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Thursday July 14, 2005 - 22:35:33 GMT
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U.S. Twin Deficits In Tactical Not Strategic Retreat

Well for someone who is convinced the U.S. twin deficits are at the core of a much weaker dollar ahead, news this week on the trade and the budget deficits has not supported my worst fears. Or has it?

The narrowing in the U.S. trade deficit came mainly from lower oil prices...they are higher last I checked. Buying dollars on a oil-price-driven narrowing in the deficit is not a structural adjustment. It is transitory. Some months it will add to the deficit too. I thought the widening in the deficit with China was far more prescient and it was not just higher imports but also reduced exports that caused this gap to widen (granted the bilateral data are unadjusted and month-to-month comparisons are not very telling). Real adjustment for the U.S. trade deficit will not come until the U.S. savings rate and foreign consumption rises and or the dollar falls sharply. Some argue that the dollar decline versus the euro of 30% through end-2004 did nothing to facilitate adjustment. But this simply means far larger nominal and real dollar depreciation is needed to adjust the imbalance than the 30% through December last year, short of a change in saving/consumption patterns (which could be prompted by policy steps like a U.S. VAT, rising U.S. interest rates crimping U.S. growth). It does not take a genius to recognize that relative growth rates drive trade far more
immediately (pace or second derivative) and far more significantly (magnitude or first derivative). Hence absent any significant shift in relative growth rates, the dollar must change by much more to facilitate an adjustment in the trade deficit...yes more than 30% in nominal terms. Should we be comforted by $55bln monthly trade deficits as opposed to $60bln? Hardly.

Am I sounding too negative? What about the improving budget deficit reported this $100bln less than first forecast or $333bln for FY2005 vs. $412bln for FY2004? I welcome it. Tax receipts are up a lot. They should be. The economy is growing at a healthy clip. Corporate profits are up and incomes are up some. Apart from growth, the Alternative Minimum Tax (Washington's most effective and least heralded income tax hike) has hit more households than anyone could have envisions and was certainly not the intent of the legislation. Indeed it is very likely to be legislated away before the November 2006 mid-term election. So nothing structural here...just a false sense of tax receipt security. On the corporate side things are good indeed. However, the Homeland Investment Act has also prompted waves of U.S. corporate repatriation of foreign earnings as firms take advantage of a significant tax savings for a one-year window. These firms might have deferred declaring lots of this foreign income or simply left it in foreign subsidiaries as working capital rather than face paying Uncle Sam roughly 30% on the repatriated dollar. And asset appreciation is generating capital gains tax receipts (stock market is rallying and real estate flipping is becoming more common). I also see the White House playing up supply side free lunch argument cuts led to higher tax receipts. Gee that means keep cutting tax rates to balance the budget...Kudlowvian style. Look too for more cuts in inheritance tax and capital gains ahead of 2006 as this notion gets further application by the free lunch optimists (or the double agents of starve the gvt). Supplemental budgets to fund the war on terror are likely too. I do not see any reason to expect the budget gap to close on a sustained basis ahead. What needs to be done to believe a budget adjustment approach is legit? Spending cuts starting with ag subsidies. Entitlement cuts starting with Medicare (mean tested). And tax hikes (sorry Reagan, Bush 41 and Clinton all had to hike taxes to close the budget gap).

Lastly, there are those who have correctly pointed out that the U.S. runs a large investment income surplus...that is U.S. investors earn more on nforeign investments than foreign investors earn on U.S. investments. This may have more to do with the type of investor than superior U.S. investment acumen. The last decade has seen a surge in foreign official investing in the U.S. asset markets by the likes of central banks (managing currencies, or preventing local currencies from appreciating versus the dollar) and OPEC (selling oil at rich prices and having dollars to invest). As a rule foreign official investors are more risk averse and buy mostly U.S. Treasuries, agencies and highly rated U.S. corporate debt...all of which have been yielding decade lows. As U.S. rates rise (beyond Fed funds) the debt service cost will rise and this surplus will turn to deficit in short order. U.S. investors in foreign markets are more risk neutral and seek riskier assets with greater payouts. But rates are falling abroad, even in Asia (China) and this advantage will diminish. Most economists watching the investment balance for the U.S. are predicting deficits by year-end. So foreign investment inflow will need to offset net investment income deficit on top of the deficit in tradable goods and services. In other words a larger burden for foreign investors to bear.

I think it is wise to avoid mistaking a "tactical" retreat (in the twin deficits) for a "strategic" retreat. The dollar rally may have more scope and time to play out, but the foundation is suspect and without a shift in relative growth rates, the dollar will ultimately bear the burden of adjustment. Deficits are sustainable until they are unsustainable. The shift in the investment income surplus to deficit projected will move the external imbalance ever closer to the unsustainable.

David Gilmore


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