Why the Current Account Deficit Helps Explain the Economics of QE3
Yesterday, U.S. Federal Reserve Chairman Ben Bernanke removed all doubt about whether or not the Fed would proceed with QE3. It’s happening. Officially, the Fed announced plans to purchase mortgage-backed securities of up to $40 billion per month (or about $480 billion per year) and to maintain a zero-interest rate policy (ZIRP) until mid-2015. Notably, this QE is open-ended, lacking any definition about the duration of the program.
QE3 is certainly substantial, but why should we expect this to work more than its predecessors? QE1, it can be argued, restored liquidity to a collapsing banking and shadow lending market by pumping $1.45 trillion into the agency and MBS markets. Importantly, this was a definitive, deliberate attempt to prevent a collapse. Under QE2, the Fed pumped $600 billion into the U.S. Treasury market with a focus on bringing down interest rates. However, both QE1 and QE2 had short, definitive lives. It seems to me that QE3’s open-ended nature is more like the U.S. current account deficit, in that it will channel money into the bond market in an open-ended way.
Wait a minute, the current account deficit? What’s that got to do with QE3 and interest rates? A lot, it turns out: in many ways the long-running current account deficit, and its mirror image, the capital account surplus, are kind of like the prequel to quantitative easing. We’ve seen this movie before. And like a low-budget horror franchise, each release (in this case, of liquidity) seems destined to deliver less impact. Let me explain.
Back when I was in business school, I floated a very pointed question to one of my professors, a well-regarded economist and econometrician. “So, what’s the big hullabaloo about the current account deficit?” I asked. This was in 1997. I’ve never forgotten his answer: “The current account deficit is the most misunderstood thing in all of economics,” he told me. “When you have a current account deficit, you simultaneously have a capital account surplus. It’s an accounting identity. So, in effect, the current account deficit means that other countries are loaning you money. That loan is invested and it all depends whether or not you get a return on that investment.”
That answer never squared with me, and I didn’t know why . . . until the financial crisis that presaged quantitative easing swept through global markets.
Here’s how the current account deficit really works: A U.S. consumer goes into Walmart to buy, say, a refrigerator. The consumer gives Walmart $1,500. Walmart keeps $500 for itself (as gross profit) and sends $1,000 to a Chinese manufacturer. Because Chinese people and businesses have no direct use for U.S. dollars, they exchange them for Chinese renminbi with their local bank. Eventually these dollars find their way to China’s central bank (as banks exchange foreign currencies for local currencies). China’s government then has a choice: keep the dollars or sell them on the currency market. If the government sells them on the currency market, it drives the value of the dollar down and the value of the renminbi up relative to each other (all else being equal). This change in currency values would harm Chinese exports by making them more expensive and help U.S. exports by making them cheaper. This is the natural imbalance correction mechanism under the current floating exchange rate system.
Alternatively, if the Chinese choose to keep the U.S. dollars, they must then invest them in something denominated in dollars. For many years, the vehicle of choice was U.S. Treasuries, so much of the current account deficit wound up in the foreign purchase of U.S. Treasury bonds — pushing U.S. government bond prices up and their corresponding yields (that is, interest rates) down. This exchange created a positive feedback loop, in which the more the trade imbalance grew the more U.S. Treasuries were bought, and that drove interest rates downward. As interest rates fell, credit expansion continued, the economy grew, and the virtuous cycle was created.
Except for one fatal flaw: It was unsustainable. Rather than being a true virtuous cycle, it was more like a morphine binge — you feel good for a while but then you must pay a steeper and steeper price as the addiction grows. Of course, this morphine binge is global insofar as many countries run persistent deficits or surpluses, and few are in balance. Interestingly, this phenomenon enables both trading partners to take on more debt than they otherwise would as both economies are goosed. But make no mistake, debt cycles don’t last forever — even when the investments are good. And today, there is a very sketchy record of mal-investment ranging from America’s housing bubble to China’s ghost cities to all the other debt-fueled investments that have been given a green light in the wake of easy money.
