G-2

On the eve of a global summit about the financial crisis, the words "Bretton Woods" are appearing with more than usual frequency (this seems to be international analogue to all the domestic FDR talk). In the FT, Stanford's Ronald McKinnon notes that the Bretton Woods negotiations were essentially a bilateral haggle between the US and Britain. Now, he argues, the real bargain to be struck is between the US and China:

To deal with the global crisis, how should the US and Chinese governments proceed?

First, the US should stop China-bashing in several dimensions. In particular, the PBC should be encouraged to stabilize the yuan/dollar exchange rate at today’s level­, both to lessen the inflationary overheating of China’s economy and to protect the renminbi value of its huge dollar exchange reserves.

Since July 2008, the dollar has strengthened against all currencies save the renminbi and the yen, and the PBC has stopped appreciating the RMB against the dollar. So now is a good time to convince the Americans of the mutual advantages of returning to a credibly fixed yuan/dollar rate.

There is a precedent for this. In April 1995, Robert Rubin, then US Treasury secretary, ended 25 years of bashing Japan to appreciate the yen­ and announced a new strong dollar policy that stopped the ongoing appreciation in the yen and saved the Japanese economy from further ruin.

But this policy was incomplete because the yen continued to fluctuate, thus leaving too much foreign exchange risk within Japanese banks, insurance companies, and so forth, with large holding of dollars. This risk locks the economy into a near zero interest liquidity trap.

Second, after the PBC regains monetary control as China’s exchange rate and price level stabilize, the Chinese government should then agree to take strong measures to get rid of the economy’s net saving surplus that is reflected in its large current account and trade surpluses.

This would require some combination of tax cuts, increases in government expenditures, increased dividends from enterprises so as to increase household disposable income, and reduced reserve requirements on commercial banks.

Then, as China’s trade surplus in manufactures diminishes, pressure on the American manufacturing sector would be relaxed with a corresponding reduction in America’s trade deficit. Worldwide, the increase in spending in China would offset the forced reduction in U.S. spending from the housing crash.

The new stimulus announced by China is potentially a huge step towards increasing China's domestic demand - i.e., getting rid of the net saving surplus. Meanwhile, the large slowdown in consumer spending in the US reduces the net saving deficit (though government spending should, at least temporarily, make up much of the gap). So there are indications of a non-exchange rate driven rebalancing (i.e., closing of China's current account surplus and America's deficit).

While McKinnon is correct that it is a good thing to take some of the pressure off exchange rates to do all adjusting, fixing the exchange rate would completely close off this channel and leave the Yuan undervalued. Furthermore, intervening to keep the exchange value of the Yuan low is what has been interfering with the PBC's domestic monetary control.

Because China has piled up so many Dollar-denominated assets, it is understandable that they would like to protect their value in Yuan terms (i.e., prevent a big Yuan appreciation...), and a nod in this direction may be part of an international negotiation, but fixing the Yuan-Dollar rate only seems to defer a necessary adjustment.

Update (11/10): Arvind Subramanian offers nearly opposite policy advice; he would have the WTO go after countries that keep their currencies undervalued (he proposes some carrots to get China to go along).

Flight to Safety?

One of the bigger ironies of the financial crisis is that the US has troubled financial institutions, a plunging stock market and a ballooning government budget deficit and demand for our government bonds is increasing: (keep in mind that the price and yield are inversely related). And now we also see a spike in demand for our currency: (foreign currency per dollar). Even the presumably relatively safe Pound and Euro took a plunge last week: (note that the scale is opposite, so the Dollar is still appreciating). However, the Japanese Yen seems relatively immune, relative to the Dollar, which means it is also jumping in terms of other currencies: In troubled times, demand for assets deemed "safe" (or "liquid" or "quality") traditionally goes up, which is why things like emerging market debt and junk bonds often suffer, regardless of the virtues (or lack thereof) of the issuers. But it is quite remarkable that, for all that is going wrong in the US, we are still on the receiving end of this flight to safety effect.

