“America`s Scary Deficit” Craig Parsons YNU-Economics Fall 2016

How big is the US CA deficit? $805 billion in 2005 For comparison, Spain: $86 UK: $58 In percent terms, this is about 6% of US GDP 2.5% of UK GDP 9% of Spain`s GDP Thailand, Mexico, et al had 7+% prior to crises

Update: 2015 US CA deficit/GDP has recently been around 2.5% of GDP, so much smaller than when some panicked in 2005. US CA Deficit in 2015 was: $460 billion (approximately)

Why do some worry about it? In absolute terms, it is HUGE Some worry that as the largest economy, it is not good to be the largest debtor Related to 2nd point, UK was not a net debtor in 19th century Economists Setser and Roubini think we should worry Levey and Brown think we are worrying too much

Main takeaway: Countries run deficits by borrowing US (govt and private) is borrowing from Japan and China and the rest of the world. Or, alternatively, China, Japan, etc. are lending to the US! Same thing!

(X-M)=(S-I) + (T-G) GDP, let`s call is `Y`: Y= C+I+G+(X-M) But it is also true that: Y=C+S+T (from the income side your money only has three places to go, spending (C), saving (S) or the tax collector (T).

`X-M` derivation continued We can equate the two `Y`s, such that: Y=Y Or C+I+G+X-M= C+S+T We can cancel the Cs on left and right side: I+G+X-M = S + T Or re-arranging: X-M = (S-I) + (T-G) Or, trade deficit is private savings plus gov`t savings

How can a country have a deficit? If X-M<0. But this can only* happen two ways: If both S-I and T-G are negative or If S-I or T-G is a really BIG negative and the other is a smaller positive. E.g. US in 2005, X-M about $792 billion T-G was about -$367 billion (budget deficit) -$792= (S-I)+ -$367 This implies that S must have been lower than I, i.e. US savings less than US investment opportunities/demand

First: Why is it so large? Recall: (X-M)=(S-I)+(T-G) 1) T is less than G (US govt spends too much) 2) S is less than I, part 1 (US citizens` low savings) 3) S is less than I, part 2 (US a great place to invest for the world) 4) *Foreign Central Banks (e.g. China and Japan, but also oil exporters, Switz, etc.) are buying huge amounts of US debt

Can US pay back its debt? Suppose all US trade deficit was `caused` by US Gov`t deficit, which is financed in turn by borrowing from Bank of China (govt). I.e. Say: X-M= S-I + T-G Assume S-I=0. -$500 billion= 0 + (-$500 billion) (also assume that all US govt deficit financed by China…which is not true. Most US debt is held by Americans.)

Can US pay China back? Yes. How does US pay back debt to owners of its debt? With dollars. US Fed can print US dollars whenever it wants. At no cost! So, if China wants US to pay back all its debt now, US will simply print US dollar bills and give them to China. What will China do with all $$? Buy US goods/exports? Buy companies in US? Probably some of both.

Big questions 1) Can this huge deficit last forever? 2) If it cannot, how will it adjust? 3) When/if it adjusts, will it adjust fast or slow?

Two possible adjustment scenarios “Hard landing” (Setser/Roubini) Rapid dollar depreciation Rapid US GDP decline and rising unemployment Therefore, global recession/depression “Soft Landing” (Levey/Brown) Gradual decline of dollar US and other governments intervene to allow smooth adjustment; no recession

Levey and Brown: “Don`t Worry” 1) Foreign central banks (China/Japan) will continue to finance US deficit/debt 2) Even if foreign banks “pull out”, US and other private investor will fill that gap 3) If there is a crash, it would hurt EU and Japan (and China?) far worse than the US, therefore they (the other countries) won`t let a crash of the dollar occur

Setser and Roubini disagree They feel Levey and Brown are wrong about all three assumptions above Thus, the US must act NOW to correct CA (through fiscal and other measures)

Is the US CA deficit different? The US CA deficit is as big as some LDCs that experienced crises However, there is at least big difference: US debt is its own currency, dollars! When Mexico and Thailand and others had huge CA deficits, and foreign debt they borrowed in dollars; therefore a peso or baht crash hurts them badly (as debt must be paid back in $) For US, who lends $-denominated debt, and must pay back the debt in dollars, this is easy to do. Simply print more US$! If the dollar falls, the value of the debt gets smaller!

How much is due to what? A recent, careful analysis (Benedetto, 2014) of US deficit reveals the following: 1) yes, some of US deficit is `US should save more` (and China should save less) 2) yes, some of US deficit is due to `US is great, or less bad, place to invest! 3) but, a LOT of it, especially recently is foreign governments buying US debt, i.e. loaning US the money (China, Japan, etc.)

Read my notes! Make sure to read the more detailed notes for Lecture 8 Try to read the two papers by Setser/Roubini and Levey/Brown A Japanese version of the notes of notes available too (no Japanese version of this PPT however. Sorry.)