States
Figure 3.1: US Current Account Deficit
plications for long-run sustainability of the ever-widening external deficit in the US, it is instructive to examine the causes of 1995 1997 1999 2001 2003 -6 -5 -4 -3 -2 -1 0 1 % of GDP
Source: OECD Statistical Compendium.
In order to understand the im
the deficit. One way of characterising the current account balance is that it is the difference between national savings and national investment. During the second half of the 1990s savings sustained rising domestic investment (see Figure 3.2). However, since 2000 there has been a strong decline in the savings rate, largely attributable to a fall in public sector saving due to the growing fiscal deficit and a decline in household saving, albeit from a low base (see Figure 3.3). Two main factors explain the fall in the household savings rate. First, strongly expansionary monetary policy resulted in real interest rates falling by about 4 per cent between 2000 and 2004 making saving less attractive and facilitating borrowing for consumption purposes. Second,
18 We are very grateful to Ray Barrell and Ian Hurst of NIESR for their assistance in using the
NiGEM model. The forecast remains the sole responsibility of the authors.
19 See Mann (2003), Obstfeld and Rogoff (2005), Blanchard, Giavazzi and Sa (2005) and IMF World Economic Outlook, September 2005.
20 Remarks by Federal Reserve Board Chairman Alan Greenspan, before the Banco de Mexico’s 80th Anniversary Conference, Mexico City, November 14th, 2005.
30 MEDIUM-TERM REVIEW 2005-2012
between 1997 and 2004 house prices have risen by about 7 per cent per annum and the associated wealth effect for homeowners has encouraged higher consumer spending.
Figure 3.2: US Savings and Investment as a Share of GDP
1990 1992 1994 1996 1998 2000 2002 2004 0 1 2 3 4 5 6 7 8 9 10 % of GDP
Source: Bureau of Economic Analysis. Figure 3.3: US Saving by Sector
The relative rise in US demand for imports compared to demand for its nt factor contributing to the current account faster growth in the US than the Euro Area nd also by an earlier recovery following the slo
Net National Saving Net Domestic Investment
1990 1992 1994 1996 1998 2000 2002 2004 -6 -4 -2 0 2 4 6 8 % of GDP
Net Private Saving Net Company Saving Net Government Saving
Source: Bureau of Economic Analysis.
exports has been another importa deficit. This is partly explained by and Japan in the late 1990s a
wdown in 2001. Between 1995 and 2001, the real effective exchange rate appreciated by about 16 per cent supporting the increasing demand for imports by the US. However, between 2002 and 2004 the real effective exchange rate depreciated by around 13 per cent, so one would expect this to negate, at least to some extent, import demand. Blanchard, Giavazzi and Sa (2005) argue that a change in preferences on the part of the US consumer towards foreign goods helps explain the persistent trade deficit.
A further driving force of the current account deficit has been the increase in the foreign demand for US assets.21 Capital inflows to the US continue as
long as foreign investors are willing to purchase US assets at the prevailing price and expected returns. Prior to the stock market correction in 2000, the massive rise in US stock prices increased the foreign demand for US equities. More recently central banks’ demand for bonds, particularly from Asian central banks pursuing quasi-fixed exchange rate regimes, have maintained capital inflows into the US. The readiness of foreigners to invest in the US has helped to keep long-term interest rates low fuelling consumption in the US.
Foreign demand for US assets has led to a massive increase in the net external liabilities of the US. The Net National Investment Position (NNIP) of a country is the difference between the value of its external assets and liabilities. Figure 3.4 shows the deterioration of this balance over time. The US currently stands as the world’s largest debtor nation and had a negative NNIP of around 22 per cent of GDP in 2004. Tille (2004) notes that only 35 per cent of US assets are denominated in dollars as compared to 95 per cent of its liabilities. This means that a depreciation in the US effective exchange rate increases the value of assets, while leaving the value of liabilities relatively unchanged. Gourinchas and Rey (2005) find that historically a depreciation in the dollar contributes about 30 per cent of the adjustment through the advantageous valuation effects on US assets. A substantial fall in the dollar is seen as one mechanism that will help restore balance to this situation.
