Budget and Current Account Deficits Jeopardize U.S. Influence, Warns Council Special Report

Budget and Current Account Deficits Jeopardize U.S. Influence, Warns Council Special Report

September 29, 2005 1:10 pm (EST)

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September 29, 2005—The United States must confront the alarmingly high federal budget and current account deficits, urges a new Council Special Report. “Failure to take the initiative to reduce the twin deficits will cede to foreign governments increasing influence over the nation’s fate. Perhaps equally alarming, it will lead to slower growth, escalating trade friction, and reduced American influence in political and economic spheres,” says the report.

Getting Serious About the Twin Deficits is authored by Menzie D. Chinn, a professor of public affairs and economics at the University of Wisconsin at Madison, who served as a senior economist for international financial issues on the president’s Council of Economic Advisers during the Clinton and George W. Bush administrations. The report is the first in the Bernard and Irene Schwartz Series on the Future of American Competitiveness, produced by the Council’s Maurice R. Greenberg Center for Geoeconomic Studies.

The report warns that the nation faces serious challenges, even if the United States avoids a precipitous collapse in the dollar and an economic recession. America’s continued descent into greater and greater indebtedness threatens an important source of its influence: the dollar’s role as the critical global currency. “A cautionary note regarding America’s current path is provided by Britain’s loss of military and political primacy in the twentieth century; that development followed a shift from creditor to debtor status. Similarly, a prolonged decline in the dollar’s value and increasing indebtedness will erode America’s dominance in political and security spheres.”

The current account deficit soared from just under 3.8 percent of GDP in 2001 to 5.7 percent last year. Historically, other countries have experienced deficits this large, but the absolute magnitude of the U.S. deficit is unprecedented because the United States—constituting over one quarter of the world economy—looms so large. At the same time, the United States has accumulated a record amount of foreign debt. Neither of these trends—in the deficit or debt—shows any evidence of being reversed.

The ever-widening current account deficit is being driven first and foremost by the fiscal deficits that the federal government has run since 2001. The expansionary fiscal policy associated with large tax cuts and spending increases has kept the value of the dollar higher than it otherwise would be, elevating labor costs of American firms above those of their foreign competitors. The policy has also stoked private consumption, sucking in additional imports. A second factor is the dependence of the U.S. economy on petroleum imports—40% of the increase in the trade deficit since the end of 2001 is accounted for by increased oil imports. A third factor is the longstanding undervaluation of East Asian currencies. The popular argument that excess savings from East Asia have caused the U.S. current account deficits has only been relevant in the past few years.

As a consequence of these deficits, the United States faces several worrying outcomes. One likely result is that foreign governments and private investors, confronted with an endless vista of U.S. budget deficits, will tire of accumulating Treasury securities. Borrowing costs for the Treasury would then rise significantly and the dollar would fall sharply. The economy would slow dramatically, driven indirectly by a slump in the housing market or directly through falling private consumption.

To address the threats posed by the two deficits, the report makes the following recommendations:

  • Confront the fiscal challenge: Current and incipient federal budget deficits are driving the account deficit ever wider. Consequently, “[r]educing the growth rate of government spending and raising tax revenues should be at the top of the country’s economic agenda.” Especially in light of new budgetary challenges posed by Hurricanes Katrina and Rita, expensive provisions of the recently passed energy and transportation bills should be rescinded. Furthermore, efforts to make permanent the tax cuts of 2001 and 2003 should be dropped.
  • Reduce energy imports: “Currently, the value of imported petroleum and oil products equals about one-third of the trade deficit.…[R]educing oil imports will reduce the rate at which the United States accumulates external debt…[and] make imports more responsive to changes in the dollar’s value…” With high energy prices here to stay and significant increases in domestic oil production unlikely, energy demand management—either through the imposition of energy taxes or meaningful fuel efficiency standards—is the only realistic option.
  • Manage a coordinated, but modest, dollar depreciation: The administration should persuade East Asian governments to allow greater exchange rate flexibility. The recent steps taken by the People’s Bank of China to let the renminbi move in line with a basket of currencies is a step in the right direction, but it is insufficient to alter trade dynamics. Only if the region’s monetary authorities simultaneously allow their currencies to appreciate will the imbalances be significantly reduced. The worrying alternative to a modest and coordinated dollar depreciation now is investor panic and a major dollar collapse down the road.

Full text of Getting Serious About the Twin Deficits.

Council Special Reports are concise policy briefs that provide timely responses to developing crises or contribute to debates on current policy dilemmas.  The content of the reports is the sole responsibility of the authors.

Founded in 1921, the Council on Foreign Relations is an independent national membership organization and a nonpartisan center for scholars dedicated to producing and disseminating ideas so that members, students, interested citizens, and government officials in the United States and other countries can better understand the world and the foreign policy choices facing the United States and other governments.

The Maurice R. Greenberg Center for Geoeconomic Studies works to promote a better understanding among policymakers, academic specialists, and the interested public of how economic and political forces interact to influence world affairs. Globalization is fast erasing the boundaries that have traditionally separated economics from foreign policy and national security issues. The growing integration of national economies is increasingly constraining the policy options that government leaders can consider, while government decisions are shaping the pace and course of global economic interactions. It is essential that policymakers and the public have access to rigorous analysis from an independent, nonpartisan source so that they can better comprehend our interconnected world and the foreign policy choices facing the United States and other governments.

Contact: Marie X. Strauss, Communications, 212-434-9536 or [email protected]

Menzie Chinn, 608-262-7397 or [email protected]

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