US economic policy makers - and, therefore, the rest of us - are in trouble. The sudden and extraordinary deterioration in the US government's finances has caught them off guard. The borrowing needs of the government now threaten to drive up the cost of borrowing, not only for the government, but for everyone else in the world as well.
In fact, interest rates have already risen, by 135 basis points over the last six weeks. This is a very serious concern because higher interest rates, if they persist, will choke off the refinancing boom in the United States that has fuelled consumption there for the last three years.
If consumption declines, the US and the global economy will go back into recession. The theory of "Crowding Out" seems to be reasserting itself. This article examines the vital role the US current account deficit will play in financing the US budget deficit.
Last year US current account deficit was $503 billion, an amount equivalent to almost 2% of global GDP. As strange as it may sound, US economic policy makers need an even larger current account deficit to help finance the US budget deficit without driving up interest rates.
That is because the larger the current account surplus of the United State's trading partners becomes, the more dollars their central banks will hold, and, more pertinently, the more dollars they will hold in US Treasury bonds. There's a catch, however.
American manufacturers, labor unions and, in increasing numbers, congressmen and senators are calling for the Bush administration to force China and Japan to allow their currencies to rise against the Dollar. The problem is, if that were to occur, the trade surpluses of those countries would decline, ensuring that the central banks of those countries had fewer Dollars to invest in US Treasuries.
This dilemma goes a long way toward explaining the confusing and ambiguous - even contradictory - statements being made by senior US officials regarding the relentless currency market intervention being undertaken by the Chinese and Japanese central banks to keep the Yuan and the Yen from appreciating against the Dollar. From the administration's perspective, given the huge scale of financing that will be required to fund the US government's budget deficits over then next two years, it truly is a dollar dilemma.
If the dollar does depreciate, foreign central banks will have fewer dollars to buy treasury bonds. In that case, interest rates may rise further and cause a global recession. On the other hand, if the dollar does not depreciate, the US current account deficit, now more than $1 million per minute, will continue on its present, near-exponential growth trajectory, but at the cost of heavy job losses in the United States, when further job losses are the last thing the Bush Administration wants to see going into an election year.
The speed and magnitude of the swing in the government's fiscal position has been breathtaking. The budget surplus in fiscal year 2001 came to $127 billion. The deficit for 2003 is now estimated (by the President's Office of Management and Budget) to be $455 billion. That's a turnaround for the worse of $582 billion over just two years.
On the bright side, the fiscal stimulus being provided by this deficit is supplying badly needed support for the economy. In the second quarter GDP numbers just released, the 25% year on year increase in federal government expenditure accounted for almost 1.6% of the 2.4% that the economy expanded during the quarter. There is no doubt that aggressive government spending will continue to help underpin the economy in the quarters ahead as well.
However, there is a grave and growing danger that all the benefit being generated by the budget deficit is at risk of being offset, or more than offset, by the impact that sharply higher interest rates could have on property values, refinancing activities and, consequently, consumption in the United States.
Policy makers certainly did not foresee such a sudden reversal in the government's fiscal position. Only a year ago, in the Mid-Session Review of the budget, the Office of Management and Budget forecast a deficit of only $109 billion for 2003, almost $350 billion less than their current estimates of $455 billion and even the current estimates may prove to be optimistic in the end.
In the second quarter, federal government expenditure amounted to $779 billion (annualized) or 7.2% of the total GDP. That represented a year on year increase of 25%.
The largest component of that expenditure was on national defense: $517 billion, a 44% increase compared with one year earlier and the largest increase since, at least, the Vietnam War. Personal consumption expenditure, however, amounted to $7,591 billion or 70% of GDP.
It expanded by a healthy 3.3% year on year; of course, in part supported by the surge in government expenditure. It was also supported by unprecedented volumes of equity extraction through home refinancing. The second quarter equity extraction figures are not available; however, according to a July 10 Financial Times article, "Refinancing hit a record $1,750 billion last year, which helped push total equity extracted by home owners to an unprecedented $700 billion in 2002, according to Fed estimates."
That sum, $700 billion, is not far short of the total amount of the federal government appears set to spend this year (see above). Freddie Mac, which naturally has an interest in downplaying the distorting role its aggressive lending is having on the property market and economy, offers what appear to be much lower estimates in a July 30 press release: "So far, in 2003, homeowners have converted about $50 billion of their home equity into cash, compared with $96 billion in the year 2002 and $83 billion in all of 2001, providing at least one leg for the sluggish economy to stand on over the last few years".
Personal consumption expenditure makes up a much greater share of US GDP than federal government expenditure. Since the stock market bubble popped in 2000, consumption has been supported by the refi-boom. Equity extraction has underpinned US personal consumption, personal consumption has held up the US economy, and the US economy, through its rapidly growing current account deficit, has fuelled the global economy.
In order for the refinancing boom to continue, however, US interest rates, or more precisely, US mortgage rates (which move in line with US government bond yields), not only have to remain low, but must, in fact, move lower to provide greater stimulus than the year before.
