Did You Hear the One About the Trade Deficit?

The White House Council of Economic Advisers is not generally known for its playful sense of humor. But in the annual Economic Report of the President, released this week, the CEA decided to have a bit of fun with the record $726 billion trade deficit.

At nearly 6 percent of gross domestic product, a deficit that large would in be treated in most other countries like the economic equivalent of Defcon 3. But rather than dwell on the negative, those wry PhDs framed their analysis not as consumption exceeding production (the so-called current account deficit), but as a consequence of cheap foreign capital financing our profligacy (the capital account surplus, which by definition is its mirror image). It's a bit like General Motors, ending a disastrous sales month, declaring what a good period it had been for inventory replenishment.

This upbeat view of the trade deficit reflects the thinking of outgoing CEA chairman Ben Bernanke, who thinks that the root cause of the world's massive economic imbalances is that the rest of the world is producing and saving too much, not that Americans are producing and saving too little. And what makes it possible for these trade deficits -- er, capital account surpluses -- to continue year after year is that foreigners have decided that the best place to stash all the cash they earn from selling us sneakers, computers and oil is right back in the United States.

There is certainly a good deal of truth in the idea of a global "savings glut." When excessive saving in Asia and Europe leads to too much capital flowing into the United States, it has the effect of bidding up the price of real estate and stocks while lowering interest rates. In turn, Americans respond by borrowing more against their newfound paper wealth, using the money to buy more stuff from overseas, creating a self-reinforcing cycle.

Viewed in this way, it is the capital surplus that drives the trade deficit, rather than the other way around. Or put more crudely, it's their fault, not ours.

What's significant about this view is that its chief proponent is no longer just a respected academic advising the president. As the new chairman of the Federal Reserve, Ben Bernanke is now the world's most influential central banker. And his instinct to view trade deficits, and the asset bubbles associated with them, as relatively benign -- or at least outside the scope of the central bank's concern -- could put monetary policy behind the eight ball.

A somewhat different view has recently been offered by Mervyn King, head of the Bank of England, and economist John Makin of the American Enterprise Institute. Their warning is that the "savings glut" is, to a large extent, really a "liquidity glut" caused by central banks, primarily those of China and Japan. For reasons that made sense in the context of sustaining growth and stabilizing prices at home, these central banks wound up printing too much money -- money that is now sloshing around the globe looking for some place to be invested.

Some of this excess liquidity has gone into bidding up the price of stocks, particularly outside the United States. Some of it has gone into real estate, particularly inside the United States. Some of it has been used to bid up the global price of commodities, such as gold or oil futures.

But a big portion of that money has gone into government bonds everywhere, creating a bond market bubble, which has the effect of lowering inflation-adjusted interest rates to ridiculously low levels.

That was evident last month when the interest rate on inflation-adjusted, 50-year British bonds fell to 0.38 percent, well below its historic norm of 2.5 percent. And we saw it last week when the U.S. Treasury, issuing its first 30-year bonds in four years, got $28 billion in bids for $14 billion of bonds being offered, making it cheaper for the Treasury to borrow for 30 years than six months.

The problem, as King and New York Fed President Timothy Geithner laid out in separate speeches last month, is that these asset-market "bubbles" now have the potential to spill over into the real economy, generating excess growth and, eventually, unacceptable levels of inflation. Rather than wait for the full measure of inflation to show up in the official numbers, when it becomes much harder to deal with, they suggest that the Fed and other central banks should consider the economic equivalent of the policy of preemption. The idea is that raising rates earlier to slow the economy and take some air out of asset prices will reduce economic pain later.

Up to now, Bernanke has staunchly opposed the idea that the Fed should prick bubbles or target asset prices. But I suspect he's about to get some polite push back from Geithner and other regional Fed presidents.

As Makin points out, even excluding food and energy, the closely watched index of "core" consumer prices was up 1.8 percent last year, near the top of what the Fed considers its acceptable range. And with labor markets relatively tight, and health, energy and commodity costs putting upward pressure on prices, and a falling dollar likely to raise the price of all those imports, it's likely that the Fed will soon have to break the news that it won't be able to stop raising rates after its next meeting on March 28, as financial markets now expect.

It's at that point that a sense of humor will come in handy.

Steven Pearlstein can be reached atpearlsteins@washpost.com.