Presentation to the Business and Community Leaders Luncheon, The Lannom Center, Dyersburg, Tenn. - April 10, 2001Budget deficits

William Poole

English

Research Papers in Economics

1
Does the United States Have a Current
Account Deficit Disorder?
Business and Community Leaders Luncheon
The Lannom Center
Dyersburg, Tennessee
April 10, 2001
and financial account. Second, and consequently,
an understanding of changes in the capital and
financial account requires an understanding of
the reasons for the large financial flows to the
United States in recent years. Third, I will explore
what might cause a reversal of financial inflows
into the United States. Fourth, I will examine
evidence from other countries that have run large
current account deficits to see how such evidence
might add to our understanding of the U.S. situ-
ation today.
Before proceeding, I want to emphasize that
the views I express here are mine and do not
necessarily reflect official positions of the Federal
Reserve System. This speech is a joint product
with Cletus C. Coughlin, vice president in the
Research Division of the Federal Reserve Bank
of St. Louis; I greatly appreciate his assistance.
However, I retain full responsibility for errors.
SOME BALANCE OF PAYMENTS
ACCOUNTING
Prior to developing my key points, I’ll discuss
a few concepts from balance of payments account-
ing to be sure we are all on the same wavelength.
A country’s balance of payments is a systematic
account of all the exchanges of value between
residents of that country and the rest of the world
during a given period of time. For my discussion
I will focus on two particular accounts within
the balance of payments—the current account
and the capital and financial account.
S
ince the beginning of 1998, the U.S.
current account balance has declined
sharply. In 2000, the current account
deficit reached 4.4 percent of U.S. gross
domestic product (GDP), which has caused much
concern about the sustainability of this large
deficit. Clearly, if this deficit is not sustainable,
questions arise as to how the United States’ cur-
rent account balance would return to levels that
could be maintained. One specific question con-
cerns the implications of a sudden reversal of
investor sentiment about the desirability of hold-
ing U.S. assets. Some commentators have raised
the specter of a financial crisis with predictions
of capital flight, sharp declines in the foreign
exchange value of the dollar, higher interest rates,
and numerous bankruptcies and defaults. Such
a scenario could produce consequences for the
U.S. economy similar to those experienced by a
number of countries in East Asia during the late
1990s.
My remarks focus on how to interpret recent
developments in the U.S. current account. I plan
to examine four related topics. First, I think some
of the analysis and commentary discussing the
U.S. current account is misinformed. Using some
terminology from balance of payments accounting,
which I will discuss later, many commentators
have expressed the mistaken view that the capital
and financial account “finances” the current
account. In fact, for the United States, changes in
the capital and financial account have been driv-
ing changes in the current account for many years.
That is, the current account “finances” the capitalThe U.S. current account summarizes all
transactions involving flows of goods, services,
income, and unilateral transfers that take place
between U.S. and foreign entities, which include
private individuals, businesses, and governments.
The current account balance is simply the differ-
ence between U.S. receipts from the rest of the
world and U.S. payments to the rest of the world
as a result of these transactions. If U.S. payments
exceed receipts, then the U.S. is said to be running
a current account deficit. During 2000, U.S. pay-
ments exceeded receipts by $435 billion.
U.S. receipts arise from exports of goods and
services, interest and dividends received by U.S.
owners of foreign stocks and bonds, the reinvested
earnings of the foreign affiliates of U.S. corpora-
tions, and gifts to the United States from foreign
residents and governments. Conversely, U.S. pay-
ments result from imports of goods and services,
interest and dividends received by foreign owners
of U.S. stocks and bonds, the reinvested earnings
of U.S. affiliates of foreign corporations, and gifts
from the United States to foreign residents and
governments.
This definition highlights a number of
important facts. First, the receipts and payments
encompass much more than the movement of
merchandise across national borders. Second,
the current account reflects the interaction of
numerous decisions by individuals, firms, and
governments both in the United States and abroad.
Third, when receipts exceed payments, the United
States, on net, is acquiring assets abroad. When
