Government Deficits are Necessary (for now)

Read this excellent article by Martin Wolf in the Financial Times, and be sure to click on the chart, which I have also pasted below:

FT chart

The private financial balance (net borrowing or net saving by households and businesses) plus the government financial balance must equal the net capital inflow from abroad.  In the 2000s, the US was running a deficit in both the private and government accounts, which had to be offset by a positive net capital inflow from abroad.  A net capital inflow for abroad must be offset by an equal current account deficit, which for the most part means a trade deficit.

Of the high-income countries, notice that in 2006 nearly all were running trade deficits, except Japan and Germany who were running trade surpluses.  Also notice that Japan and Germany have been running a high positive private balance (i.e. businesses and households are high net savers).  Japan and Germany have essentially been deflationary countries since the early 1990s, when the Japanese debt bubble burst and when Germany reunified.  Both have been borrowing demand from abroad to partially offset their shortage of private demand.

The US, Spain, Ireland and the UK have been running private deficits.  The US and the UK have been running private and government deficits.  The twin deficits were therefore offset by large trade deficits.

Since the Great Recession, all of the countries listed have become high net private savers and all are running large government deficits.  The large government deficits are necessary to offset the collapse in private demand.  With all countries turning down at once, there would be no one to make up for domestic demand shortfalls.  While international imbalances have become smaller, Japan and Germany remain net exporters and and the rest remain net importers. 

As I have been saying over and over, for the US (and Spain, and Ireland and the UK) to dig out of the financial hole, we need to start running a trade surplus.  Ideally that would come from an increase in foreign demand for US goods and services, and not by a deflationary bust in the US.  For this to occur, a structural change will need to occur in the global economy that promotes balanced international capital flows.  For a period we need countries like China, Japan and Germany to run trade deficits.  Such a structural change does not seem at hand.  Until that time, the US's only escape valve is for a weak dollar to support exports and to drive dollar investment abroad.  The investment abroad will flow into emerging market financial bubbles, which will increase foreign demand and reduce the trade deficits in developed markets.

Without structural change, the likely outcome is continued high government deficits, low US interest rates, a weak dollar and financial bubbles in emerging markets.  This is the trend to ride for this business cycle…just be sure to get off before it blows up.

More on American Manufacturing

In my previous post on US trade deficits and manufacturing productivity, I discussed how US manufacturing has actually thrived, even in the last three decades while manufacturing employment was plunging. 

Such numbers might prompt one to ask how it can be, when their are abandoned, crumbling factories all around us, particularly in the old industrial cities of the Northeast and Midwest.  There are two answers.  One is that alot of manufacturing activity has moved from the unionised North to the right-to-work South and West, where factories are allowed to be run with fewer employees that cost less.

Another is that the US has been abandoning lower tech, mostly labor-intensive, manufacturing and reallocating capital to higher tech areas.  While this is no consolation to former textile workers in the US, it's the natural evolution of things.

This chart from the Economist illustrates it nicely:

Economist mfg chart

Most advanced nations have been shifting away from low tech manufacturing and such manufacturing is being picked up by developing nations like China. In the US and Britain, where capital has been allocated the most freely, the trade balance is most positive in high tech manufacturing.  South Korea has also made great advances in high tech. 

I think the most interesting aspect of this chart is that Germany and Japan, the two largest advanced economies besides the US, have huge surpluses in mid-high tech but deficits in high tech.  I would argue the reason for this is that Germany and Japan have been among the most aggressive in promoting an industrial policy to build up the old mass market manufacturing economy (exemplified by autos) and have financial systems dominated by commercial banks.  They have very conservative systems that were great at building up the post World War II economy, but lack the venture capital/ IPO/ public stock/ high yield debt/ private equity culture that, for all its faults, relentlessly reallocates capital to the highest-return investments in innovative sectors.  They are also the two developed countries most manifestly in danger of being in secular decline.

I realize that sometime the US system gets its capital allocation very wrong, like with the recent housing bubble.  But I would like to bring up the fact that housing is the sector most heavily promoted by our government.  This "industrial policy" was successful for years, but eventually it got taken way too far and will be difficult to unwind, given all of the powerful constituencies that are now invested in promoting real estate speculation.

Housing in the US and the long term stagnation of Japan and Germany are warnings to those that would promote the heavy involvement of the US government in the economy to protect declining industries and to conduct industrial policy in growth sectors beyond the early R&D phase.

