JAMIE MCGEEVER: US twin deficits matter for the dollar, just not that much

Orlando, Florida — The combined US current account and government budget shortfall as a share of the economy now exceeds anything seen in the past 30 years, excluding the periods after the great financial crisis and the Covid-19 pandemic when the country required unprecedented fiscal support.

It is once again unnerving those in financial markets who say these “unsustainable” deficits could trigger a dollar crisis — a sharp depreciation in the exchange rate, a steep rise in interest rates, and a wave of high inflation.

The combined deficit has steadily widened to 12% of GDP from 8% a year ago. Curiously, 8% was the then record level between 2003 and 2007 that marked peak “twin deficit” fears that foreign inflows into the US would not be strong enough to prevent a destabilising plunge in the dollar.

But that period was more bark than bite. The dollar did fall — about 40% between the dot-com bust and the global financial crisis — and the twin deficits were a factor. But the secular declines in US interest rates and bond yields were probably more important, and a “savings glut” from abroad flowed into US stocks and bonds.

There was no dollar crisis, in any meaningful sense of the word. Indeed, when the twin deficits really exploded in 2008 as the government and Federal Reserve fought to prevent another Great Depression, the dollar actually rose 25%.

That said, the recent sterling crisis showed that investors can take a dim view of a currency that depends on overseas funding to plug yawning current account and government budget deficits. Even in developed economies.

As former Bank of England governor Mark Carney once said, Britain “relies on the kindness of strangers”.

While the same may be true of the US to some degree, the role of the dollar as the dominant world reserve and savings currency means strangers rely on the US too.

Tavi Costa, macro strategist at Crescat Capital, says the present deficit of 12% of GDP is already “alarming” but could deteriorate significantly — perhaps to 30% or more — when the recession he is predicting arrives.

“Twin deficits are inherently unsustainable — for Treasuries and the dollar — unless there is a shift towards a deflationary environment that stimulates demand for sovereign debt instruments,” Costa said.

In a research note in June on the dollar’s gradually fading omnipotence, JPMorgan currency strategists Meera Chandan and Octavia Popescu wrote: “US twin deficits haven’t impacted dollar transactional dominance, but [have] been loosely correlated with the dollar.”

Rule, not exception

The contrasting fortunes of Britain and sterling on one hand, and the US and the dollar on the other, show that not all twin deficits are equal.

Britain’s twin deficits as a share of national income are wider than their US equivalents, and sterling is no longer the world’s reserve currency. That has been the dollar’s unchallenged status for more than half a century.

The US provides the world with the dollars it needs to invest, trade and pay for the goods, services and commodities that are priced in the US currency.

The dollar is on one side of almost 90% of all foreign exchange transactions, is the invoicing currency in at least three-quarters of global trade — more than 95% in the Americas — and is used for about 60% of all bank deposits and loans.

There is a structural demand for US stocks and bonds too — foreigners want to put large chunks of their dollar-denominated trade surpluses into the most liquid markets in the world. And the surplus on the US capital account is simply the flip side of the deficit on its current account.

The current account has not been in surplus for more than 30 years. President Bill Clinton’s budget surplus in 1998-2001, meanwhile, is the only government surplus in more than 50 years and was the biggest since 1947 and 1948.

Twin deficits are the rule, not the exception.

The current account gap may narrow over time as the US meets more of its energy, manufacturing and tech needs at home. Onshoring and increased domestic production will in theory reduce reliance on imports.

But that will be a slow and incremental process. Meanwhile, the nonpartisan Congressional budget office in Washington expects the budget deficit will widen to 7.3% of GDP in 2033 from 5.4% in 2023.

Persistently wide twin deficits will test the appetite to use the dollar as the savings currency of choice for investors and countries around the world. And it is this appetite that will determine whether the dollar feels the heat.

The opinions expressed here are those of the author, a columnist for Reuters.