U.S. payments exceed receipts, foreigners, on
net, are acquiring assets in the United States.
When either U.S. residents acquire assets
abroad or foreign residents acquire assets in the
United States, the transactions are recorded in
the capital and financial account of the balance
of payments. A key accounting identity is that
the capital and financial account balance must
be exactly the opposite of the current account
balance for any given period of time. In other
words, a current account deficit must be matched
by a capital and financial account surplus and
vice versa. The balance of payments must balance!
There is, however, a more subtle point that is
crucial to my analysis. The accounting balance
measures, or accounts for, an economic equilib-
rium. The sum total of all purchases of U.S. dol-
lars equals the sum total of all sales of U.S. dollars.
Purchases and sales are simply the opposite sides
of the transactions in which dollars are traded
for goods, services, and assets. Markets reach
equilibrium through changes in prices of goods,
exchange rates, interest rates, and other variables
that determine the supplies and demands for
goods, services, and assets. The issue of the sus-
tainability of the U.S. current account deficit—
or its counterpart, the capital and financial
account surplus—is, then, the issue of the sus-
tainability of the combination of prices, interest
rates, exchange rates, and so forth that give rise
to the current account deficit.
INTERPRETING THE CURRENT
ACCOUNT
A common interpretation of the current
account is that an increasing current account
deficit is bad. One reason for such an interpreta-
tion is psychological—we tend to view deficits
as bad and surpluses as good. Thus, it is under-
standable that our initial instinct is to view an
increasing deficit as bad. The possible error of
this view is obvious: If the current account deficit
is bad, so also is the capital and financial account
surplus.
Concerns about current account deficits,
however, are not strictly psychological. Several
economic arguments suggest that an increasing
current account deficit can be bad. A common
argument begins by noting that to finance a current
account deficit, the United States must borrow
from abroad. Many perceive the accumulation of
indebtedness to foreigners as a problem. In fact,
the cumulative effect of U.S. current account
deficits has made the net international asset posi-
tion of the United States the largest such negative
position in the world.
Some worry that if foreign nations suddenly
attempted to liquidate their assets in the United
States, they might precipitate a financial crisis
INTERNATIONAL TRADE AND FINANCE
2here. Such actions, however, are unlikely because
foreign investors would be driving down their
own wealth. Others are concerned about the sus-
tainability of substantial levels of borrowing from
abroad. Markets, however, will provide clear
signals about sustainability by means of higher
interest rates, lower exchange rates, and reduced
credit availability. At this point, there are no
signals indicating such a problem.
Related to the issue of sustainability is the
fact that the debt must be repaid. If most of the
foreign financing is for capital goods, such as fac-
tories and equipment, that will allow for increased
U.S. production in the future, then foreign debt
is not necessarily a problem. If the foreign financ-
ing is for consumption goods, however, it may
be undesirable because future generations will
bear the burden of the debt. Accordingly, there
are some reasonable arguments to support the
view that an increasing current account deficit
can be bad.
AN ALTERNATIVE VIEW
There is another view, based on analyzing
current account changes from a different perspec-
tive, that suggests in the present circumstances
that the U.S. current account deficit is far from
bad. This view starts from the position that capital
and financial account transactions induce changes
in the current account. To emphasize this alter-
native perspective, I’ll now focus on the capital
and financial account surplus. However, keep in
mind that whenever I refer to the “capital and
financial account surplus” you can substitute
“current account deficit” because their dollar
values are identical by the rules of accounting.
To illustrate: Assume that a foreign firm
decides to build or expand a production facility
in the United States. Two recent examples related
to Dyersburg are Quebecor World’s purchase and
installation of a specialized printing press for high-
quality magazines and catalogs and Northdown
Industries’ purchase of a building that will be
converted to manufacture cat litter. In each of
these cases, foreign residents are increasing their
claims on assets in the United States. In terms of
balance of payments accounting, these transac-
