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The "Twin" deficits, once again. (US economy weekly outlook)

Contributed by Raymond James

By Scott J. Brown

The federal budget deficit and the trade deficit are often referred to as the “twin” deficits. They’re not twins exactly, but they are related. The current account deficit, the widest measure of the trade gap, was cut in half in the recession, but now appears to be widening again. The federal budget deficit reached a record in FY09. The two deficits will play an important role in the economic recovery and the trade imbalance may become a bigger long-term problem for the U.S.

The current account deficit rose to a record $215 billion in 3Q06, over 6% of Gross Domestic Product, or $2.35 billion per day. The net trade dollar outflows don’t just sit there. They come back as net capital inflows and perhaps in weaker form (the net trade outflows match the net capital inflows and the dollar moves to equate the two). The current account deficit narrowed sharply in the recession, falling below 3% of GDP, as global trade collapsed. The good news is that the global economy is recovering, and along with it, world trade. The bad news is that the current account deficit is widening again. The 3Q09 current account data won’t officially be reported until December 16, but we have initial estimates of the trade deficit in goods and services for 3Q09, which is most of the picture.

The dollar has been weakening over the last several years and the current account deficit has likely played a big part in that. A rising current account deficit means that net capital flows must rise accordingly to keep the dollar stable. The drop in the current account deficit over the last several quarters means that smaller net capital flows are required. Data available through the second quarter show that net capital inflows also fell sharply in the recession. However, there was some increase in the demand for dollars through the Fed’s swap lines with other central banks (effectively, troubled assets abroad were denominated in U.S. dollars, and efforts to defuse the situation contributed to an increase in the demand for dollars).

Another way to think about the net capital surplus (and in turn, the current account deficit) is the difference between national borrowing and national savings. The U.S. does not save enough or tax itself enough to fund business investment and the government. It relies on borrowing from the rest of the world. There’s nothing inherently wrong with this. It’s like borrowing money from a bank. The questions are, are you using the borrowed funds appropriately, are you able to make payments, and is the lender willing to roll over existing debt? In taking a personal loan from a bank, it’s a lot different if you use the money for a vacation as opposed to a college education. In the late 1990s, the U.S. had a rapid pace of business fixed investment, and those investments (mostly technology) paid off in the form of increased productivity. We were better able to service external debt. In recent years, the U.S. has borrowed money to fund war efforts in Iraq and Afghanistan and the Medicare prescription drug program, and to cut taxes.

The federal government ran a $1.417 trillion deficit in FY09, although the national debt rose by $1.885 trillion (the difference is that more money flowed into Medicare and Social Security trust funds than was paid out). Less than half of the $787 billion fiscal stimulus appeared in the FY09 deficit. The bulk of the increase was due to the recession and the financial rescue. Still, half of the fiscal stimulus will show up in FY10. Furthermore, under existing law, the budget deficit is expected to settle into a range of 3% to 3.5% of GDP after the economy has recovered and the temporary spending has faded.

Campaigning for office, Barack Obama placed a strong emphasis on deficit reduction, but once in the White House, the depth and severity of the recession forced him to place that on the back burner. The last thing you want to do in a recession, or fragile recovery as the case may be, is to raise taxes, but taxes will have to be raised eventually to address the budget situation.