How much of this to attribute to virtue versus good fortune is a good question for international economists and economic historians to contemplate. More immediately, despite all their prudent reserve-building since the crises of the late 1990's, emerging markets are once again getting hit hard. Dani Rodrik sees an urgent need for IMF action. See also Arvind Subramanian, Brad Setser and Naked Capitalism.

From a US standpoint, although we are better off with a flight into, rather than out of our currency and assets (which would cause a huge spike in long-term interest rates), the Dollar's rise is hardly benign. Until recently, the mostly-non-panicky drift downward of the Dollar was helping turn around the current account deficit - a sustained move in the other direction would be trouble for exporting and import-competing industries (indeed, Rodrik fears this could lead to protectionism).

A Beacon of Insane Deals

The sale of domestic assets to foreign owners is one manifestation of the US current account deficit (and the declining dollar is making those assets cheaper). On the Daily Show, Lewis Black considered the implications:

Evidence on the Savings Glut Hypothesis

A country's current account is the difference between its saving and investment: a country with a current account surplus is saving more than necessary to finance its domestic investment. The difference goes to purchase foreign assets, a so-called "capital outflow." In recent years, the US has been running large current account deficits ($739bn or 5.3% of GDP in 2007), which means US savings is not sufficient to finance domestic investment and the difference is made up by selling US financial assets to foreigners (i.e. the US has a net capital inflow).

In 2005, Ben Bernanke offered a novel hypothesis that the US current account deficit was driven by a "savings glut" in the rest of the world, especially in emerging market countries. The current account surpluses of the emerging countries were used to purchase US assets, contributing to high US share prices and housing values (due to long-term interest rates kept low by the inflow of foreign saving into the US bond market). This increase in the wealth of US households drove the low savings rate - i.e., US households felt they could consume more because of the increases in home equity and stock prices.

On his blog, Brad Setser provides some evidence in favor of the savings glut hypothesis:

In 2007, the savings rate of the emerging world savings was almost 10% of GDP higher than its 1986-2001 average. Investment was up as well – in 2007, it was about 4% higher than its 1986-2001 average. However the rise in the emerging world’s savings was so large that the emerging world could investment more “at home” and still have plenty left over to lend to the US and Europe. That meets my definition of a “glut.”...

The big drivers of this trend. “Developing Asia” and the "Middle East." Developing Asia saved 45% of its GDP in 2007 -- up from 33-34% in 2002 and an average of 33% from 1994 to 2001 (and 29% from 86 to 93). Investment is up too. Developing Asia invested 38% of its GDP in 2007, v an average of between 32-33% from 1994 to 2001. Investment just didn't rise as much as savings. The Middle East also saved 45% of its GDP in 2007 – up from 28% of GDP back in 2002 and an average of 25% from 1994 to 2001 and an average of 17-18% from 1986 to 1993. Investment is up just a bit -- at 25% of GDP in 2007 v an average of 22% from 1994 to 2001.

The Middle East oil producers appear to behaving in a manner consistent with the permanent income hypothsesis - if the current high oil prices represent a transitory increase in their income, an increase in saving will allow them to spread the increase in consumption over a longer time period.

The current account surpluses of "Developing Asia" (most prominently, China) are harder to make sense of. If these countries expect higher income in the future, the logic of consumption smoothing implies they should be borrowing today. Moreover, conventional assumptions about production technology imply the returns on capital should be higher where capital is scarce - i.e. capital should flow from the US (with has a large capital stock and therefore should have a low marginal product of capital) to the developing countries, rather than in the other direction (this previous post discussed the perversity of a poor country - China - lending to a rich one - the US).

Borrowing From The Poor

Notwithstanding all the hype, China remains a relatively poor country, as this International Herald Tribune story usefully reminds us:

When she gets sick, Li Enlan, 78, picks herbs from the woods that grow nearby instead of buying modern medicines.

This is not the result of some philosophical choice, though. She has never seen a doctor and, like many residents of this area, lives in a meager barter economy, seldom coming into contact with cash.

"We eat somehow, but it's never enough," Li said. "At least we're not starving."

