Brad Setser

Brad Setser: Follow the Money

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What to say when the markets are listening to Stephen Jen?

by Brad Setser
October 26, 2005

The Economist's Buttonwood struggles with something I have also struggled with:

Stephen "Interest rate and growth differentials, not current account deficits" Jen has basically been right on the dollar this year; Buttonwood, Buffet, Volcker, Rogoff and Obstfeld, Roubini and Setser and other dollar bears not so much.

Or, to quote, another dollar bear — Donald Tsang, Hong Kong's current Chief Executive link: "What's happened to gravity?"

Roubini and I did not necessarily think the dollar would fall below 1.35 against the euro, but we certainly predicted that the dollar would fall against other currencies.   There has been some convergence between the euro and other currencies, but it largely has come because the dollar has risen against the euro this year, not because the dollar has fallen against other currencies.  That is not what we predicted – though I think (and now hope) we were always clear that we saw more risks in 2006 than in 2005.

Just to be clear: the dollar has fallen a bit against the Korean won (if you include the tail end of 2004) and Brazilian real; the dollar/ euro and dollar/ yen are not the only currency pairs that matter.  But generally speaking, the dollar has risen against the other g3 currency pairs and remained broadly stable or fallen ever so slightly against key emerging economy currencies — so on net, the dollar is getting a bit stronger.

Incidentally, it is a good thing Mr. Jen thinks current account deficits do not matter, because he sure cannot do a current account forecast.   The US current account deficit in the first half of the year was around $395 billion, so I am not quite sure how Jen predicts a $760 billion deficit for the entire year.  There is no sign the current account deficit is shrinking.  Remember, the US oil import bill is likely to be way, way up in September, October and November.  Imports are making up for lost production in the Gulf.  For a tiny fraction of what Mr. Jen earns I would be happy to check his current account forecasts against the recent data … .

But that is sour grapes – Jen predicted a dollar rally back when the market was expecting the dollar to fall further, and he was right.  

I don't think Mr. Jen is not what Dan Drezner calls a "chartist"; his models just look at a different set of "fundamentals" than the "fundamentals" those of us who obsess about rising US trade deficits and US external debt look at.  I do worry about 2006, though, even if Mr. Jen does not.  Consider:

  • At some point, the interest rate differentials that have favored the dollar will stop getting wider, and might even shrink.    Perhaps by a lot, if Calculated Risk, Bill Gross and Stephen Roach are right and there is a real risk that housing prices are close to peaking, and the US consumer is close to maxing out.  That would imply the Fed first stops rising rates and then cuts short-term rates, while European rates stay constant and Japanese policy rates perhaps rise above zero; god-only knows what happens to interest rate differentials at the long-end in that scenario …
  • No more Homeland Investment Act related inflows.   The presence of a one-off tax break for bringing profits held overseas back to the US always reduced the risks in 2005.
  • The FY 06 US budget deficit is likely to be bigger than the FY 05 deficit.  
  • Even if the US economy slows, I expect non-oil imports to pick up.  THe slow growth of non-oil imports in 2005 looks like an inventory correction after exceptionally fast import growth in 04.   The complication: that inventory correction took pace even as (I suspect) the underlying trend growth in non-oil imports was slowing a bit, in part because of higher spending on oil imports.  I don't expect a return to 2004; but I also don't expect continued flatness in non-oil imports.  
  • At some point the stronger dollar will have an impact on US exports, and US export growth will slow.    Market moves do have an impact: at some point next year, I would not be surprised by a series of bad trade numbers even as the US economy slows – assuming, of course, that oil prices stay in their current range.  
  • A true perfect storm would likely require a bit of geopolitical risk to keep oil prices in their current range even as a slowing US economy slows oil demand growth.  That is certainly not inconceivable.  Iraq temporarily stopped exporting last week.  The current market requires a lot of production from rather unstable places.
  • After several years where the rising dollar value of US assets abroad (mostly the result of a rising euro and pound) limited the deterioration in the US external accounts, the US net international investment position will finally show the impact of a large current account deficit.  To avoid big valuation losses, the dollar needs to close the year at 1.35 v. tthe euro.   No one should be surprised when the BEA reports next summer that the net international investment position deteriorated substantially in 2005, but some folks may be.
  • I suspect oil exporters will start to spend more of their oil windfall – or, put differently, oil prices won't keep increasing faster than oil exporters willingness to spend their existing windfall.    Since I suspect that oil exporters are a bit more willing to keep their savings in (offshore) dollars than to buy US goods, so more spending and less saving will prove euro positive and dollar negative.

