The American economy: is the current account deficit a problem?
Gerard Jackson
The left are grinding their teeth as the Bush economy steams ahead, confounding their predictions of soup kitchens, mass poverty, economic collapse and the return of Attila the Hun. Needless to say, Republican apologists are patting themselves on the back for a job well done while slyly poking their fingers into the left’s collective eye.
It’s not my intention to rain on President Bush’s parade but there are dangerous economic undercurrents that need to be recognised. Unfortunately the very existence of these undercurrents is denied by the vast majority of economists, including those on the left.
Cato Institute’s Dan Griswold’s Bad news on the Trade Deficit Often Means Good News on the Economy is an example of what I mean. This report is being used by some economic commentators as evidence that the current account deficit is not a problem.
Larry Kudlow (NRO, 1 February 2005) quoted the following from the report: “an analysis of economic data from the last quarter century shows that a growing current account deficit (as a percent of GDP) is actually associated with faster, not slower, economic growth, as well as rising manufacturing output and falling unemployment.”
Although the statement is true it is still misleading. Now I am the first to admit that there is basically nothing wrong in itself with a current account deficit, whether it be 6 per cent or 10 per cent of GDP.
America ran a balance-of-trade deficit from the 1770s to the 1870s; throughout the nineteenth century and into the twentieth Britain ran a persistent deficit on her balance of trade.
The problems start when a country runs current account deficits on paper currencies. This means that because America is not on a species standard it is impossible to tell from Griswold’s statistics whether the current account deficit is the symptom of a monetary disturbance or the product of a healthy demand for foreign investment funds.
Griswold’s table uses “three measures of economic performance – GDP, manufacturing output, and the unemployment rate–the U.S. economy performs better in years when the current account deficit is rising as a share of GDP than in years when it is shrinking. And it performs especially well in years when the current account deficit is rising most rapidly.”
This approach seems to treat the current account as a barometer that measures the economy’s health. When unemployment falls and output rises the current account deteriorates, indicating that the economy is expanding.
(Although Griswold’s table uses per centage changes over the previous year I shall use actual per centage rates for unemployment).
In 1984 the current account worsened while manufacturing output changed by 6.4 per cent and unemployment fell from 9.6 per cent in the previous year to 7.5 per cent.
The current account also deteriorated in 1982 and 1983. However, in 1982 manufacturing changed by -5 per cent while the jobless rate rose from 7.6 in 1981 to 9.7 per cent; 1983 saw manufacturing output change by 13 per cent and the jobless rate fall marginally to 9.6 per cent.
To make sense of the 1980s figures I think we need to go to the 1970s. In 1978 M1 increased by 8 per cent and by only 1.3 per cent in 1979. It then dropped to -0.7 per cent per cent in 1980. (M1 is from January to December).
One should expect that after such a severe monetary squeeze resulting in a mild deflation that there would be a significant impact on the current account deficit, manufacturing and employment.
The current account deficit dropped from -15,143m in 1979 to -285m in 1980, rising to -5,030 for 1981 (Economic Report of the President 2004, table B-103) while unemployment rose from 5.8 per cent to 7.1 per cent.
Mr Griswold’s table shows manufacturing contracting by -1.2 per cent in 1980 and -4.1 per cent in 1981. This is what we would expect from such a tight monetary policy.
Economists should always bear in mind that the devil is in the details. Members of the Austrian school of economics not only expect manufacturing to be hit particularly hard by tight monetary policies but that the higher stages of production will suffer more so than those stages closer to consumption.
The following figures are from the Economic Report of the President 2004, table B-53, and seem to support the Austrian view. They show that iron and steel production peaked in 1979 at 123.9 and then plummeted to 104.9 in 1980 and 67.3 the following year. The production of fabricated metal products, many of which are industrial inputs, fell rapidly from 80.5 in 1979 to 67.6 in 1982.
Machinery production started to decline from 83.2 in 1979 to 59.3 in 1983, after which it began to recover. Chemical production also reached a peak in 1979 at 69.4, after which it fell in the following year to 65.6 and in 1982 it dropped to 62.4.
The motor vehicle and chemical industries require a special mention. It should go without saying that the expense and durability of cars makes them sensitive to economic downturn despite the fact that they are consumption goods.
The chemical industry is particularly interesting in the context of recent recession. Although it contracted in response to the 1979-80 monetary squeeze it continued a steady expansion after that experience. (In my opinion, this raises the question of whether the industry has become more structured to meet the needs of the lower stages of production).
What we find is that Mr Griswold’s indicators appear to change in response to changes in M1, which basically consists of currency and bank deposits.* However, from an Austrian angle what is of interest are changes in bank deposits.
The Austrians argue that fractional reserve banking artificially expands credit which then triggers the boom-bust cycle. Moreover, this credit expansion leads to malinvestments in the higher stages of production which then have to be liquidated when the monetary brakes are applied.
As bank deposits are the largest component of M1, we should therefore look to them when it comes to examining Mr Griswold’s indicators in greater detail.
Note: The Austrian perspective on these matters is somewhat more complicated than I have indicated.
*Austrian definition of M1:
1. Currency outside U.S. Treasury, Federal Reserve Banks and the vaults of depository institutions.
2. Demand deposits at commercial banks and foreign-related institutions other than those due to depository institutions, the U.S. government and foreign banks and official institutions, less cash items in the process of collection and Federal Reserve float.
3. NOW and ATS balances at Commercial banks, US branches and agencies of foreign banks, and Edge Act corporations.
4. NOW (negotiable order of withdrawal) and ATS (automatic transfer service) balances at thrifts, credit union share draft balances, and demand deposits at thrifts.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 7 February 2005