The overall improvement in the goods trade balance masked important structural shifts in U.S. goods trade. While the U.S. trade deficit in petroleum goods declined $34.8 billion (10.7 percent), the U.S. trade deficit in non-petroleum goods increased $35.3 billion (8.8 percent). Growing goods trade deficits have eliminated millions of U.S. manufacturing jobs over the past decade, and non-petroleum goods were responsible for the vast majority of the jobs displaced. Rapidly growing trade deficits in non-petroleum goods, especially manufactured products, represent a substantial threat to the recovery of U.S. manufacturing employment.

The trade deficit in non-petroleum goods ($436.6 billion in 2012) is dominated by the U.S. trade deficit in manufactured products (the trade deficit in manufactured goods increased $44.7 billion in 2012). Growing trade deficits in manufactured products have eliminated millions of U.S. manufacturing jobs in the past decade. For example, the rise in the U.S. trade deficit with China between 2001 and 2011 alone eliminated 2.7 million U.S. jobs, over 2.1 million (76.9 percent) of which were in manufacturing.

The U.S. trade deficit in non-oil goods has increased rapidly over the past three years, as shown in Figure A. The last sustained period of rapid growth in this deficit was between 2002 and 2005, when overall trade deficits and trade-related job losses grew rapidly. Overall GDP growth (which stimulates imports and growth of the trade deficit) also accelerated between 2002 and 2005, but GDP has not grown as rapidly over the past three years as in the earlier period. Going forward, with projections of weak U.S. and global GDP growth, rising trade deficits in non-oil products represent a growing threat to the fragile domestic recovery.

Figure A

Growing trade deficits with China, Japan, and Korea were responsible for all of the increase in the non-oil goods trade deficit in 2012. The U.S. goods trade deficit with China reached an all-time high of $315.1 billion in 2012, an increase of $19.6 billion (6.6 percent). Trade with China involved less than $1 billion in trade in crude and refined petroleum products. China alone was responsible for nearly three quarters (71.9 percent) of the U.S. trade deficit in non-oil products in 2012. The U.S. goods trade deficit with Japan increased from $63.2 billion in 2011 to $76.3 billion in 2012, an increase of $13.1 billion (20.3 percent). This is largely explained by a surge in autos and auto-parts imports as Japan’s economy recovered from the effects of the 2011 tsunami.

The U.S. free trade agreement (FTA) with Korea took effect on March 15, 2011. Proponents of the FTA predicted a surge in U.S. exports to Korea would result. However, U.S. exports to Korea actually declined by $1.1 billion in 2012. Worse yet, the trade deficit with Korea increased $3.3 billion (25.0 percent) in 2012. These early, disappointing results reflect fundamental problems with current FTAs, as illustrated by growing U.S. trade deficits with Mexico and trade-related job losses after NAFTA.

Unfair trade practices are responsible for a substantial share of the U.S. trade deficit. A new EPI report has shown that eliminating currency manipulation by trading partners could reduce the U.S. trade deficit by between $190 billion and $400 billion and support the creation of between 2.2 million and 4.7 million U.S. jobs over the next three years. This could reduce the U.S. unemployment rate by between 1.0 and 2.1 percentage points, increase U.S. GDP by between $225 billion and $474 billion (a rise of between 1.4 percent and 3.1 percent), and reduce the U.S. federal budget deficit by between $78.8 billion and $165.8 billion per year (which would shrink the federal deficit by between 20.4 percent and 42.9 percent). In addition, China has massively and illegally subsidized many of its industries, including steel, glass, paper, and auto parts. Japan maintains one of the most closed markets in the world, especially in the auto and auto-parts sectors—and Korea, despite the recently enacted FTA, has yet to open its market to U.S. products.

The Obama administration has dramatically increased trade enforcement in the past four years, filing a number of successful complaints against China at the World Trade Organization, for example. However, much more needs to be done to eliminate unfair trade practices, especially currency manipulation. The administration has pursued quiet negotiations for four years, with limited success. The president can eliminate China’s currency manipulation with the stroke of a pen (Bergsten and Gagnon 2012, 18), and he should announce his intention to do so if China does not substantially revalue and cease all currency intervention in the near future.

With the U.S. and European economies headed into a downturn in 2013, the time has come to eliminate currency manipulation and rebalance global trade. Rebalancing trade offers the best hope for creating millions of U.S. jobs and stimulating GDP—at no cost to the government.

— The author thanks Josh Bivens for comments and Hilary Wething for research assistance.

