In the first two articles we discussed how a nation’s currency can cause boom or bust in its economy. In this article we shall go a step further and discuss how in the current world order the currency, fiscal deficits and the current account deficits are playing out on the economic growth and how the only hope for this world to prolong the inevitable is for the US to have a continued fiscal and current account deficit.
I would start with the most basic equation taught to everyone in Eco 101 i.e. Y = C + I + (G-T) + (X-M) i.e. the GDP of any nation is the sum of consumption, investment, net government expenditure i.e. subtract the taxes and current account balance i.e. exports – imports. I would be focusing on the government expenditure and the current account part in this article. Ofcourse the consumption is what drives the current account deficit and investments. So here we go………
Thanks to reduced tariffs and free global trade treaties the investment needed to serve the US consumption is largely happening outside as the factors of production are much cheaper there. It’s important to note that even the trade today is not free or relaxed even though it may seem that way. The exporting nations of Asia hold their currencies pegged against the USD and try to implicitly keep the labour costs and material costs down which means that only US ends up keeping its end of the bargain, in any case the lower interest rate regime of the US since mid 80s has also ensured that the society moves on to become a society of mega spenders as saving at every point of time is reprimanded by Fed by printing more money. So a lower interest rate in US drives the consumer to spend and the investment to support that spending instead of happening in US happens in Asia or Latin America as the factors of production are much cheaper or artificially kept much cheaper there. This in essence means the US ends up having very high current account deficit which implies as the dollars move abroad the Asian producers have the option of
- Either let their exchange rate appreciate and let the automatic mechanism of trade balancing come into play. However this is precisely what these nations are guilty of not doing.
- So this brings us to the second option which is to let this money flow into the domestic economy which can actually be highly inflationary
- Hence the final option is to export these dollars back to US and the world and buy other assets.
This third option is the option that is not only practiced in today’s economic order but has also become so lucrative because now the US need not pay the Chinese for its goods with money but rather with “debt” – vendor finance.
So essentially this means that consumers of the US can buy goods they can’t afford and more importantly the government can maintain a military and fight the wars it can’t really afford!!! So essentially this US runs a CAD (current account deficit) and in return Asia funds the fiscal deficit of US. Now there are four combinations that can happen with these two variables and let’s see how it would impact the world. So the (CAD can go up and down) *(Fiscal Deficit of US can go up and down) = 4 combinations:
Case 1: The Current Account Deficit goes down and the Fiscal Deficit goes up: Well clearly an unsustainable and an instant Armageddon situation for the world as the growth in the developing world slows, the increasing fiscal deficit would be hard to finance by the US and what’s worse is the fact that the slowing of growth would lead to the emerging world selling US assets and the Fed ending up monetizing debt thus driving the whole world into a cataclysmic collapse while the commodity prices shooting the roof. Not an unrealistic scenario though if the consumer in US doesn’t pick up (the CAD goes down as import reduces) and the US government would end up spending more to substitute for the consumer contraction thus increasing the fiscal deficit.
Case 2: The Current Account Deficit goes down and the Fiscal Deficit goes down: Well this can happen in situations; one if the US again enters into recession which as government spending contracts and the Consumer also contracts obviously not a good situation for the world. However the other situation is bloomier which is the US discovers some export industry to bank upon and the investment cycle kicks in because of that followed by the consumer buying US goods and thus the government pulling back. Clearly this is the only situation in which the world would blossom again but as of today looks unlikely. To make it happen in my opinion the US should invest in industries of tomorrow i.e. Clean Energy and high tech (more on this a little later)
Case 3: The Current Account Deficit goes up and the Fiscal Deficit goes down: Well not a scenario that goes hand in hand. This simply implies that American consumer buys more but that clearly shows that the American economy is still structurally weak this would imply that the fiscal deficit can’t really come down. So I would simply strike off this case.
Case 4: The Current Account Deficit goes up and the Fiscal Deficit goes up: Well this is one scenario which can either prolong this problem and can indeed make it even graver or if played out well can even solve this crisis!!! This combination would continue what is happening in the world that is the emerging markets growing, US getting into more debt which would be bought by Fed and by Asia but here is what this strategy can buy “Time” this strategy buy us time and like any option this also has it’s time value. If US does invest during this time in technologies of the next generation that can really shoot up the productivity i.e. green energy, high tech like maybe high tech agriculture, nanotechnology, nuclear technology etc. then it would get rid of it’s structural deficiencies and can move gradually from a case of high CAD and Fiscal deficit to a low CAD and Fiscal Deficit and thus sustained growth, however if nothing changes it would mean that US ends up into a bigger debt spiral and this would mean that someday someone would realize that would they are holding is a complete junk that they would end up selling and thus inducing even more selling bringing this world to a complete financial breakdown.
So to conclude I would say that Ironically US running Current Account and Fiscal Deficits is the only hope for this world. Spending on Current Account and Fiscal Deficit is what I call the "Time Value" of the option on "Growth",.
I believe we are just a few year away from witnessing which turn this world takes, will this debt spiral and money printing lead us to a financial collapse and a new world order emerging out of it or will the US invest in these new technologies and seal another US decade or perhaps even a century for itself. Till that happens as I say that there be chaos before the pattern emerges……………..