In monetary economics, the trade deficit and the fiscal deficit are referred to
as the "twin deficits", as if they were genetically related twins merely
because they both contribute to increases in public debt. Yet these two
deficits are genetically opposite and can act like fighting twins to neutralize
one another in their adverse economic effects.
A fiscal deficit is created by a government spending in excess of revenue in
the domestic economy. The external penalty of a persistent fiscal deficit is
the devaluation of the exchange rate of the domestic currency in foreign trade.
A trade deficit is created by excess imports over exports in foreign trade. One
of the curative measures for a persistent trade
deficit has been conventionally identified in trade economics as a devaluation
of the domestic currency against those of its trading partners, or in
multilateral trade, against a reserve currency. Currency devaluation is
expected to make exports less costly and more competitive in price. It is also
expected to make imports more costly in local currency terms.
Therefore, there is logic in viewing a fiscal deficit as a solution to a trade
deficit through its function in devaluing the domestic currency.
Under the 1944 Bretton Woods regime of fixed exchange rates pegged to a
gold-backed dollar, it was considered normal that an economy that ran
persistent trade deficits would see its foreign trade decline unless the
currency was devalued officially, since at that time, foreign exchange markets
were not allowed to operate beyond currency settlement at the central bank of
the reserve currency - the US Federal Reserve.
A deficit in foreign trade for an open economy is equivalent to a corporation
running a loss in domestic market operation due to imbalance between cost of
production and sales revenue derived from the market price of its products. The
solution to operational losses in a corporation is to lower the unit cost of
its products without reducing quality, or to increase the unit price without
affecting sale volume, or an optimum mixture of both.
Increasing the volume of trade would cut operational losses only if the greater
sale volume reduces the unit cost of production, and provided that greater sale
volume is not achieved through price discounts. If the unit cost in sales is
fixed independent of production volume, increasing the trade volume will only
exacerbate the losses.
This happened to General Motors at a time when its labor cost per car remained
independent of volume of production to result in a negative unit profit margin.
Under such circumstances, the more cars GM sold, the higher its losses. The
solution then was to shut down production even if that would lead to losing
market share.
The monetary regime of an open economy allows the exchange rate of its currency
to be determined by market forces. The central bank can still and does
intervene in open market operations to keep the exchange rate of its currency
at the level targeted by monetary policy. This is done by selling its own
currency in the open market for foreign reserves to keep the currency from
rising in exchange value, or buying its own currency with foreign reserves to
keep it from falling in exchange value.
Depreciating a currency in an open economy without capital control and with
full currency convertibility can be achieved by a central bank accumulating
foreign reserves through selling its own currency. Or it can be achieved by
government running a persistent fiscal deficit to signal market forces to push
down the exchange rate of its currency. Thus a controlled persistent fiscal
deficit is a form of soft intervention that can produce the same result as a
hard intervention of conducting open market operations through selling or
buying the currency to accumulate or drain foreign reserves.
Even for countries that have accumulated excessive foreign reserves from trade
surpluses, such as China and Japan, the option of soft intervention with a
persistent fiscal deficit serves as a way to absorb the excess accumulation of
foreign reserves not usable in the domestic economy, through high domestic
spending from a fiscal deficit.
For countries that have insufficient foreign reserves and trade deficits, such
as the Baltic states in recent years, the option of soft intervention with a
persistent fiscal deficit serves as a relatively less painful way to reduce the
trade deficit by lowering the exchange value of its currency to stimulate more
export.
However, if the trade deficit failed to be reduced or eliminated by currency
depreciation alone, as is frequently the case, the trade deficit then can only
be reduced by lowering the trade volume or in extreme cases, stopping it
completely. In such a case, a fiscal deficit can still act as a stimulus on the
domestic economy to create needed domestic production to replace the reliance
on imports and to develop import substitutions.
Of course, the fiscal deficit must be used constructively and not for wasteful
indulgence. Furthermore, a perpetual fiscal deficit is unsustainable and will
lead to hyperinflation independent of foreign trade. But a controlled fiscal
deficit can be an effective measure to wean economies from excess dependence on
foreign trade, both for those with trade deficits or those with trade
surpluses.
Henry C K Liu is chairman of a New York-based private investment group.
His website is at http://www.henryckliu.com.
(Copyright 2010 Asia Times Online (Holdings) Ltd. All rights reserved. Please
contact us about
sales, syndication and
republishing.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