In this region of southern Henan Province, in village after village, people are too poor to heat their homes in the winter and many lack basic comforts like running water. Mobile phones, a near ubiquitous symbol of upward mobility throughout much of this country, are seen as an impossible luxury. People here often begin conversations with a phrase that is still not uncommon in today's China: "We are poor."

China has moved more people out of poverty than any other country in recent decades, but the persistence of destitution in places like southern Henan Province fits with the findings of a recent World Bank study that suggests that there are still 300 million poor in China - three times as many as the bank previously estimated.

And yet China is lending the US hundreds of billions of dollars. In The Atlantic, James Fallows has an excellent look at the Chinese side US-China economic relationship. He writes:

Through the quarter-century in which China has been opening to world trade, Chinese leaders have deliberately held down living standards for their own people and propped them up in the United States. This is the real meaning of the vast trade surplus—$1.4 trillion and counting, going up by about $1 billion per day—that the Chinese government has mostly parked in U.S. Treasury notes. In effect, every person in the (rich) United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People’s Republic of China. Like so many imbalances in economics, this one can’t go on indefinitely, and therefore won’t. But the way it ends—suddenly versus gradually, for predictable reasons versus during a panic—will make an enormous difference to the U.S. and Chinese economies over the next few years, to say nothing of bystanders in Europe and elsewhere.

Any economist will say that Americans have been living better than they should—which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.

Neither government likes to draw attention to this arrangement, because it has been so convenient on both sides. For China, it has helped the regime guide development in the way it would like—and keep the domestic economy’s growth rate from crossing the thin line that separates “unbelievably fast” from “uncontrollably inflationary.” For America, it has meant cheaper iPods, lower interest rates, reduced mortgage payments, a lighter tax burden. But because of political tensions in both countries, and because of the huge and growing size of the imbalance, the arrangement now shows signs of cracking apart.

In terms of the national income accounts, it is quite simple - negative NX for the US means that C + I + G > Y, and the opposite is true for China. To the extent that China's low consumption reflects high investment, it is arguably doing some good for its future. The trade imbalance - and concomitant financial flow, as China receives financial assets in return for the goods it sells to the US - is harder to rationalize.

The concerns about inflation don't really make sense to me - inflation is (usually, mostly) a monetary phenomenon, and China's policy of keeping its currency weak entails inflationary printing of yuan to buy dollars (and in turn, they have to use "sterlization" to try to restrain the inflationary consequences). Allowing the yuan to rise more quickly would be deflationary, because it would lower the price of imported goods. It is true that a higher consumption share of GDP would increase demand for consumer goods and this would tend raise their prices, but it would also induce a shift of resources into producing these goods. If China let its currency appreciate more and increased consumption, the Chinese people would be able to enjoy more of the fruits of their own labor as well as more imported goods.

Hat tips: Fallows' article came to my attention via Brad Setser, and the IHT article from Managing Globalization.

Do We Need a Recession?

At Vox EU, Gilles Saint-Paul offers another argument why the US needs a recession (a different one from those discussed in this previous post):

There is agreement among many analysts that the Fed should pursue a low interest rates policy in order to prevent the US credit crisis from degenerating into a recession. On what grounds are we told that? The bottom line is that monetary policy is supposed to fine-tune the economy by targeting inflation and the output gap. Thus, monetary policy is supposed to become tighter when there are fears of inflation, and looser when there are fears of a recession and no sign of inflation. Consequently, the fed’s recent moves to lower interest rates seem perfectly orthodox.

This focus on macroeconomic aggregates ignores any other effect that interest rates can have on the economy. It totally ignores that interest rates are a price which affects many allocative decisions and has important distributive consequences...

The problem is that low interest rates not only stimulate the economy, they do plenty of other things. In other words, focusing only on GDP has costs and may generate mounting problems—the low rates policy makes a current recession better, but the next one may be worse.

