Current Account Picture: June 16, 2006

June 16, 2006

U.S. current account deficit improves in first quarter

The Bureau of Economic Analysis (BEA) announced today that the current account deficit (the broadest measure of the U.S. balance of trade in goods, services, and payments to the rest of the world) fell to $835 billion (annual rate) in the first quarter of 2006, a decrease of 6.5%, or $58 billion, from the previous quarter. All the major components of current account improved in the first quarter, led by a fall in transfer payments and a decline in the deficit on goods and services trade. Key developments in the current account report include:

It appears that the long-needed decline in the dollar, which began in 2002, has begun to take hold, as U.S. goods and services exports increased 17.3% in the quarter, leading to an improvement in the trade balance.
Even with these improvements, however, the U.S. current account deficit was still the second largest on record. There is widespread agreement among economists that the deficit is unsustainable at this level. The U.S. dollar needs to fall substantially to reduce the deficit to sustainable levels.
Rapid net outflows of U.S. privately owned assets abroad, which reached a record $1.3 trillion (annual rate) in the first quarter, were primarily composed of $1.1 trillion worth of financial outflows other than direct investment. Such "hot-money" outflows have presaged sharp currency declines in other countries and could lead to "wrenching changes" in the economy if a dollar depreciation and reduction of U.S. current account deficit do not take place in an orderly fashion.¹

Total U.S. imports of goods and services were $2.1 trillion in the first quarter of 2006, 55% more than the $1.3 trillion in exports. To keep the trade deficit from widening further, exports must grow 55% faster than imports. In the first quarter, imports increased 7.4%, while exports expanded 17.3%, which is 135% faster and a much needed improvement. This shift may mark the first stage of the unwinding of the deficit. However, the trade deficit only declined at a $16 billion annual rate. In the absence of a dramatic and sustained slowdown in U.S. growth, sustained improvements in the trade balance and current account can only be achieved with a further, substantial reduction in the value of the U.S. dollar, which has declined 13% since early 2002.

The gradual decline in the dollar and improvement in the current account deficit would provide the best outcome for the economy. When the dollar rises in value, U.S. exports become more expensive and import prices fall. Between 1995 and 2002, the dollar gained about 30% in value (see chart below). As a result, the U.S. trade deficit has grown from about 1.5% of GDP to 6.4% in the first quarter, far beyond sustainability. As a rough rule of thumb, international economists have estimated that the currency must depreciate by 10% to bring about a 1 percentage-point reduction in the current account as a share of GDP. In order to bring the deficit down to a sustainable level (less than 3% of GDP), the dollar must fall by at least 30% to 40% to reduce export prices and achieve the needed increase in export growth, relative to imports. A falling dollar will also raise import prices, slowing import growth and increasing demand for goods produced in the United States.

Overvaluation of the dollar since 1995 has contributed to the growth of the trade deficit

Only large inflows of foreign investment prevented larger declines in the dollar in the first quarter. Foreign central banks, led by Asian governments, financed more than one-third of the current account deficit in this period. The Asian central banks' decision to promote their export-led growth by propping up the dollar is the largest barrier to needed dollar adjustments. If governments fail to bring about the desired orderly depreciation, markets could burst the dollar bubble, with far-reaching negative consequences for the United States and global economies.

Notes
1. Federal Reserve Board Open Market Committee stated its meeting minutes in June 2004 that "The staff noted that outsized external deficits could not be sustained indefinitely. However, the historical evidence indicated that such deficits could be quite persistent, and the adjustment of imbalances was not necessarily imminent. The adjustment, once under way, might well proceed in a relatively benign fashion, particularly if fiscal, monetary, and trade policies were appropriate, but the possibility that the adjustment could involve more wrenching changes could not be ruled out." Federal Reserve Board, "Minutes of the Federal Reserve Open Market Committee, June 29-30, 2004, http://www.federalreserve.gov/fomc/minutes/20040630.htm.

This Current Account Picture was written by EPI economist Robert Scott, with research assistance from David Ratner.

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