The preceding discussion, of course, describes what happens with the exchange of goods. But that is only part of the story. The current account is comprised of four components: goods, services, income payments, and transfers. So let’s take a look at the whole enchilada:
United States: Annual Current Account Surplus (Deficit) (Dollars in Billions)
Sources: St. Louis Fed, CFA Institute.
As illustrated in the graph, our current account deficit reached a massive $800 billion in the red in 2006. Whoa. That’s larger than most industries. What this means is that the United States “gave” foreign countries $800 billion more than these countries gave the United States. Much of the $800 billion was invested by these foreign countries in U.S. Treasuries (as well as agencies and MBS), thus contributing to former U.S. Federal Reserve Chairman Alan Greenspan’s famous puzzlement over low rates as well as the U.S. housing bubble.
Perhaps my professor could still argue that he was right — that other countries are simply “loaning” the U.S. money. But as my description shows, his answer conceals the mechanics at work. There is no reason to suggest that the current account deficit necessarily translates into a loan versus some other asset. For instance, the Chinese can do anything they want with the dollars they receive; they certainly don’t have to invest them in U.S. Treasuries. They can sell them (as mentioned), they can buy U.S. Treasuries, or they can invest in a wide range of U.S. dollar-denominated assets, such as U.S. stocks, real estate, commodity companies, etc. In fact, despite ongoing trade deficits with the United States, China has quietly been shrinking its holdings of U.S. Treasuries. As it happens, Japan has stepped up its purchases of Treasuries, largely offsetting the selling from China. Of course, China is aware of the “special relationship” it has with the United States — so it can’t simply liquidate all of its holdings of U.S. Treasuries without harming its own economic growth. Nonetheless, global mal-investment spawned by the credit bubble is massive, and the major economies of the world have generally not dealt with these problems, choosing instead monetary and fiscal stimulus in order to grow GDP.
That other, more powerful effect of the current account deficit is worth reemphasizing: Large-scale purchases of U.S. Treasuries, agencies, and MBS have pushed rates below where they otherwise would have been, providing monetary easing to the U.S. economy. In the early 2000’s, the persistent U.S. current account deficits effectively goosed growth in GDP — for both the United States and its trading partners. Moreover, because imbalances are unsustainable, persistent trade imbalances are at the heart of today’s global debt crisis, particularly in the eurozone. For instance, that means that countries that take on U.S. dollars through a current account surplus and buy U.S. Treasuries don’t need to sell them, thereby preventing the U.S. dollar exchange rate from adjusting. Hence both economies get thrown off balance. However, whether it comes from specific Fed policy (e.g., QE3) or from the current account deficit is a moot point. Why? Because money neither knows where it’s going nor where its been. It’s just money. There are only three relevant questions: Where exactly does the bubble end up? How big will the bubble be? And how much does money supply expand? As a point of reference, the U.S. current account deficit reached its peak in 2006. However, the impact of all that money flow is cumulative: Trading partners are not forced to sell their U.S. bonds at the end of each year.
Let’s look at the U.S. current account deficit on a cumulative basis to gain an understanding of how large the problem is:
United States: Cumulative Current Account Surplus (Deficit)
Sources: St. Louis Fed, CFA Institute.
That’s right, $8 trillion! Exactly how much of that $8 trillion ended up in the U.S. government bond market? I’ll leave that for another post. But with the U.S. government bond market checking in at about $15 trillion today, it is very likely that a significant portion did. Moreover, from U.S. Treasury reports, we know that holdings of U.S. Treasuries by foreign governments are substantial. With ever-increasing current account deficits since 1980, debt became its analog — even continuing total credit expansion through recessions. Of course, as banks were forced to lower their credit standards due to government policies, the acceleration of the current account deficit in the early 2000s led directly to an acceleration in housing and bad mortgage loans — leading to the financial crisis of 2008.
So, why should we expect QE3 and its attendant ZIRP to perform any differently? As noted previously, the Fed has just committed to buying $40 billion per month, or $480 billion per year, which compares to the annual current account deficit’s peak of only about $200 billion in 2006. Relative to the existing U.S. monetary base of $2.7 trillion, the $40 billion per month of new money translates into an 18% year-over-year increase in the monetary base. How efficiently that translates into money supply is difficult to say, but it is fair to say that it goes up materially.
