FLASH PMIs

Eurozone business activity rises at faster pace, but new orders continue to fall

The seasonally adjusted HCOB Flash Eurozone Composite PMI Output Index rose to 51.2 in August from 50.2 in July, thereby signalling a faster pace of output growth in the region’s private sector following two successive months in which the pace of expansion had slowed. The latest increase in activity was the fastest since May, but still modest nonetheless. Output has now risen in each of the past six months.

As has been the case throughout the current growth sequence, the overall expansion in eurozone business activity was centred on the service sector. Services activity increased solidly and at the fastest pace in four months, in large part due to the strongest expansion in France since May 2022 and a further solid rise across the euro area outside the big-2 economies. Meanwhile, services activity in Germany increased modestly.

Manufacturing across the eurozone remained in contraction, however, seeing production decline for the seventeenth month in a row, and at a marked pace that was broadly in line with that registered in July.

While growth of business activity picked up in August, the demand picture was less positive. New orders decreased for the third month in a row, with the pace of reduction only slightly softer than in July. A modest increase in services new business was outweighed by the largest reduction in manufacturing new orders since the end of last year.

The overall reduction in new business continued to be led by falling new export orders (including intra-eurozone trade). New business from abroad was down solidly, and at the fastest pace since February.

August data pointed to a fractional reduction in employment in the eurozone’s private sector, thereby ending a seven-month sequence of expansion. The second consecutive month of broad stagnation in staffing levels was recorded amid a modest increase in services employment and a solid fall in manufacturing workforce numbers. Staffing levels were down in Germany and France, but rose elsewhere.

The fall in new orders meant that companies were still able to keep on top of workloads despite not adding to their staffing levels during August, and were able to work through outstanding business over the course of the month. In fact, the latest fall in backlogs of work was solid and the most pronounced since February.

Eurozone manufacturers responded to demand weakness by scaling back their purchasing of inputs again in August. Buying activity decreased rapidly, and to the largest extent in four months. In turn, stocks of purchases also fell markedly. Firms also looked to reduce their stocks of finished goods, albeit to the least marked extent since April. Suppliers’ delivery times shortened for the seventh consecutive month in August amid reduced demand for inputs. The latest improvement in vendor performance was modest, but more pronounced than in July.

As well as being a function of current demand weakness, reductions in employment, purchasing and inventories also coincided with waning confidence regarding the future outlook for output. Sentiment dropped to the lowest in 2024 so far and was below the series average. Reduced optimism was widespread, with confidence lower across Germany, France and the rest of the eurozone, as well as in both monitored sectors.

Although input costs continued to increase markedly midway through the third quarter, the pace of inflation eased to an eight-month low. Services input prices rose at the softest pace since April 2021, while manufacturing cost inflation was unchanged from the 18-month high seen in July.

In contrast to the picture for input costs, the pace of output price inflation quickened in August. Selling prices increased at the fastest pace in four months, and at a stronger pace than the series average. Services charges rose at the sharpest pace in three months, while manufacturing output prices increased for the first time since April 2023.

• Eurozone Wages Slow Sharply, Paving Way for ECB Rate Cut Wages in the eurozone rose at a significantly slower pace during the three months through June, paving the way for further cuts in borrowing costs by the European Central Bank.

The ECB on Thursday said wages set through negotiations between employers and labor unions or similar bodies were 3.55% higher than a year earlier, a slowdown from the 4.74% increase recorded in the first three months of the year. That was a slower increase than economists expected to see. (…)

A slowdown in wage growth would suggest that services prices are also set to cool, opening the way for a second rate cut when policy makers next meet on Sept. 12. (…)

Japan: Business activity rises at fastest pace since May 2023

August flash PMI data signalled that the solid expansion of business activity at Japanese private sector firms was sustained midway through the third quarter of 2024. Growth was supported by an acceleration of services activity expansion, while manufacturing output returned to growth after declining briefly in July. That said, demand trends diverged as a solid rise in services new business contrasted with subdued demand conditions in the goods producing sector which will be worth monitoring.