The truth about US trade deficits and US manufacturing

One of my central economic tenets is that the total debt burden of the United States is too high. I blame economic policies that have encouraged excess consumption and housing investment, funded by money borrowed from abroad and by excess leverage in the financial system. Borrowing money from abroad in excess of money invested abroad creates a capital account surplus for the United States. If the US runs a capital account surplus, it must run a corresponding current account deficit to balance its accounts. The biggest component of a current account deficit is the trade deficit. I therefore believe that the best long-term fix for our problems is to adopt a set of policies that for a period of time encourages the US to run trade surpluses and a capital account deficit. In other words, we should sell more US goods abroad, while we increase savings and repay our foreign creditors.

My four point plan for running a trade surplus

  1. Maintain a stable currency and discourage the building of foreign dollar reserves;
  2. Improve incentives / remove disincentives for investing abroad;
  3. Remove / scale back policies that encourage borrowing and consuming at the expense of saving and investing; and
  4. Use policy to improve our terms of trade on energy

Right now point (1) is happening, whether on purpose or by accident. I don't expect (2) to happen anytime soon, and in fact policy seems to be running in the opposite direction. Obama talks like he believes in (3), but his policies also seem to be running in the opposite direction, with higher taxes on capital and high levels of federal borrowing. On the other hand, Obama is clearly a believer in point (4).

The composition of the US trade deficit

In the first quarter of 2009, the trade deficit was equal to 2.4% of nominal GDP (subject to revision). From 1980 to 2008, the trade deficit has averaged 3.1% of GDP.

61% of the deficit in Q1 2009 was due to our trade deficit in petroleum products. Since 1980, petroleum has accounted for 45% of our trade deficit, and the petroleum deficit has been about 1-2% of GDP. This one product is the "low hanging fruit" when it comes to targeting out trade deficit.

Not surprisingly, the US typically runs a surplus in services. In Q1 2009 the trade surplus in services was 1.1% of GDP, which is near the average level since 1990.

The level of trade deficit in goods excluding petroleum has averaged about 2% of GDP. In the goods sector, the US runs at about a balance in foods, industrial supplies and capital goods. In capital goods, the US runs a surplus in civilian aircraft (Boeing) and a deficit in everything else, including computer equipment. The bulk of the non-petroleum trade deficit is tied to autos and consumer goods.

It's not surprising that the US would run a deficit in consumer goods, many of which are labor-intensive like textiles, toys and such. The US should be able to run a trade balance or even a surplus in autos, which is actually a very productive sector in the US, but one in which we are up against rather unfair trade practices abroad. The US should also be running a bigger surplus in capital goods and non-petroleum industrial supplies.

The truth about US manufacturing

It has been so long since the US has run trade surpluses that it seems we have come to believe that it would be impossible to do so again. It is commonly believed that the US has basically stopped "making stuff". Nothing could be farther from the truth. The US is actually the largest manufacturer in the world by far and in most years is the largest exporter in the world. Also, it is important to note that the US's economy is absolutely massive relative to any other country in the world, and that trade (both imports and exports) is a relatively small part of our economy compared with even large economies like China, Germany and Japan. Also, the bulk of our trade deficits since 1980 have coincided (slightly lagged) with two periods of a very strong dollar and high real interest rates, which leads to poorer terms of trade for US manufacturers and increased investment flows from abroad. If we focus on maintaining a stable dollar rather than a "strong dollar", most of the trade deficit problem goes away.

But isn't manufacturing in the United States in decline? While manufacturing employment is certainly in long-term decline, manufacturing production continued to climb right up through 2007. The recent plunge in production has brought US manufacturing back to levels last seen in 1999. Manufacturing employment, on the other hand, is back to levels last seen around the start of World War II. The difference between these two numbers is the increase in manufacturing productivity. Before the recent downturn, we were producing roughly 7.5 times what we were producing in 1948 with roughly the same amount of manufacturing workers, working out to real productivity growth of 3.3% per year.

Manufacturing production and employment:

During the same timeframe, manufacturing capacity has been growing at 3.5% per year, so capacity utilization has fallen.

Thus, when this downturn ends, the US has plenty of scope to have its manufacturing production return to its trend line, particularly in high tech equipment and other durable goods.

The key takeaways are:

Don't confuse manufacturing employment with production. Manufacturing employment since the early 1970s has been analogous to agricultural employment in the late 1800s and early 1900s, declining even while production boomed.

US durable goods manufacturing is perfectly competitive. Capital-intensive durable goods manufacturing in the US could thrive if the US government halted the currency policies that were unduly punishing it.