U.S. trade and budget deficits

U.S. Trade & Budget Deficit

Twin deficits, a growing budget deficit along with a growing current account deficit began in 2002. In effect, the United States is borrowing from foreigners in exchange for foreign imports. Some economists like to present this as a fairly benign problem. For instance, Cooper (2005) states that our deficits are just a drop in the bucket compared to the magnitude of money in the larger world financial markets. Therefore, he concludes that our foreign investors will continue to finance our budget deficit indefinitely. Yet, others explain America's current-account deficit as the inevitable consequence of a savings glut in the rest of the world and believe that conditions in the United States don't have too much to do with foreign lending (The Economist: Danger time for America, 2006). However, for a number of reasons, the United States is responsible for the twin deficits phenomenon which is a very dangerous situation with potentially devastating consequences.

Many economists dispute the savings glut theory as the reason for the dramatic increase in foreign lending to the U.S. And believe that the party won't last forever. United States' policies are in large part directly accountable for the twin deficit and the pursuit of foreign money. Federal government policies have allowed growth in domestic demand to outstrip supply for more than ten years (The Economist: danger time for America, 2006). Thus, America has decided to borrow from the future for current prosperity. The real question is when foreigners will stop financing the current-account deficit. Already, the Chinese government is expressing interest in diversifying China's foreign-exchange reserves (The Economist: danger time for America, 2006). According to this same source, if this happens, the dollar is likely to fall and bond yields rise as investors demand higher compensation for risk. Less access to foreign money could also result in: a) higher interests rates if the government borrows domestically; b) increased inflation if the Federal Reserve monetizes the debt; c) tax hikes; or all of the above in some combination (Garrison, 2003).

Still, the government will continue to try to sell debt abroad. Garrison (2003) cautions that the budget deficit weakens our export markets. He states that changes international capital flows have been the primary consequence of increased deficits and likens this to direct competition between the U.S. Treasury and the U.S. exporting industry. He reasons that the flow of foreign funds into the Treasury prevents these funds from being available for foreign purchase of U.S. goods and services. Thus, the more our government borrows and finances with foreign funds, the more our export market will continue to deteriorate.

Frankel (2004) believes the twin deficits situation will bring about a hard landing that could materialize in any number of ways. If the U.S. is forced to start paying back foreign investors, growth will significantly slow and there is a danger of resurgence in protectionism. Frankel sees even more peril than Garrison's gloomy domestic implications. Frankel (2004) believes there will be a decline in the dollar that will result in a possible loss of United States economic hegemony and will create new rivals to the dollar such as the Euro.