Increased net imports of crude oil and refined petroleum products were responsible for about two-thirds ($61.3 billion) of the growth of the U.S. trade deficit in goods. Growth of the goods trade deficit in 2011 has slowed the recovery and suppressed domestic job creation, as domestic demand for goods has been absorbed by exporters, particularly those in China and in oil-exporting nations.

The U.S. trade deficit in non-oil goods—a deficit dominated by trade in electronics, autos, auto parts, and other manufactured products—increased from $369.7 billion in 2010 to $399.7 billion in 2010, an increase of $30.1 billion (8.1 percent). The U.S. trade deficit with China, which is dominated by trade in non-oil manufactured goods, increased from $273.1 billion in 2010 to a record $295.5 billion in 2011. This $22.4 billion (8.2 percent) growth in the overall U.S. trade deficit with China was responsible for three-fourths of the growth in the U.S. trade deficit in non-oil goods (conservatively estimated).

According to a 2011 Economic Policy Institute report, the growth in the U.S. trade deficit with China displaced 2.8 million U.S. jobs between 2001 and 2010 alone. One of the most important causes of an increasing U.S. trade deficit with China is China’s illegal manipulation of its currency. As EPI’s Josh Bivens has noted, the U.S. needs a firm and effective set of policies to confront China’s currency manipulation, but the administration and Congress repeatedly have refused to get tough with China.

China is also targeting a range of U.S. industries with subsidies and other illegal trade restrictions, recent reports show. For example, the Chinese auto-parts industry (including domestic and foreign-owned plants in China) has received $27.5 billion in government subsidies since 2001, and China’s central government has committed an additional $10.9 billion in aid through 2020. Up to 1.6 million U.S. jobs in the U.S. auto-parts industry are at risk in the coming decade due the threat of rapidly growing subsidized U.S. imports from China.

China’s illegal currency manipulation and unfair trade policies should be at the top of the agenda when Chinese Vice President Xi Jinping visits next week. Instead, news reports will likely be dominated by a few carefully orchestrated sales of big-ticket U.S. goods to Chinese buyers. We should beware of visitors bearing “gifts.” As noted by Alliance for American Manufacturing President Scott Paul, “China’s economic policies—subsidies, state owned enterprises, intellectual property theft, forced technology transfer, currency manipulation—are now the single largest impediment to job growth in America.” The United States cannot afford to wait any longer to address these policies.

The author thanks Josh Bivens for advice and comments and Natalie Sabadish for research assistance.

By Robert E. Scott, EPI Senior International Economist and Director of International Programs

The U.S. Census Bureau reported recently that the U.S. goods and services trade deficit fell from $695.9 billion in 2008 to $380.7 billion in 2009, a decline of $315.3 billion (45.3%). The historic collapse in global trade reflects the effects of the recession and financial crisis on both the demand for goods and services, and the impact of widespread shortages of loans needed to finance trade. Recent increases in monthly trade deficits reflect improving market conditions. The monthly goods and services trade deficit increased from $36.4 billion in November to $40.2 billion in December.

Goods trade deficit falls at a slower rate¹

The goods trade deficit fell from $840.3 billion in 2008 to $517.0 billion in 2009, a decline of $323.4 billion (38.5%). A decline in net oil imports was responsible for slightly more than half (56%) of the fall in the goods trade deficit in 2009. Falling petroleum imports were largely explained, in turn, by a 40.2% decline in the average price per barrel of petroleum imports in 2009. The U.S. non-oil goods trade deficit, which is dominated by manufactured products, fell from $387.8 billion in 2008 to $283.0 billion in 2009, a decline of 27%. China’s share of the U.S. non-oil goods trade deficit jumped from 68.6% in 2008 to 80.2% in 2009. China’s share of the non-oil goods trade deficit has tripled since 2000, as shown in the Figure below.

China has captured a growing share of U.S. and world markets for manufactured products through a wide array of unfair trade practices including currency manipulation, export subsidies, widespread suppression of worker rights and wages, and tariff and non-tariff barriers to exports. It has purchased massive volumes of foreign exchange over the past decade in order to suppress the value of its currency. China’s total foreign exchange reserves increased $453 billion to a total of $2.4 trillion in 2009. China took advantage of the rest of the world during the financial crisis by increasing its share of U.S. markets for manufactured products. The United States should take a leadership role in organizing an effort to end China’s currency manipulation and other unfair trade practices.

Note
1. At this date, detailed information on trade by country and product in 2009 is only available for goods trade.

