by Joseph Brusuelas, Chief Economist/VP Global strategy, Merk Investments | June 20, 2008
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Lost amidst recent data on inflation, the rise in oil prices, a deepening crisis in the housing market and the uncanny ability of Goldman-Sachs to outperform market expectations was the deterioration of the current account balance in Q1’08. The U.S. current-account deficit increased to $176.4 billion in the first quarter of 2008 vs. the $167.2 billion recorded in the fourth quarter of 2007. The primary catalyst for the increase was a decline in earnings from foreign investments and the sharp increase in the cost of imported oil. Should such an unsustainable and large deficit continue to persist, the value of the dollar over time could see another sharp adjustment due to the combination of global macroeconomic imbalance and the unwise economic domestic economic policies pursued in the US over the past few years.
In contrast to many market players, economists often pay close attention to the current account balance. The current account is one of the two primary components of the balance of payments, the other being the capital account. Precisely defined, it is the sum of the balance of trade (exports minus imports of goods and services), net factor income (such as interest and dividends) and net transfer payments (such as foreign aid). This broadest measure of trade implies that the US needs to attract roughly $1.9 billion of capital a day from foreign sources to bridge the gap in the current account. That gap, roughly translated, equaled 5.0% of gross domestic product in the first quarter of the year, which is an increase from the 4.8% posted in the final three months of 2007.
Many argue that due to the increasing depth of global capital markets, the damage that one would normally associate with large current account deficits does not necessarily have to follow. Others argue that if the current account deficit is driven by the private sector is not that problematic and that it can even be a virtue for an economy due to the large inflows of capital investment.
So, why should we care about something seemingly as arcane as the current account deficit? First, the type of deficits now facing the US are unsustainable and are linked to large global imbalances that may require non-market actors to set prices in order to facilitate what policymakers, who are often unelected and not-accountable to shareholders, refer to as an orderly adjustment. Such a move away from free market principals will only serve to cause further distortion in the price of the dollar and cannot be guaranteed to succeed.
Under normal circumstances action to reduce a current account deficit typically involves increasing exports or decreasing imports. In developing economies, such a goal may be achieved through import restrictions, quotas, duties or subsidizing exports.
However, the US economy and the US current account deficit cannot by any definition be assigned the label “normal. In a developed open economy, like that of the US, such action runs counter the free and flexible markets that are behind the increase in economic output that we have observed over the last quarter of a century. Thus, under current conditions internationally coordinated action would require placing a floor under the dollar and stimulating demand for US goods and services in Asia and the Middle East. Both lofty goals, that would be at best, very difficult policy objectives to achieve.
Because the prospect of coordinated international action is quite unlikely due to the varied interests that have to be satisfied to obtain such collective action, the policy initiative that has been pursued over the past several years has been purely a domestic endeavor. That policy has been to pursue a weak dollar to make imports more expensive and indirectly increase the balance of payments. Complementing a weak dollar policy to address a current account deficit has been a tolerance of higher domestic inflation vis-à-vis accommodative monetary policy and an increase in spending to favor domestic firms.
Second, social and political fads come and go. Yet, very little changes with respect to the logic of macroeconomics. The current account deficit as currently composed is not sustainable. The fact that it is increasing during a time of relative economic weakness should be some cause for concern. There is no guarantee that a coordinated intervention among central banks to prop up the dollar will succeed over the medium to long term. Just as important, the out of control spending on special interests and entitlement programs in Washington provide an outsized risk to the stability of the domestic economy and the long term viability of the dollar as a the global reserve currency.
In domestic terms, the attempt to derive a correction in the current account through the depreciation of the domestic currency may drive down the price of domestic goods and boosts exports relative to imports, but it also has opened the door to inflation. Instead of attempting to put into place a regulatory framework that provides incentives for pro-growth and savings policies to address the current account deficit or attempt to bring the out of control spending in Washington under control, the US has ushered in a set of policies that will stimulate a period of extended weakness for the dollar.
The weak dollar policy of the Bush administration and the accommodative monetary policy of the Bernanke led US Federal Reserve have been the primary factors that have driven down the value of the dollar. Short term there is a strong possibility that in the context of a Fed on hold in June, followed by a probable ECB rate hike on July 3, the market could observe a sharp reduction in rate expectations for the Fed and with it support for the dollar. We would not be surprised to the see the EUR/USD re-test 1.60 in the coming weeks. Medium term, a non-sustainable current account deficit is but one the primary factors that is behind our call of the EUR/USD to 1.70 and our long-term bearish outlook on the greenback.