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Global trading recasts deficits

THE BALTIMORE SUN

Once upon a time, the nation's economy seemed to follow fundamental rules, even in the red.

The extra money sent out in the economy by budget deficits stimulated a sluggish marketplace. Good. But with all that money buying goods but not producing any, the deficit raised prices and thus inflation. Bad. If the government stayed in the red too long, it borrowed so much money that the price of that money - the interest rates - would go up. Also bad.

The conclusion was that budget deficits were fine if used for a short period as a stimulus. But if they were too big or went on for too long, they could do serious damage.

So what's going on now? The latest budget out of the Bush administration puts the deficit at record levels - over a half trillion dollars, with more to come. But the two bad results, inflation and high interest rates, are at historic lows.

Does the deficit matter? Or, in a role reversal from a generation ago, are Republicans right when they now say the government can go on cutting taxes and spending money with no dire consequences? Or should we listen to those former friends of deficits, the Democrats, who now warn of danger ahead if the country stays in the red?

The short answer is that economists agree the deficit does matter, but not in the way it used to. Deficits no longer cause the classic problems in the short term - making them a tempting economic Siren song - but they can lead to great difficulties in the long term.

What's changed is the globalization of the world's economy. Those rules that explained what happened when a country's economy was a relatively closed system don't work when the entire world's money and labor supply come into play.

With globalization, the whole world can now finance the U. S. deficit - and, for a variety of reasons, is doing so. That means the deficit puts no real pressure on affect interest rates.

"If the economy were closed off, and we went into the capital markets, you would logically assume that with the government borrowing more money, the price of bonds would go down and interest rates would go up," says Steve Hanke, an economist at the Johns Hopkins University.

"But we are in a unique position because the economy is now open, the U.S. dollar is the key currency in the world - the only true international currency - and New York city is the central capital market of the world," he says. "So that what we find in studies of the U.S. deficit on interest rates is that there is virtually no effect on interest rates one way or another associated with the deficit."

That open economy also takes care of the other bugaboo - inflation. In the closed economy, the stimulus to spending caused by the deficit increased demands for goods. To get the workers to manufacture these goods, businesses had to pay higher wages, which led to higher prices. But now most manufacturers have access to the entire world's supply of labor where there is no shortage that leads to higher wages.

"China probably has an adult labor force in the range of 1 billion people," says Peter Morici of the school of business at the University of Maryland, College Park. "There is a lot of excess capacity out there."

Increasing demand for goods does not result in higher wages, but in more workers in far-off countries getting low-paid jobs. Morici notes that even if those countries have to start paying higher wages, there is enough unused capacity in the United States to take care of any inflationary pressure.

"Anytime the price of imports goes up, domestic capacity can come in and just sop up the demand," he says.

So it sounds as if deficits are now the proverbial free lunch as globalization has turned them into an economic stimulus that brings no ill effects. Those who demand they be reined in are just responding to the Puritan ethic of thrift ingrained in the American culture that has no place in this new world economy.

Unfortunately, economists say one classic law still applies - there is no such thing as a free lunch.

For one, Bonnie Wilson, an economist at St. Louis University, argues that the traditional model will still eventually come into play, it just takes longer. "In the long run, deficits are likely to put upward pressure on interest rates," she says. "Some standard figures I have been hearing from economists who have studied the budget outlook is that between now and 2012 they expect interest rates to rise about 1.25 percent."

Wilson says that effect can be seen now in an increasing spread between short-term and long-term interest rates as investors assume an increase in the future.

Andrew Lyon, a professor of economics at the University of Maryland, College Park, also sees an eventual dampening effect on the nation's economy but not one to cause much concern.

"These deficits will be crowding out more productive investments, attracting money that otherwise would go into buying new computers, or research activities," he says. "Having said that, I think most conventional economists would say it would be a very small drain on the economy, something like one tenth of 1 percent of the [Gross Domestic Product] several years out."

But these are small problems compared with what some see on the horizon. For starters, the economists agree that the United State's projected budget deficit - at $521 billion, about 5 percent of the country's $11 trillion GDP - is at the top of what is sustainable for the short term. With huge expenses ahead, it is not a good time to be running a deficit so close to the limit.

"I know that most people are not thinking about what will happen in 2030 or 2040, but I would like to entice you to do that," says Lyon, noting the huge costs associated with baby boomers aging and retiring. "The Social Security, Medicare and Medicaid deficit has been pegged at $45 trillion," he says. "That is four times bigger than the economy. Now we are talking real money."

Hanke, a member of President Ronald Reagan's original Council of Economic Advisers, fears the costs of the wars in Iraq, Afghanistan and the general struggle against terrorism.

"The scope and duration of these enterprises are undefined," he says. What concerns Hanke is that those financing the deficit by buying U.S. bonds - mainly foreigners - will decide those are no longer good investments.

"The danger is if confidence in U.S. economic strategy is lost because people perceive that strategy as inconsistent if not incoherent, then you could have a bond buyers' strike," he says. "The price of U.S. bonds would go down and interest rates would go up."

Hanke says this is not a problem caused by running a high deficit - though he says the current deficit is about at the limit of what bond buyers will tolerate without losing confidence - but by failing to control spending.

Carl Christ, an emeritus professor of economics at Johns Hopkins, notes that 40 years ago about 5 percent of the U.S. debt was in foreign hands. Now that figure is almost 40 percent.

"As long as foreigners are wiling to buy our debt, then we can run a trade deficit as well," he says. "We can send them bonds instead of goods. The real risk of our federal debt getting too big is that people begin to wonder about our credit-worthiness. Then we will not be able to borrow without higher interest rates."

Morici agrees that the huge U.S. trade deficit is an important part of this picture. Much of the U.S. deficit is financed by the central banks of Asian countries, particularly China and Japan, buying U.S. bonds. They do this, Morici says, because they buy a lot of dollars to keep the dollar strong, making their own currencies weaker and thus their exports more affordable. Those excess dollars are then invested in U.S. bonds.

But, Morici notes, the Bush administration - trying to reduce the trade deficit - has urged these countries to stop propping up their currencies.

But if that happens, then countries would not have the excess dollars that they use to finance the U.S. deficit. A decline in purchases would have the same effect as a bond buyers' strike - raising interest rates.

"It's like a bowl of spaghetti," Morici says of the world economy. "You pull on one strand and a lot of others are tangled up with it."

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