One of the main consequences of the international financial crisis was an extremely rapid reduction of the US trade deficit. The monthly deficit fell by more than half during only seven months between August 2008 and February 2009 – from $64.9 billion to $26.6 billion. This 59% reduction was equivalent to an annualised reduction from $779 billion to $319 billion.
As the US trade deficit was one of the major global imbalances held responsible for the financial crisis, according to a widely held theory, it is therefore a matter of significance that since February the US trade deficit has ceased falling. In the figures for the last three available months, May – July 2009, the deficit has actually widened slightly. Taking a three month moving average, to smooth out merely short term fluctuations, the monthly deficit reached its lowest point in May at $28.1 billion and has since increased marginally to $28.6 billion. The long term trend is shown in Figure 1 and the shorter term immediate one in Figure 2.
Relating this trend in the trade deficit to domestic developments in the US economy, it is evident that during the second quarter of 2009 the decline of US GDP was decelerating and it is possible/likely that the US economy expanded during the third quarter of 2009 – industrial production turned up in both July and August after having declined since December 2007 and the service sector is likely to have been more robust. The trend in the US trade figures, therefore, gives an indication of the likely behaviour of the US economy as it stabilises or begins to recover from the downturn.
The first feature which is clear is that the halt to the shrinking of the trade deficit confirms that the US economy is not competitive at the present dollar exchange rate – or probably anything near the current exchange rate. Despite the most severe economic downturn since World War II the US is still running an annualised deficit of over $300 billion or 2.4% of GDP in the second quarter of 2009. This may be compared, in terms of relative competitive strength, to the recession of the early 1990s – when the US actually moved into a small trade surplus. If is therefore likely that as the US economy begins to recover the US trade deficit will increase again.
Second, the fact the trade gap has ceased to close has major implications for the structure of the domestic US economy. A number of commentators incorrectly argued on the basis of the narrowing of the US balance of trade deficit, that an increase in the US savings rate was taking place. As the US balance of payments deficit, which is dominated by the trade deficit, is necessarily identical by an accounting identity to the shortfall of US domestic savings compared to US domestic investment, it was therefore suggested that as the trade deficit had narrowed US savings were rising. This blog has already pointed out that this was factually incorrect, and confused the rise in household saving, which has indeed occurred, with the movement of total US savings – that is the sum of household, corporate and government saving. What actually occurred during the financial crisis was that both US savings and US investment fell but investment fell even more rapidly than savings – producing the narrowing of the trade gap.
The February-July trade figures however show, given that the balance of payments figures are likely to mirror them, that the gap between US savings and investment has ceased to narrow. For national accounting purposes accumulation of inventories are counted as investment and may have risen during the third quarter, but there is appears little indication that fixed investment has risen. Overall US investment therefore is unlikely to have increased very greatly, if at all, during the third quarter and as the trade gap has ceased to narrow this would also mean that US savings are not rising significantly or at all. The preliminary estimate of US 3rd quarter GDP will not be released until 29 October and will cast further detailed light on these trends.
To illustrate the process which has been taking place in the internal structure of the US economy, Figure 3 shows the detailed trends in components of US GDP in the period between the start of the economic downturn in the third quarter of 2008 and the second quarter of 2009 – all figures are in current price terms. This shows clear trends. In essence a huge transfer of resources from US private investment into US net exports has taken place - with consumption, in relative terms, far less affected.
The $584.1 billion fall in US private fixed investment is actually larger than the $403.4 billion decline in GDP. It also substantially exceeds the $223.5 fall in personal consumption, and the $138.0 drop in inventories combined - the decline in US government consumption and investment is a minor $14.6 billion. The US recession, in short, is dominated overwhelmingly by the fall in fixed investment.
Nor is this decline in US investment primarily due to housing. The decline in US residential investment over this period was $122.4 billion while the decline in non-residential private investment was $323.7 billion. In short, for example, the claim made by Paul Krugman during a panel discussion with the present author that the decline in US GDP was not primarily due to a fall in investment, and that the latter was essentially due to a decline in residential investment, is incorrect.
The statistical reason that US private investment can be larger than the total fall in US GDP is because of the large rise in US net exports – which increased by $418.8 billion. This was the second largest change in major components of GDP after the decline in private fixed investment, and this combination confirms the essence of the shift in the US economy under the impact of the financial crisis – the massive transfer of resources from private fixed investment to net exports. Or, to put it another way, in order to narrow the trade gap private fixed investment has fallen drastically. This fall in investment is both cyclically the primary driving force of the economic downturn and undermines medium and long term US economic performance - given that increased fixed investment is the primary source of overall economic growth.
This shift in the structure of US GDP clearly poses a number of future choices – all of which are to some degree unpleasant.
The first possibility is that US investment remains permanently lowered – i.e. the course which has taken place since the beginning of the financial crisis is consolidated. But in that case, as fixed investment is the primary lever of economic growth, this means a lowering of the US potential growth rate.
If, however, fixed investment is to be raised, but the US trade deficit is not to expand, then the proportion of US GDP devoted to consumption will have to be proportionately cut in order to release more resources for investment. This would be to reverse the trends that have so far taken place during the financial crisis and evidently poses the question as to which sectors of consumption should be proportionately reduced in GDP –personal consumption, in which case it is likely the political popularity of the Obama administration will fall sharply? Or government expenditure –in which case in which areas?
The third possibility is that, in order to avoid reducing consumption but in order to rebuild investment, the US trade deficit widens again. This appears to be a trend which is indicated by the halt in the shrinking of the US trade deficit in the last five months. But in that case one of the fundamental global imbalances will at a minimum cease to correct itself and will probably widen again.
None of these variants, nor their possible combinations, is particularly easy. They mean that the release of the next US trade figures on 9 October will be even more than usually significant in indicating trends within the US economy.