Is it any wonder that we experienced the Great Moderation through the 1980s, 90s, and early 2000s in which the business cycle was seemingly mollified and tamed thanks to supposedly great U.S. Federal Reserve policy? The immediate consequence was lower volatility. But that was then, and this is now. Today, we have a world that has hit its limit of total debt. Despite massive stimulus and additional easing, the economy reacts sluggishly, if at all. Consequently, the effects of financial leverage will, as we move forward, be much more volatile than most investors can remember.
So what does this all mean for investors? I see three key takeaways, brought into ever-sharper relief by the onset of QE3:
- For starters, high volatility is part of the new regime, meaning that vol is probably cheaper than most models will predict. Can you say Black Swan, anyone?
- Second, QE3 will lead to more inflation and more debt. While it can goose the economy in the short term, it will heighten the downside in the long term. Waiting until the next major event unfolds is a recipe for failure. Whatever your opinion or investment strategy, position yourself before any events take place.
- Last, run payoff tables on everything. Consider both probabilities and payoffs. The magnitude of possible outcomes will be great. The new normal is a lot less normal than you might think.
In trying to make sense of today’s economic quagmire, there is one thing that I agree on with my esteemed professor — that the current account deficit is the most misunderstood thing in all of economics.
Editor’s note: An earlier version of this post understated the annual current account deficit. It was updated with the correct figure on 6 November 2013.
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35 thoughts on “Why the Current Account Deficit Helps Explain the Economics of QE3”
Like your article – very unambiguos, concise and precise
It’s actually a very interesting parallel between Balance of Payments and QE (dis)similarities brought by the author. However, what I generally lack in all discussions related to QEs (and QEternity in particular) is the distinction between the channels chosen for new money influx into the economic system.
The financing of the current account deficit is most likely done through purchases of Treasuries via primary market (i.e. newly issued Gov’t bonds) rather than secondary (i.e. private) market. It’s a genuine leverage in a sense, that existing money (i.e. export-earned revenues) is used to purchase newly created assets (i.e. “fresh” government bonds). In turn US government can use its coffers filled with foreign inflows to create fiscal stimulus, which triggers economic activity (the Keynesian view).
What the FED is doing now, is actually purchasing all kinds of assets in the secondary market from private sector. That is hardly any leverage, since all the freshly printed money will be used to acquire existing bank-owned assets. You might even argue that such actions constitute a (very backward but still) deleveraging of the system, since the FED is less likely to care if these MBS’es will default or not (by definition, the FED has no aim to earn profits on its assets), and thus in theory you could walk away from your property and be left with no debt afterwards.
And here comes the most confusing piece of puzzle that fails to explain how all that extra cash on banks’ hands will help boost the economy (or for that matter – even inflation), since (arguably) most of the new liquidity is channeled straight right back to the FED via reserve deposits. Essentially, this is the very same sterilized version of ECB’s Open Market Transactions, that leave the entire system cash-neutral on a net basis, yet allow the banks to get rid of the toxic assets.
Assuming that the US banking system had sufficient time to “detoxicate” itself after the financial crisis, and risk-taking in general is now in check due to stricter regulations of the banking system (think Volcker rule, Basel III), the real danger is that the latest round of QE will achieve exactly… nothing (?)
A very informative article. Nicely, answers a few critical “Why” and “What” questions; “why” we are in today’s economic situation and “what” will happen or expect in future according to the course of actions taken.
Thanks Amirreza, glad we can be of service!
Very nice ……………………………………………………….
Love the piece! Makes you appreciate the balance the free market brings. It also makes me wonder how to value Tips. How long does the CPI stay low? Can you have inflation with no wage growth? It is an interesting time.
