How long can we service our growing international indebtedness without causing economic disruption? This explanation of the current-account adjustment process provides fundamental knowledge that will enable the reader to form opinions about the state of affairs and to estimate the probabilities of possible outcomes.Balance of payments ; Balance of trade

Owen F. Humpage

English

Research Papers in Economics

In 1987, after six straight years of large
current-account deficits, the United
States became a net debtor country. Our
deficits have since persisted and our
debts have grown—today we owe more
than any other country—but the dire
consequences predicted by some analysts
have not materialized. Old concerns are
now reemerging as Asian and Russian
financial crises push the U.S. current-
account deficit to new record levels. It
reached $220 billion (annual rate) over
the first three quarters of 1998, raising
our debts to more than 17 percent of
GDP. How long can we continue to
service our growing international indebt-
edness without a sharp hike in U.S. inter-
est rates, a rapid depreciation of the dol-
lar, or some other economic disruption?
No economist can answer precisely. In-
stead, this Economic Commentary pro-
vides a basic explanation of the current-
account adjustment process. It offers
some fundamentals that will enable the
reader to form opinions about the state of
affairs and to estimate, albeit subjective-
ly, the probabilities of possible outcomes. 
n n   Current Accounts 
and Capital Flows
The U.S. current account records ex-
ports and imports of goods and services,
unilateral transfers (that is, gifts), U.S.
earnings on investments abroad, and
income payments to foreigners from
their U.S. assets.1  All of these items rep-
resent claims on current economic re-
sources, in contrast to the components of
the capital account (discussed below),
which represent claims on future output.
Analysts often refer to the current ac-
count as a measure of international trade,
although it includes other components.
Trade items are by far the largest cate-
gory within the current account, and
changes in our trade position seem to
dominate its movements (see figure 1).
The U.S. trade balance has been in
deficit almost continuously since the
early 1970s, despite a surplus in serv-
ices. This deficit narrowed somewhat in
the late 1980s, but has expanded again
since 1991 because of relatively strong
U.S. economic growth and the dollar’s
real (inflation-adjusted) appreciation. In
addition to the trade deficit, a growing
negative balance on investment income
since late 1996 has contributed to the
widening of the current-account deficit. 
The deficit’s persistence indicates that
the United States has not exported goods
and services of sufficient value to pay for
its imports. To settle our balance, we
have given foreigners financial claims
against our future production and have
reduced our claims against their future
output. This process, through which for-
eigners acquire such things as stocks,
bonds, and bank accounts that U.S. resi-
dents previously held, creates an inflow
of foreign capital, or, more precisely, of
foreign savings. Demonstrating the most
basic fact of economic life—that one
never gets something for nothing—an
equivalence always exists between any
current-account deficit or surplus and a
capital inflow or outflow (see table 1).2
In the previous paragraph, I described
our capital flows as responsive to devel-
opments in the current account. The U.S.
imported a surfeit of foreign goods, and
this caused an inflow of foreign capital.
The process can—and often does—
work the other way around, with capital
October 15, 1998
Federal Reserve Bank of Cleveland
Is the Current-Account Deficit Sustainable?
by Owen F. Humpage
The U.S. current-account deficit for
1998 will break all records, adding
still more to our international in-
debtedness. Our persistent shortfalls
imply neither profligacy nor an un-
stable economic situation. On the
contrary, foreign borrowing has
enhanced our economic well-being.
As our debt burdens mount, how-
ever, so does the potential for an
abrupt market correction.
ISSN 0428-1276flows initiating changes in the current
account. For example, if foreigners want
to purchase U.S. financial instruments
exceeding the amount of foreign finan-
cial obligations that Americans want to
hold, they must pay for the excess with
shipments of foreign goods and services.
As in the earlier example, an inflow of
foreign capital to the United States is
associated with a U.S. trade deficit. 
