November 14, 2005
From the desk of Winterspeak:Real deficits
Alan Greenspan recently spoke about the US current account deficit where he says:
1) The US can run larger CA deficits than before because foreign countries are more willing to lend to the US than they used to be.
2) This is more about what foreign lenders want to do than anything the US can or cannot do. US (fiscal) deficit reduction would not change things much either.
3) Even thought the US CA deficit can be larger, it cannot expand infinitely. Eventually it will stop and rates will rise.
4) This adjustment will be smooth.
Angry Bear makes the bogus point:
These are familiar themes from earlier comments by Greenspan about the CA deficit. I was most disappointed about this line in his speech, however: "a discretionary reduction in our federal budget deficit would work toward narrowing the current account deficit but, if history is any judge, to an uncertain and possibly small extent."Firstly, the current US budget deficit is not structural. The structural aspect of the US deficit comes from entitlement programs and these aren't going to start blowing up for a few years now. Since the US government uses cash accounting, this imbalance does not show up now. Bush has done more to address these imbalances than any other president by 1) trying to shrink Social Security and 2) greatly increasing Medicare via the prescription drug benefit. The current US budget deficit comes from that fact that the government is spending more than it is collecting in taxes, but this spending is not being driven by entitlement programs.This downplaying of the importance of reducing the budget deficit strikes me as almost irresponsible from a central banker. The speech was a perfect chance for Greenspan to talk about the dangers inherent in the large and sustained structural budget deficit in the US.
Secondly, the link between the current account deficit is quite distinct from the budget deficit. One has to do with imports vs exports. The other has to do with taxation and spending. Their only link is the interest rate and in the US this remains extremely low. When (if) interest rates start to rise, the current account deficit will naturally correct as imports become less attractive. I don't see how this will impact US spending on entitlement programs -- which is what drives the structural budget deficit.
Update
Good comments all around. I want to point to this link by Dreck, detailing the domestic savings rate and the impact this has had on US growth. Essentially, domestic net savings has been falling since 92 and is deep in negative territory -- in other words, US spending is being fueled by debt.
Dreck notes that "foreigners as a group must continue to hold as many dollars as is necessary to balance the books, but the price (exchange rate) may change freely." To date, for their own reasons, foreigners have been willing to hold the neccessary number of US$ for cut price rates, which means that borrowing has been really cheap.
Posted by Winterspeak at November 14, 2005 5:25 PM | TrackBack | Technorati inbound linksThe current US budget deficit comes from that fact that the government is spending more than it is collecting in taxes, but this spending is not being driven by entitlement programs.
Winterspeak: what do you mean by this, exactly? It seems to me US federal spending is "being driven" by whatever components make up the budget. That is, if, say, 40% of the budget goes to SocSec and Medicare, and 22% to Defense, and 9% to interest on the debt (and so on), then it would seem to me that 40% of "this spending" is "driven" by SosSec/Medicare, and 22% is "driven" by defense, and 9% by interest on the debt, and so on...
I seem to have missed something here. Most of what is written above is in complete disagreement with what I read elsewhere regarding the US budget and finances as a whole.
To address my specific confusion, there is this section:
The structural aspect of the US deficit comes from entitlement programs and these aren't going to start blowing up for a few years now. Since the US government uses cash accounting, this imbalance does not show up now. Bush has done more to address these imbalances than any other president by 1) trying to shrink Social Security and 2) greatly increasing Medicare via the prescription drug benefit.
Regardless of the failure of the attempt to revamp Social Security, I do not understand how the Meidcare prescription drug benefit changes actually help improve the cash flow imbalance since from what I have read this change will increase the amount of money flowing out of government.
An increase in the money flowing out makes things worse, does it not?
Perhaps I have misunderstood something or encountered bad information. Clarification would be greatly appreciated.
