AMERICA’S TWIN DEFICITS

ROBERT SOLOMON

New problems lurk with their reappearance

The United States has a large and growing budget deficit and a related large and growing balance of payments deficit. Because of the importance of the United States in the world economy, these twin deficits raise major questions, not only for this country, but also for the global economic outlook.

The term “twin deficits” originated during the Reagan administration, when taxes were reduced and the budget deficit increased markedly. The balance of payments also moved into sizable deficit as the US economy grew faster than that of its major trade partners in Europe and Asia.

A similar scenario is unfolding at present. Although the US economy is growing faster than the economies of other industrial countries and its inflation rate is relatively low, potential problems lie ahead because of the twin deficits. On the budget side, both military and homeland security expenditures are increasing rapidly as a result of the war in Iraq and concern over terrorism. At the same time, the tax reductions proposed by the Bush administration and enacted by Congress are having their effect on government revenues. On the balance of payments front, US imports of goods and services continue to increase faster than exports, adding to America’s growing external deficit.

THE FEDERAL BUDGET OUTLOOK

The federal budget, which was in surplus in the last three years of the Clinton administration, has moved into sizable deficit—$413 billion for fiscal year 2004, or 3.6 percent of gross domestic product (GDP). About threefourths of the shift in the budget from surplus to deficit between 2000 and 2004 is the result of lower taxes. The remaining one-fourth reflects higher government spending. Assuming these tax cuts are made permanent and the Alternative Minimum Tax (AMT) is amended to relieve high-income taxpayers, the federal budget deficit is likely to continue for the next decade and to increase by about 50 percent, according to analysts at The Brookings Institution.

It should be noted that this projection differs from the estimates published by the Congressional Budget Office (CBO). The CBO is required to assume the current laws will remain in effect, including, for example, the expiration of the 2001 round of tax cuts at the end of this decade. But President Bush already has requested that those tax cuts be made permanent. Similarly, the AMT likely will be amended.

WHY IS A BUDGET DEFICIT A PROBLEM?

If an economy is depressed, i.e., operating below full employment and full use of productive resources, a budget deficit encourages recovery since it provides demand for goods and services by the government and enables those whose taxes are reduced to spend more. It should be noted, however, that lower taxes for those with the highest incomes are unlikely to lead to significant increases in consumer spending.

The US economy was depressed in 2001, when real GDP declined slightly (less than one percent) from the fourth quarter of 2000 through the third quarter of 2001. From then through the fourth quarter of 2003, real GDP increased by 7.8 percent. Economic growth was close to 4 percent in the first three quarters of 2004. Thus, a reasonably strong recovery has occurred.

Capital inflows from abroad, both private and official, cannot be counted on to continue indefinitely in sufficient volume to finance the external deficit.

Despite the economic growth, unemployment, which rose to above 6 percent of the labor force in mid- 2003, has fallen off only a little. The explanation for this is the remarkable rise in productivity (output per worker). From the bottom of the recession in 2001 to the second quarter of 2004, output per working hour in the business sector increased at an average rate of 4.4 percent, much more rapidly than in the previous five years.

Capacity utilization in industry is below peak levels. With both labor and industrial capacity underutilized, the economy still has some room to grow at a more than normal pace. The budget deficit, no doubt, is helping that process in the short run.

In the longer run, the sustainability of the US budget deficit is a serious problem. How is the budget deficit being financed? As usual, it is financed by the issuance of US government securities. The debt of the federal government, represented by securities, increases each year by roughly the amount of the budget deficit. But many of those securities have been bought in the recent past by non-US entities, especially central banks of other countries. The central banks of China and Japan are buying dollars—and selling their own currencies—in order to keep their exchange rates from rising. They invest the dollars so acquired in US government securities. Thus, one of the crucial questions is how long will it be possible to finance the budget deficit in this manner.

BALANCE OF PAYMENTS—THE OTHER DEFICIT

No economy can thrive in isolation, of course. One of the influences on a country’s balance of payments is how fast its economy grows in relation to the economies of its trading partners.While the US economy is growing rapidly, some of its major trade partners are lagging badly. In particular, the economies of the European Union (EU) are rather stagnant, growing by only 1.1 percent in 2003 and an expected 2.3 percent in 2004—similar slow growth in the 1980s was termed “eurosclerosis.” And from 1992 to 2002, Japan’s economy grew by only about one percent per year, but the growth rate picked up to 2.5 percent in 2003 and somewhat more in the first half of 2004. Until 2004, many countries in Latin America grew slowly, if at all, while the American economy speeded up.