Billions of individuals make these inde-
pendent decisions about exporting, im-
porting, and investing in foreign finan-
cial instruments. As conceived, their
various transactions rarely, if ever, bal-
ance; but as executed and recorded in
our international accounts, they will al-
ways exactly net out. Exchange- and
interest-rate changes ensure their equiva-
lence. The current financial situation is a
case in point. Since 1996, international
investors have moved substantial funds
into U.S. financial securities. To do so,
they first acquired dollars, thereby en-
couraging the dollar’s 15-percent appre-
ciation in foreign exchange markets.3
This appreciation, however, fostered a
deterioration in our current-account def-
icit from $129 billion in 1995 to $220
billion in the first three quarters of 1998.
It also may have blunted the desire for
U.S. financial assets by raising their for-
eign currency prices. In addition, foreign
acquisitions of U.S. financial assets tend
to lower their yields compared to what
they otherwise would have been. Declin-
ing yields trim desired capital inflows
and discourage domestic saving. These
exchange- and interest-rate adjustments
continue until the actual trade deficit and
foreign capital inflows exactly match. In
my example (and in all other cases)
exchange- and interest-rate changes do
not eliminate a trade imbalance. These
adjustments continue only until the trade
deficit (or surplus) and capital-account
inflow (or outflow) equilibrate.4
n n    Perpetual Debt 
As recent U.S. experience illustrates,
countries with persistent current-account
deficits eventually become debtors (see
figure 2).5  The mere existence of these
debts indicates neither profligacy nor an
unstable economic situation. As long as
creditors judge us capable of servicing
our debts—paying interest and retiring
principle—on a timely basis, they will
continue to lend. Under such circum-
stances, the United States could maintain
its debtor status forever.
Since our capacity to service our obliga-
tions depends on our ability to produce,
analysts often gauge our creditworthi-
ness by the ratio of international indebt-
edness to GDP. The higher that ratio, the
greater the likelihood of debt-servicing
problems; at some upper bound, interna-
tional investors will refuse to lend to the
United States.
Although our international debts have
mounted rapidly since 1986, they
equaled only about 16 percent of GDP in
1997 and are unlikely to top 19 percent
in 1998. Economists simply do not know
how high the ratio can rise before for-
eign investors associate significant de-
fault risk with it; however, Canada and
Australia have carried debt burdens
roughly three and five times larger than
ours for many years, apparently without
dire economic consequences. In 1996,
for example, Australia’s international
indebtedness amounted to nearly 60
percent of its GDP, and Canada’s ap-
proached 45 percent. There is no eco-
nomic argument to preclude ours from
exceeding 100 percent. 
If U.S. indebtedness keeps rising relative
to GDP, however, international investors
will eventually become skittish about
holding additional U.S. debts. Then, to
entice them into purchasing additional
financial claims, the return on those secu-
rities must rise enough to provide a pre-
mium against a growing risk of default.
This would involve a depreciation of the
dollar relative to its long-term equilib-
rium, a rise in U.S. interest rates relative
to foreign ones, or some combination of
both. The greater the debt-to-GDP ratio,
the larger the risk premium is likely to
become. Besides compensating foreign
investors for a higher probability of
default, these exchange- and interest-rate
adjustments would tend to discourage
further expansion of the current-account
deficit. Whether the adjustments are
orderly or abrupt depends on how
quickly foreign attitudes about holding
our debt might change.
During 1996 and 1997, appreciation in
the effective dollar exchange rate
accompanied a sharp expansion of the
U.S. current-account deficit. As noted
before, this situation suggests that capi-
tal inflows were driving the trade deficit
and seems inconsistent with the view
that international investors are uneasy
about holding dollar assets. The chances
of an abrupt financial adjustment to our
widening deficits and debt are currently
small, but they are growing. 
n n    Debt Dynamics
Even if our trade account were to bal-
ance permanently, our overall debt-to-
GDP ratio could keep growing if the
interest costs of servicing our existing
liabilities to foreigners (which affects the
ratio’s numerator) exceeded our rate of
economic growth (which determines its
denominator). Our liabilities to foreign-
ers, of course, equal their assets in the
United States. One would expect the rate
of return on these assets to approximate
our growth rate over the long term, mak-
ing this concern seem rather inconse-
quential for the debt-to-GDP ratio.
The prospect, however, illustrates an
important problem of persistent trade
deficits and a rising debt burden. If, at
some point, foreign investors demand a
risk premium that pushes the interest cost
of our foreign liabilities above the econ-
omy’s growth rate, maintaining solvency
could require us to run a trade surplus.