tions would tend to increase the U.S. capital
and financial account surplus, which, in turn,
means that the U.S. current account deficit would
increase.
An important question is what would induce
foreign residents to increase their ownership of
assets in the United States. It is reasonable to think
that these investors would be looking at a rate of
return, adjusted for risk, that is high enough rela-
tive to investing in other locations that makes the
United States attractive. It is clear that in recent
years the United States has been an attractive
investment location. Low and stable inflation
rates, rapid productivity growth, and flexible
labor markets are a few of the characteristics that
have made the United States a rapidly growing
economy and, therefore, an appealing investment
location.
The preceding discussion suggests that we
can gain a deeper insight into changes in the U.S.
current account by examining saving and invest-
ment behavior both here and abroad. Our total
investment spending as a country must be
financed by a combination of domestic and for-
eign saving. Domestic saving consists of private
saving and government saving. Until recently,
government “saving” was actually dissaving
because government spending exceeded tax rev-
enue. Meanwhile, foreign saving directed to the
United States is reflected in the magnitude of
our current account deficit.
During the 1980s, the United States experi-
enced rising deficits in both its current account
and government budget balances. Figure 1 shows
both of these balances relative to GDP. It shows
that these twin deficits moved in tandem in some
years. Some economic analysts argued that the
federal budget deficit was driving the current
account. But that argument clearly breaks down
during the 1990s. Figure 2 shows that these bal-
ances have tended to move in opposite directions
since 1993. Moreover, based on research by
Patricia Pollard, an economist at the Federal
Reserve Bank of St. Louis, it is clear that the twin
deficit phenomenon is not a historical regularity
Does the United States Have a Current Account Deficit Disorder?
3INTERNATIONAL TRADE AND FINANCE
4
Figure 1
U.S. Current Account and Government Budget Balances: 1980s (percent of GDP)
NOTE: Quarterly data. Labels indicate first quarter of each year.
Figure 2
Recent U.S. Current Account and Government Budget Balances (percent of GDP)
NOTE: Quarterly data. Labels indicate first quarter of each year.in many advanced countries. She found that the
changes in these two accounts are as likely to be
moving in opposite directions as the same direc-
tion.
Now let’s turn our attention to saving, both
private and government, and investment. The
current account deficit increases if either saving
increases less than investment increases or if
saving decreases more than investment decreases.
Generally speaking, saving and investment are
both desirable. Saving frees up resources that can
be used for investment either here or abroad. Gross
private domestic investment, which includes the
purchases of durable goods, such as business
equipment, is essential for expanding both pro-
ductive capacity and productivity. Such expan-
sion permits more output to be produced in the
future.
Figure 3 shows that the rising current account
deficit in recent years has been accompanied by
a rising rate of U.S. domestic investment. Between
1993 and 1997, the current account generally
stayed in the range of 1.0 to 1.5 percent of GDP,
as a rising national saving rate, caused primarily
by declining federal budget deficits, kept pace
with rising domestic investment. In 1998, this
pattern changed: Investment continued to rise,
but saving stagnated and then fell slightly.
Figure 4 illustrates another fact that bolsters
the contention that an increasing current account
deficit is evidence of a strong and healthy econ-
omy. Since 1995, the foreign exchange value of
the dollar has trended upward, as shown by the
solid line in the chart. If the current account were
driving the capital account, then a weakening
dollar would likely result. This reasoning is
straightforward. A current account deficit means
that the quantity of dollars demanded by foreign
citizens to buy U.S. goods is less than the quantity
of dollars supplied by U.S. citizens to buy foreign
goods. We might expect that this excess supply
of dollars would put downward pressure on the
foreign exchange value of the dollar. Alternatively,
if the capital and financial account is driving the
Does the United States Have a Current Account Deficit Disorder?
5
Figure 3
U.S. Current Account Balance, Saving and Investment (percent of GDP)
NOTE: Quarterly data. Labels indicate first quarter of each year.current account, then a strengthening dollar is
possible. The reason is that the quantity of dollars
demanded to make investments in the United
