The current account deficit is a huge problem, but one that is impossible to put into a simple, 30-second sound bite. Therefore, outside of the realm of policy wonks and economic geeks, it gets little to no attention or airplay. This is too bad. As the US current account situation continues to worsen the possibility of a very nasty correction increases.
First, what is the current account deficit?
Most countries trade goods with each other. If a country sells more goods internationally than it purchases, it has a surplus in its balance of trade. If a country buys more goods from international trading partners, the country has a balance of trade deficit. With me so far? Good...
Remember, countries pay for all the goods they purchase. What happens if a country has a current account deficit? Well, usually they pay for the deficit with savings - money stored away for a rainy day. If the country doesn't have any savings, they have to borrow the money to pay for the deficit.
Here is a very simple illustration to help explain all the above points.
You and your neighbor regularly but and sell goods. But, you buy $100 more goods per month from your neighbor than your neighbor buys from you. So, where does this extra $100/month come from? Initially, you draw down your savings to make-up the difference. But eventually you draw down all you savings and have to go into debt to buy the extra goods from your neighbor. As this process continues, your creditors will eventually stop lending you money because you continually consume more than you produce.
Simply substitute the word "country" for "neighbor" in the above paragraph and you have a general idea for the problems a current account deficit causes.
The US is a massive current account debtor. This year the US will probably have another record trade deficit. Combine that with very low national savings and you arrive at this conclusion: the US must borrow heavily from international lenders to pay for its current account deficit.
Now, look at this chart from Angry Bear (a great economics blog). It's in the story titled "Capital Flows into the US." Notice the trend of national central banks and private lenders for 2005. Central banks have decreased their purchases of US assets and private investors have increased their purchase of US assets. This development should scare people to death for the following inter-related reasons.
During the last 6 months of 2004, several Asian central banks (Japan, China and South Korea) publicly stated they would decrease their purchase of US assets. They have done this throughout 2005. Individual investors have taken-up the slack. It's important to remember that while most central banks state they are not politically motivated, they are all political animals. While their respective purchases of US assets was founded in economic reality (usually pegging their currency to the dollar at a particular ratio), they also did this because they mutually benefited politically from the US' current account deficit. Private investors are far more economically motivated than politically motivated. When a better return on investment appears in another country or region, they will shift their investments quickly.
This is the big problem presented in the chart. As soon as other regions appear to offer a better return, expect those loans from private individuals to quickly shift away from the US. Last year, Asian central banks announced their intention to diversify away from the dollar. They have done so. Do not expect a similar announcement from private investors.