Events in many emerging-market
economies have shown that shifting
rapidly from a large trade deficit to a
trade surplus can force some rather
unpleasant outcomes: reduction in
domestic consumption, investment, and
government spending, along with a rapid
real depreciation of the dollar to spur
exports. As the next section suggests,
these adjustments must alter the relation-
ship between gross domestic savings and
gross domestic investment to shift the
trade balance.
1991 1998 Change
Current account –4 –220 –216
Capital flows 52 226 174
Official reserves 23 –66 –89
Other U.S. 
government 3 –1 –4
Direct investment –9 –32 –23
Securities 24 251 227
Other nonbank 8 48 40
Other bank 3 27 24
(Discrepancy) –47 –7 40
SOURCE: U.S. Department of Commerce,
Bureau of Economic Analysis.
TABLE 1
U.S. BALANCE 
OF PAYMENTS
(Billions of dollars)n n    Savings, Investment, and the
Current Account
As our GDP accounts indicate, the value
of a nation’s output must exactly equal
that of its income and must exactly
equal the combined value of its con-
sumption, investment, government
spending, and net exports. A country
that incurs a current-account deficit is
absorbing (through private consump-
tion, investment and government spend-
ing) more of the world’s output than it 
is producing. Such a country’s spending
necessarily exceeds its income. Imports
of goods and services make up the dif-
ference between that country’s absorp-
tion of goods and services and its pro-
duction of them, while inflows of
foreign capital (savings) fill the gap
between its domestic spending and its
income. As noted earlier, changes in
interest rates and exchange rates ensure
that these items always equate.
While these relationships are tautologi-
cal, the manner in which the components
add together can sometimes provide an
important clue about the sustainability of
the current-account deficit. If, for exam-
ple, an increase in net domestic invest-
ment accompanies the current-account
deficit, then foreign savings are financ-
ing an expansion of the domestic capital
stock and will promote a higher level of
output per capita. In this case, servicing
and eventually retiring foreign debt need
not require a reduction in future stan-
dards of living. Higher output supports
higher levels of consumption and sav-
ings, the second of which can go to-
wards servicing international debts. It
matters little that the debt-to-GDP ratio
may initially be very high, since an auto-
matic process exists for its reduction.
This scenario, which many development
economists see as ideal for emerging
markets, makes default unlikely.6
If, on the other hand, a decline in national
savings accompanies an increase in the
current-account deficit, then the inflow
of foreign savings is financing higher
levels of domestic consumption and gov-
ernment spending than would be reached
in the absence of trade. To service inter-
national debt, citizens of the deficit coun-
try must eventually reduce their con-
sumption below predeficit levels. In such
a case, the ratio of debt to GDP becomes
a better barometer of the possibility of
default. This unfortunate scenario, which
is often the outcome in developing econ-
omies, encourages default.
Since 1993, capital inflows associated
with expanding U.S. current-account
deficits have been accompanied by an
even bigger increase in domestic savings,
both public and private (see figure 3). 
Together they have financed an enor-
mous expansion of domestic investment.
This situation reduces the risk that serv-
icing our widening debts will impose an
exorbitant burden on future U.S. stan-
dards of living; it thereby decreases the
likelihood that foreign creditors will
impose a risk premium on our future
borrowing. 
n n    Big Country, Small Country 
My analysis so far has considered the
sustainability of mounting U.S. interna-
tional indebtedness from the perspective
of our ability to service our obligations
in a timely way. It has, therefore, fo-
cused on our debt-to-GDP ratio. For a
small country, that perspective would
suffice to explore the economic and
financial aspects of debt; for a large
county, like the United States, it provides
an incomplete picture. U.S. liabilities
equal slightly more than one-third of the
assets of the major developed countries.7
Since 1989, this ratio has fluctuated but
has not changed much on balance. If our
international indebtedness should rise
relative to the world’s total financial
assets—increasing the worldwide
demand for credit faster than the sup-
ply—global interest rates would
undoubtedly rise. 