One reason why the US economy is less inflation-prone than in the past is that a bigger share of any increase in domestic demand is absorbed by imports: the economy is more open than it used to be. Thus, instead of having “overheating” because demand is greater than supply, the gap between the two is filled by trade deficits. Hence, low rates stimulated consumer spending and the trade balance deteriorated by two percentage points of GDP. The US is rapidly accumulating foreign debt and that may lead to a brutal correction with a sharp drop in consumer spending and a large depreciation of the real exchange rate. In fact, that correction may have already begun. Yet the Fed is not supposed to look at the net foreign asset position of the US economy, even though both its deterioration and rising inflation are the symptom of the same problem – excess domestic demand.

The other issue is asset prices. When interest rates are very low, and expected to remain so, asset prices can be very high.... In particular, low interest rates may start asset bubbles...

The resulting policy prescription is to let the illness take its course:

All this suggests that the US has to go through a recession in order to get the required correction in house prices and consumer spending. Instead of pre-emptively cutting rates, the Fed should signal that it will not do so unless there are signs of severe trouble (and there are no such signs yet since the latest news on the unemployment front are good) and decide how much of a fall in GDP growth it is willing to go through before intervening. As an analogy, one may remember the Volcker deflation. It triggered a sharp recession which was after all short-lived and bought the US the end of high inflation.

If one views the current economic situation as "unsustainable" - i.e., that the low saving rates and large current account deficit cannot go on forever, some significant reallocation of productive resources is necessary. In particular, to get to a more "balanced" state the US needs to consume less, particularly fewer imports, and export considerably more, so we need fewer people working in consumption goods industries and more people in exporting industries. The question is whether this reallocation could be achieved without a recession - if workers could shift sectors instantly, no loss of output is necessary. However, in practice, reallocation entails "adjustment costs" - jobs in one sector need to be destroyed and people need to go through a search (and possibly retraining) process to find a jobs in another sector. In the US, there is a constant "churn" in the labor market as millions of jobs are continuously being destroyed and created, but a major reallocation would entail even more turnover than usual.

Saint-Paul is essentially saying that a low interest rate policy by the Fed is delaying this needed adjustment. It seems clear that monetary policy contributed to increases in asset prices (stocks in the late 1990's, houses more recently), and when asset prices increase, households do not feel the need to save as much - i.e. the consumption function shifts up. This is the "serial bubble blower" critique of the Greenspan Fed. There's some truth in it, but this argument may overstate the power of monetary policy - the Fed is targeting a short-term nominal interest rate. The long-term real interest rates that affect saving and investment decisions are influenced by the Fed's actions, but other factors come in to play. In particular, inflows of foreign saving have played a major role in keeping long term rates low, regardless of the Fed's actions. If our foreign creditors decided to cut back on their purchases of US assets, long term rates could rise, even if the Fed was keeping the fed funds target low - i.e., the yield curve would become much steeper.

One thing that is helping is the decline of the dollar - US exports are becoming cheaper and imports more expensive. This is starting to show up in a decreasing trade deficit. Low interest rates contribute to the dollar's weakness, so in this regard Saint-Paul's prescription would be counterproductive.

The Volcker analogy is not necessarily an encouraging one: although maybe there was no painless way to end the inflation of the 1970's (it was a "disinflation," not a "deflation"), the "double dip" recession in the early 1980's saw the highest unemployment rates since the depression. The high interest rates - partly due to the Reagan-era deficits, as well as tight monetary policy - led to an appreciation of the dollar and a large current account deficit.

Recession Watch: Buiter vs. Summers

Lawrence Summers is worried - like totally having a cow, as we used to say - about the subprime mortgage crisis and attendant credit crunch. In the a column for the Financial Times, he wrote:

Even if necessary changes in policy are implemented, the odds now favour a US recession that slows growth significantly on a global basis. Without stronger policy responses than have been observed to date, moreover, there is the risk that the adverse impacts will be felt for the rest of this decade and beyond.

Summers calls for monetary and fiscal policy need to stimulate aggregate demand:

Maintaining demand must be the over-arching macro-economic priority. That means the Fed has to get ahead of the curve and recognise – as the market already has – that levels of the Fed Funds rate that were neutral when the financial system was working normally are quite contractionary today. As important as long-run deficit reduction is, fiscal policy needs to be on stand-by to provide immediate temporary stimulus through spending or tax benefits for low- and middle-income families if the situation worsens.

