Nouriel and I went out on a bit of a limb in this paper.
Since the beginning of the year, the dollar has rallied and yields on the ten-year and thirty year treasury bond have fallen: both market moves suggest that the US is not currently having any difficulty financing the US government’s $425-30 billion estimated FY 05 budget deficit (including the costs of fighting wars in Iraq/ Afghanistan), and the US is not currency having difficulty financing its roughly $60 billion monthly trade deficit/ $700 billion plus annual trade deficit. So long as the dollar is strengthening and US interest rates are low, the market is hardly sending a signal that the US needs to cut back. Nouriel and I argue this really is too good to last, and lay out the reasons why the US will be forced to cut back before the end of 2006. Put differently, we argue that while US might be able to finance external and budget deficits of the current scale at current interest rates and exchange rates for a few more months, it won’t be able to do so for two more years.
The value of this paper is that it forced us to lay out our assumptions. Hopefully, it will force those who think deficits of the current magnitude can financed and therefore both policy makers and the markets can continue on their current trajectory to lay our their assumptions as well.
Realistically though, not too many people will want to read the entire paper. Nouriel provided a brief summary of the paper earlier, but I wanted to chime in as well and provide my own guide to the paper’s highlights.Over the past two years, the US has financed a cumulative current account deficit of about $1200 billion. ($530b in 2003, $650 b in 2004). It has done so, in broad terms, by placing about $950 billion in debt with foreign central banks, and by getting about $250 billion in financing from the private markets. Our estimate for the amount of financing that foreign central banks provided the US in 2004 by adding to their dollar reserves is now $475 billion, a bit higher than the $400 billion that I have used previously.
There is no doubt that foreign central banks have provided the majority of the (net) financing the US has needed over the past two years, and have added to their portfolio of US assets at a far faster rate than foreign private investors. But the 950b/ 250b split between central bank financing and private financing also oversimplifies: foreign private investors hold more gross claims on the US can foreign central banks, so even if foreign central banks are adding to their claims faster than private investors, equilibrium still requires that foreign private investors be willing to hold on to their current claims (at current prices), rather than dump their existing claims in the market.
The actions of US investors also matter: if they want to increase their holdings of foreign assets, that would add to the United States aggregate need to attract foreign financing. For example, in 2003 and 2004, US investors bought more foreign stocks than foreigners bought US stocks, and US firms invested more abroad than foreign firms invested in the US. This resulted in a net equity outflow of $200 b in 2003, and an estimated $150 b in 2004.
Add this $350b net (equity) outflow to the $1200 b cumulative current account deficit of the past two years to get the total amount of debt the US needed to place abroad in 2003 and 2004: $1550 billion. Even if $950 billion of that was placed with foreign central banks, foreign private investors still had to buy around $600 billion of US debt for everything to work (foreign private investors have been buying significant quanitities of US corporate debt).
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