America's Unsustainable Current Account Deficit
Never in the history of modern economics has a large industrial country run persistent current account deficits of the magnitude posted by the U.S. since 2000.
The amount of foreign capital inflows required to sustain an American economy in which both the government and individuals eschew savings and spend beyond their means -- and imports far exceed exports --has soared to record highs. But even if the foreign appetite for U.S. Treasury securities and other U.S. assets continues to grow, a day of reckoning for what economists call our "current account deficit" is likely to arrive soon. And the price will be paid in a currency drop that will significantly reduce domestic economic growth.
That's the conclusion of a study by NBER Research Associate Sebastian Edwards. In Is the U.S. Current Account Deficit Sustainable? And If So How Costly Is Adjustment Likely to Be? (NBER Working Paper No. 11541), Edwards provides a detailed analysis that culminates in blunt answers to these questions: No, it is not sustainable and the adjustment, if history is any guide, is likely to be "painful and costly," causing U.S. economic output, measured as gross domestic product or GDP, to plummet. "The results from this investigation indicate that major current account reversals have tended to result in large declines in GDP," Edwards writes. "These estimates indicate that, on average, the decline in GDP growth per capita has been in the range of 3.6 to 5 percent in the first years of adjustment. Three years after initial adjustment, GDP growth will still be below its long-term trend."
The U.S. current account deficit essentially is a reflection of the fact that U.S. expenditure exceeds its income. Escalating federal budget deficits, an anemic national savings rate, and widening trade deficits all interact to produce a ballooning dependence on large inflows of money from abroad. Edwards points out that a number of experts are particularly concerned that the reliance on foreign central banks, especially those in Asian countries, to purchase U.S. Treasury securities has made America extremely "vulnerable to sudden changes in expectations and economic sentiments."
As of 2004, the net amount of U.S. liabilities, including Treasury securities, held by foreigners was equal to 29 percent of GDP. Our current account deficit was equal to almost 6 percent of GDP and growing, giving the United States the dubious distinction, Edwards observes, of being "the only large industrial country that has run current account deficits in excess of 5 percent."
"Never in the history of modern economics has a large industrial country run persistent current account deficits of the magnitude posted by the U.S. since 2000," Edwards writes. Edwards acknowledges that, in part, the current account predicament is a reflection of the fact that the United States sits at the center of an "international financial system where its assets have been in high demand." But he points out that its record-setting account deficit "also suggests that the U.S. is moving into uncharted waters."
Edwards notes in the near-term the sustainability of the deficit will "depend on whether foreign investors will continue to add U.S. assets to their investment portfolio." In his analysis of the situation, rather than assume (as some have) that the deficit has maxed out and a pullback is imminent, he crafts a scenario in which foreign demand continues to grow, with holdings eventually reaching an equivalent of 60 percent of GDP.
"What makes this approach interesting is that even under this optimistic scenario, it is highly likely that in the not too distant future the U.S. current account will undergo significant reversal," he writes.
In other words, even if the United States has special status in the global economy and is a very attractive place to park one's money, foreign investors are unlikely to keep propping up U.S. trade and budget imbalances and spending sprees indefinitely. Edwards describes a potential future in which the demand for U.S. assets continues to increase for the next four years until the value of foreign holdings peaks at 60 percent of GDP, but then falls back to 50 percent by 2010.
The result, Edwards believes, would be a 21-to-28 percent depreciation in the value of the trade-weighted dollar and a considerable slowdown of the American economy. And that may be a "best case" scenario. He warns that the damage inflicted on the U.S. economy by a sharper and/or more immediate correction in the current account deficit could actually be much worse.
"It is important to keep in mind that this simulation still assumes that the long run net demand by foreigners for U.S. assets (will be) significantly higher -- 20 percent of GDP higher, to be more precise -- than its current level," he writes. "I have not presented the results from 'pessimistic' scenarios, where foreigners reduce their net demand for U.S. assets below the current level (of about 30 percent of GDP). Suffice it to say that under that scenario the current account reversal is even more pronounced, as is the concomitant real depreciation (in the dollar).
-- Matthew Davis