A dangerous myth concerning the US twin budget and balance of payments deficits is now stalking European and Asian capitals. It is the idea that the responsibility for these deficits is solely that of the United States and that all that needs to be done to eliminate today’s global payment imbalances is for the United States to substantially reduce its budget deficit. Acting upon this myth, without allowing for further substantial dollar depreciation, would not only be harmful to the US economy.  It would also have most untoward consequences for the global economy.

Like all good myths, the view that the US balance of payments deficit is solely the product of poor US public finances is seemingly grounded in the facts. For after all, did not the ballooning of the US balance of payments deficit over the past several years coincide with a parallel worsening in the US public finances? Did not the widening in the US external current account deficit from less than 1 percent of GDP in 2000 to almost 6 percent of GDP in 2004 almost exactly correspond to the swing in the US budget position from a 2 percent of GDP surplus to a 3 1/2 percent of GDP deficit over the same period?

Evidently unnoticed in European and Asian capitals, is the fact that the widening of the US balance of payments deficit was preceded by a substantial appreciation of the US dollar. Indeed, mainly buoyed by capital inflows into the United States during the US equity bubble of the late 1990s, the US dollar appreciated in real effective terms by over 30 percent from 1995 to the dollar’s peak in February 2002. Recognizing that it might take up to eighteen months for exchange rates to have their full impact on trade flows, might not the substantial strengthening of the dollar in the late 1990s have something to do with the subsequent worsening in the US balance of payments since 2000?

The coincident widening of the US budget and external deficits is now prompting many in Europe and Asia to propose a sharp reduction in the US budget deficit as the basic remedy to curing the US balance of payments problem. To be sure, such a course of action would have the effect of reducing US imports as a tightening in US budget policy compressed both domestic demand and output.

However, seeking to correct the US balance of payments solely by budget tightening would have an inordinate and unnecessary cost to US prosperity since a very large decline in US output would be needed to make a dent on the US external deficit. Standard econometric estimates suggest that a 4 percentage point decline in US output would be associated with less than a 1 percentage point of GDP improvement in the US external current account deficit.
     
A considerably less costly solution to the US balance of payments problem would be to complement efforts at US budget deficit reduction by allowing for a substantial depreciation of the US dollar. Such an approach would hold out the prospect that the US might restore external balance without compromising its domestic prosperity. For while a cheapening of the dollar would encourage both a switch of US demand away from imports and a switch of US production towards exports, budget deficit reduction would make the room for the non-inflationary reorientation of the US economy towards the traded good sector.
     
European and Asian calls for US budget restraint, while at the same time resisting dollar depreciation for fear of its deflationary impact on their domestic economies, would appear to be highly misplaced. For so long as the US external accounts have to adjust, European and Asian policymakers will have to cope with the deflationary consequences of declining exports and increased imports as the necessary counterpart of that adjustment. This will be true irrespective of how the US balance of payments adjustment is to be effected.
     
A basic question that European and Asian policymakers should be asking themselves is whether the domestic deflationary pressures they will experience as a result of the US external adjustment are not better confronted in the global context of a robust US economy rather in that of a US economy that is mired in recession. At a more fundamental level these policymakers should be asking themselves whether they should not now be pursuing very much easier monetary policies to allow their economies to better withstand these impending deflationary pressures.

Desmond Lachman is a resident fellow at AEI.