Us_current_account - January 2008

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Zokirjon Abdusattarov, Institute for Law and Finance

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in the rate of economic growth. Consequently, when country experiencenormal (below normal) level of growth, it has to distribute large amount ofinterest, dividend and other payments to foreign investors from the currentlevel of production of the economy, which might not be financially strongenough to produce expected results.

What is the problem with current account in the US?

There are a number of reasons why this issue has recently startedhaving increasing overtone. The current situation in the US is appalling: thecurrent account deficit has hit its record, which is 7 % of the GPD or 900billion dollars. This amount is greater than sum of GDPs of roughly 100developing countries or almost 2 % of the Gross World Product (based on theWorld Bank calculations for 2006). It is the amount of money that has neverbeen observed in the US financial history (see figure 1.). The current accountdeficit also reflects the surplus of imports over exports in the international

trade of the US. This shows that the US is losing its competitiveness and theUS economy is suffering, and the employment opportunities are going down.And finally the greater the deficit becomes, the more observers subscribe tothe view that correction must take place some time in the future withsignificant affects on the US and world economy.

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Exports of goods and services

and income receipts

Imports of goods and services

and income payments &

Unilateral current transfers, net

Years

Figure 1.Current Account of the US during 1960-2006 in millions ofdollars.

Figure 1 illustrates that since the 1980s, the US trade balance has been indeficit. The deficit significantly broadened during 1990ies when the US


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economy was experiencing boom and growing much faster than the worldeconomy attracting large stocks of international investments.

It should be noted that the international investment position of the US isnot an ingredient of the current account; nevertheless, it is immensely affectedby it since dividends and interests are, so to say, exchanged between the

US and world countries as a result of the foreign-owned assets in the US andthe US-owned assets abroad. In 1985 US foreign assets were almost equal toforeign assets in the US. But due to high economic growth in 1990ies anddramatic development of financial institutions globally, investing in the USbecame very accessible and the latter was considered as oasis of prosperityfor foreign investors. In 2006 net international investment position of the USspiked up to 2,5 trillion dollars. On this issue, Ferguson expresses the viewthat if current account deficits continue to boost the negative internationalinvestment position, eventually the cost of servicing that position, which so farhas been quite modest, would rise to an unsustainable level1. As a result theUS economy becomes very fragile and would be thrown to recession for

several years.

There is a consensus among almost all observers on imminentadjustment or correction of the US current account deficit but few scholarsagree when it will happen on how it will take place.2 Very crucial remains theissue of what triggered all these changes in the current account and shifts inthe international investment position of the US. If the reasons lie behind themonetary policy of the state then focus must be drawn on the improvement ofthe economic regulations. Or if it was the market which has given the rootcauses, then let the market to correct those trends. If it is an external cause,maybe the US economists should think of new strategies to cope with theissue. Or if it is the result of the combination of all the factors then massivechanges in the economic regulations must be made.

In analyzing these issues one should be very careful in distinguishingthe causes and responses to that, and of course, the surrounding matterswhich has no direct link. For example, the current account deficit is not acause in itself. Or it is the same with the depreciation or appreciation of thedollar. A value of the currency cannot change automatically. Causes or factorshave different sources and must be investigated independently. The followingchapter will discuss what might be the potential causes.

1U.S. Current Account Deficit: Causes and Consequences: Remarks by Vice Chairman Roger

W. Ferguson, Jr. To the Economics Club of the University of North Carolina at Chapel Hill,Chapel Hill, North Carolina, April 20, 20052

Ibid.


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Causes of the US current account deficit

In a very complex and highly interconnected field as the contemporaryfinancial environment, there is a plethora of existing factors that may havetriggered in larger or in smaller part the US account deficit. Among the

economists and the researchers though, the focus is put on 6 different causesthat can be categorized as domestic or international: the fiscal deficit, a fall inprivate saving rates, an increase in productivity growth, deterioration in foreigndomestic demand, the apparent increase of financial intermediation and theongoing rise in oil prices.The first three factors are linked to the domestic economic background,whereas the last three are internationally driven.Let us view each one of them in more detail:

1. Expansion of the fiscal deficit

The view that the US current account deficit stems from the parallel rise of

the US budget deficit is commonly addressed by the so called twin deficitshypothesis, primarily a development of the 1980s. The basis that forms thistheory is the accounting identity that the current account balance equalssaving investment:

CURRENT ACCOUNT BALANCE= S- IThen it states that taking into account that the increase in the fiscal deficitlowered public saving, this means that it also caused the national saving tolower, thus leading to an analogous increase of the current account deficit. Ofcourse, this hypothesis presupposes that private saving and investmentremain constant and only public saving alters, which is something that hardlyhappens in the real world, where all these factors constantly change andadjust to changes.

