Chairman Greenspan: Do Not Worry, Be Happy

The Chairman gave policy makers a green light not to worry about the US current account deficit: the dollar’s existing fall will lead the deficit to turn around. The Chairman’s remarks also seem to have given markets reason not to worry about the US deficits either: the dollar is now at a three month high v. the euro. The maestro can still move markets.

At least the renminbi is moving in the right direction for restoring global balance. If China wants to move toward a basket peg, now is a much better time than the end of 2004 ...

What stands behind the Chairman’s argument that "market pressures, which appear poised to stabilize and over the long run possibly to decrease the U.S. current account deficit and its attendant financing requirements," other than his (optimistic?) assertion that "the voice of fiscal restraint has regained volume"? Two things: First, he expects the long anticipated impact of the dollar’s 15% real fall to start to appear. European firms have reduced their margins to protect their US market share, but they won’t be able to do so for much longer. Second, Greenspan seems to think the US household saving rate is likely to rise, slowing the pace of growth in consumption and imports.

Maybe.

But I would qualify the Chairman’s argument in several important ways. It still seems to me more likely that not that the 2005 trade and current account deficits will be substantially larger than the 2004 deficits, and extremely large on any absolute scale.

1. So far, all the talk about controlling the budget deficit has been just that, talk. Actual deficits keep getting bigger. I have yet to see strong evidence that this is changing: Edmund Andrews is right: it is impossible to make a serious dent in the deficit if the only non-defense, non-homeland discretionary spending is on the table. Something like $15b billion in cuts is a start, but it won’t close the structural gap between what the government collects in revenues and what is spends - and there is not much evidence that the Republicans in Congress are willing to go along with the President’s proposed cuts. The FY 2009 numbers matter a lot less than the FY 2006 estimate -- $390 billion without the war. (See Nouriel for more, much more)

2. If the government balance remains a negative 3.5% of GDP, the necessary condition for limiting the current account deficit is for private investment to fall, or private savings to rise. Greenspan emphasizes that private saving is likely to rise; households won’t borrow as aggressively against their rising household wealth, and higher prices on European imports will restrain spending. In broad terms, US consumers won’t be able to tap their existing home equity to buy a new Mercedes. Perhaps. That is certainly one possible way for the current account adjustment process to begin. But I don’t think there is much evidence that this has started to happen yet. US consumption growth was quite strong in q4.

3. These broad macroeconomic trends - strong consumption led growth leading to a fall in the household savings rate and an uptick in private investment - show up in the trade data. Import growth has been strong recently. Y/Y non-oil imports are up 13%; exports are only up 10% (looking at the last three months of 2004 v. the last three months of 2003). Net out rising import and export prices, and import volumes grew at 9% and export volumes at something like 6%. Those numbers are consistent with a widening trade deficit: 10% y/y growth in BOTH import and exports leads the deficit to widen by about $50 billion (in savings and investment terms, import growth in excess of nominal GDP implies either rising investment and strong capital good imports, or a fall in savings and rising consumer good imports).

4. The US is starting 2005 in a weak position, trade deficit wise. The trade deficit likely averaged $58 billion a month in q4 2004, v $46 billion in q1. Extend out that monthly trade deficit and the 2005 trade deficit would be about $695 billion. If oil averages $41 a barrel in 2005, the same as in 2004, the US oil import bill would still rise by about $10 billion from rising volumes. That produces a $705 billion trade deficit. Add in $80 billion transfers deficit, and income deficit of say 20 billion (both from higher payments on our existing stock of debt as short-term debts are refinanced at higher rates, and from paying say 4% interest on the $650 billion the US added to its debt in 2004). That generates a current account deficit of $805 billion if the monthly trade deficit stops deteriorating, and quarterly trade deficits stay at their q4 2004 level through out 2005. Even if the quarterly deficit peaks in q1 2005, the annual deficits in 2005 - and 2006 for that matter - will remain much larger as a share of GDP than the 2004 deficit.

5. If nominal imports grow at 10% and nominal exports grow at 6%, that would add $35 billion to the trade deficit that comes from just extending out q4 2004. If oil prices stays at around $46 a barrel, that adds anther $25 billion. It is quite possible the 2005 trade deficit will exceed $700 billion substantially, pushing the current account deficit above $800 billion. Right now, it is far easier to find data suggesting that export growth is slowing than to find data that suggests non-oil imports are slowing. If you look at the monthly trade data, exports rose sharply to $95 billion in March of 2004, and then have fluctuated between $93-97 billion. There is not a clear upward trend after the end of q1. But if exports seem to have reached a plateau, monthly imports seem to keep on marching up. Here is another way to put it: If nothing changes, and monthly exports stay at their q4 rate (roughly $96.5 billion a month) and monthly imports stay at their q4 2004 rate (roughly $154 billion), imports will rise 5% in 2005 while exports will rise by about 1.5%. That is what I mean by momentum.

6. Unless something changes, I suspect the monthly deficit will creep above $58 billion the first part of 2005, so there will need to be a substantial turnout during the course of 2005 to keep the trade deficit from rising toward $750 billion (an average monthly deficit of $62.5 billion), and the current account deficit from rising to $850 billion.

7. If long-term interest rates stay at 4%, it is hard to see what prompts the US consumer to slow down. Greenspan may suspect that the consumption induced by rising house price will slow because he is taking away the recent monetary stimulus, but real long-term rate remain low. The message: borrow and build while you can.

8. Dollar weakness can easily be exaggerated - particularly if the most recent dollar rally is sustained. The US trades less with the countries that make up the major currency index that it once did (and it imports energy as well as manufactured goods from Canada), and US trades a lot with Mexico, China and the rest of emerging Asia. On a broad trade weighted basis, the dollar remains well above its level its pre-Asian crisis level. From 1990-1997, the broad dollar moved was in the high 80s or low 90s. Right now, the broad dollar is around 97. And it is worth remembering that the trade deficit tended to expand slightly over time even with the dollar at roughly 90 (on the fed’s broad trade weighted average). The dollar’s fall since 2002 will no doubt trigger a one off adjustment in the level of the trade deficit, but I am not sure that it is has fallen to the point where - at average US and world growth rates --- the trade deficit would tend to improve rather than get worse over time.

9. The broad dollar index overstates dollar weakness for another reason: the trade weights were set in 2000, and US imports from China have doubled since 2000. Consequently, the index underweights China. Chinese inflation exceeded US inflation in 2004, but since 1998, inflation rates in China have lagged inflation rates in the US - so nominal stability has not led to a significant real appreciation from inflation differentials either. [UPDATE: Rusty points out that the Fed updates the trade weights more frequently, so this point is off; I need to check if it holds for the JP morgan broad dollar -- Brad]

10. The initial effect of a Chinese revaluation would be to widen the US bilateral deficit from China, as import prices would rise faster than import volumes fell (or more realistically, import volume growth slowed) - the famous J curve. A 30% revaluation, for example, might push the bill for US imports from China up to $250 billion, for example. If Greenspan is right, we will also see the J curve with Europe this year as well: if prices rise on our roughly $210 billion in imports from the euro area by 10%, that would push our import bill to $230 billion barring an offsetting fall in the amount we import from Euroland. Such price adjustments are part of the adjustment process, but they also suggest the deficit will get worse before it gets better.

All in all Greenspan’s forecast seems to hinge on his sixth sense - import growth is set to slow. I agree that this HAS to happen at some point. But I don’t see signs that it is happening ... and the current combination of a rising dollar and falling long-term rates is hardly conducive to adjustment.