Enjoy The Capital Account Surplus

Embrace the Deficit

By DAVID MALPASS December 21, 2006; Page A16

For decades, the trade deficit has been a political and journalistic lightning rod, inspiring countless predictions of America's imminent economic collapse. The reality is different. Our imports grow with our economy and population while our exports grow with foreign economies, especially those of industrialized countries. Though widely criticized as an imbalance, the trade deficit and related capital inflow reflect U.S. growth, not weakness -- they link the younger, faster-growing U.S. with aging, slower-growing economies abroad.

Since the 2001 recession, the U.S. economy has created 9.3 million new jobs, compared with 360,000 in Japan and 1.1 million in the euro zone excluding Spain. This despite our trade deficit and their trade surpluses. Like the U.S., Spain (3.6 million new jobs) and the U.K. (1.3 million new jobs) ran trade deficits and created jobs rapidly in this five-year period. Wages are rising solidly in these three. The economics is clear (for once) that a liberal trading environment allows more jobs with higher wages as people specialize.

The latest data on growth in jobs, retail sales and housing starts, and the record level of household savings, underscores the solid economy described by Fed Chairman Ben Bernanke last month. Supporting the "solid-growth" view are rising global stock markets, strong growth of corporate profits, the narrow credit spread between Treasurys and riskier bonds, and low interest rates relative to inflation and to growth -- nominal growth in the 12 months through September was 6%, yet the Fed funds rate, usually in line with nominal growth, only averaged 4.6%.

The trade deficit and a low "personal savings rate" are key parts of the bond market's multi-year pessimism about the U.S. growth outlook. But just as the high level of U.S. savings is likely to add to future growth -- the savings rate is only low if you arbitrarily exclude gains -- the trade deficit and heavy capital inflows are also positive parts of the growth outlook. Rather than signaling a slowdown, the inversion of the yield curve -- "Greenspan's conundrum," in which bond yields are low despite solid growth and rising inflation -- is probably the result of this deep underestimate of the U.S. growth outlook, plentiful liquidity, and a backward-looking deflation premium for bonds, the reverse of the backward-looking inflation premium that kept bond yields unusually high in the 1980s.

The common perception is that Americans drive the trade deficit in an unhealthy way by spending more than we produce. To make up the difference, foreigners ship us things on credit. This sounds bad, but should be evaluated in terms of our demographics, low unemployment rate, attractiveness to foreign investment and rising household savings.

The recent surge in the U.S. trade deficit reflects, in part, the unprecedented shift in the demographics of the world's large economies. The under-60 U.S. population is expected to grow for at least 50 years while the under-60 populations in Japan and Europe are already declining and in China will turn down within a decade. They need bonds while Americans need capital. They want to save more than they invest in their own economies, and are eager to help us invest more heavily (through their purchase of bonds.) This makes good demographic sense. Older investors (concentrated abroad) need steady returns, lending to younger generations through bank deposits, bond purchases and life insurance premiums (which are reinvested in growth). Younger people (concentrated in the U.S.) need cash and debt for college degrees, houses and business startups. This creates a healthy synergy across generations and across borders.

Like young households, many companies also spend more than they produce, using bonds and bank loans, some from foreigners, to make up the difference. They add employees, machines, supplies and advertising before they produce. Growing corporations are expected to be cash hungry. This leverage is treated as a positive for companies but a negative for countries, a key inconsistency in popular economics. Rather than paying the debt back, the growing company rolls the debt over and adds more, just as the U.S. has been doing throughout most of its prosperous economic history. Part of each additional bond offering puts the company and the U.S. in the position of investing more than we save, drawing in foreign investment and contributing to the trade deficit.

With all the negativism about the U.S. economy, it's easy to forget its attractiveness. Foreigners are as eager to invest in the U.S. as we are to buy goods and services from them -- it's a two-way street. Our 10-year government bonds yield 4.6% per year versus 1.6% in Japan, while our government debt is 38% of GDP versus 86% in Japan. The comparisons with Europe are not as extreme as Japan's, but still heavily favor the U.S.

While the net foreign debt of the U.S. is growing (the result of capital inflows), household net worth is growing faster, meaning foreigners are investing in the U.S. too slowly and conservatively to keep up with our growth. Their capital mingles with domestic savings, providing $2.7 trillion of net international capital to combine with $27 trillion in net U.S. household financial savings as of Sept. 30.

The already-large foreign demand for investments in the U.S. is likely to grow from here, putting upward pressure on the trade deficit even if foreign growth continues to accelerate. The U.S. offers a relatively high and steady return on investment -- high because of the innovation and growth taking place here, steady because the commodity and manufacturing parts of many businesses are increasingly done abroad, reducing the volatility in U.S. growth. Equally important, the demographics of the world's large economies are shifting rapidly in favor of the U.S.

The trade deficit is the mechanism allowing consumption and investment in the U.S. to grow faster than in Europe and Japan. The issue for the U.S. is whether it's worth the interest costs. It's the same question facing a small business: Should it borrow money to expand the payroll, train employees, buy land and machines, conduct R&D, build inventory? Profit and credit-worthiness help make the decision.

The post-election dollar weakness pleased those who still think the U.S. is heading in the wrong economic direction. They advocate a weaker dollar as medicine for the trade deficit, often blaming it for more economic problems than we actually have.

But the trade deficit, around for hundreds of years of solid American growth, doesn't justify the inflation risk from dollar weakness or the growth risk from protectionism. And the trade deficit probably wouldn't respond to a weaker dollar anyway -- yen strength hasn't dented Japan's trade surplus, and it took a recession to create our last trade surplus in 1990-1991.

The swing vote on the dollar, and probably the controlling vote, is Fed policy. For now, this leaves unresolved the market debate over whether the U.S. will encourage dollar weakness and inflation in an effort to fight the trade deficit. More likely the Fed will fight inflation, strengthening the dollar, and leaving the trade deficit dependent on U.S. growth and demographics -- right where it should be.

Mr. Malpass is Bear Stearns's chief economist.

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