States relative to the quantity of dollars supplied
to make investments abroad can more than offset
the excess supply of dollars for current account
transactions. Given the attractiveness of U.S.
assets, the dollar strengthens as international
investors buy U.S. assets.
In fact, the relationship between investment
and the current account for the United States
appears to be a broad empirical regularity. Across
developed countries that have experienced large
current deficits, Pollard finds that the current
account deficit systematically tends to increase
as investment rises and tends to shrink as invest-
ment declines.
A return to smaller current account deficits
requires a rise in saving and/or a fall in invest-
ment as a share of GDP. Both of these changes
took place during the late 1980s in the United
States. Exactly when and how, or even whether,
the present U.S. current account will shrink
remains to be seen.
My investment discussion makes clear
another critically important point. It is misleading
to refer to the United States as a “debtor” nation.
A significant share of international investment
in the United States is equity investment. Inter-
national investors who purchased shares of
“dot-com” companies do not have to be repaid.
Obviously, both domestic and international
investors buy assets with the expectation of ade-
quate returns, but may be disappointed after the
fact. The important question is not whether
investments made in 1999 will have to be repaid,
but whether the U.S. investment climate this
year and in the future will remain attractive to
all investors, both domestic and international.
To date, my conclusion continues to be that
the U.S. investment climate remains robust, per-
haps surprisingly so given the extent of the stock
market decline. Weaker near-term prospects seem
not to have dimmed the long-run outlook of
INTERNATIONAL TRADE AND FINANCE
6
Figure 4
U.S. Current Account Balance and Real Trade Weighted Exchange Rate (percent of GDP)
NOTE: Quarterly data. Labels indicate first quarter of each year.robust growth. Moreover, the dollar remains
strong on the foreign exchange markets. It does
not appear to me that the U.S. capital and finan-
cial account surplus is about to decline sharply.
And that is good news rather than bad news.
CONCLUDING COMMENTS
What is clear from my discussion is that the
capital and financial account drives the current
account. The large U.S. current account deficit
in recent years is the result of a large capital and
financial account surplus. These annual surpluses
reflect a healthy and growing U.S. economy that
has provided an excellent environment for invest-
ment. A similar comment applies more generally
to developed economies that have experienced
large current account deficits. An examination
of the evidence shows that increased gross pri-
vate domestic investment is systematically asso-
ciated with increasing current account deficits. If
longer-run U.S. economic growth declines, then
it is reasonable to expect the U.S. current
account deficit to shrink. However, as long as
the fundamentals of the U.S. economy do not
deteriorate rapidly, the prospects of a financial
crisis are very slim. Thus, my answer to the
question posed in the title of this presentation is
that the United States certainly does not have a
current account deficit disorder.
With respect to my own responsibilities, one
fundamental that I see as crucial for a healthy
U.S. economy is the control of inflation. An
increasing inflation rate complicates the decisions
of all economic actors and raises doubts about
the real returns on U.S. assets—one of the conse-
quences being that the attractiveness of acquiring
and holding U.S. assets relative to foreign assets
is reduced. Such a development would cause the
capital and financial account surplus to decrease
and, thus, the current account deficit would also
decrease. Even though some might view such a
change in the current account as desirable, the
key to assessing the desirability of such a change
hinges on the reason for the change. Rising infla-
tion is not a desirable event condition for the U.S.
economy.
I hope the perspective I’ve offered on the U.S.
current account deficit is useful to you. If nothing
else, remember that it makes no sense to be con-
cerned about that deficit unless you are also con-
cerned about the capital account surplus, because
one is a necessary implication of the other. A lit-
tle accounting can take us far in the direction of
focusing on the real issues and not just on that
scary word “deficit”!
Does the United States Have a Current Account Deficit Disorder?
7

Does the United States have a current account deficit disorder?

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Does the United States have a current account deficit disorder?

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