Double the deficits, double the pain for the US

Double the deficits, double the pain for the US

The Trump administration readily touts the benefits of its recently-passed fiscal stimulus package, but it doesn’t so willingly acknowledge its implications.

A key consequence of the tax cuts and greater government spending will be the return of historically elevated twin deficits, the term used by economists to describe negative trade and budget balances.

Rising twin deficits signal growing underlying macroeconomic vulnerabilities, and we believe they are an important risk factor to monitor for the U.S. economy going forward.

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Why are the twin deficits set to rise? On the budget side, the Tax Cuts and Jobs Act and Bipartisan Budget Act will by their nature leave a substantial hole in the federal government’s coffers.

 

Our baseline forecast expects the federal budget deficit to widen by about 1 percentage point from about 3 percent last year to over 4.5 percent by the end of 2020.

On the trade side, we believe that U.S. imports will respond fairly strongly to robust domestic consumption and investment that is likely to come on the heels of the stimulus, resulting in a larger trade deficit.

All told, Oxford Economics forecasts that the twin deficits will reach a cumulative 7.5 percent of GDP by the end of 2020 — the highest since the global financial crisis.

The burgeoning twin deficits beg the question: Who will pay for all of this spending? The funding can only come from two sources: domestic or foreign. The current domestic landscape suggests that U.S. household and business savings won’t be able to “pick up the check."

The U.S. household savings rate is minimal, currently close to a historic low of 1.4 percent of GDP. Businesses won’t be able to fill the funding gap, either. The corporate sector’s surplus was about only 1.0 percent of GDP last year.

So, the gap between domestic savings and investment inherently have to be filled by foreign capital inflows. Foreign investors already play an important role, today owning about 45 percent of outstanding U.S. Treasury debt, roughly 40 percent of U.S. corporate bonds and 15 percent of U.S. equities. These shares will have to rise in the coming years as the twin deficits grow.

Ironically, the twin deficits are set to make the U.S. more dependent on foreign capital even as the Trump administration seeks to take a step back from the global economy by implementing more protectionist measures.

We believe it is likely that the late-cycle fiscal stimulus will more than offset any impact the recently-introduced tariffs could have on reducing the trade deficit.

The only real way to reduce the trade deficit would be to correct the shortfall of U.S. savings relative to investment. However, recent domestic policy choices look set to exacerbate this chronic imbalance.

Looking ahead, though rising twin deficits are a sign of growing structural imbalances, we nonetheless expect the broader funding environment to remain conducive to foreign investors’ continued purchasing of U.S. assets.

We think persistent trade surpluses abroad, the dollar’s position as the world’s reserve currency, the United States' role as a global safe haven and the liquidity of U.S. financial markets will support foreign flows into U.S. assets.

In recent decades, such factors buoyed foreign demand for U.S. assets even as the economy consistently ran twin deficits. We expect the dollar to drift modestly lower while yields gently rise, keeping U.S. assets attractive and encouraging future capital inflows.

Yet, the current environment contains important risks. Although we think a full-blown trade war is unlikely, the chances of one occurring are slowly rising as the Trump administration looks to be ramping up its protectionist approach to trade.

More protectionist policies could fray the United States' relations with key sources of capital flows just when the rising twin deficits make the U.S. economy more reliant on external financing. The experience with the U.S. Smoot-Hawley Tariff Act of 1930 offer some lessons on what could happen in the event of a wider trade conflict.

Back then, global trade volumes collapsed by 40 percent and global capital flows dried up after the U.S. imposed tariffs on a host of imports. The stakes are higher today than back then, as the U.S. economy is today much more reliant on foreign capital inflows.

If foreign demand were to weaken, there may be a significant depreciation of the dollar and/or a substantial jump in U.S. interest rates, which could potentially choke off the U.S. economic expansion.

Oren Klachkin is the lead economist at Oxford Economics, an economics research firm that provides global forecasting services and quantitative analysis.