Overall optimism levels remained above average to indicate that firms were confident that output will continue to rise in the months ahead. The level of business confidence eased to a 19-month low, however. Anecdotal evidence pointed to concerns over labour constraints, particularly in the service sector where employment growth slowed, and also rising price pressures.

Indeed, overall selling price inflation fell to its lowest since November 2023 despite average input costs rising at the fastest pace in 16 months. Signs of margin pressures were present not only among manufacturers but also in the service sector where new orders growth remained solid, thereby highlighting that private sector firms are partially absorbing price increases in order to remain competitive and to support sales.

The U.S. flash PMI is out later this morning.

CONSUMER WATCH

Discount-Hungry Shoppers Propel Sales Gains for Target, T.J. Maxx Retailers say shoppers are resilient and hunting for deals.

(…) “I think we see an incredibly resilient consumer in the face of high inflation and some of the other challenges they have been facing to manage their household budget,” Target Chief Executive Brian Cornell said on a call with reporters. Shoppers remain focused on value, he said.

Target’s comparable sales, those from stores and digital channels operating for at least 12 months, rose 2% in the three months ended Aug. 3 from the same period a year earlier. (…)

Target lowered prices in the latest quarter compared with the same period last year, executives said. That helped propel a 3% rise in shopper visits during the quarter, they said. The average dollar amount those people spent per trip fell slightly in the quarter. (…)

Last week Walmart, the country’s largest retailer by revenue, said that its most recent quarterly U.S. comparable sales excluding fuel rose 4.2% from a year earlier. Walmart last week reported a slight uptick in its general-merchandise category—discretionary items such as electronics and home goods—which had been in decline for 11 quarters. (…)

Two percent comp growth may sound low, until one realizes that retail inflation was negative for over 12 months. TGT’s +2.0% quarter was in fact close to +2.5% in real terms. WMT’s was even more impressive.

TJX comp store sales were +4%. Management noted that the current quarter is off to a good start. Recall that Walmart’s CEO earlier said that “things have been remarkably consistent” and that “we aren’t experiencing a weaker consumer overall.”

A good back-to-school season generally augurs well for holiday sales.

Speaking of inflation:

Business Inflation Expectations Decreased to 2.2 Percent

Minutes Show Fed Officials Gearing Up for September Rate Cut

Minutes released Wednesday showed that “several” of the 19 Fed officials saw “a plausible case” for cutting rates by 0.25 percentage point at the July 30-31 meeting or indicated “that they could have supported such a decision.” (…) “The vast majority” of officials agreed that “it would likely be appropriate to ease policy at their next meeting,” in September, if inflation data continued to come in about as expected. (…)

US job growth in year through March was far lower than estimated

First, what is the QCEW?

The publication of nonfarm payrolls as estimated by the establishment survey is certainly one of the most closely followed economic news items each month, as it gives an idea of the vitality of the job market. It is, however, a rather imprecise report, since it is based on responses to a survey with a fairly small sample size of around 120,000 companies and fails to reflect net business creation in a timely manner.

To compensate for these methodological weaknesses, once a year, the Bureau of Labor Statistics benchmarks the level of nonfarm payrolls to a much more comprehensive employment series called the Quarterly Census of Employment and Wages (QCEW). The latter derives its job estimate not from a survey, but from tax records and cover roughly 95% of businesses in the United States. (…)

In part, this reflects the backward looking nature of the birth/death model used in the establishment survey to estimate net business creation. Historically, this model has failed to reflect increases in business bankruptcies and has therefore tended to overestimate job creation at the end of business cycles. Such an overestimation is probably taking place now, as high interest rates weigh increasingly heavily on businesses. (NBF)

The BLS:

The department’s estimate for total payroll employment for the period from April 2023 to March 2024 was lowered by 818,000. The revision represented a total downward change of about 0.5% and means that monthly job gains during the period averaged roughly 174,000, compared to the previously reported figure of 242,000.

