Beware of The Twins!
A twin deficit arises when a country maintains both a budget deficit and a trade deficit. This article will touch on each component of the twin deficit and will conclude by highlighting the relationship between the two. After all, the reason it is referred to as the twin deficit is because the two are related. Today in the U.S. the level of the twin deficits are an additional tailwind for interest rates that investors should not ignore.
The Budget Deficit
Just as many of us maintain our own personal budget (tracking our income and expenses) so does the U.S. government. From the income the government receives by collecting taxes, it pays its expenses. When income exceeds expenses, a budget surplus exists. When the opposite is true, expenses are higher than income, a budget deficit is created. For the majority of the past 50 years, the U.S. has had a budget deficit. It has been able to fund this deficit primarily thanks to its status as a reserve currency, which has enabled it to borrow as much as it wants without any repercussions, such as a collapsing currency or runaway interest rates or inflation, or all of the above. Think other countries, like Argentina for example, that are not so lucky when they overspend. Or even Canada, where a very weak dollar does not buy much when Canadians travel to Europe or the U.S.
Typically, the size of the budget deficit (the extent to which expenses exceeds income) tracks the economic cycle. In other words, a struggling economy results in fewer jobs with the government collecting less taxes. This is generally when governments are forced to spend more, in order to attempt to revive the economy. As the economy recovers, the government collects more taxes as employment and consumer spending picks-up, while expenses decline because that extra government spending is also no longer required. The budget deficit then declines and, on a rare occasion, a surplus may even arise during good times. The idea is that surpluses created during an economic upswing act as a buffer against the deficits created during the inevitable downturn. Then the whole process starts over.
The U.S. is no longer following this natural progression. Despite being in the 9th year of a positive economic cycle, the U.S. instead of generating surpluses has embarked on a multiyear process of significantly increasing its budget deficit (via tax cuts and extra spending) in an effort to buy future votes. The Congressional Budget Office estimates that the annual deficit will average $1.2 trillion and account for over 5% of GDP by 2019, an increase from 3.5%. This is a clear indication that the government is living beyond its means. Excluding the financial crisis, when unprecedented spending measures were needed to prevent an outright depression, the last time the U.S. had a budget deficit this high as a percent of GDP was in the 1980’s. In the 80’s, the Baby Boomers were entering the labour force which was a huge stimulant to economic growth. Today, the U.S. is at the tail end of the demographic curve as 10,000 baby boomers retire each day and are ready to collect their social insurance and Medicare. Generating a 5% of GDP deficit with a young labour force is one thing, doing so with an aging demographic is another.
In order to cover this rising deficit the government will need to issue more debt. During the financial crisis, the Federal Reserve itself was the marginal buyer of U.S. debt in order to stimulate the economy back to health. Today, the Federal Reserve is no longer a buyer. It has turned off its money printing press, now that the financial crisis is over, and is in fact shrinking its balance sheet by $600 billion per year. To make matters worse, foreign governments may be starting to become net sellers of U.S. debt as well. The combined effect of these two forces will likely have ramifications in the form of higher bond yields to attract new buyers for all this debt, which at the same time will place further pressure on the deficit via higher interest expenses. Further upward pressure on yields may of course also come from higher rate hikes by the Federal Reserve should any inflation result from a stronger economy. It is worth noting that the 10 year U.S. treasury yield, as shown below, continues to hit new highs not seen in years.
The Trade Deficit
When a country produces a good within its borders, then sells this good to a foreign country, the transaction is classified as an export. If the same country purchases a good from a foreign country, this transaction is an import. Each country actively monitors this flow of goods coming in and out of their country in what is known as a Balance of Trade. If the value of all a country’s exports exceeds its imports, the country has a trade surplus. Conversely, if the value of imports exceeds exports, the country has a trade deficit.
Since 1975, the U.S. has maintained a trade deficit due to multiple factors:
To be the global reserve currency requires a trade deficit: - Post World War II, the U.S. became the global reserve currency. This means that the U.S, dollar is the main currency of payment for global trade. For the U.S. dollar to maintain this status, it must ensure that its currency is easily and readily attainable by foreign countries such that it must be in high supply. The only way for the U.S. to supply such a large quantity of its currency to the world is by maintaining a trade deficit with the rest of the world (the U.S. must buy more imports than it sells in exports). By doing so, it is “supplying” the world with U.S. dollars (used to pay for imported goods), which are later used by foreign countries in conducting additional global trade.
