Debating the ‘twin deficits’

An ongoing debate among economists about America's surging "twin deficits" in foreign trade and the federal budget and the concomitant decline in personal saving, is the focus of the winter issue of a new quarterly public-policy journal, the American Interest. Allen Sinai, chief global economist and president of Decision Economics Inc., expressed considerable concern about the trends in the twin deficits. Philip Merrill, who served in the Bush administration for two and a half years as president of the Export-Import Bank of the United States, offered a remarkably sanguine view.

According to economic theory and simple arithmetic, the twin deficits generally tend to push the economy in opposite directions. In the short term, huge budget deficits have an expansionary effect on the economy, while rising trade deficits, as a simple arithmetic fact, exert a negative effect on the economic growth rate. Thus, economists who are worried about these trends are concerned about their long-run impact if they are not reversed or significantly moderated. So, the debate isn't about the recent past. It is about the future.

Asserting that the trade and budget deficits "represent a dangerous and threatening imbalance in the U.S. economy," Mr. Sinai says "the debt and potential debt service associated with financing both deficits could exert a huge drag on the performance of the U.S. economy and ultimately Americans' standard of living." As a share of the U.S. economy, the trade deficit has increased from a negligible level of 0.6 percent of gross domestic product ($39 billion) in 1992 to 4 percent of GDP ($421 billion) in 2002 to $726 billion last year (5.8 percent of GDP). In recent years, because Americans have borrowed trillions from foreign investors to finance the twin deficits, future debt-service payments will increasingly be sent abroad. America's net international investment position has deteriorated by more than $2 trillion over the previous decade, reaching a negative $2.5 trillion by the end of 2004. That negative $2.5 trillion figure excludes the impact upon America's net international investment position as a result of the $1.044 trillion total for the twin deficits ($726 billion in trade and $318 billion in budget) in 2005.

Warning that "the deficits are expected to rise sizably and to generate increased debt relative to GDP" between 2007 and 2012, Mr. Sinai says "there is a significant risk that, during this period or perhaps before, financial markets and the economy might suffer." Indeed, between now and 2012, if the trade deficit continues to grow at the same rate it has grown over the last decade (an average compounded rate of 22.4 percent per year) and if nominal GDP increases according to its decade-long trend rate (5.4 percent), then the 2012 trade deficit would reach $3 trillion, or 16.6 percent of GDP. Such a trend is unsustainable. What might happen before then? Mr. Sinai argues that "[t]he dollar would fall, interest rates would rise, and the stock market would decline." "Unfortunately," because "societies such as the United States do not typically react to problems before the sky actually falls," Mr. Sinai warned that the "twin deficits represent a distinct danger on the road ahead."

For his part, Mr. Merrill argues that the problem with the deficits "is vastly exaggerated. So long as the U.S. economy is growing faster than either our trade or budget deficit, they are not critical problems." Referring to 2004 data, he says "U.S. annual growth is greater than the $600 billion trade deficit or the $400 billion budget deficit." Well, nominal GDP advanced by $745 billion in 2005, when the trade deficit reached a nearly identical amount of $726 billion. (The closely related 2005 current-account deficit, which includes international transfer payments and investment-income data, will likely reach $840 billion, which, according to Mr. Merrill's standard, would be considerably higher than the change in GDP.)

Meanwhile, the Bush administration projects that the unified budget deficit will rise by a third this year. But the unified deficit includes massive current surpluses in the Social Security trust funds, whose long-term solvency is highly questionable, at best. Remove Social Security from the budget calculations, and one finds that the remaining on-budget deficit totaled $1.6 trillion over the past three fiscal years. During the same period, nominal GDP increased by $1.9 trillion. Generating $1.6 trillion in on-budget deficits to produce $1.9 trillion in nominal GDP growth does not seem sustainable or desirable.

Messrs. Sinai and Merrill agree that official government statistics understate personal saving. There is merit to that argument. Those data, for example, exclude soaring housing values and do not fully capture the income from other capital gains. "In America, which is very much an ownership society in which most people's main savings is the equity on their home, this is a misleading omission," Mr. Merrill says. Thus, Mr. Merrill says he doesn't "worry about our savings rate any more than I lose sleep about the [trade and budget] deficits and the dollar."

It is, however, worth noting that America has been a homeownership society for decades; but only in 2005 did the personal saving rate, which averaged 8 percent during the 1970s, 1980s and 1990s, become negative -- for the first time since 1933. Moreover, Mr. Merrill effectively rebuts his own argument about soaring home values replacing traditional savings. Detecting a "current real estate/housing bubble," Mr. Merrill says there "is likely to be a 30 percent collapse in U.S. housing prices in the near future." That would wipe out trillions and trillions of dollars in effective household savings that he had earlier cited as a major reason for his sanguinity.

The twin deficits, and a $6 trillion deflation of a housing bubble, mean less sound sleeping for many economists, especially those who agree with Mr. Merrill, as they look toward the future.