The Bureau of Economic Analysis reported on September
14th that the U.S. current account deficit improved slightly,
to an annualized $763 billion in the second quarter of 2007.
The deficit was essentially unchanged, once the transitory impacts
of government transfers are ignored.
The current account deficit improved from 5.8%
of GDP (revised) in the first quarter to 5.5% in the second
quarter, as shown in the figure below. The falling dollar has
also helped reduce the deficit. The U.S. trade deficit with
Canada and Europe has improved significantly this year, but
it has continued to grow with China and other Asian countries,
and with oil producing states. In the long run, a significant
reduction in the current account deficit will only be possible
with a further, substantial drop in the dollar against all currencies.
Orderly adjustment is unlikely unless China, Japan, and other
Asian countries allow the dollar to fall against their currencies.
U.S. private investment abroad has more than tripled
over the past 18 months. This raises the chances of a rapid,
disorderly dollar decline and a financial crisis that could
cause domestic interest rates to spike and push the economy
into recession. The chances of a hard landing will grow if the
dollar is not allowed to unwind smoothly through coordinated
changes in economic policy in many countries very soon.
A large, transitory reduction in government grants
explained most of the improvement in the current account in
the second quarter. The balance of payments on income, which
includes net payments on foreign investment and on government
debt, also improved in the second quarter. However, there will
be substantial downward pressure on these payments in the future
because of rapid growth in the U.S. net foreign debt.
The current account deficit means that, based on
these second quarter data, the United States is spending $760
billion more per year than it is producing. A current account
deficit must be financed by an equal and offsetting capital
inflow, which represents net borrowing or the sale of U.S. assets
to the rest of the world. In effect, the United States is living
beyond its means and selling off national assets to pay its
bills. The current account deficit has nearly doubled in this
decade, increasing from $417 billion in 2000 to $760 billion
in the second quarter. The cumulative, net U.S. international
debt reached $2.5 trillion in 2006.
Payments on U.S. government debt, in particular,
have nearly doubled, from $85 billion in 2000 to $158 billion
in the second quarter (annual rate). The United States has benefited
in the past because foreign investors tend to earn lower rates
of return on their U.S. investments than U.S. investors earn
on their foreign holdings, on average. This is due, in part,
to the fact that foreign governments hold a substantial share
of U.S. debt in the form of low-yielding government debt. Foreign
investors also earn lower rates of return on their foreign direct
investments in the United States. This asymmetry is unlikely
to persist in the future.
Foreign central banks have financed most of the
U.S. current account deficit since 2000. China alone purchased
$250 billion in foreign exchange in 2006, primarily in the form
of U.S. Treasury securities; these purchases will likely reach
$450 to $500 billion in 2007, with two-thirds of those purchases
going for U.S. assets (Setser 2007). China is buying foreign
exchange in order to maintain an undervalued exchange rate,
which artificially reduces the cost of its exports and supports
its burgeoning trade surplus with the United States and the
rest of the world.
The cost of U.S. foreign borrowing is likely to
rise in the future. Recently, central banks in China and other
countries announced plans to diversify their holdings into higher-yielding
assets. China announced plans to set up a new state investment
agency, with an initial capital investment of $200 billion and
an additional $200 billion over the next few years (Maidment
2007).
Many economists now agree that large U.S. current
account deficits are unsustainable in the long-term. Federal
Reserve chairman Ben Bernanke (2007) acknowledged in a speech
on September 11 that "the U.S. current account deficit
is certainly not sustainable at its current level." While
downplaying the risks of a crisis in the short-term, he did
acknowledge that as the current account deficit is reduced,
"real interest rates should rise."
A rapid surge in capital outflows from the United
States could precipitate a more serious financial crisis or
"hard landing" for the U.S. economy. Outflows of U.S.
private investment have more than tripled in the past 18 months
from $500 billion in 2005 to $1 trillion in 2006 and $1.8 trillion
in the first half of 2007 (annual rate). So far, these outflows
and the borrowing needed to finance the trade deficit have been
offset by corresponding capital inflows, including large and
growing purchases by foreign central banks and government-owned
investment funds.
The rapid growth of these outflows is consistent
with scenarios suggesting that a financial crisis will result
in a "hard landing" for the U.S. economy. But for
those purchases by foreign central banks and governments, the
dollar might have collapsed already. If private investors decide
that a dollar collapse is imminent, massive capital outflows
could ensue as everyone scrambles to dump dollar denominated
assets. The likely result would be a financial crisis that foreign
central banks could not control, leading to severe recession
in the United States and a slowdown in the world economy.
A substantial and controlled reduction in the dollar,
of perhaps 40% or more, would be the best and most effective
way to bring about an orderly reduction in U.S. trade and current
account deficits and lower the risks of a financial crisis.
It would expand U.S. exports by making exports cheaper, and
import growth would decline due to rising prices. China has
prevented this adjustment from taking place by intervening in
foreign exchange markets. The risks of an international financial
crisis appear to be growing. China must be persuaded to
stop manipulating its currency, to promote trade adjustment
and prevent a financial crisis and recession in the United States
and world economies.
Dr. Robert
E. Scott, PhD is Director of International Programs at The Economic
Policy Institute.
References:
Bernanke,
Ben S. 2007."Global Imbalances: Recent Developments and
Prospects". Lecture at the Bundesbank, Berlin. September
11.
Maidment, Paul. 2007. China recycles its trade
dollars. Forbes, April 2.
Setser, Brad. 2007. "Foreign Holdings of U.S.
Debt: Is Our Economy Vulnerable." Testimony before the
House Budget Committee, June 26.