Tuesday, September 14, 2004

The second quarter current account statistics are in, and man, what a doozy.
The U.S. current-account deficit--the combined balances on trade in goods and services, income, and net unilateral current transfers--increased to $166.2 billion in the second quarter of 2004 (preliminary) from $147.2 billion (revised) in the first quarter. The increase was more than accounted for by an increase in the deficit on goods and a decrease in the surplus on income. The surplus on services increased, and net outflows for unilateral current transfers decreased.
For those of you keeping score at home, a month ago the General estimated that the 2004:II deficit would come in around -$161bn. Reality turned out to be even worse than my bearish deflationista self could imagine! And not only is this a huge increase in the deficit -- a 13% jump (or is that a fall?) in a single quarter. Combined with the lackluster GDP growth of 2004:II, the current account deficit for the second quarter stands at an incredible 5.7% of GDP!!

For any normal country, this would be the signal call for a free-fall of the currency. Clearly the dollar is living a charmed life -- but how long do you want to count on magic?

Back in the days of Reagan when the US current account deficit first began to swell, the worst it ever ran was 3.45% of GDP. The last time we were in that kind of territory was 1999. Even before this last quarter, the worst stood at 5.15% in 2003:I, nearly repeated in 2004:I (5.13%). 5.7% is a monster of a figure no matter how you slice it.

Since 2003:IV the current account is in a literal freefall. The deficit grew 31% in just six months.

The most ominous sign is the waning positive balance on income, which in the second quarter was at its lowest level in almost two years. More importantly, the net balance on income was down 78% from last quarter and down 68% from the quarterly average of 2003. It has been the net positive flow of income into the United States that has been one of the few saving graces of the growing current account deficit, offsetting the huge trade deficit with a small but net positive flow of income from US capital investments abroad.

With the United States' net investment position at around -30% of GDP, the balance on income was bound to turn negative sooner or later. In fact, its consistent ability to keep its head above water was a minor miracle for over 15 years, i.e. since the US became a "net debtor country". From 1960 to 1997 the US never ran a quarterly net income deficit. Not once. The second half of 1998 saw two consecutive quarter of net outward flow of investment income, but the trend was solidly reversed by ten consecutive quarters of positive net income. Since 2001, however, US net income flows have been on a wild ride, more than once reversing course by ten billion dollars in just 6 months.

While income receipts over the last three quarters have been fairly constant, income payments have skyrocketed. After nine straight quarters in the $60-71bn range, payments shot up to $84bn in 2004:II. And with all the debt the US is taking on from foreign lenders, how could they not?

It seems hard to reject the claim that the US is entering into a debt spiral. Ever larger trade deficits are amassed, paid for through more and more debt from foreigners (government and corporate bonds) and selling more and more property to them (stocks, real estate, fixed capital). The net income on that debt and property becomes negative (with a net investment position of -30% of GDP, how could it not?), thus income flows out. Thanks to the big trade deficits, the only way to bring that income back is to amass more debt and sell more property, which leads to more net outflows of income, which can only be brought back via more debt and more property sales, etc. etc.

What can end this spiral, bringing it to a close short of an Argentina-like catastrophe? [1] A dramatically falling dollar and/or [2] a dramatically rising US current account balance, say to around -2.5% of GDP (where the US was as recently as 1998). [2] without [1] just isn't a serious possibility; even with [1], [2] might be impossible short of a serious recession (which 'solved' the current account deficit in 1991). After all, this isn't going to be accomplished with a gargantuan growth in exports; imports will have to fall as well.

And when I say a "serious" recession, I mean it. In 1991 the US pulled out of a deficit of only around -1.5% of GDP. The recession of the early 1980s erased a deficit of just -0.5% of GDP, and the 1973-74 recession erased one just as small. Remember, we're at -5.7% of GDP now. Even to get to -2.5% we'll have to traverse over $300bn of territory, this when our trade balance is around minus $50bn a month.

Are you worried yet? I am.

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