Academic journal article The Cato Journal

The Unsustainability of the U.S. Twin Deficits

Academic journal article The Cato Journal

The Unsustainability of the U.S. Twin Deficits

Article excerpt

Global current account imbalances are increasing rather than decreasing. The U.S. current account deficit was about $665 billion in 2004 and rose to $791 billion (around 6.5 percent of GDP) in 2005, and it is likely to grow to more than $950 billion in 2006 and well above $1 trillion in 2007. Most other regions of the world--with the exception of Central Europe--are now running a current account surplus. Thus, with the exception of a few countries--Turkey, Australia, New Zealand, Iceland, Spain, Britain, and some Central European countries--most of the world is running a current account surplus and financing the U.S. current account deficits. Moreover, unlike some of these other countries running current account deficits, the United States is also running a large budget deficit that is growing--after a drop in 2005--at rates that are worrisome. Thus, the United States appears to be experiencing a twin fiscal and current account deficit whose medium- to long-term sustainability is doubtful.

The stability of this global current account disequilibrium is widely debated. According to some (Dooley, Folkerts-Landau, and Garber 2004, 2005), we are in a new Bretton Woods 2 (BW2) regime where Asia and most of the emerging world is now actively pegging its currencies to the U.S. dollar and thus following a mercantilist policy of undervalued currencies that lead to export-led growth. The resulting current account surpluses lead to an accumulation of official foreign exchange reserves that imply a cheap financing of the U.S. current account deficit. According to the supporters of the BW2 view, this is a stable disequilibrium that could last for a decade or two. In fact, this BW2 regime and the growing global imbalances are unsustainable and bound to unravel in the next couple of years. The U.S. current account deficits--bound to rise above 7-8 percent of GDP in 2006--07--imply an accumulation of foreign liabilities that will lead the U.S. net foreign debt to grow from the 25 percent of GDP level of 2004 to over 50 percent by 2010. Thus, the issue is whether foreign investors--both private and public--will be willing to accumulate U.S. assets at the net rate of $800 billion to $1,000 billion a year for the foreseeable future.

Those who believe in the sustainability of such trends point to the strength of the U.S. dollar in 2005 and to the low levels of U.S. long-term interest rates--the so-called bond market conundrum. They also argue that global imbalances are not due to the U.S. fiscal deficits but, rather, to other phenomena such as a global savings glut or foreigners' desire to accumulate U.S. assets (the "capital account surplus" interpretation of the current account deficit in the Council of Economic Advisers 2006 Economic Report of the President). However, a careful analysis of the data refutes the complacency of financial markets and the revisionist interpretations of the U.S. external deficit.

Why the Dollar Must Fall

The U.S. dollar did indeed appreciate in 2005 after falling relative to floating currencies in 2002-04, but the factors leading to such a dollar appreciation--in spite of a large and growing current account deficit--were all cyclical. In 2006, the laws of gravity--a growing current account deficit--will dominate the cyclical forces that lifted the dollar in 2005.

Such cyclical forces were several: (1) the increasing differential between short-term interest rates in the United States relative to Europe and Japan as the Fed kept on tightening while the European Central Bank (ECB) and the Bank of Japan (BOJ) remained on hold; (1) (2) the increase in the relative growth differential between the United States, Japan, and the European Union (EU) as the United States kept on growing around potential while Japanese and eurozone growth was sub par; and (3) the effects of the Homeland Investment Act (HIA) that led to the return to the United States of almost $200 billion of U. …

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