The Bush Economy: TIE Sat Down with Richard Clarida, the Bush Treasury's Former Point Man for Economic Policy, for Some Frank Talk on Deficits, Rate Spreads, and Inflation Risks. Here's How He Answered Our Questions

Article excerpt

How Big a Risk Is the U.S. Current Account Deficit?

The U.S. current account deficit is substantial, both in size and as a share of GDP. There's no single cause of the current account deficit. We sometimes talk about a "capital account" theory of the current account compared with a Keynesian, demand-side theory of the current account. I have become persuaded that there is a capital account channel that, to some extent, is now contributing to the U.S. current account deficit. But obviously, a lot of the U.S. current account deficit is homegrown--a low national savings rate, a negative household savings rate, and until recently, a high investment rate, driven by historically elevated residential investment on top of a historically average business fixed investment.

As we know from accounting, high rates of investment and low rates of saving compared to the business cycle produce a current account deficit. However, other factors--in particular the Bernanke "savings glut"--have tended to make the U.S. current account deficit larger than it would be otherwise. We're now in a situation of both large global imbalances and low global real interest rates. Looking at the markets in inflation-linked bonds, we see that both spot and forward the real interest rates are historically low.

A contributing factor is the savings glut, which I define as an excess of global saving relative to desired global investment at the interest rates that prevailed in the 1990s. It's important to distinguish between the savings glut and Bretton Woods II. These are related but distinct phenomena. Bretton Woods II is the arrangement whereby China and some of the other large emerging or emerged economies try to benefit from trade surpluses, foreign direct investment inflows, and fixed exchange rates. As we know, such a country must accumulate reserves. But the savings glut is an independent driver of low global rates, and because the United States tends to have a very interest-elastic response to low interest rates due to the housing sector, it's not surprising that our current account deficit has grown over this time. Indeed, I calculate that roughly 75 percent of the increase in the current account deficit between 2001 and 2005 was accounted for by the rise in residential investment. Note I did not say "caused," but the magnitudes of the housing boom and the widening of the current account deficit are comparable.

Do I worry about the current account deficit? Before, during, and after my stint at Treasury, I have said that a current account deficit at current levels probably will not be sustained. It's a theoretical issue whether or not it's sustainable in some abstract textbook sense. The adjustment under most plausible scenarios will be orderly and will entail a weaker dollar, so I'm not in the camp of some respected scholars who think that the current account and the dollar are unrelated phenomena. But I don't see a disorderly adjustment as a baseline scenario.

Is There a Link Between Today's Sea of Liquidity and Low Interest Rates?

The argument that the low riskless real rate is being driven by excess liquidity created by global central banks has a lot of force if we are talking about the global economy circa 2001-04. What I look at is not the current real rate or the current setting of nominal interest rates, but the forward real rates which approximate where the markets think real rates are going to be in five years or so. What's striking is how stable those rates have been over the past several years, even though the Fed funds rate has moved from 1 percent to the current 5.25 percent.

From 2001 when the Fed began aggressively to cut rates until late 2005, the world has been awash in liquidity. The European Central Bank only started hiking in December 2005 and the Bank of Japan only started hiking in July 2006, and just got rid of quantitative easing in the spring of 2006. By traditional measures comparing nominal interest rates to nominal growth, that could be seen as an indication of some of the hangover from that excess liquidity. …