China dominates U.S. non-oil trade deficit in 2009

by Robert E. Scott

The large U.S. trade deficit in goods peaked in 2008, but has declined sharply thus far in 2009 as the global recession significantly reduced demand for U.S. exports and imports alike. But one constant remains: China’s rising share of the non-oil goods trade deficit, which recently peaked at 83% of the total U.S. non-oil goods trade deficit (see Chart). This deficit is dominated by the U.S. trade deficit in manufactured goods. In short, aside from oil imports, the U.S. trade deficit is dominated by our import of Chinese manufactured goods.

Beginning in August 2008, monthly U.S. non-oil exports fell 25% ($27 billion), and imports fell 33% ($47 billion), so the monthly trade deficit declined 53% ($20 billion). China’s trade with the United States was the great exception: both imports and exports from China fell at a slower rate, so the monthly non-oil trade deficit with China fell much less (29% or $7 billion). As a result, China’s share of this deficit has surged from 69% in 2008 to 83% through May 2009.

China could do much to reduce this imbalance by revaluing its highly undervalued currency, giving up energy subsidies for exports, and forgoing the dumping of exports in the U.S. markets. China’s huge stimulus program has kept its economy growing at an 8% rate this year, and is able to consume many more U.S. exports.

Increase in oil prices, fall in investment income exacerbates current account deficit woes

By Robert E. Scott with assistance by Lauren Marra

The Bureau of Economic Analysis said yesterday that the U.S. current account deficit, the broadest measure of foreign trade and investment income flows, increased to $176.4 billion in the first quarter of 2008.  The deficit increased from $167.2 billion in the fourth quarter of 2007, an increase of 5.5%.  Measured as a share of gross domestic product (GDP), the current account deficit increased to 5.0% in the first quarter, up from 4.8% in the last quarter of 2007.
 
The growth of the goods and services trade deficit explained only about $1.1 billion of the $9.1 billion increase in the current account deficit in the first quarter. Much of this was dominated by oil imports, as the U.S. deficit in petroleum products was responsible for 56% of the U.S. deficit on goods and services trade in the first quarter. Soaring petroleum prices increased the U.S. trade deficit in petroleum products $10 billion (12%) in the first quarter, despite a 2% fall in the volume of petroleum imports (U.S. Census Bureau 2008). 

Non-oil imports increased less than 1% in the quarter, a reflection of the slowing U.S. economy and the cumulative effects of a lower dollar, which declined 25% between its peak in February 2002 and March 2008 in real, inflation-adjusted terms.
 
Exports increased at a very healthy 17% annual rate in the first quarter, reflecting continued growth in global demand for U.S. goods and services, also helped by the falling value of the dollar.

A sharp decline in net U.S. investment income in the first quarter, shown in the chart below, was responsible for most of the increase in the U.S. current account deficit in the first quarter.  The U.S. balance on income declined by $6.6 billion and accounted for nearly three-fourths of the growth in the current account deficit (the black line in the chart). 
 

U.S. current account deficits must be financed with foreign borrowing and/or the net sale of U.S. assets.  This growth in foreign debt implies that, over time, U.S. payments of interest and profits to foreign investors will rise.

These payments to foreign investors have traditionally been more than counter-balanced by very high returns earned on foreign direct investments made by U.S. companies. In the first quarter of 2008, payments to U.S. owners of FDI exceeded U.S. payments to foreign holders of U.S. FDI by $69 billion, as shown in the chart (red line).¹

Although still positive, this income balance declined sharply from the previous quarter, and, its decline accounted for almost the entire decline in total net investment income, and, indeed most of the decline in the U.S. current account balance.2   The drop in net FDI income likely reflects in large part the global slowdown.  The International Monetary Fund projects in its most recent Economic Outlook that growth rates in the G-7 countries will drop from 2.2% in 2007 to 0.9% in 2008.

The rapid growth of U.S. FDI abroad is a mixed blessing for the U.S. economy.  The increased flow of profits on U.S. FDI abroad has reduced U.S. current account deficits in recent years.  However, it also reflects the rapid growth of outsourcing and job loss.  Between 2000 and 2005, the balance of trade of U.S. multinational companies declined from a surplus of $2.8 billion to a deficit of $112 billion.  The benefits of profits gained on these investments have not offset the losses of trade, output, and jobs to the U.S. economy that result from the offshoring of U.S. factories.

References

U.S. Census Bureau.  2008.  “ FT900:  U.S. International Trade in Goods and Services.”  Washington, D.C. April. 

