adjustment would look pretty much like it does at the moment.

June 9, 2007 in Federal Reserve and Monetary Policy , Housing , Saving, Capital, and Investment , Trade Deficit | Permalink


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There is actually an even simpler explanation:

1) Net foreign investment must equal the cumulative trade deficit (their dollars must by definition ultimately return to the US)

2) Foreign investment in the US can be assumed to be in all asset classes, since even if it is not their buying of one asset will make other assets more attractive to domestic investors.

3) Therefore, changes in net foreign investment must be equally offset by changes in net trade and reduced borrowing by US consumers must be accompanied by less spending on foreign goods.

It doesn't have to hold in any given year, but in the long run it is almost a mathematical identity.

Posted by: Trent | June 09, 2007 at 03:21 PM

According to Roach, there is no global savings glut, just a shift in the mix away from rich countries.

Posted by: BR | June 09, 2007 at 04:03 PM

The current account deficit may narrow because our demand for foreign credit weakens or because the supply of that credit weakens. In both cases, the implication for the dollar is that it declines, other influences held unchanged. However, the implication for interest rates depends critically on whether the reduced external borrowing reflects demand- or supply-side influences. A deceleration of MEW in resopnse to a less robust housing sector -- assuming it is even relevant -- would be a demand-side development and could not generate upward pressure on interest rates. Calculated Risk has this point wroong.

Posted by: Gerard MacDonell | June 15, 2007 at 01:58 PM

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