The sharply lower number is the first of two “benchmark” annual revisions undertaken by the department as it collects more accurate data only available in the months after it publishes the monthly payrolls report.

If the tally holds through the final revision in February, it would be the largest downward revision since the 902,000 reduction to employment in March 2009.

It also chimes with the view of some economists that data-gathering issues mean the strong job gains previously reported have been systematically overestimated.

Private employment growth was revised down by 819,000, or 0.6% below what had been previously estimated by the department. Government employment was basically unchanged.

The professional and business services category saw the biggest reduction of jobs, shedding 358,000, or 1.6%, from the prior estimate, followed by leisure and hospitality at 150,000 jobs, down 0.9%. The hard-pressed manufacturing sector saw a reduction of 115,000 jobs, also down 0.9%.

The few sectors that saw upward revisions included private education and health services, up 87,000, or 0.3%; transportation and warehousing, up 56,400, or 0.9%; and utilities, up 1,700, or 0.3%.

The revisions suggest government and private employers had about 157.3 million workers on their books in March on a seasonally adjusted basis, down from about 158.1 million as previously reported.

Labor Department data will continue to reflect the original estimates until the final benchmark revision is published in February 2025. Final revisions are typically not far off the preliminary ones.

“This is a noticeably larger than a normal revision … it wouldn’t be a stretch for the Fed to assume that recent job growth is also being overstated, strengthening its decision to shift attention from inflation toward the labor market,” said Ryan Sweet, chief U.S. economist at Oxford Economics. (…)

So, by March 2024, national employment increased 1.3% as measured by the Quarterly Census of Employment and Wages (QCEW) program. The original BLS data showed employment up 1.9% YoY last March. That declined to +1.6% in July.

Applied to Aggregate Weekly Payrolls, the reduction in job numbers would trim payrolls growth down from +5.9% to +5.3% in March 2024. Payrolls growth was +4.8% in July.

Meanwhile, today’s downward revision in payroll employment didn’t elicit a market reaction. The annual revision for the 12 months through March 2024 implies average monthly payroll growth was roughly 173,500 rather than 241,600. That’s roughly the same as during 2018 and 2019, before the pandemic. Today’s revision implies that productivity growth will probably be revised higher from 2.9% to 3.4% y/y through Q1-2024. We are still expecting to see stronger August economic indicators, confirming that the labor market and the economy have normalized and are in good shape. That’s all fine with us. (Ed Yardeni)

Goldman Sachs:

(…) we think that today’s downward revision to payroll growth exaggerates the degree to which job growth has been overstated by about 500k, both because the QCEW likely excludes many unauthorized immigrants who are not in the unemployment insurance system but were correctly picked up in payrolls initially, and because the QCEW itself has tended to be revised up in recent years. As a result, we think the true downward revision should be about 300k or 25k per month, which would imply that monthly job growth over this period was closer to 215-220k than the initially reported 242k, but not as low as the 174k pace implied by the revisions.

Bank of Korea Holds Rate Steady, Signals Pivot to Easing Soon The bank now expects GDP to grow 2.4% and inflation to average 2.5% for 2024.

Canada Railways Lock Out Workers as Talks Fail, Snarling Trade Moody’s Corp estimated C$341 million per day impact to Canada

Chinese Imports of Chip Gear Hit Record $26 Billion This Year China has been stockpiling ASML systems and foreign machinery

Chinese firms imported almost $26 billion worth of chipmaking machinery, according to fresh trade data released by China’s General Administration of Customs this week. That surpassed the previous high mark in 2021 and comes as American, Japanese and Dutch officials work on increasing restrictions on Chinese companies. (…)

During the period, Chinese companies bought more lower-end equipment after the US and its allies tightened controls on their access to the most cutting-edge technology. That spending spree has helped drive Dutch exports to China to new highs, exceeding $2 billion in July for only the second time on record.

