U.S. Current Account Deficit

By the end of 2005 the U.S. current account deficit (the trade deficit plus some other stuff - take a course in international economics) was running at an annual rate of almost $900 billion. This is about 7 percent of GDP, which is absolutely huge, and to many observers, terrifying.

There are two ways to think about what causes trade deficits. One way is to start from the basic national income accounting identity, which says that S-I=CA: national savings minus investment equals the current account balance. According to this interpretation, countries experience current account deficits when they save too little or invest too much. In the U.S. at present, the culprit is clear: in 2005 households spent more than they earned (household savings was negative!) for the first time since the Great Depression, and the government, which had been running budget surpluses (positive government savings) until 2001, now has budget deficits as far as the eye can see. This leaves business savings (retained profits) as the only source of savings in the U.S. economy, and it's not enough to finance all the investment that we want. According to standard economic theory, the shortfall of savings causes interest rates to rise, which attracts funds from abroad, which causes the dollar to appreciate, which makes our goods uncompetitive relative to foreign goods, which gives us a big whopping trade deficit.

This analysis appeals to the economic moralist in all of us. An economic moralist is one who believes that macroeconomic outcomes are the result of individual or national character flaws. In our case, we have a trade deficit because we're living beyond our means. As consumers, we care nought for the future, preferring to spend our children's inheritance on big houses and high livin'. As citizens, we insist on a government that showers us with goodies (mortgage interest deduction, Social Security, Medicare, war) but are unwilling to allow ourselves to be taxed to finance them. The solution is to tighten our belts: less extravagant expenditure, higher taxes, fewer government transfers to the middle class.

An alternative interpretation of the current account deficit starts from another basic accounting identity: sum(CA)=0. That is, national current account balances must sum to zero. This must be true because the world as a whole does not trade with other planets, so if one country has a trade surplus, another country somewhere on earth must have a corresponding trade deficit. Ben Bernanke proposed an explanation based on this perspective in a series of speeches last spring. He argued that the reason the U.S. has a current account deficit is that other countries save too much, not that we save too little. Because these countries (think China, Japan, India, the oil producing countries) save more than they invest, interest rates outside the U.S. fall, and savings sloshes into the U.S. This drives U.S. interest rates down and asset prices (stock market, housing market) up, causing U.S. households to save less while also driving up the value of the dollar, resulting in a big whopping trade deficit.

Bernanke's theory (known as the "saving glut" hypothesis) was greeted with a great deal of skepticism, because (a) it seemed to absolve the U.S. of responsibility for its own trade imbalance, which emphatically does not appeal to the economic moralists, and (b) Bernanke was offering a theory that downplayed any impact of budget deficits at a time when he was on the short list for the position of chair of the Federal Reserve. Nevertheless, Bernanke's theory has one big piece of empirical evidence that works in its favor: U.S. interest rates have been extraordinarily low during the last 10 years or so, as predicted by the savings glut theory, whereas the insufficient domestic savings hypothesis would predict that our interest rates would be relatively high. For this reason I think Bernanke's theory ought to be considered the leading candidate among explanations for the current account deficit.

I've been thinking for awhile now about why other countries have chosen such high rates of saving and what the implications are for the world economy. Here's a hypothesis that I'd like to explore. High savings rates around the world are the product of a development strategy pushed consistently over the last four or five decades by successive U.S. governments, the World Bank, and the International Monetary Fund, and supported by most academic economists. One element of the strategy is "export-led growth", the idea that the key to development is to gear your economy towards exporting manufactured goods to developed countries (in particular the U.S.). This is clearly the path followed by Japan during its high growth phase in the 1950s to 1980s, as well as Korea, China, and the rest of Asia.

Latin America historically has pursued a different set of policies which focused on supporting domestic consumption and building up domestic industries behind tariff barriers. These policies were strongly criticized by development agencies and economists beginning in the 1960s. Irresponsible macroeconomic policy decisions during the 1970s and 1980s, meanwhile, led many Latin American countries to pile up huge foreign debts; during the worldwide recession of the early 1980s most of these countries were unable to make payments on these debts. The ensuing debt crises gave the development agencies (led by the U.S.) an opening to force a change in development policy towards export-led growth. Countries were encouraged to liberalize trade and conduct macroeconomic policies to promote high savings rates, so that the resulting trade surpluses could be used to generate funds to make payments on the foreign debt.

Meanwhile, austerity is the officially sanctioned policy in Europe as well. The monetary union established in the 1990s was accompanied by a fiscal policy compact designed to prevent countries from running budget deficits. Tight monetary policy has kept interest rates relatively high and GDP growth relatively low. The trade account for Europe as a whole, by consequence, is roughly in balance.