The Fed may be seeing things the same way - markets responded positively to a hint that the fed may lower the federal funds rate at its Dec. 11 meeting. The Times reported:

Speaking one day after another top Fed official signaled that policy makers might have to reduce interest rates to head off trouble, Mr. Bernanke pledged that the Fed would remain “exceptionally alert and flexible” in setting policy.

Maybe they're just stretching, and drinking more coffee? Amidst all this freaking out, the BEA reports that the US economy grew at an annual rate of 4.9% in the third quarter (revised upward from the preliminary estimate of 3.9%, Ecconbrowser breaks down the numbers). A growth rate like that is normally cause for concern that the economy is "overheating," to which the Fed would respond by raising rates. Willem Buiter offers an incisive, contrarian assessment of the US economic situation under the headline "Should the Fed raise interest rates?":

Judging from the noise, moans and calls for policy relief coming from the financial sector, one could be forgiven for believing that the end of the world is neigh. It's not...

The good news in all this is that much of the financial sector has become quite detached from the real economy. The implosion of much of this formerly privately profitable but never socially productive financial intermediation will have little if any adverse macroeconomic effect. Many, perhaps most, financial institutions today are engaged in a gigantic, worldwide game of musical chairs in which vast fortunes are won and lost every day, but nothing of macroeconomic significance happens...

All the Sturm und Drang in the financial sector today only matters from a macroeconomic perspective, if it has a material effect on household consumption and on household and corporate investment. In my view, rather little of it does.

He goes on to argue directly against Summers, making a case that fiscal and monetary policy should not be used stimulate consumption now because a shift away from consumption into saving is exactly what's needed to correct the current account deficit:

There can be no doubt that private consumption expenditure (about 70% of US GDP and also by far the most stable component of GDP) is going to weaken significantly. And so it should. The long-overdue and necessary increase in the US private saving rate is a necessary domestic counterpart to the long-overdue and necessary reduction in the US external trade deficit, which is the contribution of the US (necessary and long overdue) to global rebalancing....

Surely the time for a consumption slump in the US is now, when the weakness of the US dollar and the strength of global demand will mitigate the impact on aggregate demand and employment? If not now, then when or under what circumstances?

And he also has harsh words for the Fed:

Throughout the crisis, the Fed's communication policy with the markets has been atrocious. My fear is that this communication policy mess reflects a deeper confusion/disagreement in the Fed about how to respond to the crisis, and about both the ultimate and the proximate objectives of monetary policy.

In addition to communicating poorly, Buiter believes the Fed is too responsive to financial markets:

They fear a large fall in the stock market; they fear financial market turmoil; and they can be moved to cut rates if there is a sufficient crescendo of anguished voices from the financial markets and money centre banks. We all know that the Great Depression of the 1930s started with a stock market collapse and was aggravated by bank runs and a misguided monetary policy. The collapse of the multilateral trading system was the final nail in the coffin. Perhaps our central bankers have studied the 1930s too much.

Ouch. That's a swipe at Bernanke, who was a noted academic expert on the depression before becoming Fed chair.

On a related note, Economists' View has a useful summary of a recent speech by St. Louis Fed President William Poole, defending the Fed against the accusation that it is too concerned with bailing out financial markets.

SWF, enjoys investing, pina coladas

One consequence of the US current account deficit is increased foreign ownership of American assets - essentially, our trading partners are getting stocks and bonds in exchange for all the goods they're sending us.

Because of central bank intervention in foreign exchange markets and since we buy much of our oil from state-owned firms, much of these assets are in the hands of foreign governments. Traditionally, much of this wealth has been invested in US Treasury bonds, but increasingly foreign governments are forming "Sovereign Wealth Funds" (SWFs) with more diversified portfolios, including, in some cases, purchases of whole companies. The New Yorker's James Surowiecki writes about the concern this is generating:

What are people so anxious about? The first concern is obvious: no one wants foreign states, especially those which might be anti-Western, acquiring Western companies that have anything to do with national security or advanced technology. But policymakers also believe that having governments play an active role in the stock market and in the global economy might make the whole system less efficient and productive, since government-run companies would likely think about things other than the bottom line, including protecting the interests of their home country. This situation has put free-marketeers in a peculiar quandary. They usually favor the free flow of capital in the world’s markets, but, in this case, supporting the free flow of capital would mean letting governments run American companies, which no free-market economist thinks is a good idea.

