-->By Martin Hutchinson
Published 1/5/2004 10:38 AM
WASHINGTON, Jan. 5 (UPI) -- The $500 billion per annum U.S. balance of payments deficit cannot be financed indefinitely by persuading foreigners that Wall Street is moving forever upward, nor by arm-twisting Asian central banks into buying Treasury bonds and bills. To rebalance it, the dollar will have to drop and U.S. exports will have to increase to meet imports. Unfortunately, close examination of U.S. trade statistics suggests that the latter may be a problem.
Balance of payments surpluses and deficits are produced by two countervailing factors: trade and finance. When a country's imports exceed its exports, its balance of payments accounts will move into deficit. This will have one of two results: either the currency will depreciate, making the country's exports once more competitive and reducing the attractiveness of imports, or foreign financial flows will enter the country, allowing the flow of funds to be balanced overall even though the balance of payments is in deficit.
The flow of funds into the country may be autonomous, attracted by better investment opportunities, both direct (factories and entire companies) or portfolio (stocks and bonds.) Alternatively, as in many emerging markets running payments deficits (for example, Brazil in 2002), it may be produced by interest rate movements in the domestic economy; if bond and money market yields in a country are higher than in its competitors, and the currency is not expected to decline sharply, foreign bank investment will be attracted to it.
The distinction is important: as the United States demonstrated during the nineteenth century, autonomous foreign investment can finance a payments deficit for a very long period indeed. On the other hand, as Argentina demonstrated in the 1990s, foreign funds inflows that are attracted by high domestic interest rates are unsustainable; at some point the currency risk becomes too great, the"hot" money flows out and the currency depreciates sharply.
In the United States, there is a certain amount of structural balance of payments deficit, probably around $100 billion per annum, that finances itself automatically. The United States is the world's largest market, with labor laws that are relatively favorable and taxation that by European standards at least is relatively low. Furthermore, the demand of international business (and crime!) for dollar bills as its preferred form of cash provides additional financing for the deficit, in this case without any cost at all to the U.S. economy, since cash pays no interest. Thus over the business cycle as a whole, in equilibrium, the U.S. can be expected to run a payments deficit of around $100 billion per annum, with fluctuations above and below that level according to relative business conditions in the United States and the rest of the world.
In this respect the United States is different to, and probably healthier than, the last global hegemon, nineteenth century Britain. In spite of pursuing a strong currency"gold standard" policy throughout the nineteenth century, Britain ran a trade surplus through most of the century, particularly in the latter period of 1870-1914, which surplus was used to accumulate the world's largest ever portfolio of international investments, all liquidated at fire-sale prices in World Wars I and II. The result was that the British domestic economy was starved of capital and innovation, grew relatively slowly and lost ground to its competitors. Since the vigorous spendthrift is likely to end up richer than the idle rentier, the current U.S. economy is in the long run healthier.
However, the U.S. balance of payments' trend since the middle 1990s has been altogether more problematic. From a position close to equilibrium in 1993-95, the deficit has consistently widened. In the late 1990s, this was not a particular problem; capital inflows into the surging U.S. stock market were huge, and the U.S. economy was running white-hot, so it was reasonable that the United States should run a larger payments deficit financed by these autonomous flows, and that the currency should even strengthen, as the apparent Federal budget surplus drew money into Treasury bonds.
With the bursting of the stock market bubble in 2000, one would normally have expected the U.S. payments deficit to subside, perhaps even moving into small surplus as the excesses of the late 1990s were corrected. This did not happen. For the first two years after the bubble peaked, the Federal Reserve's aggressive monetary policy produced a bull market in Treasury bonds, and in housing finance, both of which attracted autonomous foreign investment in a similar way to the stock market in 1995-99. The dollar consequently remained strong and the payments deficit, which would have been expected to decline as the economy ceased overheating, failed to do so.
Since early 2003, the position has been more dangerous. The payments deficit has continued to expand slightly, to its current $500 billion per annum, as the economic recovery produced by the Fed's loose money policy has sucked in imports. Although the U.S. stock market has substantially recovered, very little of that rise has been produced by foreign money flows; strength in 2003 appears to have been produced mainly by domestic institutional investors, chasing relative performance, only latterly by domestic retail investors, and hardly at all by foreign portfolio investors.