Finally, let me reinforce one of the points Buttonwood makes, namely that "Official statistics capture only a fraction of what the [central] banks do with their fast-growing foreign-exchange reserves ($2 trillion higher since 2000)."  Recorded central bank inflows into the US certainly have slowed this year, but, interestingly, global reserve accumulation has not slowed.  Rather the set of countries adding to their reserves has changed.  Think China, Russia and the oil exporters of the Middle East rather than China, Japan and everyone else in Asia.

Look at the data from the first half of the year.

China's total reserve increase (adjusting for valuation) was around $137 billion (including the $15 billion transferred to a state bank, the unadjusted increase was $116 billion); recorded inflows to the US were about $49 billion.  We know what China did with around 40% of its money, but not what it did with the remaining 60%. 

And we know far more about China than about Russia and the Middle East.  Russia's current account surplus in the first half of the year was $60 billion (its reserves grew by $32 billion – probably more if you adjust for valuation – even as Russia paid down its external debt).   OPEC – which is statistically dominated by oil exporters in the Middle East – exports about three times as much oil as Russia.   So take $150 billion — a bit less than three times Russia's current account surplus — as a ball part estimate for OPEC's current account surplus in the first half of the year.  Consider one key country: Saudi Arabia.  SAMBA forecasts a 2005 Saudi current account surplus of $96 billion, and a $47 billion increase in official Saudi assets.   That is probably a bit low …    

So the combined current account surplus of Russia and OPEC almost certainly topped $200 billion in the first half of the year, with Russia and Saudi Arabia leading the way. 

Where did that money go?  Don't look to the US data for any clues.

The total purchases of US bonds (as measured by the TIC data) by both private investors and central banks in Russia and the Middle East: $5 billion.  Total purchases of bonds and stocks (as measured by the TIC data):  $6.5 billion.  Data here.

In other words, we know the US TIC data is not picking up what the Russia and the Middle East are doing with their petrodollars.   The banking data may hold more clues, but it comes with bigger lags.

But in some sense, Russia and the Middle East have to be financing the US – or financing European capital inflows to the US.  The estimated 05 current account surplus of the oil exporters ($400 billion) is larger than the total current account deficit of the world IF you exclude the estimated current account deficit of the US.  The global "adding up" constraint is real.  If the US accounts for 75-80% of the world's current account deficit, in aggregate, 75-80% of the world's current account surplus has to find its way to the US.

It does seem that US 10 year yields are finally ticking up, but that probably has more to do with higher levels of inflation than with any shift in foreign demand.  Buttonwood is right that private interest in Treasuries has picked up even as demand for Treasuries from official actors (above all the Bank of Japan acting for the Japanese MOF) has fallen; I just am not sure that private interest is unrelated to the surge in offshore petrodollars …   unfortunately, I cannot point to any clean set of data to support my suspicions. 

21 Comments

  • Posted by PC

    You wrote:

    “I don’t think Mr. Jen is not what Dan Drezner calls a “chartist”; his models just look at a different set of “fundamentals” than the “fundamentals” those of us who obsess about rising US trade deficits and US external debt look at. I do worry about 2006, though, even if Mr. Jen does not.”

    In the long run, the market is a weighing machine and so fundamentals will be reflected ultimately “provided you get the fundamentals right in the first place.” Easier said than done. Otherwise we would not have Enron, Worldcom…….given the army of analysts on Wall St. Also the majority of fund managers don’t beat the indexes and that tells you something about how difficult it is to get the fundamentals right.

    Even if you get the fundamentals right, there is the issue of timing. As Keynes said, “Markets can stay irrational far longer than you can stay solvent.” Also on Wall St., you will be out of a job if you are wrong for a few quarters.

    Of course, things are different in the academic world where you can afford to have long time horizons and cannot afford to argue with the market. I suspect that’s also why Jen is paid a lot more than professors in the academic world – he has to deal with reality.

