EconSouth (First Quarter 2005)

The Evolution and
Implications of the U.S.
Current Account Deficit

With the global economy more interconnected than ever, the U.S. current account deficit has attracted a good deal of attention lately. Placing this economic measurement in perspective is central to understanding its potential effects.

Running a current account deficit is not new for the United States; the country has run one for decades. The deficit’s growth has its roots in various factors including the level of U.S. consumption spending and consumers’ appetite for imported products.

The current account report—a yardstick of a country’s trade and international investment position—has attracted a lot of attention in the United States, where the report has shown a large and growing deficit. The deficit’s record size and its potential effects on the domestic and world economies have economists taking a closer look.

The current account balance is the net value of a country’s international trade in goods and services plus the net value of income payments and transfers to and from foreigners. For the United States today, there is a deficit in each of the components of the current account. But the trade deficit is by far the largest element and is the main cause of movements in the current account deficit over time. The income payment deficit mostly reflects net interest payments made by the United States on its foreign debt while the largest component of the transfer deficit is foreign aid.

A current account deficit is financed by borrowing abroad. In 2004 the U.S. current account deficit was more than $600 billion, equivalent to 5.7 percent of the nation’s gross domestic product (GDP). This deficit absorbed approximately two-thirds of the cumulative current account surpluses of the rest of the world. Never before has the United States run such a large current account deficit in dollar terms or as a share of GDP, nor has the deficit ever been as large relative to the global economy. This imbalance, unusual by historical standards, has been one factor putting downward pressure on the U.S. dollar.

A historical perspective
Running a current account deficit is not a new development for the United States. In fact, the country has run such deficits for more than 20 years. But since 1997 the deficit has grown substantially, both in absolute terms and relative to GDP, increasing from 1.5 percent of GDP in 1997 to 5.7 percent in 2004 (see chart 1).

Two factors have been important contributors to the growing current account deficit since the late 1990s: U.S. investment and consumption spending. For most of the second half of the 1990s, private-sector investment increased as a percentage of GDP while the consumption share remained relatively stable (see chart 2). This condition started to change around the year 2000 as consumption’s share of GDP increased while the investment share declined. So, unlike the situation in the second half of the 1990s, when the current account deficit could be perceived as helping fuel investment spending by increasing imports of capital goods, most of the increase in the current account deficit since that time appears to be supporting consumption spending by the United States.

Growing pains
Over the past decade, the U.S. trade deficit has increased almost sevenfold to about $518 billion, with imports increasing by roughly $1.029 trillion and exports expanding by only $512 billion. Today, imports of goods and services account for 18 percent of U.S. GDP while exports make up only 13 percent.

The relative underperformance of exports can be attributed to a variety of factors. For one thing, economic growth in the United States has consistently exceeded the growth rate of its major trading partners, so U.S. consumers are buying more imports than foreigners have been buying U.S. exports. As chart 3 shows, most of the export demand for U.S. products comes from countries whose economies are growing more slowly than the U.S. economy.

Chart 1
U.S. Current Account, 1992–2004
Source: U.S. Treasury Department
Chart 2
U.S. Consumption and Investment as a Percent of GDP, 1994–2004
Source: Haver Analytics
Chart 3
Foreign Demand for U.S. Exports in 2003
Source: Federal Reserve Bank of Atlanta
Chart 4
Nominal Trade-Weighted U.S. Exchange Rate Versus Major Currencies
Source: U.S. Treasury Department

The impact on the dollar
Both the magnitude and the composition of the trade and current account deficits have attracted recent scrutiny because of their effect on the strength of the U.S. dollar. Basic economic theory predicts that consumers’ increased demand for imports would eventually lead to a currency depreciation. Holding other variables equal, the increased expenditures on foreign goods increases the demand for foreign currencies, putting upward pressure on the value of those currencies relative to the dollar.

Although much attention has been paid to the fall in the dollar’s value, especially during the second half of 2004, the dollar has actually been losing ground to major currencies for more than two years (see chart 4). This shift can also be partly explained by other countries diversifying their currency holdings by selling dollars and buying other currencies. The resulting fall in demand for dollars relative to supply causes the dollar’s value to fall, just as the value of any commodity would.

Some currencies—mainly the euro, the British pound, and the Canadian dollar—have appreciated considerably against the U.S. dollar. But because a number of important U.S. trading partners—mainly Asian countries—maintain a fixed or partially fixed exchange rate pegged to the U.S. dollar, those nations’ central banks have borne a disproportionate share of changes in the value of the dollar as they stabilize their currencies. Indeed, since 2001, Asian central banks’ U.S. dollar reserves have increased by $1.2 trillion, roughly two-thirds of the cumulative U.S. current account deficit over that period.

The record size of the current account deficit and its potential effects on domestic and world economies have economists taking a closer look at this flow of capital.

Purchases of the dollar by foreign governments have been crucial in allowing the United States to sustain its current account deficit, weather a weakening dollar, and maintain low interest rates. Yet important risks exist, one of them being rising protectionist pressures that could increase when the trade deficit is large.

The challenges ahead
The large current account deficit is one of the more prominent factors influencing the U.S. economy today. Over time, a weaker dollar should help to restore external balance because the less favorable exchange rate will dampen U.S. consumers’ appetite for foreign goods and services. Nonetheless, narrowing the U.S. current account deficit in an orderly manner will remain a challenge for policymakers.

This article was written by Diego Vilan, a senior economic analyst in the regional section of the Atlanta Fed’s research department.

 

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