International Picture, December 18, 2007

December 18, 2007

U.S. current account deficit improves despite growing Asian trade deficits

The Bureau of Economic Analysis reported yesterday that the U.S. current account deficit shrank to $178.5 billion in the third quarter of 2007, falling by 0.4% as a share of GDP. Despite the aggregate improvement, the U.S. trade deficit with China rose sharply in the quarter, reflecting the fact that dollar has not fallen as rapidly against the yuan and other Asian currencies as it has against other major currencies (such as the Euro and the Canadian dollar).

The goods trade deficit fell to $199.7 billion, improving sharply in the third quarter. Exports rose 5.3% in the quarter (up 17% over the past year), while imports only increased 2.8% (4.5% over the year). The slowdown in imports was responsible for most of the improvement in the trade balance. The decline in the real, broad, trade-weighted U.S. dollar, which has fallen 17.2% since 2002, explains much of the improvement in the trade deficit since late 2005. But for the cost of oil imports, which increased by more than $180 billion per year since 2002, the improvement in the trade deficit would have been much greater.

The U.S. trade deficit with Canada and Europe has improved significantly this year, but it has continued to grow with China 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 the currencies of these latter countries. The decline in the broad dollar since 2002 masks sharp differences in exchange rate trends across countries. The dollar has fallen 36% against the Euro in particular (in inflation-adjusted terms) since the first quarter of 2002 (see Chart). However, the dollar has lost only 9% against the Chinese yuan since 2002, and the dollar has actually risen slightly in value against the Japanese yen. These countries intervene heavily in currency markets to prevent the dollar from falling against their currencies, boosting their competitiveness against U.S.-based production.

Persistence of stubbornly large U.S. trade deficits continues to pose the threat of a dollar collapse. The United States had to sell or borrow a net total of more than $3 billion per business day to finance its current account deficit in the third quarter. If domestic or foreign investors grow concerned about the ability of the United States to finance these deficits, a run on the dollar could result. A striking finding is that the United States experienced the largest net outflow of financial securities since 1960 (other than treasuries) in the third quarter. If capital flight from the United States spreads, it could trigger a dollar collapse, a spike in interest rates, and a hard landing for the domestic economy.

Outflows of foreign financial investments likely reflect a number of factors, including concern about sub-prime mortgage lending, which caused stock markets here and abroad to crash in August, and concern about the continuing ability of the United States to finance its large current account deficits. The trade deficit is likely to improve over the next year as the U.S. economy slows or slides into recession. This would be a propitious time for countries that have become too reliant on exporting to the U.S. market (China and Japan, most conspicuously) to re-orient their currency policies and spur consumption growth in their home markets. This development would be good for both the United States and its trading partner economies and would lead to a more stable global economy.

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