Economic Indicators | Health

International Picture, June 15, 2007

Share this page:

June 15, 2007

U.S. current account deficits contributing to surging long-term interest rates

by Robert E. Scott

In its regular quarterly report the Bureau of Economic Analysis said today that the U.S. current account deficit rose $19 billion to an annualized $770 billion in the first quarter of 2007, the result of a $22 billion increase in transfer payments and a $3 billion improvement in the balance on income. The report helps explain recent increases in U.S. interest rates. Sharply falling net purchases of long-term Treasury securities since 2004 have contributed to rising rates for the benchmark 10-year treasury bond, which is up 0.4 percentage points (40 basis points) in the past month.

The current account deficit means that, based on these first quarter data, the United States is spending $770 billion more per year than it is producing. A current account deficit must be financed by an equal and offsetting capital inflow, which represents net borrowing or the sale of U.S. assets to the rest of the world. In effect, the United States is living beyond its means and selling off national assets to pay its bills. The current account deficit has nearly doubled in this decade, increasing from $417 billion in 2000. Today’s $770 billion represents 5.7% of GDP.

Foreign central banks have financed most of the U.S. current account deficit since 2000. China alone purchased $200 billion in foreign exchange in 2006, primarily in the form of low-return U.S. Treasury securities, and its foreign exchange purchases surged to $125 billion in the first quarter of 2007 alone. China is buying foreign exchange in order to maintain an undervalued exchange rate, which artificially reduces the cost of its exports and supports its burgeoning trade surplus with the United States and the rest of the world.

Recently, central banks in China and other countries announced plans to diversify their holdings into higher-yielding assets. China announced plans to set up a new state investment agency, with an initial capital investment of $200 billion and an additional $200 billion over the next few years (see “China Recycles Its Trade Dollars,” by Paul Maidment in the April 2 Forbes). Today’s current account data show that foreign investors, including central banks, have been steadily reducing their purchases of long-term Treasury securities since 2004. As illustrated in the figure below, rapidly growing foreign purchases of U.S. treasuries beginning in 2002 played a significant role in driving down interest rates on benchmark 10-year treasury bonds. Falling foreign purchases of treasuries starting in 2004 have contributed to increases in those interest rates since late 2005.

U.S. interest rates and net foreign purchases of long-term treasury securities

Many economists are now arguing that large U.S. current account deficits are unsustainable in the long term. A substantial reduction in the value of the dollar, of perhaps 40% or more, would be the best and most effective way to reduce U.S. trade and current account deficits. It would expand U.S. exports by making exports cheaper, and import growth would decline due to rising prices. China has prevented this adjustment from taking place by intervening in foreign exchange markets. Falling purchases of U.S. treasuries, which could sharply increase U.S. interest rates, might reduce trade deficits by pitching the economy into a recession.  A goal of U.S. policy should be to persuade China to stop manipulating its currency so that continued disruption of financial markets and of the U.S. and world economies can be prevented.

To view archived editions of INTERNATIONAL PICTURE, click here.


See related work on Health

See more work by Robert E. Scott