Hi Mark! Regarding your question on CPI and Tips, one needs to be very careful. TIPS are indeed tied to CPI, but we can have significant inflation that is not captured by CPI. Just because the Fed is printing $480 billion per year in new money does not mean it necessarily flows into CPI from an economic point of view. For instance, new/easy money could create bubbles in various asset markets (e.g. stocks) or geographies outside the US (e.g Canada, Argentina, etc.). From an accounting perspective, the government has an incentive to understate these numbers because so much of government spending is tied to cost of living (CPI, COLA, etc.). Moreover, by including housing in CPI which has been deflating and food which is inflating creates some offsets which mollify reported CPI, but grossly understate the impact of Fed policy. All that said, it looks like the down side in US housing has abated and the Fed’s recent actions should strengthen the upside for inflation considerably.
I’ve been reading the Economist and other prominent publications for years and nobody has explained this unsustainable phenomena as clearly and concisely as you just. You even juiced it further with a note on how to incorporate these issues into the investment portfolio. Thanks again Ron!!
You are welcome!
Very nice, a very very informative article.
With the Fed printing dollars to buy MBS, it appears to be more of a stealth bank bailout. If the money is going towards repairing bank balance sheets, will this actually affect the money supply and cause inflation?
Hi Prathamesh! Thanks for your question. I don’t have a good handle on who the existing owners of MBS are. I suspect that it is a pretty diverse lot between big banks, commercial banks, asset managers and plan sponsors. Because the Fed is going through the secondary market with QE3, there is a stronger likelihood that the new money will make it out of the banking system – depending on who the sellers are. If it is mostly asset managers and plan sponsors, then I think the money will make it out of the banking system to a larger degree. In addition, the extended low rates might, just might, influence aggregate private sector credit to grow faster. I don’t view this as a good thing, but new loans would transfer money from the commercial banks to the real economy. To better understand how this works, look up my piece titled Government Debt: a Gentleman’s Wager. So, it’s not clear how efficiently the new and growing monetary base translates into money supply, but the nature of QE3 means that it will be more “efficient” than going through the primary market.
Banks hold about $1.5T in MBS.
The announced purchases of bank assets by the Fed through the end of ’13 is expected to total $735 billion, which is an equivalent to half of banks’ current holdings of MBS.
Sorry, $1.34 trillion.
I just liked your article a lot , it’s just clear .
I am from Egypt and you may have heard that our gov.nowadays is negotiating a loan from IMF claiming that this is the only way out.
I would like to know your point of view regarding getting such loan in our case , which is a developing country that produces next to nothing , import almost everything , high rate of unemployment and an increasing rate of population .
I don’t believe getting loans is the answer , i believe we need to think outside the box , can you give me some ideas that can help developing countries like us .
Thank you very much in advance .
Hi Amira! Thanks for your questions. Unfortunately, I have limited familiarity with Eqypt, its economic profile or its culture for that matter. All I can offer is generalities and perhaps you can derive some benefit. You state that Eqypt produces next to nothing, imports almost everything, has a high rate of unemployment and increasing population. Odds are that its political structure is inadequate, not the skills of its people. As you describe Eqypt’s circumstances, my thoughts quickly shifted to Hong Kong, because it developed as a little island economy – from essentially the same starting point – only a stone’s throw from communist China. Hong Kong imported almost everything yet was able to grow from a simple, agrarian economy to a thriving, wealthy economy during the mid 20th century while China completely stagnated. Another example would be East and West Berlin after WWII. One subtle point raised by my article is that when countries don’t manage their current account/trade balance, they open themselves up to the political control/influence of these supraregional governmental bodies (IMF, UN, etc.). If a country’s trade were in balance, its internal demand for goods and services would be met by internal producers. Now, when there are leaks (deficits) it is made up for with government bailouts, IMF loans and money printing – i.e. tools of political control. The solution to all of this is free markets – truly free markets. For the first 150 years of America’s existence, it used to be this way (sometimes called Laissez Faire), but we are a far cry from that now. Nevertheless, the blue print is out there. Study economic history and your solution will present itself. Hope this helps!!!
Thank you for shedding the light on the most misunderstood thing in all of economics.