    By the way, T-Note yield is not just ticking up, but it’s on the verge of a major upside breakout similar to the Nikkei 225 before its 15% rally recently. See http://investorsdiary.blogs.com/my_weblog/2005/09/tnote_yield_for.html

  • Posted by bsetser

    PC –

    Thanks for the technicals on the Treasury breakout — and for highlighting all the reasons why jen is jen and I am not. I still think his model will get something massively wrong, because it omits a variable that has not been important in the past but i suspect will be important in the future. As for “getting the fundamentals right” this is one of the easiest and most clear cut cases I have seem. a trade and transfers deficit of 6.5 -7% of GDP v. exports of 10% really pushes a lot of boundaries, and will lead to very rapid external debt accumulation. The real problem is calling the timing, and tis true that the markets think in quarters and former policy economists (never really have been an academic) have a bit longer time horizons.

  • Posted by MTC

    PC and Dr. Setser:

    I have been listening to the intellectual argument between you two for many a moon now. A buzzing in my ear tells me that there must by a synthetic bridge between your two positions. Dr. Setser’s position that “something that cannot go on forever will stop” seems unassailable. But so is PC’s underlying premise that markets do not commit suicide–they have to be murdered.

    Now its off to find the new Kotlikoff paper on the impact of Chinese savings.

  • Posted by Edward Hugh

    “Jen has basically been right on the dollar this year;”

    Yes, and this is more or less the view I’ve been taking. I think the interest differentials at the end of the day only more or less reflect underlying long term growth differentials. This isn’t to say that CA deficits long term don’t matter, but that in the short-to-medium term I don’t see structurally how the US one can unwind.

    What goes up must come down, but not if its strapped to the ceiling it doesn’t. China is one part of the story, and Germany and Japan are another. (Obviously you will tell me the oil exporters are another, but this could unwind if lower global growth – which would seem to be implied by any of the ‘crash’ scenarios, were to arrive).

    So long as Germany, Japan and China remain export driven I just don’t see any short term correction (any slowdown in the US will simply be exported to the three of them), or any significant downward move in the dollar versus the yen and the euro (and I don’t see the Chinese administration allowing any dramatic change in the yuan). You are obviously right, it could fall vis-a-vis third currencies like the Korean Won or the GB pound, but I don’t see any of this being very dramatic.

    Basically the whole world is watching and waiting to see whether a self-sustaining recovery in domestic demand in Germany and Japan (which would also then drive investment) is coming. I don’t see this, ergo I don’t see the correction. You obviously need to be somewhere in the other camp.

    France is a different story from Germany, but unfortunately there is no longer a French Franc. My feeling is that growth (or the lack of it) in Germany and Italy is what is driving policy at the ECB and hence the relative value of the euro.

    Of course if we weren’t in the world of Bretton Woods (either one or two) things might be very different.

    @ MTC

    “Now its off to find the new Kotlikoff paper on the impact of Chinese savings.”

    Yep, this is one I mentioned a couple of weeks back. I don’t really completely buy the way they use effective labour, which is what the story stands or falls on it seems to me.

    Another paper in a similar line is:

    http://paa2005.princeton.edu/download.aspx?submissionId=50572

    Tomoko Kinugasa and Andy Mason. This is another Chinese savings save the world story. I do think they have a point about increasing life expectancy being an important part of the picture though. I have slightly modified my view recently: I would now say that the key drivers are median ages (the level effect) and rate of increase in life expectancy (the rate effect).

  • Posted by PC

    Mr. Setser,

    You wrote:

    “As for “getting the fundamentals right” this is one of the easiest and most clear cut cases I have seem. a trade and transfers deficit of 6.5 -7% of GDP v. exports of 10% really pushes a lot of boundaries, and will lead to very rapid external debt accumulation.”

    I totally agree with you on the bearish fundamentals of the US Dollar. So does Buffett and Gates etc. So you have these legendary investors on your side. However, markets have been known to do really out of whack things and as much as I agree with you, I trust price action more. I will let price action do the talking ultimately.

    “The real problem is calling the timing, and tis true that the markets think in quarters and former policy economists (never really have been an academic) have a bit longer time horizons.”