Notes

1. Another mystery of international payments flows which contributes to the U.S. surplus on FDI payments is that U.S. holders of foreign FDI earn a rate of return that is more than twice the rate earned by foreign holders of FDI in the U.S.  One hypothesis is that foreign firms manipulate the transfer prices used to ship goods to their U.S. subsidiaries in order to minimize U.S. tax obligations.  

2. U.S. government payments (interest on foreign holdings of government securities) fell sharply in the first quarter, as U.S. interest rates dropped.

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U.S. current account deficit improves in 2007 despite rising oil prices

by Robert E. Scott with research assistance by Lauren Marra

The Bureau of Economic Analysis said last week that the U.S. current account deficit, the broadest measure of foreign trade, improved to $738.6 billion in 2007. The deficit fell from $811.5 billion in 2006, a decline of 9.0%. The current account deficit improved from 6.2% of GDP in 2006 to 5.3% for the year 2007. The decline in the current account deficit reflects the slowing U.S. economy and the cumulative effects of a lower dollar, which declined 22% between its peak in February 2002 and December 2007 and 6% in 2007 in real, inflation-adjusted terms. Although the current account deficit is likely to decline again in 2008 for the same reasons, further reductions in the U.S. structural deficits are unlikely unless China and other Asian countries allow the dollar to fall substantially against their currencies.

The cheaper dollar and strong global growth have stimulated U.S. exports, which have grown more than 14% per year since 2004 and increased 15% in 2007. At the same time, the U.S. economic slowdown and the falling dollar reduced the rate of growth of U.S. imports, which fell to 8% in 2007. The current account balance includes all goods, services, and investment flows between the United States and the rest of the world. Despite the improvement in the deficit, the United States still borrowed more than $2 billion every day in 2007 to finance its trade deficit.

The current account deficit also improved in the fourth quarter, falling from $709.8 billion (annualized) in the 3rd quarter to $691.7 billion in the fourth quarter. The deficit fell to 4.9% of GDP in the fourth quarter, the lowest level since the first quarter of 2004 (see chart). The U.S. trade deficit in petroleum products was responsible for more than one-half of the current account deficit in the fourth quarter. The United States must reduce reliance on imported, non-renewable energy sources in order to stabilize and reduce its current account deficits.

The current account improved in the fourth quarter despite a sharp increase in oil imports and the goods and services trade deficit. The decline in these accounts was more than offset by a sharp drop in income payments (profits) on foreign direct investment in the United States. This reflects both the slowdown in the U.S. economy and fallout from the U.S. financial crisis.

The U.S. trade deficit with Canada and Europe improved significantly in 2007, but it continued to grow with China and with most oil producing states. In the long run, a sustained reduction in the current account deficit will only be possible with a further, substantial drop in the average, real value of the dollar against currencies that have not yet been allowed to adjust significantly against the dollar. To date, the relative decline in the dollar has been limited largely to sharp drops against major currencies such as the euro and the Canadian dollar. Adjusted for inflation, the dollar is down 32% against a basket of major currencies, but has only declined 13% against the currencies of China and a group of other important trading partners (OITP). Orderly adjustment is unlikely unless China and other Asian countries allow the dollar to fall farther against their currencies.¹

Many economists now agree that large U.S. current account deficits are unsustainable in the long term. As the United States finds it more difficult to attract the capital needed to finance its current account deficits, the sharply declining dollar is creating an even harder landing for the domestic economy. Inflows of private foreign capital into the United States fell nearly two-thirds in the 2nd half of 2007. Foreign central banks increased official purchases of U.S. assets by over $100 billion in the fourth quarter in order to stem the dollar’s decline.

A substantial and controlled reduction in the dollar of perhaps 40% or more, relative to February 2002, 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. This implies an additional dollar fall of 10-15% against the major currencies, on average,2 and 30% against the OITP currencies. It would expand U.S. exports by making exports cheaper, and dampen import growth due to rising prices. China and other foreign governments have prevented this adjustment by intervening in foreign exchange markets to block the fall of the dollar. 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 deeper financial crisis and recession in the U.S. and world economies.

Notes
1. See Economic Snapshot, Moving Toward a Sustainable Dollar, for further details.
2. The dollar has already fallen more than 40% against some major currencies, such as the euro, but is only down 12% against the Japanese yen. If the yen is allowed to catch up to the euro, relative to the dollar, and if similar appreciation of OITP currencies occurs, this may obviate the need for further adjustments by other major currencies.