You succinctly stipulated the ramification of QE3 in the long run while most pundits fail to elaborate. I especially savor your perspective on how the acceleration of the current account deficit in the early 2000s played a part to the financial crisis of 2008.
While you pointed out Chinese and other central banks exercise discretions to purchase a wide range of the dollar-denominated assets, not solely U.S. Treasuries, you didn’t address how the interdependence of dollar can actually help to fuel U.S. economic growth and may inadvertently lead asset bubbles as it did in the 2000s.
There is no other currency like the dollar as euro has proven itself an inferior alternative. Dollar is the reserve currency and still the most commonly used currency to settle trades. Its inherited status has positioned the U.S. not only as one of the top destinations for capital inflows but also the only country in the world can afford to exercise monetary easing without facing the ultimatum from the international investors. In 2000, Paul Krugman predicted a fire sale of U.S. Treasuries in imminent future. It didn’t occur. The least thing Chinese and other central banks want to do is to take a hair-cut on their dollar-denominated assets, be it equities, bonds or mortgages.
I absolutely agree with your takeaways. Volatility is the new normal. But I am more sanguine on the U.S. economic outlook, at least in the near term.
So, can i just simply understand that the QE3 will positively impact the Current Account Deficit by devalue of USD relativing to other currencies and therefore help US exports by making them cheaper?
Interesting article. It would be useful to allude to the segment of the current account which is largely underpinning the deficits i.e. goods, services, income payments or transfers. Going forward, if the US economy is adopting import-substitution measures, there could be some positive developments in the account.
Second, at a time when the global economy is experiencing immense volatility and US monetary authorities have exhausted all the conventional measures, I am wondering what you would prescribe in place of QE3. Thank you.
Hi Mala! I can look at the breakdown of the balance of payments in future pieces, but I do know that the biggest driver of the current account deficit has been the trade deficit. In 2006, the trade deficit peaked at about $750 billion while the current account deficit hit “only” $200 billion. So, on balance, everything else was positive… A deflating currency (which the Fed is engaged in) should help ease the trade deficits, but not without creating other problems in the economy (i.e. mis-allocation of capital).
In place of QE3, I would prescribe free markets. For starters, impose some form of trade balance mechanism (e.g. Buffett’s fixed exchange vouchers, Gold standard, etc.). My work suggests that trade balance would produce about 7-9 mm new jobs in the US. Reduce gov’t spending to get fiscal budgets in balance. And eliminate easy money to get balance back between savers and lenders. The current trajectory is a road to nowhere.
This is really a great conversation. I find it very difficult to plan for this from an asset allocation standpoint. Tips seem too expensive and CPI is not reliable (as Ron stated). I also don’t trust gold for the obvious reasons. And equities only seem to work with mild to moderate inflation. Does anyone have any other ideas?
If you believe in inflation (as I defined it), then the appropriate response is hard assets. Just be careful of the landmines of bubbles popping. Agricultrual assets are pretty good. Weak/sluggish developed economies plus growing middle class in developing economies plus higher inflation plus food being a necessity should translate into sustained growth. How much is already priced in is up to you. There are reasons not to trust gold (hypothecation, e.g.), but there are strong reasons to trust it. See my recent piece titled “Gold Investing: What is the ‘Barbarous Relic’ Really Worth?” Hope this helps!
Thanks again Ron! I will check out your book on Gold. I would love to get a better handle on valuing it.
Great articles I must say. One clarification. You mentioned that as the current account deficit grew, more treasuries were bought by the likes of China driving the interest rate lower, leading to credit expansion, especially post 2000, but I read somewhere that the Fed lowered the the interest rates in 2001 to stimulate the economy post the dot com crisis. Do both these factors come into play when we are talking about the credit expansion?
Yes, consider it a lalapalooza effect. Not only was the Fed actively lowering rates and easing monetary policy, but the current account deficit acted in concert to amplify the effects. Thanks for the question!
Author seems to have a very poor understanding of BoP and any arguments as to effect current account deficits had on rates are simply erroneous.
