Here are some more thoughts on the debate over the source of the U.S. current account deficit and whether it matters.
There has been a tremendous amount of debate regarding the origin and implications of the U.S. current account deficit that has developed, especially over the past couple of years.
With the deficits showing no sign of abatement– indeed the consensus is for the deficit to yawn even wider to 7% of GDP in 2006– now seems a good time to provide a little empirical content, leavened with some theory, to the debate over the origins of the imbalance.
This is especially true since there is a marked division between those who believe the ever expanding deficit is cause for alarm, and those who argue that not only is the deficit not worrisome, but it is even a good thing.
Growth and deficits
First, let’s examine the argument that current account deficits are either a sign of good times, or an unalloyed good in and of themselves.
According to this view, the current account surpluses in Europe and Japan are the result of lackluster economic growth and consumption.
Proponents of this view dismiss the idea that the United States should take active steps to shrink the current account deficit, characterizing such actions as proposals to throw the U.S. into recession, so that growth rates here will be as slow as those in Germany or Japan.
(They also ignore the fact that even with faster U.S. growth during the 1990’s, the deficit was smaller.)
Often, they argue that the deficit will be remedied if the rest of the world follows the U.S. lead in implementing pro-market reforms. The eventual growth bonus arising from such policies will turn current account surplus economies– the euro area, Japan– into deficit economies.
Unfortunately for this cheery worldview, the empirical evidence is not supportive; as Catherine Mann and Katherina Plueck at IIE (Figure 4) have pointed out, even a robust– but still plausible– acceleration of growth abroad will do little to reduce the deficit.
A related argument relies on the intertemporal model of current account balances. In this framework, deficits signal future economic strength.
Ignoring the lack of empirical evidence for this approach, this argument would be more convincing if U.S. GDP growth were being maintained by investment rather than consumption and, more importantly, if the lending to the United States took the form of purchases of stock and direct investment.
Instead, a large proportion of capital flowing to the United States takes place in the form of purchases of U.S. government securities– not purchases of American stocks or direct investment in its factories.
The fact that foreign central banks are doing so much of the lending suggests that the profit motive is not behind the ongoing flows to the United States.
Saved by revaluation effects?
A second argument relies upon the observation that, despite the recent record deficits, the net international investment position did not deteriorate going from 2003 to 2004, and is (only!) -21% of GDP.
This phenomenon occurs because most U.S. overseas assets are denominated in foreign currencies, and when the dollar loses value, most of America’s assets gain value. But we can only rely upon this effect working in our favor if either of two conditions holds:
(1) unanticipated dollar depreciation continues, or (2) foreign investors remain happy with their present holdings of American assets at current interest rates.
I believe neither is likely to hold true indefinitely. (Some seem to hope that dollar depreciation continues indefinitely; Jeff Frankel and I argue that this will lead to erosion of the dollar’s role as the world’s key reserve currency.)
If the future is roughly like the past, then a trade deficit of 1.4 percent of GDP is consistent with stabilization of the level of indebtedness.
For sure, this is smaller than the 7% that seems to be the consensus number for 2005.
Hence, we are headed toward greater and greater indebtedness.
The “Savings Glut” view
Finally, there is the very popular view, most closely associated with the new CEA Chair Ben Bernanke, that there is a global “savings glut”:
The large current account surpluses in the rest of the world, particularly in China, but more generally in East Asia and continental Europe, are at the heart of the pattern of global imbalances.
These current account surpluses have to be offset somewhere, and that somewhere is in the United States, largely because of the greater attractiveness of American assets.
While the savings glut view has some intellectual merit, particularly for the last couple of years, there is reason to suspect that much of its newfound popularity stems from how it conveniently absolves U.S. elected officials from taking action.
After all, in this worldview, fiscal policy cannot really have an impact on the current account deficit.
This is an odd argument. First, over half of the financing of the U.S. current account in 2004 was accounted for by accumulation of dollars and U.S. Treasury securities by foreign central banks.
This is not a “savings glut” in the sense of excess private savings flowing to the United States. Second, it does not make sense to think of the East Asians essentially forcing the United States to consume beyond its means and borrow from them.
The idea that developments in the United States are driven by those in East Asia appears at variance with common sense when the U.S. economy is three times the size of developing and industrializing East Asia and 30 percent larger even after Japan is combined with this grouping.
In addition, my recent work with Hiro Ito finds that out-of-sample estimation for the 2001-03 period indicates little role for special circumstances such as the “savings glut”.
What’s the other possibility?
I think that the conventional wisdom is more plausible:
there is a savings scarcity in the United States, driven largely by the federal budget deficit, and it is this savings drought in the United States that has been sucking in excess savings from the rest of the world for most of the past five years.
What about the low interest rates? In my view, the low interest rates are more the function of expansionary monetary policy, and corporate savings at home, rather than excess savings abroad (except for government/central bank purchases of U.S. treasuries).
(And let’s be clear about where the low U.S. savings is primarily coming from: it is government dis-savings that is doing most of the harm here; blaming low household savings is a smokescreen, since the private savings rate in 2004 was slightly higher than it was five years before that, largely due to a surge in corporate savings.)
Hence, notwithstanding Greenspan’s assertions, there is probably substantial scope for external adjustment via budget deficit reduction (as in OECD analyses and IMF simulations).
Why we shouldn’t be complacent
To the extent that savings abroad are to blame for some portion of the U.S. current account deficit, there are reasons to doubt the durability of continued East Asian lending to the United States. First, Chinese lending to the United States in the form of purchases of U.S. Treasury securities can continue only as long as the People’s Bank of China can prevent the expanding reserve accumulations from spilling over into money creation.
Otherwise, inflation will accelerate, eroding Chinese competitiveness or spurring capital flight.
Second, if East Asian investment rebounds, interest rates will rise at exactly the same time as U.S. national savings is declining.
The consequences of a collision of expanding U.S. budget deficits and rising interest rates abroad is not pleasant.
Current account adjustment in the United States will entail adjustment of factors of production out of the nontradables sector (housing, some services) into the tradables sector. Interest rates in the U.S. would rise relative to what they would otherwise be.
Interest sensitive sectors will take an additional hit. Even if a scenario of financial disruption (say in the hedge funds or in other derivative markets
don’t take a hit) is avoided, there could still be substantial economic pain – pain that might be avoidable if action is taken sooner rather than later.