Figure 3.4: Net International Investment Position
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 -30 -25 -20 -15 -10 -5 0 5 % of GNP
Source: IMF, International Financial Statistics, Various Issues.
The US cannot live beyond its means forever and at some point, either the negative NNIP and the costs of servicing that debt will become too great a burden on the US or else foreign investors may decide that they hold adequate US assets in their portfolios and stop purchasing them. A fall in the value of the dollar would temporarily improve the trade balance but may be insufficient to put the US current account back on a sustainable path. Obstfeld and Rogoff (2004) and others have argued that structural reform needs to take place in the US to counteract the causes of the deficit. Several leading academics have attempted to estimate the scale of the adjustment necessary to bring the US back on to a sustainable path. Obstfeld and Rogoff (2005) suggest that the real effective exchange rate needs to depreciate by about 30 per cent to bring the current account deficit back onto a sustainable path. They also argue that a change in domestic absorption is necessary for adjustment, not just a fall in the
32 MEDIUM-TERM REVIEW 2005-2012
dollar. Blanchard, Giavazzi and Sa (2005) also find that a substantial dollar depreciation is likely to occur over the medium term.
There are a variety of possible mechanisms that, separately or through some combination of them, could lead to an unwinding in the US imbalances:22
• An increase in the household savings rate. This could be triggered by a slowdown in the housing market in the US.
• A fall in US asset prices.
• A substantial tightening of US fiscal policy which would increase domestic savings.
• A major depreciation in the value of the dollar.
• Strong growth in the rest of the world which would increase the demand for US exports.
As there is no consensus about when the adjustment is likely to take place, the mechanism(s) by which it will take place and whether the adjustment will be gradual or rapid, it is difficult to take account of it in medium-term forecasts; yet it very much colours our view about the future prospects of the US economy. Due to this uncertainty, we present two alternative scenarios for the US going forward. In the High Growth forecast we assume that there is no adjustment to the US current account deficit.
The key forecasts for the US economy are presented in Table 3.1. Following the slowdown in 2000-2001, growth in the US has gained momentum and short-term prospects remain favourable. Our baseline forecast is for annual average real GDP growth of 3.1 per cent between 2005 and 2010. In the short-term, consumption is expected to remain a significant driver of growth; with much of the consumption growth itself generated by wealth effects from sizeable house price rises, as well as robust equity prices. This leaves the household sector very exposed to house price changes or sharp interest rate increases.
Our forecast for the dollar/euro exchange rate in the High Growth forecast incorporates a slight depreciation of the dollar; it is expected to average $1.29 over second half of this decade. A depreciation of the dollar should lead to higher inflation but as the depreciation is quite moderate it will put limited upwards pressure on the rate of price growth. The inflation rate, as measured by the consumer expenditure deflator, is expected to average 3 per cent growth between 2005 and 2010. The main focus of Federal Reserve policy in recent years has been to foster price stability while maintaining sustainable growth in output. The Federal Reserve reacted aggressively in response to the slowdown in 2000-2001 by cutting interest rates to fifty-year historical lows. By 2004 inflationary pressures started to build so the monetary authorities have responded by gradually increasing interest rates. Short-term interest rates are expected to gradually increase over the course of the decade and are expected to average 4.4 per cent over the 2005 to 2010 period.
Underlying this benign growth forecast is a continued deterioration in the current account balance, which as mentioned above, is unsustainable. Using the NiGEM model we simulated the impact of a gradual correction in the US. The scenario we examined is one in which the US government reduces its fiscal deficit and in which the household savings rate rises. The increase in personal savings could be triggered by a fall in asset prices, in particular house
22 There has been much speculation that a major realignment of the Chinese renminbi, which is quasi-pegged to the dollar, could help redress the problems in the US. However, recent research shows that while an appreciation of the renminbi will lead to a fall in Chinese exports, Chinese domestic prices react very quickly and the real exchange rate moves back almost to where it was before such a change (EUROFRAME-EFN, Autumn 2005 Report). As a result, even if the Chinese authorities responded favourably to calls for them to aid the international adjustment process by adjusting their currency it would do little to solve the problem of the US balance of payments deficit.