The New York Times ran an article on the spending spree of oil producing countries under the headline "Oil Producers See the World and Buy it Up." One notable deal was Abu Dhabi's $7.5 billion investment in Citigroup yesterday. The Times reported:

A falling dollar, a growing pile of oil revenue and an interest in not being overshadowed by neighboring Dubai’s increasingly high profile spurred Abu Dhabi to break with its low-key investing tradition to purchase a big $7.5 billion stake in Citigroup.

That is the view of analysts, economists and deal makers who keep an eye on the secretive Abu Dhabi Investment Authority, the largest sovereign wealth fund in the world, with assets estimated at $650 billion. Despite its size, Abu Dhabi’s royal family has been largely content to pour money into low-return, low-profile investments — until now.

But Abu Dhabi, the largest oil producer of the seven city-states that compose the United Arab Emirates, is worried enough about the eroding value of its pile of petrodollars that it appears ready to pursue more big-ticket deals.

The article has a nice sidebar listing some other notable SWF purchases.

Should we be concerned? Surowiecki suggests that if we really don't like foreign governments buying our companies, we might want to change our own behavior:

The prospect of American companies being sold to foreign states is, to be sure, disconcerting. But it’s a problem of our own making. The reason that sovereign wealth funds are so flush with cash is all the dollars we spend on oil and Asian consumer goods. If we want to consume far beyond our means, then, one way or another we’re going to end up selling off assets to pay for it. Passing laws barring foreign states from acquiring American companies may help treat the symptom. But it’s not going to do much to cure the disease.

China Trade

For a long time, China's trade surplus with the United States was largely offset by a trade deficit with much of the rest of the world, leading to a roughly balanced trade position overall. This fact could be pointed to by those who wished to defend China against accusations of "unfair" trade practices. Not any more.... This week's "Off The Charts" feature in the NY Times has the (official) numbers, which show that China's trade surplus began to balloon in late 2004. Floyd Norris writes:

This week, China reported that its trade surplus for October came to a record $27 billion, a figure that is larger than its surplus for the entire year of 2003.

But even as it was posting a record surplus, China was reporting that its imports were at the lowest level in several months, and were particularly weak from Europe.

Over the last three months, China imported an average of $9.7 billion a month from Europe, a figure that was almost 5 percent lower than imports in the same three months of 2006. It was China’s biggest year-over-year decline in imports from Europe since 1998, when China was only a marginal presence in world trade, rather than the dominant force it has become.

Because China intervenes heavily in foreign exchange markets to limit the appreciation of the Yuan versus the Dollar (i.e. they are keeping the value of their currency artificially low), it has inherited some of the depreciation of the Dollar versus the Euro (i.e. European goods have become more expensive to China and Chinese goods cheaper to Europeans).

US exporters may be reaping the benefit as their European competitors get priced out of the market - according to the Census Bureau's Foreign Trade Statistics, the US exported $5.6 billion worth of goods to China in September, up 21% from a year ago (US imports from China were $29.4 billion, so the deficit is still huge, but shrinking).

In addition to its currency market intervention, China appears to be doing other things to promote a trade surplus. The NY Times reported on Friday:

Few American industries have had more success in selling goods to China than makers of medical devices like X-rays, pacemakers and patient monitors. Which is why a recent Chinese decree was so troubling.

The directive, issued in June, called for burdensome new safety inspections for foreign-made medical devices — but not for those made in China. The Bush administration is crying foul.

Even more worrisome to the administration is that the directive seems part of a recent pattern in which Chinese officials issue new regulations aimed at favoring Chinese industries over foreign competitors...

