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Twin deficits can damage economies and equity markets

John Redwood, Charles Stanley's Chief Global Economist, looks at countries with twin deficits such as the US.

Twin deficits can damage economies and equity markets

by
John Redwood

in Features

07.03.2019

If a country runs a large state deficit and a large trade deficit at the same time, it is prone to financial accidents and to borrowing crises. Periodic financial disasters in countries such as Argentina and Venezuela occur when falls in their domestic currency make repaying foreign debts particularly expensive, and when poor financial discipline deters world investors from lending more. Foreign investors are best avoiding such risks, as they can lose a lot on both the local currency and the local stock market. The world markets may no longer prepared to lend more money to buy imports the country cannot afford or to pay public sector wages that are not covered by tax receipts. Brazil is currently being required to rein in its huge state deficit of 7% of GDP by market forces, which led to a lower exchange rate and higher interest rates.

This rule does not usually apply to the US, which currently is borrowing 4.5% of its GDP for extra state spending, and 2.3% of GDP to enjoy more imports than exports. US debt and US real assets are sufficiently attractive to make financing these large deficits relatively easy. It is true that the US has put up its interest rates much more than the rest of the developed world, making it more attractive for international investors to own dollars and to buy US Treasury bonds for an income. The US usually borrows in her own currency making repayment easier. The US is also a favoured location for inward investment, providing extra cash to meet the foreign trade bills. Ironically whilst the President wants to get the trade deficit down, the combination of higher interest rates and good investment opportunities has led to a stronger dollar, making imports cheaper and more enticing to US consumers.

Japan has been running a large state deficit for many years. Currently at 6% of GDP, it is not causing financial stress or posing problems borrowing the money. The reason is Japan only borrows from itself, and has taken to printing money to buy up much of the debt it issues anyway. By the twin mechanisms of yen bond issues and central bank buying of the bonds, Japan has allowed the state to live well beyond its means for many years. The debt build is huge, but half of it is now owned by the state itself and all of it remains around a zero interest rate, posing no difficulties in paying the bills. In effect, the Japanese state can spend more than it collects in taxes by simply creating more yen to pay the bills. This would normally be inflationary and end in tears but, in the case of modern Japan, there is no inflation so it is surprisingly stable. Japan is not building up a big external debt, and is running a healthy balance of payments surplus.

It is traditional to see the problem as being a problem just for the large deficit countries. IMF programmes usually recommend austerity, demanding cuts in spending and tax increases to curb state deficits when they initiate a lending programme to a country in financial trouble. These measures also cut consumer demand and therefore the demand for imports. Equity markets fall away as the crisis mounts, and rally once the offending state starts to rein in spending. It is also possible to see it as a surplus problem. Germany has a very high current account surplus based on its strong exports of 7% of GDP. Saudi Arabia has an 8.6% current account surplus and Russia 5.5%, reflecting oil revenues. China runs a large surplus with the US though its worldwide current account surplus is more modest. Germany also runs a surplus on its state accounts, so the total surplus is 9.2% of GDP.

President Trump thinks a lot of the problem is created by the super-surplus states rigging trade against countries such as the US that allow good access to its market, but are blocked when they seek to export back. He wants to get the surpluses down by getting these countries to cut their tariffs and remove non-tariff barriers to trade. His current attack on China may result in some improved terms for US access to the Chinese market, less onerous terms on US investors in China, and some better guarantees about respect for intellectual property. Given the current numbers it would seem likely President Trump will then open up a new flank in his trade war by making demands of the EU and Germany. He is likely to draw attention to the higher tariffs on US cars into Germany than the other way round, and to non-tariff barriers to trade in agriculture and maybe services.

The German surplus is a problem for the Eurozone as well as for Donald Trump. Somehow, all that money Germany collects from taxing more than it spends and from selling more than its buys has to be recirculated. As Germany shares a currency with other countries, it is particularly important to find a way to route the extra euro Germany accumulates from trade and tax, back to those who want to buy German goods. So far, this has been achieved by Germany lending large sums at zero interest to the European Central Bank, and that central bank lending it on to commercial banks in the deficit countries. Some think more of the state surplus should be given as grants to the rest of the zone, as it would be in the US or UK currency zones where the rich parts fund social security benefits, local government and regional policy programmes in the poorer parts. Meanwhile, President Trump might decide to highlight the big international imbalance, and to query just how many German cars the US ought to be buying. If this happens, it will occur at a bad time for the German industry, caught as it is by a general downturn in demand and by big pressures to switch its output to an entirely new range of electric vehicles.

We will keep watching the twin deficits, and worry most about those countries that owe a lot in foreign currency where the markets can push them into crisis at great speed.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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