Increase in foreign debt undermines U.S. financial stability

A weekly presentation of downloadable charts and short analyses designed to graphically illustrate important economic issues. Updated every Wednesday.

Snapshot for March 14, 2001.

Increase in foreign debt undermines U.S. financial stability
The current account is the broadest measure of the U.S. trade deficit. America's trade deficits must be financed either by borrowing from foreigners or by selling U.S. assets abroad, which in either case increases net international indebtedness. The U.S. current account deficit for 2000 was $435.4 billion, or 4.4% of U.S. gross domestic product (GDP). Both measures were all-time highs for the United States.

This deficit will sharply increase U.S. net international debt in 2000, as shown in the figure below.1 Even if the U.S. trade deficit in goods and services stops growing, payments of interest and other types of property income will keep growing until the trade balance is positive and debt levels fall. But if current trends continue apace, total debt could rise from 15.8% of GDP in 1999 to about 60% in 2010. Unfortunately, there is presently no reason to believe that these trends won't continue relentlessly along their current course.

While the above projection is not meant to be taken as a forecast, it does illustrate a situation that, while highly unlikely, should be avoided for a couple of reasons. First, a current account deficit that is currently at 7-8% of GDP but potentially rising fast has to be financed in some way. There is a limit to the extent to which any country can become indebted to the rest of the world. Second, even if large future deficits could be financed, they will lead to a rapidly growing flow of interest and profits out of the U.S. If the debt rose to 60% of GDP, the loss would probably approach 2.5% to 3.0% of U.S. income, which would certainly be painful for the economy.

If the flow of foreign financing into the U.S. suddenly dries up, it will destabilize domestic financial markets. Such destabilization could cause interest rates to rise sharply, the economy to stagnate, or both, threatening growth around the world. Large and growing foreign debts are a key part of the trade deficit's threat to the U.S. economy.

Notes:
1. Data on the net U.S. financial position in 2000 will be released in June, 2001.

Sources:
Bureau of Economics, International Transactions reports at: http://www.bea.doc.gov/, and analysis by Wynne Godley of the Levy Institute. Also, see the final report of the U.S. Trade Deficit Review Commission, Chapter 4 -- Democratic Commissioners Viewpoint [PDF] from The U.S. Trade Deficit: Causes, Consequences, and Recommendations for Action.

This week's Snapshot by EPI economist Robert E. Scott.

Check out the archive for past Economic Snapshots.