Discussion ofCurrent Account Fact and Fiction

by Backus and LambertNouriel Roubini

Stern School of Business, New York University

Is the US CA Deficit Unsustainable?

• Conventional wisdom: Yes• Backus-Lambert wisdom: NO• Shooting at “Straw Man” Hypotheses:

– U.S. deficits are unprecedented– Deficits are usually associated with fiscal deficits– Large deficits cannot last– Deficits are always followed by real depreciation– The US is living beyond its means

• Papers results mostly based on a number of simple correlations and charts. Interesting but not passing the test of formal economic analysis.

• The paper is a bit sketchy and unfinished.

Solvency Constraints

• IBC/No Ponzi Game Condition: Undiscounted sum of all CA balances must be equal to the initial stock of net foreign liabilities.

• Or discounted sum of trade balances must be equal to initial stock of net foreign liabilities

• US has a problem as in 2004 it had a 6% of GDP CA deficit and an equivalently large trade deficit

Unprecedented? Likely to last?

• Large deficits cannot last forever; adjustment can be sudden and painful based on many recent studies on emerging and advanced economies: Freund and Warnock (2005), Edwards (2005),Clarida et al. (2005), Milesi-Ferretti and Razin (2000), Kamin et al. (2004), etc.

• You can run large “surpluses” for much longer than “deficits” as in the latter case foreign financing may suddenly stop

• Persistent deficits are mostly prior to WWI and driven by investment booms

Unprecedented? Likely to last?

• Large surpluses in OECD countries may be driven by poor demographics; US may not be as bad as Europe or Japan but it should, on net, run CA surpluses not deficits given its long-run social security and health costs problems. Need for deeper analysis of this.

• US deficit is “unprecedented” in the sense that the while the US is the largest country in the world, it is also the largest net debtor and the largest net borrower ever. Superpowers tend to be net creditors and net lenders.

• All of the world, with few exceptions, is running a surplus while the US is running a persistent and growing deficit. Paradox of EMs lending to the US.

Practical Solvency Constraint

• Resource Gap: difference btw the current trade balance and the trade balance required to stabilize the external debt to GDP ratio:

• (r-g) D/Y = Required TB• Depending on assumptions on r and g U.S.

Resource Gap is 5% to 6% of GDP• Debt dynamics is real ugly under most

scenarios. How to stop this debt dynamics?

Sustainability of CA deficits depends on their nature/cause

• Intertemporal CA approach insights:– Deficits driven by productive investment are

good and more sustainable for longer– Deficits driven by unsustainable fiscal deficits

are bad and less sustainable over time– Deficits driven by unsustainable low private

savings may lead to a hard landing (US consumption rate is steadily increasing)

– So, whether a deficit is sustainable and for how long depends on its causes/nature.

US CA Deficits

• 1990-2000: Deficit driven by an investment boom (new economy) growing faster than increase in public savings

• 2000-2004: CA deficits worsens by 2% of GDP in spite of a fall on I/Y of 4% of GDP. Why? Public savings went from 2.4% surplus to a 3.6% deficit, a 6% of GDP turnaround.

Twin Deficits?

• Of 6% fiscal change 4.6% due to fall in revenues; 1.4% due to increase in spending (mostly defense/homeland security)/

• Tax revenues in 2004 the lowest in 50 years (since 1951)

• Structural fiscal deficit rather than cyclical• Of course, most of CA and fiscal balance

negative correlation (“twin divergence”) is driven by output shocks (business cycle). But controlling for that, exogenous fiscal shocks can lead to “twin deficits”

Are US consumers Ricardian? No

• Ricardian effects are consistent with twin deficits: tax-smoothing plus intertemporal CA model

• 2000-2004: not much change in private savings in spite of 6% fiscal turnaround

• 1992-2000: 5% fiscal turnaround with only modest fall in private savings

• Studies suggesting Ricardian effects do not include data on recent twin deficit episode or are based on dubious calibrated simulations.

Explanations of US CA Deficit in 2000-2005

• Fiscal: Twin Deficits• Global Savings Glut• Global Investment Drought• Bond Conundrum in 2004-05 has kept savings

low and investment higher, thus worsening the CA, but it depends on a number of factors:– FX intervention by central banks– Investment drought and some savings glut– Easy monetary policies– Technical/Structural factors

Financing of CA Deficit matters

• 1990s: Deficit financed by long-term equity/FDI from private sector investors

• 2000s: Deficit financed by short term debt flows from official investors (central banks)

• Myth: US CA deficit due to foreign investors wanting to invest into US high yielding assets and capital.

Financing of CA

• Until 2000: Net FDI/Equity Portfolio financing was a $200b surplus

• In 2003-2004: Net FDI/Equity Portfolio financing was a $200b deficit

• So, in 2004 on top of a $665 b deficit, US had to borrow in the form of debt $865 b because of negative FDI/equity flows

• 70-75% of deficit financed by foreign central banks ($500 plus in 2004)

Twin Deficit Financing

• 100% of US fiscal deficit is financed by non-residents

• 53% of all Treasuries held by non residents

• Average (marginal) maturity down to 55 (33) months

• Treausury financing needs in 2006: over $ 1,000 billion

US CA Adjustment: Orderly or Disorderly?