The result of the relatively stronger US economy is that US imports of goods and services have increased much faster than exports in the last few years. From 1998 through the third quarter of 2004, imports of goods and services, including military expenditures abroad, rose by 63 percent, while exports advanced by 24 percent. As a result, the US trade deficit on goods and services increased from $164.9 billion to an annual rate of $577.8 billion, growing from 1.9 percent of GDP in 1998 to 5.0 percent in 2004.

There is another factor influencing the balance of payments. If a country invests more than it saves and its government spends more than it collects in tax revenues, the country inevitably will make up the difference by importing more goods and services than it exports. This means that the country will have a deficit in the current account of its balance of payments. If the excess of investment over saving is offset by a surplus in the government’s budget, the current account of the balance of payments will be close to zero. This relationship can be expressed in technical economic terms, but the general point is clear.

The balance of payments on current account involves more than trade in goods and services. There are also payments to other countries and receipts from abroad for tourist spending, business and professional services, interest and dividends, and government and private remittances.

Including these transactions, the US balance of payments deficit on current account increased from $209.6 billion in 1998 to an estimated $626.8 billion in the first half of 2004, or an advance from 2.4 percent of GDP to 5.4 percent of GDP. The 2004 deficit is much larger, relative to GDP, than was experienced in the 1980s. In that period, the sharp depreciation of the dollar led Treasury Secretary James Baker to negotiate the “Louvre Agreement,” which aimed to stabilize exchange rates among the major industrialized countries.

In addition to transactions on current account, there are substantial financial payments and receipts (i.e., capital-account transactions) by individuals, companies, and governments. These include establishing corporate production facilities (direct investment), securities purchases and sales, bank lending and receipt of deposits, and transactions both by the US government abroad and by foreign governments and central banks in this country. For example, American corporate and individual investors and banks purchased assets or made loans abroad, for a total of $425 billion (annual rate) in the first half of 2004, compared with $283 billion in 2003. At the same time, foreign governments (including central banks) and private entities acquired assets in the United States. In 2003, private investors from abroad purchased no less than $364.4 billion of American securities, including US government securities, reflecting, no doubt, the performance of the US economy relative to other economies in the world. Foreign official bodies acquired $194.6 billion of US government securities and deposited $49.4 billion in US bank accounts.Much of this sum represents purchases of dollars by the central banks of China and Japan, as noted earlier. These inflows continued in the first half of 2004.

THE UNCERTAIN FUTURE

As the economy continues to expand and approaches full use of productive resources and full employment, the Federal Reserve is more than likely to continue to raise its short-term interest rates incrementally, but steadily.

It also will be necessary to reduce the budget deficit if inflation is to be avoided, and as a contribution to lowering the balance of payments deficit. Shrinking the budget deficit requires cutting expenditures or raising taxes, or both. Unless this is done, not only could prices rise faster, but the excess demand would spill over to imports and enlarge the current-account deficit even more. In an election year, higher taxes and decreased spending were never popular proposals for the electorate to hear, but it is clear that some budgetary action is necessary.

Even apart from the dangers of a growing budget deficit, it is not at all clear that the present currentaccount deficit can continue to be financed. Capital inflows from abroad, both private and official, cannot be counted on to continue indefinitely in sufficient volume to finance the external deficit.

If the US twin deficits continue and capital inflows from abroad fall off, the exchange rate of the dollar will depreciate well below its current level, as happened in the 1980s. This scenario would lead to increased US exports and slower growth of imports, but it also would raise prices of imported products. The danger is that the depreciation could overshoot, and lead to serious international problems.

No one wants to predict a crisis, or portend gloom and doom. But the warning signs are there. The International Monetary Fund’s World Economic Outlook (April 2004) notes that

...the prospect of continuing large US fiscal and external deficits and the implied external borrowing adds to concerns about international imbalances, increasing the chances of a disorderly resolution, including a rapid fall of the dollar and a rise in US long-term interest rates.

A “disorderly resolution” of the twin deficit problem is not a happy prospect. What can be done about it? Given the relationship between the investment-saving balance and the budget balance, the obvious answer is that something has to be done about the large US budget deficit. That means either a reduction or slowdown in government spending, or an increase in tax rates—or a combined approach balancing the two.

Robert Solomon (CC ’66) was at the Federal Reserve Board from 1947-1976 and served as adviser to the Board (1965-1976) and director, Division of International Finance (1966-1972). He currently is a guest scholar at The Brookings Institution and president of R.S. Associates, Inc., which publishes his monthly International Economic Letter.

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