In that case, the higher interest costs
associated with our outstanding obliga-
tions might push our debt-to-GDP ratio
upward, even if the noninterest part of
the debt remained stable as a fraction 
of GDP. The debt dynamics could again
become precarious, eventually increas-
ing the chances of a substantial risk pre-
mium. For a country the size of the
United States, the sustainability of a
current-account deficit depends on the
debtor’s capacity to service its debts and
on the world’s ability to finance them.
n n    Debt and Welfare 
The U.S. current-account deficit and
international indebtedness are likely to
rise sharply over the next year or so.
This will undoubtedly alarm many
observers, some of whom may clamor
for a policy response. Pundits and poli-
cymakers should remember, however,
that our international indebtedness is a
market outcome, reflecting in the aggre-
gate the choices made by millions of
FIGURE 1 CURRENT-ACCOUNT
BALANCE AND TRADE
BALANCE
FIGURE 2 INTERNATIONAL
INVESTMENT POSITION
FIGURE 3 DOMESTIC INVESTMENT
AND SAVINGS AND
CURRENT-ACCOUNT
DEFICIT
a. Through 1998:IIIQ.
SOURCE: U.S. Department of Commerce,
Bureau of Economic Analysis and Bureau of
the Census.
SOURCE: U.S. Department of Commerce,
Bureau of Economic Analysis.
a. Through 1998:IIIQ.
SOURCE: U.S. Department of Commerce,
Bureau of Economic Analysis.individuals throughout the world. It
involves a sequence of transactions
whereby debtors receive additional
resources today and creditors increase
their opportunities for future consump-
tion. The interest rates and exchange
rates underlying these transactions were
not established by fiat; they were deter-
mined by the market. This is not to say
that the potential for an abrupt market
correction—a sharp depreciation of the
dollar or a rapid rise in U.S. interest
rates—will not increase with our indebt-
edness. Instead, it emphasizes that our
indebtedness has enhanced our welfare. 
n n    Footnotes
1.  The $220 billion (annual rate) current-
account deficit in the first three quarters of
1998 resulted from a $166 billion deficit in
goods and services trade, a $39 billion debit
associated with unilateral transfers to foreign-
ers, and a $15 billion debit from net interest
and dividend payments to foreigners. 
2. As table 1 indicates, measurement errors
create an unfortunate discrepancy between
these accounts. 
3. The dollar’s appreciation is based on a
trade-weighted average of the exchange rates
of our top 15 trading partners. See Federal
Reserve Bank of Cleveland, Economic Trends
(August 1998), p. 19. Economic Trends also
provides frequent updates. 
4. When the current account expands, the
dollar can move in either direction. As
shown in the example used here, when an
inflow of foreign capital initiates the adjust-
ment to a higher current-account deficit, the
dollar appreciates. When an increase in im-
ports produces a higher current-account
deficit, the dollar depreciates. See Owen F.
Humpage, “A Hitchhiker’s Guide to Under-
standing Exchange Rates,” Federal Reserve
Bank of Cleveland, Economic Commentary
(January 1, 1998). 
5. Figure 2 shows the difference between the
stock of U.S. holdings of foreign assets and
the stock of U.S. liabilities to foreigners, a
capital balance. The title of figure 2 follows
the official designation for this series, which
erroneously suggests flow (or change in)
investments each year. See U.S. Department
of Commerce, Survey of Current Business,
vol. 78, no. 10 (October 1998), p. D57. 
6. Often, however, capital inflows to devel-
oping countries augment domestic savings
but are channeled into unproductive invest-
ment projects. 
7.  These figures are based on a comparison
of U.S. international liabilities with the total
international assets of Australia, Austria,
Canada, Finland, France, Germany, Italy,
Japan, Netherlands, Spain, Sweden, Switzer-
land, and the United Kingdom. The data are
from the International Monetary Fund, Inter-
national Financial Statistics.
Owen F. Humpage is an economic advisor at
the Federal Reserve Bank of Cleveland. 
The views stated herein are those of the
author and not necessarily those of the Fed-
eral Reserve Bank of Cleveland or the Board
of Governors of the Federal Reserve System.
Economic Commentary is available elec-
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Is the current-account deficit sustainable?

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Is the current-account deficit sustainable?

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