The U.S. current account deficit - Whose problem is it?

International  Economics II 0309414 /  1

Contents

1.  Introduction  2

2.  The nature of a country’s current account  2

3.  The deficit in the United States  2

4.  A general view on capital inflows  3

5.  Effects on the US economy  3

6.  Effects on economies outside the US  4

7  . Landing scenarios’  6

8.  Conclusion  7

  Bibliography and List of References  8

Appendix 9   

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International Economics II 0309414 / 1

1. Introduction

Since the beginning of the 1980s in almost every year the United States (US or USA) current account has shown a deficit. After a brief overview about the components of a country’s current account this work provides an analysis of the US deficit’s effects on the US economy. Furthermore it investigates effects on economies outside the US in order to verify whose problem it is.

2. The nature of a country’s current account

The current account is a calculation of a country’s transactions with other countries. It encompasses the merchandise trade that consists of imports and exports of goods. Furthermore services rendered with foreign organisations e.g. travel and transportation are included. The third part is investment incomes that are paid to a foreign country or vice versa e.g. dividends. Finally unilateral transfers that encompass transactions that are not for goods or services belong to the current account e.g. charity transactions (Yarbrough and Yarbrough 2000 p. 522 - 524).

3. The deficit in the United States

Generally a current account deficit can mean that the respective country “is living beyond its means” because public and private savings are less than consumptions and investments (Mann 2002 p. 131). The large US federal budget deficit would be an argument that the country lives beyond its means. But on the other hand it can mean that the “country is an oasis of prosperity” (Mann 2002 p. 131). Per definition a current account deficit also is accompanied by a net capital inflow. Thus a deficit of the current account can also mean that the country is able to attract foreign investors. Cooper (2001 p. 218) states that the US current account deficit is so large because the US economy is strong. It makes up a quarter of the world economy and fundamentals and performance are better than others. In order to understand the impacts of the US current account deficit it is advisable to have a closer on the account’s components and identify what position causes the deficit. Figure 1 demonstrates that the

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origin of the deficit is the merchandise trade balance. In the year 2001 the imports exceeded the exports by almost US $ billion 450.

Whether a country exhibits a surplus or a deficit in its current account is related to its savings. (Griswold in Rugman and Boyd 2003 p. 189). Public savings in the US is negative so the country exhibits also a fiscal deficit. An occurrence of a current account deficit and a fiscal deficit is called “twin deficits” because “they are derived from similar policy fundamentals” (Mann 2003 p. 135). The US current account is also strongly related to the development of the US dollar. In the past 20 -25 years the dollar increased with the current account deficit and vice versa. Figure 2 provides an illustration of the dollar value over the time. As the savings gap in the US enhances the current account deficit it also causes a capital inflow in the US. The mechanism that causes capital inflows due to a low private and public savings is as follows. In the case of decreasing savings on the capital market and ceteris paribus constant domestic investments the interest rate will increase (see Figure 3). A higher interest rate attracts foreign investor to transfer their investment to the respective country. Furthermore the investors of this capital have claims regarding the future outputs of the country. Griswold (in Rugman and Boyd 2003 p. 200 - 201) calls this phenomenon a “stake in America’s prosperity”.

4. A general view on capital inflows

Figure 4 shows that without capital mobility the m arginal productivity of capital in the US is higher than in the other country (C). Allowing mobility of capital there will be an inflow to the US (C*). As the national Gross domestic product (GDP) can be expressed as a multiplication of the marginal productivity and the capital stock, the capital inflow would lead to an increase of the US-GDP and a decrease of the other country’s GDP.

5. Effects on the US economy

The ownership structure of assets changed in the US. The US net investment position turned into a negative one in 1989 when direct investment is valued by its market value. That means that foreign investors own more US assets than Americans own foreign assets. This gap has

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been about $ 2 trillion in 2003 (Griswold in Rugman and Boyd 2003 p. 199). At the end of 2001 $ 4 trillion of the $ 9.2 trillion foreign assets where equity, such as direct and portfolio investments (Griswold in Rugman and Boyd 2003 p. 199). This means that foreigners have an important direct influence of companies in the US and also the US economy. Many American people complained when a Japanese investor bought the Empire State Building. But this phenomenon is a result of capital inflow due to a negative current account. Thus it also results from the US economy consuming more than they are producing.

If $ 4 trillion capital inflow was invested in equity hence $ 5.2 trillion would be invested in debts. American private households but also the US government (by causing rapidly increasing fiscal deficits) are making debts in order t o finance their extensive consumption. Especially since 2002 capital inflows are increasingly debts. And accumulating debts leads to the obligation to pay more and more interest. This fact may mean that the next generations will inherit the obligations caused by this generation in order to guarantee their extensive consumption. But comparing the return on investments foreigners receive with the extent of the US economy this figure is still comparatively low. (Griswold in Rugman and Boyd 2003 p. 200) Therefore the ability of the US economy to pay the return on investments should be secure even if the US current account deficit and the connected capital inflow are sustainable.

6. Effects on economies outside the US

In this chapter the effects on other economies than the US economy are analysed, especially those who extremely depend on their export. These economies are marked by a comparatively high proportion of net export to the GDP. Even if there is evidence that the US current account deficit can be sustainable global investors will not increase their stake in the US economy by increasing their share in the US portfolio of assets forever (Mann 2002 p. 149). Global investors’ willingness to increase their share of US assets will stop at an uncertain point of time. If global investors buy less US assets than they formerly used to do, also the demand for US dollars will decline. On the foreign exchange market there will be also a depreciation of the US dollar. The phenomenon of overshooting exchange rates might enhance the effects on this scenario. Overshooting exchange rates occur when the exchange rate of a currency responds to alterations of variables more in the medium run than in the long run (Yarbrough and Yarbrough 2000 p. 810). The example in the appendix (Figure 5)

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