Economics Update (July-September 1998)
Economics Update (July-September 1998)
The U.S. Current Account Deficit:
Is There Trouble Ahead?
hile few economists foresee tough economic times on the horizon for the United States, the recent growth in the U.S. current account deficit has given rise to some concerns. But should this increase be a cause for worry? Joseph A. Whitt Jr., an economist at the Federal Reserve Bank of Atlanta, recently offered a perspective on the rising deficit in a presentation at the Bank.
The Current Account
The current account is a measure of the difference between a country's income and current spending, leaving aside balance-sheet transactions such as borrowing, lending, and purchasing or selling of assets to foreigners. A current account deficit means that spending exceeds income; a large deficit is often interpreted as a warning sign of financial difficulty ahead. In recent years, both Mexico and Thailand had large current account deficits just before they were hit by financial crises that led to large exchange rate devaluations, sharp increases in inflation and severe recessions.
The United States has experienced current account deficits in every year since 1982 (see Chart 1). In the mid-1980s, the size of the current account deficit and the associated balance of trade deficit became both a political and a policy issue. After peaking at $168 billion in 1987, however, the current account deficit shrank substantially and ceased to be an issue for most.
Federal Government Budget and Current Account Deficit
Note: During 1990-92, the current account deficit was distorted when various foreign governments repaid large amounts of money to the United States to offset costs associated with the Gulf War.
Source: Haver Analytics
The U.S. Current Account and Selected Components: 1997
Source: Haver Analytics
Now the deficit is growing again. In fact, the final data for 1997 show a current account deficit of $167 billion. Measured as a percentage of gross domestic product (GDP), last year's current account deficit was 2.1 percent, well below the 3.6 percent deficit in the peak year of 1987. Many forecasts, however, predict the deficit will widen sharply in 1998 and 1999 — perhaps to $300 billion, nearly as large a percentage of GDP as the 1987 deficit.
Examining its major components helps provide an accurate picture of what is happening in the current account (see Chart 2). The largest component of the U.S. current account is the trade deficit, which was nearly $200 billion last year. Partially offsetting the trade deficit was a surplus in tourism and business services ($81 billion) that has been fed, in part, by the influx of tourists to the United States in the past several years.
Another component of the current account is net investment income, which represents income that U.S. residents receive from their investments abroad (dividends, interest and profit remittances) minus the income that foreigners receive on their investments in the United States. In 1997 net investment income was negative (-$14 billion) for the first time in decades as U.S. residents, corporations and the government paid out more to foreigners under this category than foreigners paid to the United States.
What is generating the widening current account deficit? During the 1980s it was common to regard the current account deficit as a consequence of that period's large federal budget deficits. According to this "twin deficits" concept, loose fiscal policy, as evidenced by budget deficits, was supposed to stimulate aggregate demand for goods and services, some of which would spill onto imports and result in a trade and current account deficit.
Although the budget deficit and the current account do sometimes move together, that movement did not happen in 1997. The federal budget deficit has shrunk considerably during the past several years — to only about $30 billion during calendar year 1997 — even as the current account deficit has widened (see Chart 1). How can this divergence occur? A current account deficit must be financed, either by inflows of private capital from abroad or official reserve flows.
The twin deficits approach tends to treat capital and reserve flows as residuals that respond passively to changes in the current account. The budget deficits of the 1980s not only stimulated the demand for imports but also pushed up U.S. interest rates, thereby attracting inflows of private capital needed to finance the resulting current account deficit. With today's relatively open financial markets and massive international capital flows, however, it sometimes makes more sense to regard capital flows as the dominant player and the current account as the residual that responds passively.
While the twin deficits idea is intriguing, it cannot explain today's U.S. current account deficit. An alternative view regards the recent widening of the deficit as the consequence of good policies that have made the United States the premier country for investment by foreigners, combined with bad policies elsewhere that have encouraged capital outflows from other countries. In the past several years the U.S. economy has been growing more rapidly than Western Europe's and Japan's, offering an attractive venue for foreign companies to expand their operations.
The United States also tends to attract capital inflows whenever financial turmoil occurs in other regions or countries. Recent examples include the Asian financial crisis, and before that, the problems in Mexico and Argentina.
Is the ballooning current account deficit a sign of trouble ahead for the United States, as it may have been for a country like Thailand? Probably not. For one thing, even if the current account rose to 3 or 4 percent of GDP, the U.S. deficit would still be much smaller than Thailand's deficit just before its financial crisis. More importantly, because of the unique position of the dollar in international finance, the capital inflows that have come into the United States have been invested in dollar-denominated securities. In Thailand, much of the capital inflow was in the form of loans that were denominated in a foreign currency such as the dollar. When the crisis hit, Thailand's central bank had only a limited amount of dollars that it could lend to support the banking system. If a similar crisis hit the United States, the Fed would have no such lending limit.
While in the past a widening current account deficit may have signaled trouble ahead, the recent and predicted increases in the U.S. current account deficit do not appear to be cause for alarm in the near term.
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