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Paradox of Plenty

Author: Roger M. Kubarych
April 5, 2005
Council on Foreign Relations

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The US current account deficit reached a record $665.9 billion in 2004, or 5.7% of GDP. The Q4 2004 figure was far worse: an annualized $751 billion or 6.3% of GDP. The majority of US economists – and many financial market professionals, as well -- are alarmed by the magnitude and rate of growth of the external deficit. They worry how long it can be financed without adverse consequences for financial markets. They call attention to the fact that the US has become the world’s largest net debtor nation, with a negative net liability position of $2.65 trillion at the end of 2003 (the latest official figure) and an estimated $3.2 trillion at present. Their worst fear is a so-called “hard landing” in which capital inflows suddenly dry up, US interest rates soar, and the dollar plummets, causing the nasty combination of diminishing economic growth and rising inflation. They call for urgent steps to bring the deficit down as soon as possible, including fiscal policy restraint and an orderly decline in the value of the dollar.

The paradox is that despite these warnings and the legitimate concerns that motivate them, the dollar has been going up lately, not down. The yen traded above 107 this week, essentially back to the levels of December 2003. The euro traded under $1.30, well below its $1.36 peak of December 2004 and only marginally higher than its levels of early last year. Other currencies that had been strengthening against the dollar, for instance the Canadian dollar, have either stabilized or eased back.

Naturally, this mild dollar rally may turn out to be nothing more than a brief respite for the US currency. It is not hard to envisage renewed downward pressure later this year as market participants are reminded that the US trade and current account deficits are continuing to swell. That is our forecast.

But it is important to consider the implications of some alternative scenarios that have been articulated in the past few days in research papers published by economists David Levey and Stuart Brown in the journal Foreign Affairs (The Overstretch Myth, or How We Learned to Stop Worrying and Love the Current Account Deficit), by Bear Stearns analyst David Malpass in a Wall Street Journal op ed piece, and by some former Bush administration officials. As Levey and Brown put it, “chronic current account deficits reflect strong economic fundamentals rather than fatal structural flaws.” If that’s true, then policy-makers should not seek a major decline in the value of the dollar or immediate retraction of fiscal stimulus, but rather let nature take its course. On this reasoning, the recent dollar rally is not an aberration but an appropriate response to relative US economic, financial, and political advantages. The dollar may defy predictions and move even higher.

Underlying this benign view of the US current account deficit are several observations that deserve careful consideration. First, by definition, the deficit is equal to the difference between domestic investment and savings. In 2004, gross domestic investment was $2,307 billion while gross saving was $1,607 billion. There was also a statistical discrepancy of about $35 billion, bringing the current account deficit to $666 billion. Cutting the current account deficit requires either lowering investment, increasing savings, or reducing dissavings (the largest component was the federal government’s budgetary deficit of $433 billion). The conventional view is that Americans save too little and the government deficit is too big.

The contrarians readily concede that the government deficit ought to be reduced, although they are divided on how and how fast to accomplish that. And they admit that personal saving is only a small share of disposable income. But they argue that personal outlays are overstated. That is because much of that spending is actually for investments such as consumer durables (autos and home furnishings, for example) or educational expenses that build up “human capital.” In fact, the Federal Reserve’s Flow of Funds accounts accept at least part of that reasoning. Fed economists tabulate personal savings rates with and without consumer durables. On the former basis, the savings ratio is considerably higher.

Personal Saving, as % of disposable personal income

Source: Federal Reserve Flow of Funds

They go on to argue that personal disposable income is understated, since the method of calculating income leaves out capital gains on holdings of securities. Indeed, this source of household sector net worth has been increasingly important in recent years, as corporations have bought back hundreds of billions of dollars of stock in order to boost equity values rather than paying higher dividends (which are counted in personal disposable income). Taking into account both factors, Malpass computes an adjusted personal savings rate averaging about 10% over the past ten years. The emergence of a large and growing current account deficit is thus traceable to strong investment expenditures by both business and households, as well as to enlarged government budget deficits in the past few years, rather than to profligate consumers.

Second, steady increases in the net debtor position of the United States have eroded but not yet eliminated the positive balance on net investment income that the US still enjoys. In 2004, for example, earnings on US-owned assets abroad amounted to $365.9 billion, while payments to foreigners on their much larger magnitude of assets in the US came to just $336.1 billion. The US is in a large net debtor position but the assets owned by US investors continue to generate far higher yields than those on US assets owned by foreigners.

Moreover, the net debtor position itself is not static. A number of experts pointed out how sensitive calculation of that position is to valuation changes brought about primarily by fluctuations in exchange rates and in equity prices. Generally, because the US is able to finance its current account deficit in dollars, while accumulating assets denominated mainly in foreign currencies, depreciation of the dollar substantially improves the US net international asset position on a mark to market basis. For instance, in 2003, the most recent year for which official data is available, the net international investment position of the US deteriorated only by about $100 billion, as compared with a more than $500 billion current account deficit for that year. Since 1977, the cumulative current account deficit of the US adds up to close to $4 trillion, as compared with a net international liability position that went from about $0 to $2.65 trillion. Part of this reflects the fact that US investors operating abroad have concentrated more on direct investments and on purchases of equities, while foreign investors putting capital in the US -- especially foreign central banks and other official institutions -- have put a much heavier weight on money market and bond investments, on which capital appreciation is far less of a factor.

International Investment Position of the US
$ trillion, at year-end 2002 & 2003

Direct investment positions at market value

The US current account deficit has become larger and larger because US spending growth has exceeded output growth and investment has exceeded savings. Much of the financing of the deficit has come from private capital inflows seeking higher returns and the safety and convenience of transacting in US capital markets. But part reflects policy judgments by foreign governments and central banks, especially but not exclusively in Asia, that their export-led economic growth requires, at least for the medium-term, a relatively competitive exchange rate with respect to the US dollar. They acquire dollar assets as part of exchange rate management policy, not to seek higher yields. They scale back their dollar acquisitions when private sector demand for US assets goes up and conversely they intervene in greater scale when private capital flows subside. This kind of exchange rate management is a throwback to the way the global monetary system used to work. It is a far cry from the freely floating exchange rate system as practiced by the European Union. But as long as the US administration is comfortable with its consequences for the US economy and financial developments, the paradox of plenty – the world’s richest country as measured by per capital net worth absorbing the greatest share of global excess savings – will continue.

The implications for the financial markets are these: Only a gradual, step-by-step increase in short-term interest rates determined by the Federal Reserve; a modest further rise in US long-term bond yields; mediocre stock market performance; and limited moves in dollar exchange rates, relative to what would be required to induce a significant improvement in the magnitude of the US current account deficit.

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