According to a study by Fed economist John Rogers and Professor Charles Engel , the U.S. current account deficit may be near optimal levels based on expected economic growth trends among wealthy countries. Let’s take a look:

Dramatic growth in the U.S. share of gross domestic product – net of investment and government spending – among wealthy countries has been “one of the most striking economic developments of the last 25 years,” according to the study by Fed economist John Rogers and University of Wisconsin Professor Charles Engel.

While noting major caveats, the study finds “the size of the U.S. current account deficit may be justifiable if markets expect further growth in the U.S. share of advanced-country GDP.” A country’s current and expected-future share of world economic output determines its optimal ratio of consumption to output, Engel and Rogers say.

The authors say their modeling could contain important flaws undermining the idea that the U.S. current account reflects optimal consumer decisions. If simplifications and assumptions in the study are wrong, “it may turn out, as many have been warning, that the deficits have put the U.S. on the path to ruin,” the economists say.

The study’s findings could falter if East Asian economies reverse their role as large net savers and lenders in international capital markets, or if the U.S. loses the “exorbitant privilege” that allows it to earn higher rates on its foreign investments than foreigners earn on investments in the U.S., they say.

The economists also say they were unable to reach firm conclusions about the path of foreign exchange rates over the next 25 years.

But their study cites long-term economic growth trends that appear to justify the size of the U.S. current account deficit relative to economic growth expectations.

Since 1993 consensus long-term forecasts have consistently and widely underestimated U.S. economic growth relative to G7 countries as a whole, the study says. “The current forecasts for the future, however, show that the markets expect a large increase in U.S. share of GDP – almost precisely the amount that we calculate would make the current level of deficit optimal,” it says.

Federal Reserve Chairman Alan Greenspan and other Fed officials have said recent sharp growth in the U.S. current account deficit – the broadest gauge of the country’s trade gap with the rest of the world – can’t persist indefinitely. The deficit reached $195.8 billion, or 6.2% of GDP, in the third quarter of 2005, and it is expected to have hit a record for 2005 as a whole.

In a speech last month, Greenspan suggested he has become less concerned about the trade deficit’s potential to spark financial market turmoil because the deficit stems partly from a global increase in cross-border trade and investment. But he also warned of dangers from unchecked U.S. government budget deficits and the potential for protectionist barriers to international trade.

Of course they readily admit: If simplifications and assumptions in the study are wrong, “it may turn out, as many have been warning, that the deficits have put the U.S. on the path to ruin”.

Gee that’s nice.
We think we are right but if not, we are on the path to ruin.

Once again we see economists projecting forever into the future the trend they see today. Since 1993 the US GDP has been underestimated so now the assumptions have been revised to “expect a large increase in U.S. share of GDP”.

One look at China and India should be enough to convince anyone that now is precisely the wrong to be increasing assumptions about the US. The economists missed the dot com boom, the housing boom, the internet revolution, and now with China, India, and other countries coming of age the US is supposed to be the engine of growth for the world? Marc Faber warns of projecting trends forever into the future in his classic book “Tomorrow’s Gold”. I highly recommend it.

If ignoring China and India was not bad enough, Rogers and Engel seem to ignore how grossly overstated our GDP is with hedonics and imputations. Please see Grossly Distorted Procedures for an explanation.

The two biggest distortions are the amount of rent you pay yourself if you own a house, and the value of the free checking account that you should be paying your bank for. The Government imputes the total value of “free checking accounts” to be worth a mere $335.2 billion and adds that number to the GDP. The government also assumes that homeowners are paying themselves $153.8 billion in rent. That too is added to the GDP. The Total Of All Distortions (TOAD) is $3892 billion out of a total GDP of $11004 billion. My math says the US GDP is 35% overstated. Bear in mind that is what the government readily admits to. Could it be that the real TOAD is far uglier? By the way those are 2003 numbers, the government is way behind on reporting imputations. It is likely the distortions have grown more extreme. The bottom line is simple: lop off one to two points off the GDP for a more better estimate as to what is really happening. That just might help explain why the jobs growth during this recovery has been so anemic.

Just as Rogers and Engel are promoting the “Free Lunch Theory”, Timothy Geithner, the New York Federal Reserve president proclaims the account deficit ‘unsustainable’.

Timothy Geithner, president of the New York Federal Reserve, on Monday dismissed the view that the US current account deficit was sustainable, suggesting the risk of a sudden fall in the dollar would grow the longer the trade gap widened.

In a speech at the Royal Institute of International Affairs in London, Mr Geith-ner said the problem could not necessarily be expected to solve itself.

“Time does not necessarily help. The longer these gaps continue to build, the greater the ultimate adjustment required, and the greater the risks that accompany that process,” he said.

“The plausible outcomes range from the gradual and benign to the more precipitous and damaging,” he said. “The size and duration of these [global] imbalances, perhaps the most visible of which is the US current account deficit, present challenges – and risks – for the world economy.”

“A prolonged continuation of the exchange rate ar-rangements that have given rise to the large increase in foreign official investments in US financial assets is unlikely to be consistent with the domestic requirements of those economies and for this reason many are already in the process of change,” he said.

“Even if we could be confident that the world would be comfortable financing the US on these terms for some time, that fact alone does not mean that it is prudent for the US to continue borrowing on this scale.”

Mr Geithner repeated his call for US politicians to reduce the budget deficit. The fact that the US is using much of the money borrowed from abroad to finance public spending, he said, increased the dangers. If it was being invested in the productive capacity of the US tradeable goods industries, this would at least help the US to pay back its foreign obligations.

I suppose it is refreshing to see the FED saying something that makes some semblance of sense. The problem however, is that under Greenspan the FED let problem after problem get out of hand while he became the top cheerleader for the US productivity miracle. As for me, I think we are now so far down the path to ruin, that we can all but rule out the “gradual and benign” in favor of a “more precipitous and damaging” ending.

Mike Shedlock / Mish/