- The Washington Times - Saturday, January 14, 2006

As the chairman of President Reagan’s Council of Economic Advisers (CEA), Martin Feldstein distinguished himself as a deficit hawk among a sea of supply-siders who mocked him in public for his fiscal concerns. At the same time, an extraordinarily tight monetary policy appropriately pursued by then-Federal Reserve Chairman Paul Volcker produced a significantly overvalued dollar, which generated then-record-level trade and current-account deficits. Indeed, soon after the dollar reached its inflation-adjusted, trade-weighted peak in 1985, the U.S. current-account deficit climbed to the then-astonishing levels of 3.3 percent of gross domestic product (GDP) in 1986 and 3.6 percent in 1987.

As the former CEA chairman, Mr. Feldstein watched from his perch at Harvard University as the dollar plunged by 30 percent by April 1988. As a result, the trade deficit declined precipitously, reaching 0.5 percent of GDP in 1991, when the current account actually registered a tiny surplus.

Today, huge federal budget deficits are back, having totaled more than $1.1 trillion over the past three fiscal years. Large as they are, the budget deficits are actually dwarfed by the trade and current-account deficits. Over the last three years, the cumulative trade deficit exceeded $1.8 trillion, while the current-account deficit reached $2 trillion. Last year’s current-account deficit reached 6.4 percent of GDP. That’s 3 percentage points above the worrisome levels of the mid-1980s.

Meanwhile, as the budget and trade deficits were soaring in recent years, the personal saving rate was plunging. Compared to $250 billion in personal saving in 1995, for example, the annualized level of personal saving for last year’s third quarter had plummeted to a negative $159 billion, reflecting an annualized swing of more than $400 billion. (Even that sizable swing pales compared to the fiscal reversal, as the federal budget moved from a surplus of $236 billion in 2000 to a $412 billion deficit four years later.)

These unsustainable trends in the personal saving rate and the budget, trade and current-account deficits are all interconnected. With the collapse of personal saving, the massive financial capital inflow (which is the flip-side of the current-account deficit) was needed to finance the soaring budget deficit. Indeed, 100 percent of the $1.1 trillion in cumulative federal budget deficits over the past three years was effectively financed by foreign investors, both private and public. The residual financial inflows from overseas were needed to prevent business investment in capital equipment from plunging.

Twenty years after he left the CEA, Mr. Feldstein, who also holds the prestigious position of president of the National Bureau of Economic Research, remains a bona fide conservative economist, albeit from the deficit-hawk’s camp. In Tuesday’s Financial Times, Mr. Feldstein sounded an alarm in an op-ed headlined, “Why Uncle Sam’s bonanza might not be all that it seems.” He warned that 2005’s current-account deficit, which approximated $800 billion, “is widely predicted to move much higher”; and he approvingly observed that “[e]xperts estimate that the real, trade-weighted value of the dollar must fall by at least 30 percent just to shrink the trade deficit to a more sustainable level of 3 percent [of GDP]. Much larger dollar declines,” Mr. Feldstein noted, “are also possible.”

In addition to suggesting that U.S. interest rates might have to climb much higher to continue attracting the capital inflows upon which America has become increasingly dependent, Mr. Feldstein specifically rejected the view that the current “inflow is coming primarily from private investors who are attracted by the strength of the American economy.” That view, by the way, is strongly held by Treasury Secretary John Snow. However, Mr. Feldstein points out that today — in contrast to the second half of the 1990s, when “the current-account deficit was financed by a net inflow of equity funds” — there is “very little equity flow to the U.S.” Moreover, in contrast to the widely held belief that private investors are purchasing the bonds and shorter-term fixed-income instruments that are now being used to finance the overwhelming majority of today’s current-account deficit, Mr. Feldstein convincingly argues that many of those bonds are actually being bought by OPEC nations and other governments, which are merely using private intermediaries to make bond purchases for them.

Finally, he debunks the view that current capital inflows significantly exceed the amounts needed to finance the current-account deficit. If Mr. Feldstein’s legitimate worries come to fruition, the result could well be a hard landing.

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