A more complex version of the twin deficits hypothesis contends thatthe increased fiscal deficit causes domestic demand to rise, then domesticdemand in turn drives interest rates higher relative to foreign interest rates.This spread leads of course to increased investments from abroad, thusraising the value of the dollar, which affects the current account deficit bywidening it.

While this hypothesis is valid in terms of theory, the empirical datashows otherwise: The expansion of the fiscal deficit contradicts with the dataof 1990s when the US was confronted with a simultaneous rise of the trade

deficit and budget surplus instead of deficit. Moreover, in an internationallevel, empirical data taken from the economies of Japan and Germany,suggest the same that account surpluses can coexist with budget deficits.Thus, we can conclude that the expansion of the fiscal deficit had rather littlecontribution to the expansion of the account deficit of the USA.

2. Fall in the private saving rateThe facts clearly depict a substantial decline in US private saving rates:

Since the mid-1990s, the private saving rate has fallen from 5% of disposableincome to less than 2%, and the gross private saving (including corporatesaving) has also decreased from 16% to less than 15% of the GDP.

The lower saving rate implies higher private consumption, which in turncauses a rise in the GDP growth, which then increases the interest rates. The


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high interest rates account for the appreciation of the dollar and the resultingdecline in investment spending.

Yet, some researchers point out that various economic developments suchas the deterioration in private saving rates might just be an economicresponse to big economic fundamental shocks. For example, a rise in the

value of housing combined with lower interest rates may lead to a shift inhousehold saving behavior and do not actually affect the US current accountdeficit, at least to a large extent.

3. Increase in productivity growthBoth, the expansion of the fiscal deficit and the fall in the private saving

rates imply that the US current account deficit is the consequence of anincreased consumption of Americans relative to their income. The lastdomestic factor that is suggested to have played a big part in the expansion ofthe account deficit, appears to be the increase in productivity growth fromabout 1-1,5% during 1975-1995 to 3% after 1995 onwards.

First of all, the higher growth increased the perceived rates of return in USassets and investments, therefore increasing the foreign demand for thoseassets and investments. This resulted in substantial increase in capitalinflows, the demand for dollars rose also and all these led to an appreciationof the dollar.

Furthermore, the perceived increased rates of return on US assets andinvestments had a considerable impact also on the domestic demand forthem, which also rose. This rise in domestic demand triggered a sense ofeuphoria, which resulted in increased consumption and finally to a decline insaving rates.

Indeed, the empirical data support this theory, as the above mentionedfall in private saving rates and the 1990s sharp increase in asset pricessuggest.

4. Deterioration in foreign domestic demandIn an international level, the fall of domestic demand due to other

factors that led to an increase in saving rates and a decrease in investment,may be held responsible for affecting negatively the US account balance.The deterioration of foreign domestic spending increased the supply of capitalto the US, caused a fall in US interest rates and resulted in appreciation of thedollar.

In particular, in many parts of the developing world, as for example inthe South East Asia, following the major financial crisis of 1997, empirical datashow a clear decrease in investment rates even though the saving rates haveremained stable. This factual development led many State governments topursue lower exchange rates so as to enhance their exports in an attempt tostimulate economic growth. This policy contributed in part to the furtherincrease in the US account deficit.

Once more, the empirical data proves this point: ever since 1999, thedeveloping countries overall have had account surpluses, forcing theindustrialized world countries and mainly the US to experience accountdeficits.

Moreover, in general, the decrease in the foreign domestic demanddecreases the foreign GDP, which limits US exports. The limit in US exports


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accordingly, leads to a decrease in US net exports, thus lowering the USinterest rates. The lower interest rates account for increased consumptionspending, which explains largely the rise of the account deficit since the mid-1990s.

5. Developments in the global financial markets.

During the past decades, the lift of significant barriers and constraintsin international flow and mobility of capital has resulted in an overallenhancement of the outflow of funds from national saving to foreigninvestments. The typical destination of these outflows is States that have asteady financial and investor-friendly environment, that it ensures theinvestors property rights and boasts good rates of returns. One of the mostpopular destinations of the foreign capital fund is that fulfils all the abovecriteria is the US,

The empirical data shows a reduced correlation between national

saving and investment rates which can be attributed to the fact that domesticsavings are vastly used to finance foreign investments.