Jack,
I think you're right. In addition, other mistakes in the post are
a) "Structural" from Angry Bear is meant as the opposite of cyclical. A "structural" budget deficit is a deficit that occurs at full employment. Structural is not used to refer to entitlement programs.
b) The current account is by definition equal to the capital account. The capital account is the difference between domestic savings and investment. The government deficit is a significant (negative) component of domestic savings. There is clear and significant link between the two deficits.
Tom
So you are claiming, Tom G, that if we graph the federal budget deficit against the current account deficit, we will discover a strong and statistically robust correlation between the two? That is untrue. Indeed, in other years, deficit hawks used to spout the "crowding out" hypothesis, that federal deficits suck up domestic investment capital, not suck in foreign capital. So which is it?
Questions for you all
1) The FX market is dominated by financial flows, not trade flows. If the US interest rates rise relative to world interest rates, wouldn't this cause a further inflow of capital and a stronger dollar (via. the monetary model.) Both greater inflows and a stronger dollar will stimulate imports.
2) Isn't the adjustment mechanism not so much a reflection of rising interest rates per se, but rather foreigners stopping the inflow of capital, which in turn causes a rise in interest rates (slowing down the economy) A slowdown in the economy hurts imports via the MPI (ie Y * MPI, lower Y leads to less imports).
I ask this because now that US interest rates are rising, we are seeing a stronger dollar, despite the fact that the current account deficit is huge.
THanks
Matt
"Bush has done more to address these imbalances than any other president by 1) trying to shrink Social Security and 2) greatly increasing Medicare via the prescription drug benefit."
In point (2), does "address" suddenly start to mean "expand"?
I believe there is a muddying of terms above. See the work of Wynne Godley, for starters. If the government and private sector are dissavers, foreign capital will by necessity fill the gap (at a market clearing price, of course).
It bears repeating - foreigners as a group must continue to hold as many dollars as is necessary to balance the books, but the price (exchange rate) may change freely.
Y81,
No, I am not claiming that. I do believe if you looked at a large sample of you would see a positive relationship between the two factors though.
In the long-run, I agree the primary effect of government deficits is to depress domestic investment. In the short-run though, they can drive trade deficits.
Which part of my argument do you disagree with? That the capital account = current account? The government deficits, at least in the short run, effect the capital account?
Tom
sammler -- the only president in modern times to srink the size of governemtn was Clinton.
Yow say Bush tried, but Clinton actually reformed welfare and massively cut the size of actual spending on entitlements.
the supply side side tax cuts promised to raise savings and investments. But nonresidential fixed investment -- capital spending -- peaked at 14% of GDP under Carter, fell through the Reagan terms and bottomed at 10% of GDP under Bush I befroe rebounding to 14% of GDP under Clinton and collapsing back to 10% of GDP under Bush II. Meanwhile, the savings rate has fallen from 15% when Reagan first implemented tax cuts designed to increase savings to the current negative levels.
The evidence says the supply side tax cuts have not worked.
The current account deficit has to equal the domestic savings -investment gap and interest rate spreads have to rise enought to attract sufficient foreign capital to fiance the deficit.
All the supply-side tax cuts have accomplished is to shift the US from the worlds largest creditor to the worlds largest debtor.
At the individual level, people are not saving enough for retirement or healthcare when they are older.
Could this be because people expect retirement and old-age health-care costs will be covered by Social Security and Medicare?
Are people making rational decisions based on government promises? Why save when you have "earned" Social Security? And when, as we all know, healthcare is free.
I am an accountant, but I've never understood why we should require business to report on an accrual basis and allow government to report on this goofy fund balance accounting system aka "cash". Admittedly I was weak on theory, (theory of accounting always struck me as similar to theory of dance; bullshit by another name.)
If the federal government were required to report on an accrual basis, then the public would be able to assess the true costs of legislation. We would not have discussion about deficits and/or surpluses that are all the result of estimation and whether we spend a dollar on September 30 or October 1.
Frankly, I find governmental accounting to be highly manipulative; in a way that would bring extreme censure if it was practiced by a publicly traded company.
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