Dutch company ASML’s sales to China surged 21% in the second quarter to hit almost half of its total revenue, with sales consisting of unrestricted older systems as Beijing pushes to make more mature types of semiconductors. ASML is the sole supplier of the most advanced lithography equipment required to make cutting-edge chips. China’s Semiconductor Manufacturing International Corp. relied on ASML’s older generation of lithography machines to achieve a technological breakthrough last year, Bloomberg News has reported.

Chinese chipmakers are expected to grow their output by 14% to 10.1 million wafers per month in 2025, or nearly a third of the global industry’s production, after achieving a 15% increase this year, trade group SEMI estimated in June. (…)

LIQUIDITY WATCH

Quantitative Tightening Goes Global for the First Time, in Test for Markets Central banks have moved to slim their balance sheets

After having sailed through uncharted waters repeatedly over the past two decades, the developed world’s top central banks are entering a new stretch: For the first time, they’re engaging in joint quantitative tightening.

Last month’s decision by the Bank of Japan to steadily shrink its portfolio of bond holdings in coming years means it’s now engaging in balance-sheet contraction alongside the Federal Reserve, European Central Bank and Bank of England. While QT, as it’s known, is different in each jurisdiction, it involves a withdrawal of the liquidity that central bankers pumped into their economies during the pandemic crisis by buying bonds.

When the Fed conducted QT for the first time, policymakers were blindsided by unanticipated disruptions to money markets in 2019. While Chair Jerome Powell has said the Fed learned lessons from that, and pledged a halt before trouble emerges, there’s no guarantee for smooth sailing — particularly now that investors are facing a global drain on cash.

Many on Wall Street anticipate the Fed’s QT program only has months to go, as the US central bank shifts to cutting interest rates to help support the economy. The Fed already in June eased the pace at which it’s shrinking its bond portfolio. (…)

“Bond purchases by central banks in earlier years plied economies with cash, and part of that was used to invest in riskier assets such as equities,” Barrow wrote. “But now these central bank asset piles are being reduced and that presents a challenge for investors.” (…)

Shirai, a professor of economics at Keio University in Tokyo, also noted that many central banks are now lowering interest rates. That should help limit any downward pressure on bond prices from QT, she said. (…)

While bank reserves parked at the Fed appear sizeable at around $3.3 trillion, some market participants have highlighted the risk of worrisome cracks appearing, similar to those seen five years ago — arguing for a near-term end to QT. Meantime, if acute funding pressures did suddenly emerge, the Fed today has liquidity backstops that it didn’t have back in 2019 to address such a scenario. (…)

Like the Fed, the Bank of Canada has been shrinking its balance sheet for more than two years now. This year, the program has had the effect of impairing the functioning of short-term funding markets, forcing the BOC into periodic interventions. Nevertheless, Deputy Governor Carolyn Rogers said last month indicated the bank would keep going with QT for now because the balance sheet wasn’t yet “normalized.”

Even more determined on normalization is the BOE, which has taken the most aggressive approach — actively selling off bonds from its portfolio, not just reinvesting fewer maturing securities. To address any market liquidity issues, it’s encouraging banks to use a range of lending facilities to get cash from the BOE as needed — known as a demand-driven system. (…)

Japan is a newcomer to QT. Last month, the BOJ announced a program to scale down its purchases, with the expectation that holdings will shrink by 7% to 8% over a little less than two years — taking the amount of maturing bonds into account. Citigroup Inc. estimates a ¥10 trillion ($69 billion) drop by the end of March 2025. The BOJ pledged to be flexible as it proceeds, and to review the program next June. (…)

“Most if not all of the governments are in acute need of public financing and debt issuance,” said Stephen Jen, chief executive of Eurizon SLJ Capital. “How could the central banks fully prosecute their QT plans against this headwind of large debt issuances?”

Full prosecution would be all the harder if markets are unsettled. The big moves in the yen and global equities at the start of this month “should be a wake-up call — volatility is back,” said Jerome Jean Haegeli, a former official at the Swiss National Bank and International Monetary Fund.