    I wasn’t referring to you as an academic. Your work is much better than a lot of these professors though I dislike your political opinions.

  • Posted by PC

    Good article below on why T-Note yield may breakout sharply. A sharply higher yield cannot be good for the economy and markets.

    The Wall Street Journal

    October 27, 2005

    CREDIT MARKETS

    DOW JONES REPRINTS
    This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool at the bottom of any article or visit:
    http://www.djreprints.com.

    - See a sample reprint in PDF format.
    - Order a reprint of this article now.

    Sharp Rise in Treasury Yields
    Spurs Mortgage-Market Selling
    By DANIELLE REED
    DOW JONES NEWSWIRES
    October 27, 2005; Page C4

    Mortgage bonds, the biggest market in the U.S. fixed-income universe, are like the proverbial elephant in the room — when they move, the ground trembles.

    A sharp rise in Treasury yields caused the $5.5 trillion mortgage market to stir, igniting heavy selling that quickly spilled over into the interest-rate swaps market and back into the government-bond markets.

    That is because mortgage investors must adjust their portfolios to better reflect a rising rate environment, which involves unloading longer-dated securities like Treasurys and mortgages as well as swaps.
    [Treasury Yields]

    If Treasury yields climb further, more selling is likely. “If we move off this pretty quickly to the 4.80% [on the 10-year note] level, you could see more selling,” said Amin Majidi, director of mortgage-backed securities research for Deutsche Bank in New York.

    The 10-year Treasury yield rose as high as 4.60%, its highest closing level since March 28.

    At 4 p.m., the benchmark 10-year note was down 17/32 point, or $5.3125 per $1,000 face value, at 97 9/32. Its yield rose to 4.597% from 4.530% Tuesday, as yields move inversely to prices. The 30-year bond was down 1 3/32 point at 108 11/32 to yield 4.801%, up from 4.732%.

    In contrast, risk premiums on mortgage bonds and swaps widened by a relatively modest 0.01 to 0.02 percentage point.

    While the absolute levels of widening in mortgage bonds were relatively contained, the movement demonstrates how quickly a sharp rise in the yield of Treasurys can set off a chain reaction that starts in the mortgage-backed securities market and quickly spreads to other bond markets. And at the heart of this dynamic is the mammoth U.S. housing market and, in particular, homeowners.

    As the 10-year Treasury yield, the baseline from which mortgage-interest rates are priced, rises, fewer homeowners will opt to refinance their mortgages and fewer homes will be sold. As a result, the average life of a mortgage-backed security extends, because less principal is paid off early because of refinancings and sales.

    This longer average life, in turn, has a direct negative impact on the dollar value of a mortgage-backed security, because there is greater risk to holding a security for a longer time. And as yields go higher, the dollar value of securities falls.

    The drop in prices in turn prompts some investors to sell mortgages. The selling can cause the securities’ prices to fall further, exacerbating the original problem. Investors can also sell other long-dated assets to balance their portfolios, sending Treasury yields even higher in what can become a vicious cycle of selling.

    And finally, as rates rise sharply, investors can choose to receive a floating rate in an interest-rate swap contract, and pay a fixed rate. This last option will tend to send fixed-rate swaps spreads wider, as swaps investors demand a higher return for receiving fixed payments.

    Yesterday, mortgage investors appeared to be doing all of the above.

    Corporate Bonds

    Ford Motor Credit, the finance unit of Ford Motor Co., unexpectedly tapped the unsecured dollar-debt markets, selling a total of $1 billion, the second such offering since its parent was downgraded to junk. But it had to offer a generous return to tempt investors.

    The bonds sold through Barclays Capital, Deutsche Bank Securities and LaSalle, a unit of ABN AMRO. The $500 million five-year notes carry a coupon of 8.625%, and yield 8.843% or 4.375 percentage points over Treasurys. Ford Credit also sold $500 million two-year floating-rate notes with a yield of 3.00 percentage points over the three-month London interbank offered rate, currently at 4.230%.

    Ford Credit is rated Baa3 and triple-B-minus by Moody’s Investors Service and Fitch Ratings, respectively, the lowest high-grade ranking. Standard & Poor’s rates the finance unit double-B-plus, its highest junk-bond rating.

