What’s causing the trade deficit?

Gosh darn it, if part of being a transatlantic fellow for the German Marshall Fund of the United States means going to northern Italy for the rest of this mid-June week to try and promote greater transatlantic understanding, then I have no choice but to do my duty. Blogging could be erratic over the next few days. Talk amongst yourselves. Here’s a topic — is the a massive current account deficit a function of the sizeable budget deficit, the low U.S. savings rate, currency manipulation, or a global savings glut? The global savings glut argument has been advanced by Ben Bernanke, who is likely to be the next Fed chairman. A quick precis of his argument: I will take issue with the common view that the recent deterioration in the U.S. current account primarily reflects economic policies and other economic developments within the United States itself. Although domestic developments have certainly played a role, I will argue that a satisfying explanation of the recent upward climb of the U.S. current account deficit requires a global perspective that more fully takes into account events outside the United States. To be more specific, I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving–a global saving glut–which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today…. [S]pecific trade-related factors cannot explain either the magnitude of the U.S. current account imbalance or its recent sharp rise. Rather, the U.S. trade balance is the tail of the dog; for the most part, it has been passively determined by foreign and domestic incomes, asset prices, interest rates, and exchange rates, which are themselves in turn the products of more fundamental driving forces. Instead, an alternative perspective on the current account appears likely to be more useful for explaining recent developments. This second perspective focuses on international financial flows and the basic fact that a country’s saving and investment need not be equal in each period…. That inadequate U.S. national saving is the source of the current account deficit must be true at some level; indeed, the statement is almost a tautology. However, linking current-account developments to the decline in saving begs the question of why U.S. saving has declined. In particular, although the decline in U.S. saving may reflect changes in household behavior or economic policy in the United States, it may also be in some part a reaction to events external to the United States–a hypothesis that I will propose and defend momentarily. One popular argument for the “made in the U.S.A.” explanation of declining national saving and the rising current account deficit focuses on the burgeoning U.S. federal budget deficit, which in 2004 drained more than $400 billion from the national saving pool. I will discuss the link between the budget deficit and the current account deficit in more detail later. Here I simply note that the so-called twin-deficits hypothesis, that government budget deficits cause current account deficits, does not account for the fact that the U.S. external deficit expanded by about $300 billion between 1996 and 2000, a period during which the federal budget was in surplus and projected to remain so. Nor, for that matter, does the twin-deficits hypothesis shed any light on why a number of major countries, including Germany and Japan, continue to run large current account surpluses despite government budget deficits that are similar in size (as a share of GDP) to that of the United States. It seems unlikely, therefore, that changes in the U.S. government budget position can entirely explain the behavior of the U.S. current account over the past decade…. The weakening of new capital investment after the drop in equity prices did not much change the net effect of the global saving glut on the U.S. current account. The transmission mechanism changed, however, as low real interest rates rather than high stock prices became a principal cause of lower U.S. saving. In particular, during the past few years, the key asset-price effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported record levels of home construction and strong gains in housing prices…. The expansion of U.S. housing wealth, much of it easily accessible to households through cash-out refinancing and home equity lines of credit, has kept the U.S. national saving rate low–and indeed, together with the significant worsening of the federal budget outlook, helped to drive it lower. As U.S. business investment has recently begun a cyclical recovery while residential investment has remained strong, the domestic saving shortfall has continued to widen, implying a rise in the current account deficit and increasing dependence of the United States on capital inflows. According to the story I have sketched thus far, events outside U.S. borders–such as the financial crises that induced emerging-market countries to switch from being international borrowers to international lenders–have played an important role in the evolution of the U.S. current account deficit, with transmission occurring primarily through endogenous changes in equity values, house prices, real interest rates, and the exchange value of the dollar.

Is Bernanke correct? This argument does jibe with recent research suggesting that reducing the budget deficit doesn’t have a large impact on the trade deficit. However, for critiques of this argument, see Daniel Gross’ link-rich essay in Slate, as well as cogent posts by Brad Setser and this post by Brad DeLong. My take — this isn’t an either-or question. Bernanke identifies a cause that has been underplayed by administration critics, but Bernanke himself makes it clear that he thinks domestic factors also play a role. Much more disconcerting is this section of Bernanke’s speech:

Because investment by businesses in equipment and structures has been relatively low in recent years (for cyclical and other reasons) and because the tax and financial systems in the United States and many other countries are designed to promote homeownership, much of the recent capital inflow into the developed world has shown up in higher rates of home construction and in higher home prices. Higher home prices in turn have encouraged households to increase their consumption. Of course, increased rates of homeownership and household consumption are both good things. However, in the long run, productivity gains are more likely to be driven by nonresidential investment, such as business purchases of new machines. The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be. A third concern with the pattern of capital flows arises from the indirect effects of those flows on the sectoral composition of the economies that receive them. In the United States, for example, the growth in export-oriented sectors such as manufacturing has been restrained by the U.S. trade imbalance (although the recent decline in the dollar has alleviated that pressure somewhat), while sectors producing nontraded goods and services, such as home construction, have grown rapidly. To repay foreign creditors, as it must someday, the United States will need large and healthy export industries. The relative shrinkage in those industries in the presence of current account deficits–a shrinkage that may well have to be reversed in the future–imposes real costs of adjustment on firms and workers in those industries.

There is another danger — the encouragement of speculative investment in housing in the U.S. and elsewhere. See the New York Times‘ David Leonhardt and Motoko Rich, as well as the Economist, for more on this.