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U.S. trade balance improves for first time since 2001

by Robert E. Scott with research assistance from Lauren Marra

The U.S. Department of Commerce reported yesterday that the goods and services trade deficit fell to $711.6 billion or 5.1% of GDP in 2007, a decline of $46.9 billion since 2006. The trade deficit dropped by an unexpectedly large $4.4 billion in December due to a sharp drop in imports of autos and vehicle parts and consumer goods. The sharp drop in imports in December provides further evidence of a U.S. slowdown in the fourth quarter. Today’s report also indicated:

* The U.S. merchandise trade deficit, which includes only manufactured goods and commodities, declined $22.7 billion (or 2.7%) to $815.6 billion in 2007, while the services surplus increased to $104.0 billion, a $24.2 billion improvement (30.4%).

* The U.S. trade deficit with China rose $23.7 billion (or 10.2%) to $256.3 billion, offsetting improvements in the trade deficit with other countries such as Canada, Germany, the U.K. and other EU countries, Taiwan, Brazil, and Chile.

* The cost of U.S. petroleum imports also increased $27.9 billion (9.6%) in 2007; a small decrease (1.5%) in the volume of total energy related petroleum imports was more than offset by a $6.26 per barrel (10.8%) increase in the average unit cost of crude oil.

* The U.S. had a $53.5 billion global trade deficit in advanced technology products (ATP) in 2007, a $15.4 billion (40.6%) increase over 2006 levels. Trade with China can account for the entire U.S. ATP deficit in 2007 and most of the increase in the ATP deficit. The United States had a trade surplus in ATP products with the rest of the world of $14.2 billion in 2007. The United States had an ATP deficit with China of $67.7 billion in 2007, an increase of $12.6 billion over 2006.

While trade balances between the United States and many of its most important trading partners are improving, the trade deficit with China continues to grow, and the dollar value of oil imports continues to grow rapidly.

The U.S. goods and services trade deficit improved for the first time since 2001. The deficit fell to $711.6 billion (see Figure A below), or 5.1% of GDP in 2007, a sharp drop of 0.6 percentage points over the deficit in 2006. The improvement in the deficit was explained, in part, by continued rapid growth of U.S. exports, which increased a record $176.1 billion (12.2%) in 2007, as shown in the Figure A. A slowdown in import growth to 5.9% ($129.2 billion) also played a key role. The slowdown in import growth in 2007 reflects softening in consumer spending in the overall economy. Both the import slowdown and export growth were probably driven in part by the depreciation of the dollar in recent years.

The U.S. deficit in manufactured goods improved from $690 billion in 2006 to $679 billion in 2007, a decline of 1.6%. Manufactured imports are responsible for the bulk of the U.S. trade deficit. The manufacturing sector lost 3.3 million jobs between January 2001 and December 2007, including 200,000 jobs lost in 2007 alone. More than 32,000 U.S. manufacturing establishments closed between 1998 and 2005.

Trade deficits, manufacturing job losses, and plant closures are due, in large part, to overvaluation of the U.S. dollar. Much needed increases in the value of other currencies against the U.S. dollar since 2002 are largely responsible for the improvement in the U.S. trade balance in 2007. On a broad, inflation-adjusted, trade-weighted basis, a broad cross-section of currencies has gained 28% against the dollar since 2002, and 6.9% in 2007, as shown in Figure B. Most of that improvement has come against a group of major currencies, including the Euro and Canadian dollar, and the U.S. trade balance with those regions improved significantly in 2007. These currencies have gained 42.6% since 2002, and 7.9% in the past year alone.

In contrast, the currencies of “Other Important Trading Partners (OITP),” a group that includes China and a number of other East Asian nations that tightly manage the value of their currencies against the dollar, have gained only 12.5% in value since 2002 and 5.8% last year. As a result, the U.S. trade deficit with these countries continued to grow in 2007. (See: A Plunging Dollar? How Far and Relative to What?). Sustained improvements in the U.S. trade deficits will be unlikely unless the managed currencies are allowed to appreciate substantially (e.g., 30% to 40%).

Improvement in the U.S. trade deficit in 2007 was due to the combined effects of appreciation of the Euro and other currencies over the past five years, and the initial effects of a U.S. slowdown. The U.S. trade deficit in 2007 still exceeded 5.1% of GDP, an amount considered unsustainable by most economists. The deficit could start growing again once the current slowdown ends, unless governments in China and other OITP countries agree to substantially raise the value of their currencies. This is a good time for other countries to re-orient their currency policies and spur consumption growth at home. These developments would be good for both the United States and its trading partners and would lead to a more stable global economy.

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December 18, 2007

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

by Robert E. Scott

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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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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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.

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.

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