    –Aparajita Saha-Bubna contributed to this article.

    Write to Danielle Reed at danielle.reed@wsj.com1
    URL for this article:
    http://online.wsj.com/article/SB113033859673180016.html

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    (1) mailto:danielle.reed@wsj.com
    Copyright 2005 Dow Jones & Company, Inc. All Rights Reserved
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  • Posted by Charlie

    I read in a few places that yesterdays unusual fixed income market activity was due to the fear the new fed chair would keep raising rates in order to combat inflation. I don’t have any links off hand. If this is so, I don’t see this as the beginning of a trend. Rather some temporary panic induced volatility.

    On an aside…
    Has anyone noticed that gasoline prices have dropped lower than pre-Katrina prices? At least in my neck of the woods it’s happened.

  • Posted by OldVet

    I agree with Setser and dollar bears because the US growth rate is going to be falling soon and the interest rates are going to rise, but based on inflation rather than a healthy economy. Housing markets in US show every sign of price declines which is going to kick consumption in the head. It’s not just about oil prices. Overall, a reversal of the last 9 months dollar trend is in order. Even with higher interest rates, there is increased risk in holding US bonds and portfolio instruments.

    Even old day-late-and-a-dollar short Chas Schwab recently recommended buying into emerging equity markets recently, though they are more consistently positive on Japan. For more risk averse types, simply taking a position in non-US currencies is quite attractive right now. That’s what the market is telling me, anyhow.

  • Posted by José

    How does the trade deficit-currency connection work when you’re dealing with a country that is part of a strong currency union (Spain, now the OECD trade deficit champ in terms of GDP). Does Spain get a free ride like Italy does on its bonds?

  • Posted by jm

    An important factor in market behavior is that many of the players are playing with other people’s money, and have personal incentives to maximize short-term performance rather than long-term. In some cases, they are irrevocably committed to courses which can be predicted to lead in the end to disaster, and their only choice is when they will allow disaster to come; clearly they will choose to have it come as far in the future as possible, not now — perhaps they will have reached retirement age, found another job, or become filthy rich off stock options or 20% hedge-fund payouts before then.

    Japanese insurance companies, for example, must find investments that pay interest now, or be obviously in trouble very, very soon; thus a Japanese participant in one of the Morgan-Stanley convocations about a year and a half ago, in a discussion about whether the yield differential between US and Japanese compensated adequately for risk of dollar decline, remarked that “3% looks pretty good to us”.

    Remember always that Keynes quote about the good banker not being one who forsees danger and avoids it, but one who when ruined is ruined in a thorooughly conventional way along with his fellows.

  • Posted by bsetser

    Jose – good question, and one worthy of a full post. basically, being inside a currency union makes financing a deficit easier, since, barring an exit from the union, there is no currency risk if germany finances spain. but there are other kinds of risk — at some point, folks will start charging more to lend to spain, and spain will have to adjust, with that adjustment coming via growth differentials (slower growth in spain v. rest of europe) and price differentials (prices increase less/ fall more in spain than in the rest of the currency union). i would argue france in the early to mid 90s offers a good example of this kind of adjustment. Higher nominal rates, less nominal inflation thus higher real rates than in germany, and slower real growth. la politque du franc fort …

  • Posted by Gcs

    i’m put in mind of an old distinction

    pure home towner sports fan
    vs
    fan with a bet down
    and
    money on the line

    you get some of both here brad

  • Posted by psh

    ‘combined current account surplus of Russia and OPEC … Where did that money go?’

    Down the tubes of two of the world’s least transparent banking jurisdictions, Russia and Lebanon: To Lebanon, with outstanding Eurobonds growing 28% annually and a single bank, Audi-Saradar Group, with assets of half of GDP. Or to Russian banks. With foreign investors scared off by soft credits & asset-stripping, they don’t bother with retail business — they serve as financial arms of large enterprises, lend short-term to the export sector, act as private bankers to the oligarchs, and provide access to offshore accounts.

    It would be great if some trust guys showed up to tell stories, but they’re so discreet, they’re no fun.

