from Follow the Money

One more point on Martin Wolf

December 22, 2004

Blog Post

It is a simple point, but an important one. Wolf says the United States would be fine if it reduced its current account deficit from 6% of GDP to 3% of GDP. External debt to GDP then stabilizes at 50% of GDP. All true.

But remember that cutting the current deficit in half likely requires cutting the trade deficit by much, much more. Right now, net interest payments on US external debt are close to zero. That is largely due to a combination of good investments (The US accumulated a lot of European assets when it was running current account surpluses in the 50s and 60s, and these assets generally provide the US with a decent return) and good luck: foreigners hold lots of US debt, and US interest rates are very low.

But over time, as debt levels rise and US interest rates rise, the income balance will turn negative. If the US pays just 4% interest on a (net) external debt to GDP ratio of 50%, interest payments would be 2% of GDP. A 3% of GDP current account deficit therefore is consistent with a trade deficit of 1% of GDP -- compared to about 6% of GDP now.

This oversimplifies. If the US continues to earn a higher rate of return more on its offshore assets than it pay on its external liabilities, its "income" from borrowing abroad to invest abroad (what I call financial intermediation) will offset some of the interest payments on its net debt. A net external debt of 50% of GDP might imply external assets of 50% of GDP and external debts of 100% of GDP. Suppose the US pays 4% on all its liablities, and earns 5% on its assets. US net interest payments would be 1.5% of GDP in this scenario. Then a trade deficit of 1.5% of GDP is consistent with a current account deficit of 3% of GDP.

My point is simple: cutting the current account deficit in half over time will require cutting the trade deficit by more than half. Realistically, the trade deficit (technically, the balance on trade and transfers) will need to fall by between 4.5 and 5% of GDP ...

There is no guarantee that the US will be able to bring its current deficit down to 3% in an orderly way. Emerging markets typically do not adjust smoothly. Rather, once capital inflows dry up, they swing from current account deficits to current account surpluses. They rarely end up in the sweet spot -- that is, they typically are not able to run the small ongoing current account deficits that can be consistent with a stable debt to GDP ratio.

Then, again, the US is not (yet) an emerging economy -- even if its debt to exports ratio is starting to look rather scary by any standard. Yet it is not inconceivable that foreign investors could completely lose confidence in the US during the inevitable adjustment process that reduces the US current account deficit from 6% of GDP to 3% of GDP. In that scenario, the US would lose the ability to attract the ongoing inflows needed to sustain a current account deficit of 3% of GDP, and be forced to adjust more. Sometimes external creditors put a country on a very short least, and demand that it reduce its debt to GDP ratio. Unlikely to happen to the US. Yes. Impossible. No.