This is a good example of how regulations can be used to create "non-tariff barriers" to imports, which is why World Trade Organization rules require "national treatment" (i.e. apply regulations in the same way to imports as domestically-produced goods). This would appear to be clear grounds for a case at the WTO. It will be interesting to see if the Bush administration will take them on... Or maybe we should let the Europeans do it.

Taming The Twins

The trade deficit and fiscal (federal budget) deficits are sometimes referred to as the "twin deficits." They are linked by the identity: NX + NFP + Tr = NS - I; where NX is net exports (if negative, a trade deficit), NFP is net income from abroad and Tr is international transfers. Together, they are the current account, of which NX is by far the largest part - i.e. the US trade deficit drives the US current account deficit. The other side is national savings (NS) less investment (I), where national savings is private savings and government savings. The fiscal deficit is negative government savings; NS can therefore be thought of as the savings left after subtracting the part borrowed by the government. So, ceteris paribus, the trade deficit (-NX) and the fiscal deficit (which reduces NS) move together - hence the "twin deficits."

Last week brought news that both of deficits are shrinking. The CBO reported preliminary estimates that the federal deficit decreased to $161 billion in fiscal year 2007, from $248 billion the year before (the federal fiscal year ends in September). The biggest change in the spending side was a $65 billion decrease in "other programs and activities" (i.e. not defense or entitlement programs), which the CBO attributes to some one-time-only events:

The decrease in outlays for "other programs" was mainly due to unusually high spending in 2006 for activities related to the 2005 Gulf Coast hurricanes and for the subsidy costs recorded for student loans. Payments received in 2007 for licenses auctioned in 2006 for use of the electromagnetic spectrum further reduced net outlays. Excluding those three activities, spending for this category rose by about 1 percent.

On the revenue side, income tax revenue surged by $118 billion - partly this is the "automatic stabilizer" effect (taxes rise as incomes rise). A large part of the increase came from "nonwithheld income":

Nonwithheld income and payroll tax receipts gained about $55 billion (or 13 percent) in 2007. The two main components, quarterly estimated payments and final payments with tax returns, both grew at about that same rate. Nonwithheld receipts grew more slowly than the 19 percent rate recorded in 2006. The double-digit growth in 2007 probably reflects continued strong growth in income from sources other than wages and salaries.

Presumably, that would mostly be "capital income" like dividends, interest income and capital gains - growth in this type of income is consistent with the rising inequality reported by the IRS (see previous post).

As for the trade deficit - the BEA and Census Bureau reported exports of $138.3 billion and imports of $195.9 for a deficit of $57.6 billion for the month of August. That's $1.4 billion less than July and $10 billion less than August, 2006. This may, in part, reflect the continuing decline the in the value of the dollar, which makes US products cheaper to foreigners (increasing exports) and makes foreign products more expensive to Americans (decreasing imports). By country/region, the largest deficits were with China ($22.5 billion), OPEC ($11.4 billion) and Europe ($11.1 billion). Here's the NY Times story.

Who Our Creditors Are

The corollary of massive borrowing by the United States - the current account deficit was $811 billion in 2006 - is accumulation of US assets by foreigners (a "capital inflow"). As I discussed recently, this has generated some worry about a crisis if our creditors lose their appetite for holding US assets.

On his outstanding international macroeconomics blog, Brad Setser looks at the data on official reserves (e.g. foreign asset holdings of central banks) and finds that "Central banks came close to financing the entire US current account deficit." He writes:

I estimate that the world's emerging economies -- if those emerging economies that don't report detailed data on the currency composition of their reserves acted like those who do report -- are now adding about $200b to their dollar reserves a quarter. That is a pace sufficient to finance the entire US current account deficit. Central banks continue to buy more dollars when the dollar is heading down than when it is going up to keep the dollar's share in the (aggregate) portfolio constant -- and effectively serve as the dollars buyers of last resort in the global financial system.

Private flows still matter, of course. But right now private inflows roughly match private outflows, so all the heavy lifting required to finance the US external deficit is being done by the world's central banks. Their willingness to hold dollars allows the US to finance itself in dollars even when there isn't a lot of global demand for dollar assets.