  • Posted by Riz

    I too believe that there will come a time when interest rate differentials will stop moving in favour of dollar strength. However, I do not think this implies a bout of dollar weakness will follow.

    By the time the Fed is through with its hiking, the dollar’s life a funding currency for the high-yield / carry trade will truly be over. Its difficult to see a stabilisation in rate spreads, or even a moderate narrowing, in 06 as providing sufficient stimulus to reverse this trend.

    With due respect, it is also difficult to see the twin deficit problem, as ugly as it is, triggering significant USD depreciation next year. I recently happened across an article from 1997 that argued for USD weakness on these fundamental grounds – its true the deficits have notably widened since then, and in the long-run, these factors will weigh on the USD. However, the number of times that observers have used the deficit problem to predict a USD decline as being just around the corner, only to be proven wrong , suggests significant scope for disappointment.

  • Posted by Guest

    “How does the trade deficit-currency connection work when you’re dealing with a country that is part of a strong currency union (Spain, now the OECD trade deficit champ in terms of GDP). Does Spain get a free ride like Italy does on its bonds?”

    It seems to me that while Spain and Italy seem to get a free ride now this is likely change in the future. Previously Italy could partially ‘default’ on its debt vis à vis foreign investors by way of devaluing the Lira (the USA is officially planning to do this). That after all was part of the reason interest rates were higher than in creditor countries like Germany. With the advent of the euro debtor countries do not have that option anymore.
    Superficially the current situation wrt Spain and Italy seems similar to Argentina in the 1990s, they get low interest rates by issuing debt in another country’s currency, but they might find out that issuing debt in another currency comes with a price, you have to pay it all back or abandon the peg eventually with all the problems that entails.
    Thus it becomes even more critical that the deficits are used to finance investments that will allow the country to service its debt in the future.

  • Posted by bsetser

    Riz –

    there is a big difference between a trade deficit of 2% of GDP and almost no net external debt and a trade deficit of 6.5% of GDP and net external debt of 30% of GDP; the US export sector v. GDP is also smaller than in 97. any dollar appreciation now would tend to produce a 8-9% of GDP trade/ current account deficit. so i don’t think the “folks were wrong in 97 so they may be wrong in 06″ argument holds. the dollar may hold, but it will do so for fundamentally different reasons this time around.

  • Posted by Riz

    Brad, I know it may sound strange, but I don’t see a USD adjustment as necessary pre-requisite to deficit improvement. Likewise, I don’t think a dollar appreciation will have a big impact in terms of further deficit deterioration. The link between the exchange rate and the external deficit just doesn’t seem to be that clear.

    Instead, I would look to the economic recoveries in Europe and Japan to combine with reduced domestic demand in the US, to help stabilise the external deficit in 06. The decline in US demand could stem from a higher saving rate, which in turn would be prompted by higher interest rates and an easing housing mkt. At the same time, higher interest rates would continue to lend support to the dollar, perhaps maintaining the willingness of foreigners to keep financing the deficit.

    This may be a low probability scenario in many people’s eyes, but it is, at least for now, my central scenario from a market perspective. I just keep on thinking that a continuous widening deficit is the consensus view and is so well priced in to the dollar, that the risk may be skewed in the other direction.

  • Posted by bsetser

    Riz — Slow growth/ high rates is certainly one scenario. I don’t really have a good sense of what the markets expect for 06. My sense is that they expect the $ to stay at its current levels for a bit longer because of Homeland investment act related flows, but at some point, that source of support dies. I also think there is a poorly thought out expectation that the current account deficit will stay constant at its current level (6.5% of GDP) largely b/c it has stayed there since q4. I think that is a mistake since interest payments alone will add 0.5% of GDP to the current account deficit in 06 (try 5%*800b for this year’s external debt, plus some increase in the average rate on the existing stock, so a constant trade deficit = rising current account deficit). I don’t think this dynamic is yet well understood.

    The scenario where i see the deficit falling is one where oil prices fall, giving a one off gain (assuming that falling oil imports are not offset by rising non-oil imports).

    I quite honestly don’t think the stronger growth in Japan and europe scenario works, for three reasons.

    1) the dirty little secret of us trade is that $ depreciation worked, and US exports to europe have been growing fast despite slow growth in Europe. exports to europe are growing faster than exports to asia right now — and it ain’t cause europe is growing faster. $ depreciation alone is not enough, but it is not irrelevant either.