• With a CA deficit going to 7% of GDP, how can you reduce it down to sustainable 2%, i.e. a 5% CA and trade balance adjustment?

• If adjustment via fall in investment, recessionary effects• If adjustment via sharp fall in private consumption rate

and increase in private savings rate, also a risk of a recession

• Better to adjust via an increase in public savings (control spending, reverse some tax cuts)

• Given imbalance, slower growth may be inevitable by now.

CA deficit worsened in spite of US dollar fall in 2002-2004. Why?

• Not just J-curve• Not just oil shock• You need expenditure reduction in

addition to expenditure switching• If expenditure reduction does not come

from fiscal, it will have to come from a fall in private consumption and investment driven by a sharp increase in interest rates.

CA deficits and depreciations

• Overvalued currencies may cause large and growing current account deficits. So, in short run, CA deficits are not associated with depreciation, rather the reverse.

• But, at some point, overvalued currencies associated with unsustainable currrent account deficits will lead to large real depreciation.

• Typical examples: emerging market crisis. Similar association in advanced economies and the US. See other studies on current account reversals (Freund and Warnock (2005), Edwards (2005),Clarida et al. (2005), Milesi-Ferretti and Razin (2000), Kamin et al. (2004), etc.)

Recent literature suggest that CA reversals can be disorderly

• They are often disorderly in emerging markets• In advanced economies consumption and fiscal-

driven, as opposed to investment-driven, CA deficits are associated with reversals that lead to slower growth and larger real depreciations

• From a global perspective it is different to have a 7% deficit in a small open economy or in a very large sized open economy such as the U.S. Global implications of disorderly adjustment would be severe.

Living beyond our means?

• Yes, based on increase in net foreign liabilities. Solvency constraint must hold by definition. Consumption needs to fall as share of GDP

• Looking at household net worth rather than country’s net worth (debt) is misleading in terms of sustainability of external deficit

• After bursting of equity bubble, household net worth to C ratio was back to historical average while net foreign debt has been rising

• Recent increase in net worth to consumption is all driven by a housing wealth increase. Another bubble?

Deficit Grew as Investment Fell

US Savings and Investment

10.00%

12.00%

14.00%

16.00%

18.00%

20.00%

22.00%

1996 1997 1998 1999 2000 2001 2002 2003

% o

f G

DP

Savings Investment

Rapid rise in Debt Inflows

Debt flows needed to finance the current account

-400

-200

0

200

400

600

800

1000

2000 2001 2002 2003 2004

$ b

illi

on

Debt flows Equity flows Current account deficit

Current account deficit rises even if trade deficit stabilizes

Baseline

-2.00%0.00%2.00%4.00%6.00%8.00%

10.00%12.00%14.00%16.00%18.00%

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

% o

f G

DP

Trade Deficit Income Deficit Current account deficit

Trade deficit constant

-4.00%

1.00%

6.00%

11.00%

16.00%

2000

2002

2004

2006

2008

2010

2012

2014

% o

f G

DP

Trade Deficit Income Deficit Current account deficit

Need sustained fall in trade deficit to stabilize external debt to GDP ratio

• Sustained adjustment eliminates the trade deficit by 2015.

• Debt/GDP ratio stabilizes at 55%

• Current account deficit is still 5% of GDP in 2008, even though trade deficit is 3.7%.

Fast Adjustment

-2.00%0.00%2.00%4.00%6.00%8.00%

10.00%12.00%14.00%16.00%

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

% o

f G

DP

Trade Deficit Income Deficit Current account deficit

Bottom line: the current trajectory is unsustainable

US NIIP

0.00%

20.00%

40.00%

60.00%

80.00%

100.00%

120.00%

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

% o

f G

DP

Baseline Trade deficit constant Fast Adjustment

The implications of the current system

Asian financing of the U.S. external debt

0

2000

4000

6000

8000

10000

12000

2000

2002

2004

2006

2008

2010

$ b

illi

on

Asian reserves

Treasuries held abroad

US NIIP

Asian reserves --forecast

Treasuries abroad --forecast

US NIIP -- basline

Hard landing scenario in the absence of US fiscal adjustment

• Sharp fall of the dollar as foreign financing starts to shrink

• Sharp increase in US long-term interest rates as foreign financing of twin deficits shrinks.

• Fed forced to increase short rates to stem US dollar free fall and ensuing inflation

• Unraveling of carry trades and leveraged bets • Risk of a systemic crisis if an HLI collapses.• Sharp fall of other risky assets (equities, housing, EM

debt, high yield, etc.).• Sharp US and global economic slowdown or outright

recession