“Global QT, should it continue well into 2025, is more likely than not to continue to trigger volatility spikes,” said Haegeli, chief economist at the Swiss Re Institute in Zurich.

FYI: Capital spending by the largest tech firms:

Source: @WSJ

U.S. Election Monitor

• From FiveThirtyEight

Data: FiveThirtyEight. Chart: Axios Visuals

• Goldman Sachs

Vice President Harris leads former President Trump by around 1.5pp in national polling averages and is very narrowly ahead in the swing state that would provide the winning electoral vote (currently this appears to be Pennsylvania). Prediction markets imply 52-54% odds that Harris wins in November.

Since August 1, the odds of a Republican White House victory (-10pp) and sweep (-4pp) have continued to decline, while the odds of Democratic divided government—a Harris victory and Republican control of one or both houses of Congress—have risen the most (+11pp), and that is now the most likely implied scenario, but the outcome is very uncertain.

Tim Walz’s approval stands 6pp ahead of JD Vance’s.

The Senate playing field favors Republicans, but Democrats are still polling ahead in most of the seats they currently hold. Prediction markets imply a 29% chance of a Democratic majority (up 1pp in August).

Control of the House still appears narrowly divided, and most indications continue to suggest it will remain close next year. Democrats have a small lead in national generic ballot polling and prediction markets imply 63% odds of a Democratic majority (up 8pp in August), but seat-by-seat ratings from several widely followed sources tilt slightly Republican and suggest the majority in 2025 could come down to a few seats.

Inflation rate eases, cementing case for Bank of Canada rate cut

The Consumer Price Index rose at an annual rate of 2.5 per cent in July, down from 2.7 per cent in June and matching analyst estimates, Statistics Canada said Tuesday in a report. It was the lowest annual inflation rate since March, 2021.

Inflationary pressures are easing in many areas, with prices for passenger vehicles, travel tours and electricity falling from a year earlier. The housing sector – a persistent area of financial pressure – is also showing signs of slight moderation. (…)

At the July rate announcement, the Bank of Canada’s six-person governing council said that it was putting more emphasis on downside risks to the economy and the possibility that inflation could undershoot the 2-per-cent target on the way down. This marked an important shift in how the central bank is approaching its monetary-policy deliberations. (…)

Some measures of core inflation – which strip out volatile movements in the CPI – cooled last month. On a three-month annualized basis, the central bank’s preferred measures of core inflation rose by an average of 2.7 per cent in July, down from 2.9 per cent in June.

Consumer prices rose 0.4 per cent in July from June, in figures that were unadjusted for seasonality. Gasoline was a key contributor to the increase: Those costs rose 2.4 per cent during the month.

Grocery prices rose 2.1 per cent in July on an annual basis, matching the increase in June. Groceries have experienced a pullback from peak increases of roughly 11 per cent in late 2022 and early 2023.

Conversely, there are several products that are experiencing price cuts. For example, the price of passenger vehicles fell 1.4 per cent in July, year-over-year. This is being driven by the used-car segment, which has seen prices tumble by 5.7 per cent over the past year as inventory levels improve.

Shelter costs rose by 5.7 per cent on an annual basis, down from a 6.2-per-cent pace in June, and the first reading below 6 per cent since December. With interest rates in decline, this is easing some pressure on mortgage interest costs. While those costs have soared by 21 per cent year-over-year, that is down from peak increases of roughly 30 per cent in 2023. (…)

Dethroning King Dollar

John Authers:

The dollar’s weakening is growing impossible to ignore, and it stains the otherwise remarkable recovery on Wall Street after one of the biggest market selloffs since the pandemic. The currency slumped in Tuesday trading to its lowest point this year. Its recent troubles precede the unwinding of the yen carry trade (which has resumed this week), and its pain is the gain for developed market peers. The euro and the pound surged to 2024 highs. The dollar fell against the Swedish krona despite the Riksbank delivering its second rate cut this year:

This is more of a US problem than a resurgence by other currencies. Bannockburn Global Forex’s Marc Chandler dismisses the idea that European markets are driving the euro’s exceptional performance. Rather, he assesses that what’s moving the foreign exchange markets are events in the United States, especially increasingly imminent rate cuts:

It’s not about what’s going on in Europe. I don’t think people are getting more optimistic about China, but people are getting more pessimistic about the top-dog country being among the best-performing economies. I still think we live in a world where what happens in the US often drives the capital markets.

