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Sunday, April 11, 2010

Is the U.S. Current Account Deficit Sustainable?

Marc Labonte
Specialist in Macroeconomic Policy

America's current account (CA) deficit (the trade deficit plus net income payments and net unilateral transfers) rose as a share of gross domestic product (GDP) from 1991 to a record high of about 6% of GDP in 2006. It began falling in 2007, and reached 3% of GDP in 2009. The CA deficit is financed by foreign capital inflows. Many observers have questioned whether such large inflows are sustainable. Even at 3% of GDP, the deficit is probably still too large to be permanently sustained, and many economists fear that the decline is temporary and caused by the recession. Further, a large share of the capital inflows have come from foreign central banks in recent years, and some are concerned about the economic and political implications of this reliance. Some fear that a rapid decline in capital inflows would trigger a sharp drop in the value of the dollar and an increase in interest rates that could lower asset values and disrupt economic activity. However, economic theory and empirical evidence suggest that the most plausible scenario is a slow decline in the CA deficit, which would not greatly disrupt economic activity because production in the traded goods sector would be stimulated. 

The financial crisis that worsened in September 2008 would seem to be a good test case of the type of event that could lead to the feared "sudden stop" in foreigners' willingness to finance the CA deficit. While the recession deepened following the crisis, it has not been via a sudden decline in the dollar or a sudden broad spike in U.S. interest rates. On the contrary, the dollar appreciated in value in the months after the crisis and foreign demand for U.S. Treasury bonds has risen since the crisis worsened. On the other hand, there was a large decline in private foreign capital inflows beginning in 2008; had it not been for foreign government purchases of U.S. securities, the CA would have been in surplus in 2009, all else equal. 

One long-term consequence of large and chronic CA deficits has been the growing foreign ownership of the U.S. capital stock. A large CA deficit is not sustainable in the long run because it increases U.S. net debt owed to foreigners, which cannot rise without limit. A larger debt can be serviced only through more borrowing or higher net exports. For net exports to rise, all else equal, the value of the dollar must fall. This explains why many economists believe that both the dollar and the CA deficit will fall further at some point in the future. To date, debt service has not been burdensome. Because U.S. holdings of foreign assets have earned a higher rate of return than U.S. debt owed to foreigners, U.S. net investment income has remained positive, even though the United States is a net debtor nation. 

Since 1980, most episodes of a declining CA deficit in industrialized countries have been associated with slow economic growth. Only two episodes were associated with a severe disruption in economic activity. Because most of the episodes involved small countries, these cases may differ in important ways from any corresponding episode in the United States. Historically, a few other countries have had a higher net foreign debt-to-GDP ratio than the United States has at present; however, if CA deficits continue at current levels, the U.S. net foreign debt could eventually be the highest ever recorded. 

This report also reviews studies on the CA deficit's sustainability. Some of the studies suggest that a large dollar depreciation could eventually be required to restore sustainability. But the inflation-adjusted 25% depreciation of the dollar from 2002-2008 had little effect on the CA deficit, which kept growing until 2007. The CA deficit did not decline rapidly until after the financial crisis of September 2008—a period with little trend movement in the dollar.

Date of Report: April 2, 2010
Number of Pages: 16
Order Number: RL33186
Price: $29.95

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