    2) the math doesn’t work. Goods exports to europe and Japan at the end of 05 will be a bit over $250b — say $270 b (about a third of all goods exports) Say $100 b in service exports are two Europe and Japan too. So total exports to these regions = $350 billion. Assume faster growth leads exports to japan to pick up and keeps exports to europe strong despite less support from the dollar, so exports to Europe and japan grow by 10%. That is + $35 b. The interest on the 04 debt alone is $40b (800*.05). plus if oil stays at 60, that implies a slight pick up in oil imports over the entire year, and non-oil import growth is likely to pick up from its stall in 05 (so far) …

    3) You can get the same result from looking at standard elasticities — which suggest us imports are more responsive to us growth than us exports are to world growth (remember, world growth was its highest in 30 years or so in 04, and the uS deficit still went up … ). Suppose US growth slows and European and Japanese growth increase so everyone grows at 2.5% — and assume that is enough growth to keep oil at 60. With a higher elasticity in the US (say 2) than in Europe and Japan (say 1.5), US import growth would still be larger than US export growth (5% v. 3.75% in my example). And remember, to keep the trade deficit constant, given that the US imports 50% more than it exports, exports have to grow 50% faster than imports to keep the trade deficit constant. 5% import growth demands 7.5% export growth (two times what i got in my example) to keep the trade deficit constant. and a constant trade deficit = a higher current account deficit.

    all in all, the math just doesn’t add up. barring a big fall in oil, a small acceleration in growth in europe and japan and a small decelleration in the US just won’t close the deficit. a recession in the US would have an impact — probably in the first instance through lower oil prices.

    given all the obstacles created by rising interest payments and the gap between imports and exports, something big has to change to really close the deficit — and i suspect all cyclinders of adjustment need to be firing. demand growth in the US has to slow; demand growth abroad has to stay strong despite getting less impetus from the us and the dollar needs to fall more — and fall not just against europe and japan, which now account for only about 1/3 of US trade.

    sorry for the long response.

  • Posted by Movie Guy

    Pretty good discussion.

    Regardless of the short-term moves in currency valuation shifts (those that aren’t buffered), the problem of the WTO trade model remains in place. It’s a black hole with regard to many investment flows.

    I believe it’s time to focus attention on the import mix so that some economists and others out there develop an understanding of how imports by product type will occur in the future. This applies to Europe, Japan, as well as the United States.

    If some develop for the import mix for the countries concerned, then it will become clear that trade gaps will not be erased without major changes in currency valuations. Europe nor the United States can expect much improvement on reducing imports until the domestic production/taxation models are revamped.

    Richard Fisher, Dallas Fed, is one to monitor on this subject. He understands that investment attraction resulting in domestic production gains will require major ‘marketing package’ changes.

    There is way out of the trade flow box that so many have embraced and promoted. Perhaps it time that key economic professionals took the time to study the production components in the existing model. It’s not going to reverse itself without major currency shifts, and that’s highly unlikely. Aside from tariffs and exports restrictions and discouragements (China, for example), a partial answer may be significant modification of production/investment inducing ‘marketing packages’. I do not believe that the efforts will have much impact on slowing or balancing the effects of the WTO trade flows, but I fully expect the efforts to be undertaken. Tax reductions for businesses and minimization of regulatory requirements will be primary targets of such campaigns.

    But, at the end of the day, the existing trade flow patterns on a general percentage basis will persist. As will the U.S. trade deficits. Study the import mix. The answers are readily available.

  • Posted by Movie Guy

    That should read: There is no way out…

  • Posted by Riz

    Brad, no need to apologise re the length. Your points are good and have moved me closer to your position. I still think the risks of lower domestic demand and higher savings (from housing mkt risk and higher borrowing costs) could be a big factor in reducing the rate of external balance deterioration.

    However, the points you have raised are very strong and highlight the risk of betting against the trend of an ever widening deficit.

    In the meanwhile, cyclical factors seem to playing the dominant role in the fx mkt and I am happy to speculate on modest USD appreciation. Its all about timing.

    I heed the warning.

    : )