A strong currency - As a reserve currency, people are forced to buy and hold U.S. dollars to be used for global trade making the currency stronger than it otherwise would be. This makes U.S. produced goods more expensive for foreigners to purchase and foreign goods cheaper for Americans to buy, resulting in the propensity to have more imports than exports.
A weak savings rate - The strength of the U.S. economy has allowed Americans to prosper, and their lack of propensity to save has made them the world’s largest spenders, keen to buy what the rest of the world exports.
Bottom line, a budget deficit ultimately requires additional capital via borrowing (buyers of their debt via government treasury bills) in order to fill the financial gap created by the government spending well beyond its means. The interest rate paid on that debt by both foreign and domestic buyers will have to be attractive enough relative to other investments available to them. It is also highly dependent on how responsible a government is deemed to be, as the ultimate risk is default (where you lose the money that you lent them). Although the U.S. government has never defaulted on their debt, over time just about every other country has. As spending becomes reckless (to buy votes rather than to provide basic services and to truly help the economy only when needed), this risk of default rises, and buyers of debt securities will demand higher yields in order to compensate for this risk. Generally, if the currency does not have reserve status, the level of debt will ultimately also be reflected by a weaker currency.
Tying the Two Deficits Together
So in simple terms, the U.S. government requires a trade deficit to finance its reckless spending. This is because every time the U.S. buys a foreign good it pays for that good in U.S. dollars. This in turn leads to the foreign country accumulating lots of U.S. dollars. Instead of the foreign country leaving this money in cash, it will invest back into the U.S. by buying the most liquid asset available: U.S. Treasuries. In essence, foreign countries are “forced” to buy U.S. debt which allows the U.S. government to maintain a budget deficit. This creates a reinforcing cycle in which the foreign purchase of U.S. debt keeps bond yields low which in turn encourages increased borrowing and spending by the U.S. government and its citizens, which then results in higher deficits.
With its budget deficit set to significantly increase in the coming years, and the U.S. savings rate being at an all-time low, the U.S. will necessarily require a higher trade deficit. This is contrary to Trump’s idea that he can ramp up the budget deficit and reduce the trade deficit at the same time. Although the U.S. does have a very large trade deficit with China (for better or worse), this has resulted in the Chinese investing heavily in U.S. treasury debt which the U.S. needs. Lowering the trade deficit with China would mean China would have less U.S. dollars and thus less need to buy U.S. debt, causing upward pressure on U.S. bond yields and crowding out private sector borrowing.
Since the end of World War II the U.S. has been a globally dominant power. It is now facing the rise of an equal and opposing power in China. This threatens the life line of foreign capital that the U.S. has so heavily relied upon. It is no secret that China does not like its reliance on the U.S. dollar as a global reserve currency. As a result, it is taking initiatives to move away from this reliance. The most powerful example of this is China’s “One Belt One Road” initiative. China is investing heavily in countries as it builds out its distribution network from Asia and Europe to Africa and the Middle East. In a direct contrast to how the U.S. has operated, China is taking a hands off approach and providing capital to these nations without dictating how their countries should be managed. These nations will become important trading partners with China, and as a result will likely eventually be “encouraged” to accept Chinese currency (yuan) as payment to buy Chinese goods. Already China is the largest buyer of commodities. Since it buys more oil than the U.S. there is really no reason why oil should be priced in U.S. dollars instead of yuan. Ultimately this will result in the displacement of the U.S. dollar. Europe has already started to include the Chinese yuan in their foreign exchange reserves and the Russians are talking about accepting yuans for oil instead of US dollars.
Needless to say, foreign investors are becoming more cautious about the ability of the U.S. to sustain twin deficits on this scale. Until the government gets its fiscal responsibilities in order by reducing the deficit, we should expect the trade deficit to persist which means the twins are here to stay. Ultimately this will not be good for either interest rates, or the dollar.
The Summerhill Team