Yankee Dollar Blues: How Will the Us Correct Its External Deficit?

Listener: 12 March, 2005.

Keywords: Macroeconomics & Money;

Underneath much of economics is the notion of “homeostasis”, the tendency to respond to an external shock by adjusting internally to maintain equilibrium. So a surge in demand for a product results in its price rising, reducing the amount demanded and increasing the amount supplied.

Indeed, the argument among economists about the Depression of the 1930s amounts to whether there was homeostasis so that unemployment was a transitional phenomenon, or whether there was no significant self-correcting mechanism so that an external adjustment, such as increased government spending, had to be imposed.

Today the worry is the falling US dollar. Is there an automatic mechanism to correct the situation or, perish the thought, is the situation more pathological?

The external shock that has caused the falling dollar was the Bush administration’s cutting of taxes, switching the US Government from being a saver running a budget surplus, to a borrower running a budget deficit. The US economy became a major net borrower from the rest of the world, spending more than it produces. This gap between expenditure and production is covered by additional importing. The resulting deficit in the current external account is covered by foreign borrowing.

In most economies, foreign borrowing pushes up the exchange rate, as we saw in the 80s when the Rogernomic policies involved substantial budget deficits. However, the US dollar is the international currency, so when the US borrows offshore, the increased competition for the available funds pushes up the exchange rates of other economies, and the US dollar falls relative to them.

Homeostasis, if it is to happen, requires a reduction in the US savings deficit. There are some additional savings as the US economy expands, but apparently not enough. Any increase in private savings has been overwhelmed by greater private investment, as firms increase capacity to meet the expansion. The increase in tax revenue as the economy expands has been insufficient to offset the tax cuts.

Are there any other self-equilibrating mechanisms? Under Alan Greenspan, the US Federal Reserve has been lifting its interest rates. If it lifts them far enough – ouch! – that might encourage people to save rather than spend, although the effect is likely to be small. The larger effect is that higher interest rates discourage investment, so there is a need for less savings. (This is the channel the Reserve Bank of New Zealand relies upon to restrain demand.)

US interest rate hikes could be a remedy, but that would be painful to the whole world. There are likely to be complicated effects as other countries raise their rates to compete for the world’s savings, so no one knows how high the interest rates may have to go. Rates may be being lifted too slowly, and the world will wallow in disequilibrium for some time, making the eventual adjustment very painful.

Some journalists say that the lower US dollar will encourage exporting and reduce importing, while the opposite occurs elsewhere in the world, including here. But that does not resolve the US savings shortage. One possibility is that the falling dollar will raise US domestic prices as their prices for exports and imports go up. The US external sector is only a third proportionally of what it is in many countries, so the inflationary pressures (and hence the inflationary self-correcting mechanism) from exchange rate depreciation are not so high. When they come into full force, the outcome could be internationally explosive.

There is at least one further major complication. Thus far I have treated the US here as if it is a lone economy. Currently, some Asian economies – especially China – have maintained a fixed exchange rate with the US dollar, and invested their savings in US bonds. In effect, the US tax cuts are being covered by loans from Asians, but only temporarily, because the lending will have to be redeemed. We don’t know how long this financing arrangement will go on for, and we know even less about what will happen when the Asians change their strategy. An inevitable outcome must be that the European currency, the euro, will become more prominent in inter-national finance. As the Chinese say, “May you live in interesting times.”