The fact that the US is late to the policy-easing party is exerting pressure on its currency, despite helping the dollar to rally earlier this year. This chart shows how optimism for rate cuts in the US is growing compared to elsewhere:

The dollar’s troubles coincide with a significant decline in US Treasury yields, which have picked up only slightly since the big stock market selloff at the start of the month. Standard Chartered Bank’s Steven Englander views this as a case of “risk on” dollar weakness as markets recover from the rout:

You’re seeing asset equity market rebound — typically the dollar-negative signal — as US yields come down. But in contrast, in the last week of July and the beginning of August, US yields aren’t coming down because of safe haven issues. They’re coming down because the market is comfortable that inflation is coming down. So, this combination of the market reading risk and, at the same time, the rates are coming off while global equities are picking up, is historically a dollar negative.

Investors see a September rate cut as a certainty even with several important economic data prints still to come. Whether the Fed delivers its usual 25 basis-point cut or aims higher will depend on that data. Investors leaning toward 50 basis points expect a significant worsening in the job market that leaves the Fed with no other option. Such an outsized move would exacerbate the dollar’s precarious position. For now, markets are broadly convinced that a quarter-basis point reduction to the fed funds rate is in order. Englander argues that while this is enough to maintain risk appetite and keep yields flowing, it remains detrimental to the dollar. (…)

The dollar is still super-strong, Juckes adds, just not as strong as it was. Pointing to the Bank of International Settlements’ broad real effective exchange rate for the dollar, which takes into account different inflation rates, he shows that the dollar is still above its 1998 peak during the Asia crisis and Long-Term Capital Management meltdown. It’s also about 40% higher in real terms than at the Global Financial Crisis low. That’s not “weak” in his book:

Juckes says, however, that there may have been so much foreign money invested in dollar assets (led by Magnificent Seven stocks and US Treasury bonds) for so long that the currency could slip a long way once it starts to fall. This is not necessarily alarming. He points out that the massive Reagan/Volcker dollar rally of the 1980s “unwound completely without a recession,” while the currency was back at 1995 levels by 2004 without much weakness — even though Alan Greenspan cut rates sharply. The other possibility is that “there are a lot of people who actually believe what is priced into the rates curve, i.e., a serious slowdown, big easing cycle etc.” (…)

The New Consensus on Trade Is Wrong and Dangerous The populist left and populist right are now closely aligned in their support for protectionism. Good luck with that.

One of the most enduring fallacies in politicians’ talk about economics is the idea that trade deficits are a problem in their own right, regardless of why and how they arise. If you’re importing more than you’re exporting, goes the argument, you’re a loser – and the key to success in economic policy is to attack this imbalance. In the US, the populist left and the populist right are now closely aligned in their support for this nonsense.

It’s dangerous as well as tiresome. The measures meant to cut trade deficits invariably fail, but not harmlessly: They also cause collateral damage. Republicans and Democrats have come to support an expansive range of protectionist policies. As countless times before, these self-defeating initiatives will end up proving the point.

Note first that balance-of-payments deficits necessarily mirror external financial surpluses. The two are equal as a matter of accounting identity – different ways of measuring the same thing. The capital-account surplus standing alongside a balance-of-payments deficit means that the economy is using foreign capital to invest more than it’s saving. This might be a good thing, depending on what produced these matched imbalances. High investment financed by foreign saving means faster growth. But if policies aimed at raising exports and lowering imports result in less investment, shrinking the trade deficit is a bad idea.