The turn of the domestic capital towards foreign investment and inparticular, towards US assets, leads to a decrease in US interest rates thatrepresent the risk premium of the foreign investors for holding US assets.The subsequent fall of the interest rates, increases the demand for US assetsand leads to a rise in the value of the dollar. Therefore, the current accountdeficit expands.

6. The rice in oil pricesThe on-going sharp rise in the oil price has had a major impact on US

economy. The US oil import bill has increased from 68 billion dollars back in1999 to 180 billion dollars in just 5 years, an increase of 110 billion dollarsroughly.

Of course, part of this increase in oil bill, is due to an increasingdemand for oil, but most of it reflects increases in price than quantity ofimported oil. The consequence is an increase in the imports by 110 billiondollars that puts negative pressure on the account balance.


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Putting it All Together

As we have described throughout our paper, there is no single factorthat is responsible for the all the trouble with the current account balance. Thecurrent account balance is sensible to the above mentioned changes in the

causes at various levels. Figure 23

demonstrates the degree of contributionsof each cause.

As one can observe from the chart, no single cause makes upprevalent contribution to the whole changes. However, we should alwayskeep in mind that in highly osmotic economies, the various causes anddevelopments are always interrelated to a bigger or lesser extent, and this

consideration urges us to put more emphasis on two out of the abovementioned six causes, that seem to play a bigger role in the widening of theUS account deficit than the others.

Those two main causes have to be the increased productivity growththat has attracted substantial amounts of foreign saving and the decreasedforeign demand, which boosted saving in these foreign economies.Nonetheless, one should not at any point conclude that the rise in currentaccount has been the result of various distinct developments within the globaleconomy, because the historical data point to the worldwide enhancement of

3 The graph is taken from

http://www.federalreserve.gov/boarddocs/Speeches/2005/20050420/default.htm#fig_6


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the financial intermediation, due to the ongoing globalization, liberalizationand technical innovation that embraces and affects not only the highlydeveloped western economies, but mainly the whole global economy, and thedeveloping economies even more. In fact, many scholars suggest, that it wasin the first place, the assurance that the US economy could easily finance its

budget deficit from the global financial markets that triggered the expansion ofthe budget deficit itself and, thus, led to the subsequent expansion of thecurrent account deficit as well.

Possible remedies

This consideration has many important implications on the possibleremedies than can be applied to the problem. Taking a more holistic approachto the issue, as we did so, suggests that the problem could and should becorrected by the way of self remedy. Many causes of the account deficit canbe reversed by the natural course of things: foreign domestic demand could

rebound, US private saving could increase and the continuing increase inforeign productivity growth will eventually lead to these countries runningthemselves account deficits, thus narrowing the US deficit accordingly.

Notwithstanding, there is room for government driven actions thatfacilitate the process of reducing the account gap. The public sector mustactively engage in policies that will reduce the budget deficit. Then, the netexports could be enhanced, without having to cut back on investment alongthe process of reducing the account deficit.

Indeed, the G7 forum explicitly stated that persistent action should beundertaken by governments and states to cope with the global imbalancesand ensure perpetual growth. Of course, one can easily understand that theseadjustments are slow and time-consuming and therefore, there are bound tobe short or mid term fluctuations in asset prices, interest rates and exchangerates as the private investors re- evaluate their investment strategies.


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The paper is prepared based on the following sources:

1. The Current Account Deficit and the US Economy by C. Fred

Bergsten, Peterson Institute, Testimony before the Budget

Committee of the United States Senate, February 1, 2007

2. U.S. Current Account Deficit: Causes and Consequences:

Remarks by Vice Chairman Roger W. Ferguson, Jr. To the

Economics Club of the University of North Carolina at Chapel

Hill, Chapel Hill, North Carolina, April 20, 2005

3. Analyses of the widening of the deficit include, among others,

Catherine L. Mann (2002), "Perspectives on the U.S. Current

Account Deficit and Sustainability," Journal of EconomicPerspectives, vol. 16 (Summer), pp.131-52

4. Implications of the U.S. Current Account Deficit, David H.

Howard, The Journal of Economic Perspectives, Vol.3, No.4.

(Autumn,1989 ), pp.153-165.

5. http://www.bea.gov

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