Twin Deficits at the Flashpoint?

June's enormous US trade deficit should be a wake-up call to America and the rest of the world. It is a direct manifestation of a lopsided global economy that remains biased toward unprecedented external imbalances. As long as the US continues to live well beyond its means and as long as the rest of the world fails to live up to its means, this seemingly chronic condition will only get worse. The imperatives of global rebalancing are reaching a flashpoint. America's record $55.8 billion trade deficit in June was a shocker. Annualized, it is equivalent to a $670 billion shortfall, or 5.75% of nominal GDP. Nor can this deterioration be explained away by surging oil prices. Excluding petroleum products, the trade deficit for goods still widened by $2.7 billion in June -- an enormous swing by any standards. The plain fact of the matter is that America has never come close to running such an outsize external deficit before. By way of comparison, the last time the US had a "foreign trade problem" was in the latter half of the 1980s; back then, the trade deficit (as measured on a national income accounts basis) peaked out at 3.2% of GDP in the second quarter of 1987. Needless to say, that was not the most tranquil of times in financial markets. As America's external imbalance widened in mid-1987, the dollar came under sharp downward pressure and US interest rates were pushed higher. Those were the classic manifestations of a current account adjustment that many (myself included) believe were at the heart of the stock market crash of October 1987. Today's external imbalances dwarf those of 17 years ago.

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A Central Banker's Nightmare:
Inflation and Slow Growth Together

One of the dirtiest words in the economic lexicon is making the rounds again: stagflation. Defined as a noxious blend of stagnant growth and rising prices, stagflation last appeared in force in the 1970s, when it bedeviled U.S. policy makers and gradually degraded the standard of living of average Americans. Economists long thought a repeat to be extremely unlikely. But now, they are starting to worry again. The fundamental problem: Oil prices are kicking up inflation across the world, at precisely the same time that economic growth appears to be slowing. If oil prices keep climbing, and inflation rates exceed growth rates, some economists say the U.S., Asia and other regions could face a troubling scenario in which policy makers have to fight some of the same demons that plagued the U.S. back in the days of disco. "Oil at $45 a barrel is a stagflation problem," warned economists at UBS Ltd. in a recent research report. By their reckoning, sustained prices at that level would slow global growth rates by almost half a percentage point in 2005 and by about one percentage point in 2006. Perhaps more important, such prices would push inflation up by about the same amount -- giving the world its first taste in years of what stagflation can be like.

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