September 17, 2007
Despite improving U.S. current account deficits, risks of financial crisis may be growing
by Robert E. Scott
The Bureau of Economic Analysis reported on September 14 that the U.S. current account deficit improved slightly to an annualized $763 billion in the second quarter of 2007. The deficit was essentially unchanged, once the transitory impacts of government transfers are ignored.
The current account deficit improved from 5.8% of GDP (revised) in the first quarter to 5.5% in the second quarter, as shown in the figure below. The falling dollar has also helped reduce the deficit. The U.S. trade deficit with Canada and Europe has improved significantly this year, but it has continued to grow with China and other Asian countries, 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 all currencies. Orderly adjustment is unlikely unless China, Japan, and other Asian countries allow the dollar to fall against their currencies.
U.S. private investment abroad has more than tripled over the past 18 months. This raises the chances of a rapid, disorderly dollar decline and a financial crisis that could cause domestic interest rates to spike and push the economy into recession. The chances of a hard landing will grow if the dollar is not allowed to unwind smoothly through coordinated changes in economic policy in many countries very soon.
A large, transitory reduction in government grants explained most of the improvement in the current account in the second quarter. The balance of payments on income, which includes net payments on foreign investment and on government debt, also improved in the second quarter. However, there will be substantial downward pressure on these payments in the future because of rapid growth in the U.S. net foreign debt.
The current account deficit means that, based on these second quarter data, the United States is spending $760 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 to $760 billion in the second quarter. The cumulative, net U.S. international debt reached $2.5 trillion in 2006.
Payments on U.S. government debt, in particular, have nearly doubled, from $85 billion in 2000 to $158 billion in the second quarter (annual rate). The United States has benefited in the past because foreign investors tend to earn lower rates of return on their U.S. investments than U.S. investors earn on their foreign holdings on average. This is due, in part, to the fact that foreign governments hold a substantial share of U.S. debt in the form of low-yielding government debt. Foreign investors also earn lower rates of return on their foreign direct investments in the United States. This asymmetry is unlikely to persist in the future.
Foreign central banks have financed most of the U.S. current account deficit since 2000. China alone purchased $250 billion in foreign exchange in 2006, primarily in the form of U.S. Treasury securities; these purchases will likely reach $450 to $500 billion in 2007, with two-thirds of those purchases going for U.S. assets (Setser 2007). 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.
The cost of U.S. foreign borrowing is likely to rise in the future. 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 (Maidment 2007).
Many economists now agree that large U.S. current account deficits are unsustainable in the long-term. Federal Reserve chairman Ben Bernanke (2007) acknowledged in a speech on September 11 that “the U.S. current account deficit is certainly not sustainable at its current level.” While downplaying the risks of a crisis in the short-term, he did acknowledge that as the current account deficit is reduced, “real interest rates should rise.”
A rapid surge in capital outflows from the United States could precipitate a more serious financial crisis or ‘hard landing’ for the U.S. economy. Outflows of U.S. private investment have more than tripled in the past 18 months from $500 billion in 2005 to $1 trillion in 2006 and $1.8 trillion in the first half of 2007 (annual rate). So far, these outflows and the borrowing needed to finance the trade deficit have been offset by corresponding capital inflows, including large and growing purchases by foreign central banks and government-owned investment funds.
The rapid growth of these outflows is consistent with scenarios suggesting that a financial crisis will result in a ‘hard landing’ for the U.S. economy. But for those purchases by foreign central banks and governments, the dollar might have collapsed already. If private investors decide that a dollar collapse is imminent, massive capital outflows could ensue as everyone scrambled to dump dollar denominated assets. The likely result would be a financial crisis that foreign central banks could not control, leading to severe recession in the United States and a slowdown in the world economy.
A substantial and controlled reduction in the dollar, of perhaps 40% or more, would be the best and most effective way to bring about an orderly reduction in U.S. trade and current account deficits and lower the risks of a financial crisis. 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. The risks of an international financial crisis appear to be growing. China must be persuaded to stop manipulating its currency to promote trade adjustment and prevent a financial crisis and recession in the United States and world economies.
References
Bernanke, Ben S. 2007.”Global Imbalances: Recent Developments and Prospects”. Lecture at the Bundesbank, Berlin. September 11. http://www.federalreserve.gov/newsevents/speech/bernanke20070911a.htm
Maidment, Paul. 2007. China recycles its trade dollars. Forbes, April 2.
Setser, Brad. 2007. “Foreign Holdings of U.S. Debt: Is Our Economy Vulnerable.” Testimony before the House Budget Committee, June 26.
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