World savings rates have gotten an additional boost in the last decade by two other events. First, the Asian financial crisis of 1997 induced the countries of that region to embark on a policy - blessed by the IMF and other agencies - of accumulating massive foreign exchange reserves to use in defense of their currency pegs. This required suppression of domestic demand and continued promotion of exports. Second, rising oil prices have transferred huge amounts of money to oil exporting countries, which have thus far invested that money in the U.S. and other developed countries rather than in their own economies.

The result is that everywhere you look around the globe you see countries that have consciously adopted high savings policies. In Europe these policies have resulted in a trade surplus of $2.5 billion in 2005 (a miniscule amount; essentially balanced trade). Japan has a trade surplus of $164 billion, China $158 billion, Latin American $30 billion, and so on (note I haven't mentioned Africa - Africa is too small economically as to make a big difference in world trade flows). The trade surpluses in these countries are the result of conscious policy choices. To the extent that the governments of these countries will alter macroeconomic policies to ensure the maintenance of large trade surpluses, the result has to be a large trade deficit in the remaining countries, in particular the U.S.

This world economic structure surely has its benefits. Countries like China have experienced phenomenal rates of growth and improvements in living standards. U.S. corporations get access to cheap labor by using the developing countries as export platforms. U.S. consumers get cheap manufactured goods in exchange for IOUs (all those US Treasury securities and other assets that foreigners seem to have a limitless capacity to hold). But the system has a dangerous weakness identical to that identified by John Maynard Keynes in his writings on the world economy from the 1920s to 1940s. Specifically, there is a deflationary bias which could spell trouble for the world economy in the future.

In the 1920s, the US was the major surplus country and the UK was the major deficit country. Keynes’ argument in a Tract on Monetary Reform (1923) and other writings was that in an environment of fixed exchange rates, the only cure for prolonged imbalances in the current account was for the surplus countries to allow inflation (thus allowing their real exchange rates to appreciate) and/or for the deficit countries to allow deflation (thus allowing their real exchange rate to depreciate). The surplus country – the U.S. – was unwilling to allow inflation beyond a certain level, and was under no pressure to adjust. The deficit country – the U.K. – on the other hand, would be forced to pursue deflationary policies in order to defend its currency peg because otherwise currency speculators would exchange pounds for gold and ultimately force Britain to abandon its pegged exchange rate. Because the U.S. was under no pressure to pursue inflationary policies and Britain had to pursue deflationary policies, the world economy as a whole experienced deflation, culminating in the Great Depression.

In the negotiations over the post World War II international monetary system (in which Keynes was Britain’s representative), Keynes pushed this analysis further, seeking to design a system in which deficit countries would be spared painful adjustment, and the deflationary bias would be removed from the world economy. The Bretton Woods system which came out of these negotiations incorporated some of Keynes’ suggestions. Specifically, Bretton Woods was a system under which all currencies were pegged to the dollar, but countries with large balance of payments deficits could periodically devalue their currencies rather than deflate.

Bretton Woods was abandoned officially in 1973 and since then the major economies have allowed their currencies to float. In recent years, however, the world economic system has begun to resemble more and more the Bretton Woods system as the newly industrializing countries in Latin America and Asia have fixed their currencies to the dollar (and fixed them, in the case of Asia, at an artificially low rate). Meanwhile during its slow growth period beginning in the 1990s Japan has actively intervened in currency markets in order to keep the yen from appreciating.

Consequently, we now have a system where all of the big surplus countries have currencies that are de facto pegged to the U.S. dollar. The world economy looks an awful lot like that of the 1920s, but with the U.S. playing the role of the U.K. as a deficit country, and Asia-Latin America playing the role of the U.S. as surplus country. The U.S. cannot devalue its currency relative to the currencies of Asia and Latin America without their consent. We are therefore pushed to pursue deflationary policies in order to deal with our trade imbalance – the belt-tightening approach favored by the economic moralists. But Keynes taught us that this route is fraught with danger. Serious belt-tightening in the U.S. could potentially cause a serious recession here and in the exporting countries.

The way out is a coordinated agreement to raise the savings rate in the U.S. while lowering savings or increasing investment expenditures in the rest of the world. This will not be easy, however, because it would mark a departure from the fundamental approach to developing countries that we have pursued since the 1960s. It would require backing off from export-led development in Asia and substantial restructuring of debt (or outright debt forgiveness) in Latin America. Personally I don’t think we have the stomach for that; I fear we’ll put off serious corrective action until we’re forced to do so by a severe worldwide recession.