The tools economists use to examine exchange rates and current accounts are mostly based on optimal behavior of individuals - e.g. a European investor will make a decision about whether to hold a German bond or a US bond by comparing the return on the German bond to the expected return on the US bond, converted to euros, and the dollar-euro exchange rate is ultimately determined by the demand for dollars from such investors (and the parallel behavior of US investors on the other side of the market).

Setser's finding reminds us that governments play huge roles in foreign exchange markets, and their motives are very different. In particular, many countries - primarily "emerging markets," of which China is most prominent - intervene in foreign exchange markets to keep the values of their currencies artificially low, making their exports cheaper. This involves selling their currency (increasing the supply of it and lowering its value) for dollars. In the process, the governments accumulate dollar reserves.

We still need to be concerned that our creditors might reduce their willingness to finance our current account deficit, but it is crucial to bear in mind how much of that financing is coming from governments rather than private investors maximizing expected returns.

Don't Look Down!

The greenback has sunk to parity with the Canadian loonie, and hit its all-time low against the Euro. In part, this reflects the Fed's interest rate cuts, which made investing in dollars less attractive. But the dollar's slippage does raise a bigger worry - that we could be headed for a current account "reversal." The the flip side of the US trade deficit (5.2% of GDP last quarter) is a "capital inflow" - in exchange for the goods they send us in excess of the goods we send them, our trading partners receive financial assets. That is, the US economy has become heavily dependent on borrowing from abroad. If our foreign creditors anticipate further declines in the dollar, they have an incentive to sell their US financial assets now... which would cause the dollar to fall further, which gives more reasons to unload dollar-denominated assets before everyone else does....

Or, as Paul Krugman asks, "Is This the Wile E. Coyote Moment?" There is considerable academic debate on the "sustainability" of our current account deficit (I seriously doubt it). If there is a reversal, does it come gradually, or all at once in an emerging-market style crisis? The upside of a dollar rout would be that exporting and import-competing industries would gain a price advantage over their foreign rivals (though it takes a while for exchange rate changes to "pass through" to consumer prices). The downside for consumers would be higher prices for imported goods (which would show up as inflation in our price indexes, presenting the Fed with a dilemma). More importantly, if the inflow of foreign finance is curtailed, long-term real interest rates would rise significantly.

Recall that GDP is the sum of government purchases (G), consumption (C), investment (I) and net exports (NX). The fact that NX is a negative number allows C + I + G to add up to more than 100% of GDP. The decline in the dollar would help with NX (our exports become cheaper to foreigners and imports become more expensive). Higher interest rates would reduce C and I. If the current situation is unsustainable, some rebalancing is necessary over the long run, but if it happens quickly, it could be quite unpleasant....

Krugman's asking the right question... has our ACME capital inflow kit (undoubtedly made in China) allowed us to run off the edge of a cliff? Is it time to turn to the kids watching at home and hold up a sign that says "gulp!"? However, if I'm correct on the laws of cartoon physics, we won't fall unless we look down.

On a related note, Ben Bernanke revisited his "savings glut" hypothesis of the current account deficit in a recent speech. This deserves more attention, but I'm not sure I'll get to it (fortunately, Econbrowser's Menzie Chinn did).

NB: the "current account" and trade deficits are not exactly the same, but they are closely related. The current account includes the trade deficit and also net income on foreign assets, but the trade deficit accounts for most of it.

Update (9/25): Here's The Economist's take (they're not so worried), and an op-ed by Morgan Stanley's Stephen Roach (who is worried).

Swapping Lemons with China

The US trade deficit with China is essentially an exchange of goods for financial assets; rather than getting an equal amount of goods in exchange for what they sell to the US, the Chinese are getting financial assets - stocks and bonds, etc. - in return. Or, in other words, the Chinese are purchasing US financial assets with their goods.

Lately, there has been much attention the fact that some of the goods we are importing from China have turned out to be unsafe - toys with lead paint, for example. As Dani Rodrik explains, the recent credit crisis has shown that many of the financial assets that we are selling to the Chinese (and other foreign investors) are also, arguably, unsafe.