Foreigners do not fund and can not fiscal deficits unless the sovereign issues foreign currency bonds. They fund current account deficits. That the size of the current account deficit is exactly equal to the net foreign funding is axiomatic. Those are not new dollars buying treasuries (actually a large amount of FX reserves was invested in super-senior AAA tranches of ABS prior to the credit crisis) and they simply can not affect interest rates in any way shape or form.
An incremental dollar in China reserves means either one less dollar in RoW reserves, one less dollar is American savings or one more dollar in American liabilities. They are zero-sum. The extra dollar used to buy an asset by China (through SAFE or Huijin) was obtained by selling an asset elsewhere. There is no net effect to interest rates from this operation.
China was able to amass a large trade surplus with the US by allowing PBoC to control the currency and due to certain factors that allowed PBoC to buy USDs from exporters without the necessity of sterilization (by “printing” RMB), which, in combination, allowed China to avoid a level of revaluation that would shrink their current account surplus. China did this because current account surpluses mean you are effectively exporting unemployment.
Your professor was right and you are wrong. A US current account deficit is simply a an exchange of foreign goods and services for the promise of future American goods and services. All a massive negative cumulative current account means is a huge amount of pent-up demand for American goods and services. No more, no less.
It has nothing to do with quantitative easing in any way shape or form and to imply that it does is irresponsible and a disservice to your readers
Sorry for the late reply as I just had occasion to revisit and saw your post. You have a very lengthy comment, so I will not touch on everything. However, you presume that the US Public has the exact same appetite for US Treasury securities that a foreign central bank, like the Bank of China, has. Without doing research to verify, there is a very, very strong likelihood that the Bank of China has a MUCH greater affinity for government bonds than does the average person in the US. So, as the Current Account Deficit ramped up in the 1996-2006 time frame, the aggregate demand for US Treasuries increased, all else equal. This does in fact explain why foreigners bid up Treasuries and reduced interest rates. I know it is common among academics to discard Current Account Balances for the reasons you cited, but such disregard is only true in a static world. However, in a world where the Current Account balance is changing rapidly (relative to GDP), as highlighted in my article, the impact is pronounced. The question I have for you is: Why would you expect two vastly different groups of people (Bank of China, and the American Public) to have identical preferences (and utility) for allocation of capital? Regarding your comment on pent-up demand for American goods and services, the answer is it all comes at a price. The United States has roughly 150 years of history while under some form of the gold standard in place where the Current Account was roughly in balance. Are you suggesting that there was no variance in the global demand for US goods during this stretch? The complexity of this subject is too large to tackle here, but suffice it to say that Current Accounts remain in balance when there is some form of a gold standard and do not when it is absent. It has nothing to do with “demand for American Goods” as the standard keeps the whole international monetary system in balance from income, to goods, to services to transfer payments. One needs to look through the myriad ways free market based supply and demand are distorted by government policies. With all due respect, loosen up on your text books and follow the bouncing ball.
Loved the article! Great explanation of a fairly complex topic. Curious to know if you have considered the impact of the USD being the world’s reserve currency on your analysis. This seems to be an equally strong force along with the BoP on the popularity of US Treasuries.
Excellent article but where did you get the current account data. Bureau of economic analysis shows a goods deficit of nearly 840 billion for 2006, a goods and services deficit of about 750 billion, and a current account deficit of about 800 billion not 200 billion. The 200 billion looks like quarterly data not yearly data.
R. E. Marinaccio
Richard, thank you so much for your comment. I just rechecked the data and realized that you are right, I inadvertently used quarterly data. Upon investigation, I see that the FRED database (St. Louis Federal Reserve) automatically takes the average of the quarterly data, rather than the sum. Of course, the larger numbers only bolster the argument I make, so the body of the work remains in tact. Thanks for the catch and I will be sure to update that article! Nice work 🙂
I’ve searched the internet for a chart showing the cumulative current account deficit, and yours is the only one I’ve found. It’s very helpful. Are you planning to update it with more recent data? It would be especially interesting if you superimposed foreign government holdings of US Treasuries.