Treasury bond prices peaked in June 2003; since that time they have tended to retreat, while the fairly substantial decline in the dollar has made Treasury bonds an unattractive investment for non-U.S. investors, so that even the increased supply caused by the yawning Federal budget deficit has not drawn in significant additional autonomous portfolio flows. Instead, the deficit has been financed by Asian central banks, seeking to protect themselves against a rise in their currencies against the dollar by buying U.S. Treasury securities with their payments surpluses, and thereby suppressing the natural rise in their own currencies. The autonomous investment flows, in other words, have been replaced by politically directed investment flows.
This can continue, but only for so long as Asian central banks wish to devote an ever increasing share of their reserves to an asset that is depreciating in price, denominated in a currency that is depreciating modestly against their own currencies and sharply against those of Europe.
The above analysis has two implications. First, the dollar will continue to be weak for some time to come, and may well drop far below its current levels against the euro. Second, U.S. exports must increase or imports decline until the payments deficit is closed (since the decline in the dollar will have a sufficient effect on confidence that the"equilibrium" $100 billion per annum payments deficit will take some time to re-establish itself.)
However, this will be very difficult. Total exports of goods and services in 2002 were $982.8 billion, compared with imports of $1,401.4 billion, a deficit of $417.6 billion, which has widened to around $500 billion in 2003, as imports have increased by around the same percentage as exports, but from a much higher base. With exports around $1,000 billion, and the trade deficit around $500 billion, the problem is clear: the deficit needs to narrow by a figure which is fully 50 percent of current export volume.
The decline in the dollar we have seen so far will have some effect, not yet apparent because of the delays involved. However, even at $1.26 to the euro, the dollar is only at its 1997 level, so it's worth looking at U.S. export sectors, to determine where the 50 percent increase in exports will come from, that will be necessary to balance trade without a sharp decrease in imports and consequently in living standards.
The most important single 3-digit SIC code for U.S. exports in 2002 was not aircraft, as you might have guessed, but code 776,"thermionic, cold cathode and photo cathode valves" with $47.6 billion of exports. Presumably these are not being used for radio equipment, as would have been the case in 1925, but for medical imaging equipment. A good business, but probably not one capable of growing exponentially (exports from the 77 sector as a whole grew by only 5 percent in the five years 1997-2002.)
Second is indeed code 792 -- aircraft and associated equipment, at $44.9 billion. The passenger aircraft business is close to a world duopoly, between Boeing and Airbus. Boeing could normally be expected to gain market share as the dollar declined, making its costs more competitive against Airbus. However, the company has spent too little on innovation in the last 30 years, and is now losing world market share rapidly to the newer product range of Airbus. Exports in this sector are likely to decline going forward, and imports to increase.
Third is code 784, parts and accessories of motor vehicles, with exports of $29.2 billion. This is part of an enormous 2-way trade in the motor vehicle sector, in which the U.S. is in huge overall deficit (motor vehicle and parts exports were $60.3 billion, imports $168.7 billion.) It would be nice to think that the parts exports were ending up in China, and benefiting from that country's excitingly rapid growth. In the long run, I doubt it; the Chinese do not appear to be driving Buicks, and parts manufacture for China is generally cheaper and more efficient either locally in China or in South East Asia.
Fourth is code 752,"automatic data process machines" (don't you love the 50s terminology?) at $27.4 billion. Ah, at last, you think, a sector with some real chances for export growth! Wrong. Exports for the office machinery sector as a whole have declined from $51.6 billion to $39.7 billion in 1997-2002, and the United States is now in large deficit, with sector imports of $77.0 billion.
Fifth is sector 764, telecommunications equipment, with exports of $26.1 billion. However, that too was down on 1997, with the bursting of the telecom bubble, and the sector's trade deficit was $41.4 billion, quadrupling since 1997. Again, not an apparent growth area.
You get the general idea. With the possible exception of the valves, there are few big sectors in which the U.S. is both competitive and likely to expand its exports rapidly. Of course, if the dollar declines enough, exports will rise purely on a price basis, and imports decline. But exchange rates will have to move a very long way to make this happen.
Expect a bumpy road on the U.S. balance of payments front going forward, a further severe decline in the dollar, and substantial upward pressure on import prices to consumers. The long vaunted superiority of U.S. living standards over those in Western Europe and Japan may now be about to disappear.
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