Tariffs on imported EVs, say, combined with subsidies for EVs made in the US will certainly reduce imports of EVs and create new jobs in EV factories. But what happens if the investment-saving gap doesn’t change? Then the trade deficit won’t change. The cut in EV imports will be matched either by a rise in other imports or by a cut in total exports, which is to say that jobs elsewhere will be lost. Consumers are now obliged to buy expensive EVs rather than cheap EVs, which represents an economic loss. Jobs have been moved around – and that, admittedly, might be a legitimate policy goal – but they haven’t been created on net. And the trade deficit hasn’t budged.

By the way, if the subsidies aren’t paid for with higher taxes or cuts in other public spending, the government must borrow more, which reduces national saving, which requires either lower investment or a bigger capital-account surplus. And if it’s the latter, this ingenious assault on the trade deficit will end up making it bigger.

Because of this underlying logic, Trump-style tariffs as a solution to America’s supposed trade-deficit problem garner next to no academic support. But a more sophisticated line of analysis recognizes the importance of the saving-investment balance for trade and employment, and suggests another policy approach. In effect, it agrees with ordinary old-fashioned protectionism in blaming foreigners for US “deindustrialization,” but shifts the focus to capital flows.

The decade leading up to the crash of 2008 is the center of this version of the story. The trade deficit surged in those years, alongside a dramatic increase in capital inflows following the Asian financial crisis of the late 1990s. (Asian central banks expanded their foreign-currency reserves by buying huge amounts of US Treasury debt.) The inflows drove up the dollar and made imports cheap and US exports expensive; the trade deficit expanded accordingly.

This view suggests two superficially plausible responses. First, do what you can to keep the dollar cheap. Second, deter excessive capital inflows by taxing them. Robert Lighthizer, Trump’s former US Trade Representative and presumably a key adviser if Trump wins a second term, appears to favor both. Trump has also mused over the need to give the president a say in Fed policy, perhaps with the aim of using low interest rates to keep the dollar cheap.

A new paper by Maurice Obstfeld, formerly chief economist of the International Monetary Fund, explains the defects of this subtler way of blaming foreigners for US economic problems.

The saving-glut story, according to Obstfeld, works pretty well for the first part of the decade. The supply of capital to the US did surge, the dollar did appreciate and the trade deficit grew rapidly as Asian investors and central banks forced their lending on America – all as you would expect. The problem is that starting in 2002, the dollar began to depreciate. This suggests a switch in the balance of supply and demand for capital. Before 2002, the dominant force was excess foreign supply (causing the dollar to rise); from 2002 it was excess US demand (causing the dollar to fall despite the continuing capital inflow). The trade deficit kept widening despite the dollar’s depreciation because imports grew even faster than exports under the pressure of too much domestic demand.

On this telling, the culprit after 2002 was excessively easy financial conditions in the US – due partly to the Federal Reserve’s interest-rate cuts and, more important, a surge in domestic borrowing and asset prices driven by financial deregulation and innovation. “For the most part,” Obstfeld says, “foreign capital did not push in during 2002-06, it was pulled in.” So much for the first remedy – keeping the dollar cheap. This doesn’t necessarily shrink the deficit. Also, if you keep it cheap by commanding the Fed to suppress interest rates, the deficit might very well expand, and you’ll get soaring inflation as a bonus.

What about the other remedy – taxing capital inflows? This would indeed reduce the capital-account surplus and hence the trade deficit, but only by raising the cost of borrowing and discouraging investment. If the Fed resisted this growth-depressing effect by keeping rates low, the result would again be higher inflation. As before, misdiagnosing the problem leads to a remedy that makes things worse.

Trade deficits are dangerous mainly because of the stupid policy responses they tend to provoke. However, when for some reason they do in fact need to be reduced, remember that there’s a straightforward and effective way to do it: Reduce the investment-saving gap with lower public borrowing. In the end, trade deficits are caused and cured with macroeconomic policy, and the best trade policy is fiscal control. Strange that no US politician is talking about that.