prices. This is one of the many possible adjustments that could happen in the US. The effect of these changes is to produce a reallocation of resources within the US economy as envisaged by Obstfeld and Rogoff (2005). There is considerable uncertainty as to when this adjustment is likely to happen. For the sake of simplicity we have started our simulation in 2007, though this should not in any way be seen as being a forecast of the timing of such an event; if adjustment starts later it is likely to have more severe consequences. It is also possible that the correction could happen quickly, meaning that the impact on the US and the wider world economy would be more concentrated in the immediate two to three years after the adjustment.
Table 3.1: Forecasts for the US Economy
2003 2004 2005 2006 2007 2008 2009 2010 2000- 2005 2005- 2010 2010- 2015
High Growth Forecast
Per Cent Annual Average % Change Real GDP Growth 3.2 4.4 3.9 3.9 3.3 2.9 2.8 2.7 2.8 3.1 2.5 Annual Average Inflation* 1.9 2.2 2.7 3.9 3.1 2.7 2.7 2.8 2.1 3.0 2.8
Short-term interest rate 1.2 1.6 3.4 4.2 4.5 4.7 4.9 5.0 3.0 4.4 5.0
Exchange Rate ($ per €) 1.13 1.24 1.26 1.26 1.27 1.30 1.32 1.34 1.06 1.29 1.39
Fiscal Deficit (as a % of GDP) -4.6 -4.3 -3.5 -3.7 -3.4 -3.2 -3.2 -3.2 -2.5 -3.4 -3.3
Current Account Balance (as % of
GDP) -4.7 -5.7 -6.6 -5.8 -5.4 -5.3 -5.4 -5.6 -5.1 -5.7 -6.3
US Current Account Adjusts – Low Growth Forecast Per Cent Annual Average % Change Real GDP Growth 1.6 1.2 1.4 1.7 2.1 Annual Average Inflation* 4.2 3.0 2.1 1.4 0.7
Short-term interest rate 6.2 5.7 5.2 4.6 3.9
Exchange Rate ($ per €) 1.37 1.42 1.46 1.50 1.55
Fiscal Deficit (as a % of GDP) -2.6 -1.9 -1.3 -0.7 0.2
Current Account Balance (as % of
GDP) -5.0 -4.5 -4.3 -4.1 -3.9
*Consumer Expenditure Deflator.
The fall in the value of households’ assets reduces their perceived wealth. Many households will react to this change by reducing consumption and raising their savings to rebuild their wealth. This would have a negative impact on domestic demand. There is an element of circularity here because the expectation of such a decline could actually be the trigger for, say a fall in asset prices. In addition, we have assumed that part of the US imbalances will be corrected with a fiscal tightening over the medium term. This means that taxes will slowly rise and/or expenditure will grow at a lower rate over the medium term. This heightens the negative impact on households because we assume the government does not intervene to try and kick-start the economy by adopting expansionary fiscal policies. Overall, this shock would have a serious negative impact on US growth, knocking around 2 percentage points off the growth rate in the short term.
As a consequence of the downturn in the US economy the dollar would fall by about 10 per cent compared to the High Growth forecast in the first four years after the shock leaving the exchange rate at $1.50 by 2010, $0.16 higher than in the High Growth forecast. The fall in the value of the dollar would lead to an upturn in US inflation in the short term. Measured by the consumer expenditure deflator, consumer prices could be around 1 percentage point higher in the first year of the shock as compared to the High Growth forecast. As a consequence of higher inflation the Federal Reserve would tighten
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monetary policy in the short term providing a further negative impulse to growth. This helps explain why the impact on growth is more negative in the short term. The rise in US inflation would be temporary so in the medium term the Federal Reserve would cut interest rates again. In the medium term the improved competitiveness of the US economy, as a result of the depreciation of the dollar, coupled with the easing in monetary policy would stimulate the US economy so that it could grow by an average of 2 per cent per annum between 2010 and 2015, half a percentage point lower than in the High Growth Forecast. Underlying this scenario is a gradual improvement in the current account balance.