Biden’s budget gamble and the twin deficit problem

The United States is no stranger to the twin deficit problem of a large budget deficit and a large external deficit. But never before has it had a twin deficit problem on the scale that it is likely to have under its present budget policy.

This should be a major concern to policymakers since it could seriously undermine the long-run status of the U.S. dollar as the world’s dominant international reserve currency. It could also have serious implications for the long-run U.S. inflation outlook. 

A basic economic truth that successive U.S. administrations have chosen not to grasp is that a country’s external deficit is not the result of the degree to which it engages in protectionist trade policies. Rather, it is the result of the degree to which the country chooses to consume more than it produces. If the country goes on a spending spree that raises its expenditures above the amount that the country produces, then it will run an external deficit. Conversely, if it produces more than it consumes, it will run an external surplus.

An important insight of John Maynard Keynes was to realize that this fundamental economic truth can be expressed in terms of a country’s savings and investment levels. If a country saves less than it invests, it will run an external deficit. Conversely, if it saves more than it invests, it will run an external surplus.

The Trump administration singularly failed to grasp this fundamental economic truth in its quest to eliminate the external deficit. At the same time that it resorted to increasingly protectionist policies to improve the trade balance, it engaged in a large unfunded corporate tax cut at a time that the economy was close to full employment. That tax cut had the effect of increasing the general government budget deficit to close to 6 percent of GDP in 2019 and of reducing the government’s saving level. It should have come as no surprise then that no progress was made in reducing the country’s external deficit under Trump’s watch. 

In the years immediately ahead, there is every prospect that the U.S. external current account deficit will widen significantly from its current high level of around 4 percent of GDP. It will do so as a result of the large budget deficits, which are now likely in the wake of the COVID-19 pandemic and which are bound to reduce the country’s long-run savings performance. According to the IMF, the U.S. general government deficit widened to a record peacetime level of 15 percent of GDP in 2020 and is likely to remain at that very elevated level in 2021.

It’s very unlikely that the budget deficit will return to its pre-pandemic level anytime soon given the Biden administration’s bold longer-run public spending proposals. For the decade ahead, the Biden administration is proposing a Jobs Plan and a Families Plan, both of which have $2 trillion price tags. Not being fully funded with corresponding tax increases, these two programs are bound to constitute a further drain on public savings.

To date, the large erosion in government saving has not led to a marked widening in the external deficit since it has been almost entirely offset by a record increase in private savings. Stuck at home during the COVID-19 lockdown, households largely saved the government transfers that they received. But now as the economy reopens and most Americans have been vaccinated, we must expect that a large amount of household pent up demand will be released and that the external deficit will widen.  

At a time that the U.S. is the world’s largest debtor country and foreign central banks are already starting to reduce their dollar holdings, the U.S. can ill-afford a prolonged period of large external deficits. Such deficits could raise questions about the United States’ willingness to repay its debt, which could induce foreigners to further reduce their dollar holdings. That, in turn, could precipitate a dollar crisis that could have serious implications for the country’s long-run inflation outlook.

Valery Giscard D’Estaing, when he was Charles De Gaulle’s minister of finance, used to complain that the dollar’s status as the dominant international reserve currency afforded the United States an exorbitant privilege in the sense that it could borrow massively in its own currency. One has to hope that American policymakers do not take that privilege for granted and realize that it can be lost by years of undisciplined budget policies. Maybe then there will be a chance that corrective economic measures will be taken before it is too late. 

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.