The current account deficit is not a sexy story. It does not have the intrigue of the Abramoff scandal, the constitutional ramifications of domestic spying or the sheer guttural attraction of down-and-dirty hardball politics. The current account is an arcane concept that seems divorced from everyday life and politics. However, it is very real and the current US account deficit is at crisis levels. While nothing bad has happened yet, while it exists at current levels the US will continually sit on an economic precipice.
Two prominent economists -- Raghuram Rajan of the IMF and Timothy F. Geithner of the NY Fed made speeches over the past few days detailing the problem. Their comments are below.
First, here is a very simple explanation of a current account deficit. Supposed you and your neighbor regularly buy and sell goods from each other. However, you buy $100 more per month than your neighbor. So every month, you have to come up with an additional $100 over and above the money you make from your neighbor. At first, you draw down your savings. However, at some time you deplete your savings yet continue buying. So your neighbor starts to extend credit for $100 month.
This is the US' current situation. The US savings rate turned negative in 2005, indicating US consumers were regularly consuming more than they made. As a result, the US is now more reliant than ever on foreign creditors to finance the trade deficit.
Here is an overview of the basic problem, from a presentation by p>
The United States is running a current account deficit approaching 6 1/4 percent of its GDP this year and over 1.5 percent of world GDP. And to finance it, the United States needs to pull in 70 percent of all global capital flows.
The generally accepted economic rationale for a current account deficit is 5% is the maximum percentage a of GDP a current account deficit can attain before the host country experiences currency devaluation which in turn lowers the current account deficit. The US is already far over that level. The main reason the dollar is up is US interest rates are some of the highest of all industrialized first world countries.
In addition, a vast majority of the money flows of the entire world are bound for the US in one capacity or another. The Bush administration has spun this fact to argue the US is so wonderful that creditors are simply dying to lend the US money. What this argument fails to realize is at some point creditors may simply tire of footing the US current account bill and start to either pull out of the US market (highly unlikely) or demand higher interest rates to adequately compensate them for the risk (more likely). The Bush team and the RWNM wants everyone to think this situation can go on indefinitely. NY Fed Chairman Timothy F. Geithner disagrees.
...it is not difficult to see that if the deficit continues to run at a level close to 7 percent of GDP--and most forecasts assume it will for some time--the net international investment position of the United States will deteriorate sharply, U.S. net obligations to the rest of the world will rise to a very substantial share of GDP, and a growing share of U.S. income will have to go to service those obligations. This fact alone suggests that something will have to give eventually, and this raises the interesting question of how these imbalances have persisted on a path that seems unsustainable with so little evidence of rising risk premia.
Geithner is essentially saying the US' current account position is simply begging for a radical and painful economic adjustment.
There are several arguments made to justify this situation continuing in perpetuity. Geithner solidly dismantles each:
One view is that the rise in the surplus saving of the rest of the world, the relative ease with which capital now moves across borders, and the increase in the relative attractiveness of claims on the United States together may suggest that the world can sustain larger imbalances, more easily, for a longer period of time than would have been possible in the absence of these conditions. This is true. But even if we could be confident that the world would be comfortable financing the United States on these terms for some time, that fact alone does not mean that it is prudent for the United States to continue borrowing on this scale, particularly given that doing so means that the net obligations of the United States to the rest of the world are likely to rise sharply relative to GD
In short, even though the rest of the world may want to, the US would simply be increasing its net indebtedness if it continues on this path. At some point, the US has to start saving and investing in itself again.
Another argument for being relatively sanguine about the risks evokes the so-called Lawson Doctrine, noting that when imbalances are principally the reflection of the decisions of private savers and investors, those imbalances should not be a concern to policymakers. This may be true, but it does not apply to the present circumstances. The fact that we are using a substantial part of the resources we are borrowing from the rest of the world to finance an unsustainable level of public dissaving leaves us more vulnerable than if those resources were being used for productive private investment.
Here, Geithner states an important point: the actual use of borrowed funds is a very important. The current US policy is consumption above current income levels (as evidenced by the current negative US savings rate). Borrowing money to consume is simply bad and reckless macro-economic policy.
Some have drawn comfort from the adjustment process experienced by other economies with large external deficits. Industrial countries that have gone through a process of current account rebalancing have not generally experienced particularly damaging moves in interest rates or exchange rates. But the present circumstances seem sufficiently different from historical precedent that history may not be a particularly useful guide. And even in these past cases, the adjustment process did entail a slowdown in GDP growth, increasing unemployment, and a sharp fall in investment.
The sheer size of the US current account deficit makes this situation unique. In addition, the adjustment process would still be very economically painful - high unemployment, lower growth and lack of domestic investment as surplus funds go to pay debt.
So, what could happen as a result of the current account deficit? Raghuram Rajan, provides three possible generic scenarios.
The best case scenario is that demand shifts smoothly from deficit countries to surplus countries, even while aggregate world demand grows--the proverbial soft landing. There are two other possibilities. One is that as monetary and fiscal stimulus is withdrawn, consumption demand from the deficit countries, notably the United States, contracts sharply. Domestic demand from surplus countries does not keep pace, and even falls, because external demand has indirectly been pulling investment--for example, in the case of Germany or China. In this worst case scenario, we get a contraction of global demand, with only moderate correction of current account imbalances. A second possibility is that adjustment is forced by the financial side, because the real side is seen as unlikely to adjust on its own. Investors become unwilling to hold increasing amounts of U.S. financial assets, demand higher interest rates and some exchange rate overshooting, which in turn forces U.S. domestic demand to contract. Again, if this happens abruptly, it could cause a slow down, as well as financial market disruptions. Of course, overlaying all this is the specter of protection that could make things worse.
There is no hard evidence regarding the possibility of any of the above scenarios - all are just as likely or unlikely. The first scenario is the basic goldilocks scenario - everything is eventually just fine and dandy. In the second scenario, the US stops its torrid pace of consumer purchases which dries up the market for export-driven economies like China and Japan. Their respective economies don't have the capacity to buy excess goods, leading to a general global slowdown. Finally, there is the possibility that creditors either tire of lending money to the US or find a better rate of return on their investment.
The US is essentially sitting on an economic ledge, where any stray wind or random world event could send the economy hurtling off a cliff. This is no way to run the finances of the world's largest economy. Instead of being a net debtor to the rest of the world and the market of last resort, we should be driving growth with new products and technologies that countries want to buy from us. Instead, the country as a whole us charging the latest thing and praying the bill never comes due.
There seems to be a thread running through the RWNM's basic argument about the current account deficit that assumes the US is too big to fail. None of the bad scenarios will ever materialize because the world needs us more than we need them.
People use to think the same thing about Ford and GM.