Fred Bergsten, Director of the Peterson Institute for International Economics, gave an excellent presentation in Washington today explaining how his recent research with his Institute colleagues demonstrates that deficits do matter–even in a global economy where the U.S. is able to finance those deficits with a lot of foreign capital. Under a current-policy-extended type of scenario which the authors call the “fiscal erosion scenario”:
…by 2030, the deficit in trade in goods and services reaches $3 trillion; net investment income transfers to foreigners exceed $2.5 trillion despite the fact that American investments abroad continue to earn a much higher return than foreign investments in the United States; the current account deficit thus exceeds 15 percent of GDP (and could reach 25 percent on plausible estimates of induced effects on interest rates); and the country’s net foreign debt climbs to 140 to 175 percent of GDP. The main transmission mechanisms are a rise of 240 basis points in US interest rates, compared with the “benign baseline,” and a corresponding rise of more than 20 percent in the exchange rate of the dollar that severely undermines the international price competitiveness of US exports.
Note the mention of the 240 basis-point rise in interest rates. In other words, the U.S. bumps up against a limited supply of capital from which to borrow, even on the global capital market. And when there’s excess demand, the price of borrowing–i.e., the interest rate–rises.
Dean Baker seems to forget that there are two sides to the global capital market when he tries to suggest that current trends for deficit spending don’t imply high interest rates and that we’re maybe even lucky that other countries are in recession too:
This [New York Times] article [which suggests that rising interest rates imply rising concern about the budget deficit] also misrepresents some other aspects of the government’s financial situation. For example, it asserts that because most of the rest of the world is in recession there is less money to lend to the United States: “Most of the world is in recession, and other nations have rising borrowing needs as well.”
In fact, the opposite is the case. It would be harder for the United States to borrow if the rest of the world were growing rapidly and there were many competing demands for capital in both the public and private sectors.
But when crowding out happens, it’s due to excess demand for capital. Excess demand can occur when demand is too high, yes. But it can occur when supply is too low, as well. When other countries no longer have “savings gluts,” there’s less global capital available for the U.S. to borrow. And that’s what Fred Bergsten was explaining today, with these warnings about the “fiscal erosion” scenario:
The main conclusion is that the United States would face sizable costs and adjustment requirements under anything approaching this outcome. About 7 percent of GDP annually would be transferred to foreigners to service our huge international debt position, thus denying ourselves access to this sizable share of US output for either consumption or investment. At some point we would almost surely have to reduce the external deficits by contracting domestic demand by at least 13 percent of GDP annually, perhaps twice as great as the maximum impact of the current crisis.
The clear policy implication of this analysis is the need to restore the US budget position near or to balance over the course of the economic cycle, including achievement of at least modest surpluses during periods of strong economic growth (like 2003–06). Fiscal policy is the only tool that both is under the control of our governmental authorities and will clearly move the country’s international economic position in the right direction. Even if such a policy shift does not lead to an improvement in the external imbalance, as in fact the move to budget surplus in the Clinton years did not close the current account deficit, the stronger fiscal position would produce a more robust private investment environment that could generate the wherewithal to repay foreign creditors and still provide for domestic consumption. These global implications of fiscal policy thus add sharply to the case for early action, as soon as possible after recovery from the current crisis, to put the budget on a sustainable long-term trajectory.