Suddenly that is no longer happening. Just as 10 year government bond yields have risen from a low of 3.1% in June to 4.5% in recent days, 30 year mortgage rates have surged from 5.21% on June 19 to 6.14% on July 31, jumping 50 basis points in the last two weeks alone.
The question arises, did that jump in interest rates occur because 1) the market believes there will be a strong recovery in the US that will soon push up inflation rates and interest rates; 2) because the Fed failed to cut interest rates by 50 basis points in the FOMC meeting of June 24/25 as the market had expected; 3) because Alan Greenspan told congress on July 15 that unorthodox monetary policy (i.e. buying 10 year treasury bonds to drive down their yields) would probably not be employed, undermining the "Bernanke Put"; or, 4) because on July 15 the Office of Budget and Management revised up its estimates of the 2003 US budget deficit from the previous estimate of $304 billion it made in February to $455 billion?
The answer is probably some combination of all of the above.
However, the two announcements on July 15 were particularly shocking in combination. Not only would the government need to borrow $150 billion more than previously estimated this year (and again next year), but moreover, the Fed was no longer promising to do whatever it took to keep interest rates from rising, even if that meant printing money to buy bonds (as it had previously hinted that it would do). It's not surprising that interest rates have jumped 50 basis points since then.
Now what? If interest rates stay at current levels, the refinancing boom will certainly end. If they move higher, property price might even begin to fall. Despite the aggressive fiscal stimulus being applied, either of those scenarios would have a seriously negative impact on the US economy.
For that reason, economic policy makers will be under a great deal of pressure to make interest rates fall again. The promise to use unorthodox monetary policy to drive down yields is likely to be revived. But will the market buy into the promise a second time after being burned once already?
The Fed may be forced to back up its words with deeds this time. However, it is not certain how well those untried and unorthodox policies would actually work in practice.
Given all this uncertainty about the direction of interest rates, it has no doubt occurred to officials within the administration that it could be very helpful all around if the US current account became even bigger than the record breaking 5% of US GDP it hit last year.
Again, the larger the US current account deficit becomes, the more dollars foreign central banks have to invest in US Treasury Bonds. Thus a strategy that allowed the US current account deficit to swell further could be exactly the thing needed to allow the government to finance its record budget deficit without pushing up interest rates and "crowding out" the private sector or killing off the property boom.
The reader might ask, "Isn't a half a trillion dollar current account deficit large enough to fund the $455 billion budget deficit?"
Here, the point that must be kept in mind is that up until now, the large dollar surpluses of the United States' trading partners were available to finance debt issued by other sectors of the US economy. During the peak of New Paradigm Bubble in the late 1990s, the US government temporarily enjoyed a budget surplus (leaving aside the issue of the unfunded Social Security program).
This was due to all the bubble tax revenues, mostly from capital gains taxes on stocks. During those years, 1998 to 2000, the government stopped selling new Treasury Bonds.
Yet that was also the period, following the currency devaluations of the 1990s, that the current account surpluses of our trading partners expanded very sharply, hitting $400 billion by 2000. Since there were no new US treasury bonds for those countries to buy with their dollar surpluses, they bought agency debt (Fannie Mae and Freddie Mac) and corporate bonds instead. That sparked off the property boom in the US and also facilitated the incredible misallocation of corporate credit at that time. It is no coincidence that the peak of the US economic bubble occurred when there were no new treasury bonds being issued to absorb the growing dollar surpluses of the United States' trading partners. In large part, that bubble happened because the rapidly growing dollar stockpiles of the surplus countries of our trading partners had to be invested in other kinds of US dollar-denominated assets.
How different the picture is today. The US budget deficit has swung from a large surplus to a record high deficit. It would be so much easier to fund that deficit if the US current account deficit widened by another $300 billion or so to, say, $850 billion (or 8% of US GDP). Then, there would be enough new dollars to finance the budget, to fund Fannie and Freddie, and to create a couple more Enrons, to boot.
How aggressively will the Bush administration pressure China and Japan to allow their currencies to appreciate against the dollar at a time when US funding requirements are exploding and interest rates have already shot up? "Not too aggressively" would be the clear cut answer if only US unemployment were not at a 20 year high and if only consumer sentiment were not being eroded by the lack of jobs.
The coming months are likely to prove a testing time for officials in the Treasury Department. Do they want the dollar to fall or don't they? They will have to choose their words carefully. Already, circumstances seem to have forced them to adopt Alan Greenspan's style of circuitous locution.
In the short term, it is difficult to guess what measures the administration will adopt in an effort to sustain the imbalances in the US economy: record budget deficits, record trade deficits, record low savings rates, the property/refinancing bubble. If China and Japan do escape having to revalue their currencies against the dollar over the next 12 months, they may have the administration's need to fund the budget deficit at low interest rates to thank for it.
Over the longer term, however, the outlook is much more certain. There is nothing than can prevent the imbalances in the US economy from coming unwound. Not even the United States can continue going into debt to the rest of the world at the rate of US$1 million per minute forever. The Dollar Crisis has only just begun.
Richard Duncan is the author of The Dollar Crisis: Causes, Consequences, Cures (Wiley: 2003). The book can be purchased by contacing Randhir Prakash at FinanceAsia on: (852) 21225228 or [email protected].
