FROM 1971 TO 1982 THE U.S. current account balance as a share of U.S. GNP averaged roughly zero.(1) Starting in 1983, however, the United States experienced increasingly large current account deficits, which reached 3.3 percent and 3.4 percent of GNP in 1986 and 1987, respectively. This tendency toward larger deficits was reversed gradually during the rest of the decade, and by 1991 the current account was near zero again. But starting in 1993 the current account again began to record increasingly large deficits, which grew to 3.6 percent of GNP in 1999 and 4.4 percent in 2000. This history of the current account prompts several questions: What is the source of the large current account deficits of the 1990s? Are they likely to remain with us indefinitely? If not, should we expect them to fade away slowly as they did in the 1980s? Or should we expect instead a sharp reversal in the near future?
In this essay I interpret these trends in the U.S. current account from a perspective that focuses on the behavior of the country portfolio. The country portfolio is defined as the sum of all productive assets located in the United States, plus the U.S. net foreign asset position (that is, the sum of all claims on foreign assets held by U.S. residents minus the sum of all claims on U.S. assets owned by foreign residents). By the composition of the U.S. portfolio I mean the share of the net foreign asset position in it.(2) According to the portfolio view, it is useful to separate changes in the current account into two components: changes in the size of the country portfolio, which I call portfolio growth effects, and changes in the composition of the country portfolio, or portfolio rebalancing effects. A simple application of this approach reveals a clear picture: the recent current account deficits are mostly the manifestation of the spectacular increase in U.S. wealth experienced in the 1990s. Contrary to a widely held belief, these deficits do not reflect a rebalancing of portfolios toward U.S. assets and away from foreign assets.
A natural question follows: Why did U.S. wealth increase so much in the 1990s? I explore two alternative hypotheses. The first views the increase in wealth as reflecting a rapid accumulation of an intangible form of capital. The second is based on the notion that the 1990s were characterized by the appearance and growth of a bubble in the U.S. stock market. Although both explanations exhibit interesting elements, neither is fully satisfactory. Our inability to account for the growth in wealth makes the task of predicting the future direction of the U.S. current account quite difficult, if not impossible. Nevertheless, each of these stories has a different ending, and I discuss them below.(3)
A Portfolio View of the Current Account
The point of departure for a portfolio view of the current account is the celebrated mean-variance theory of Harry Markowitz and James Tobin.(4) According to this theory, investors choose their portfolios by optimally trading off risk and return. The optimal or mean-variance-efficient portfolio contains the risk-free asset and an optimal combination of risky assets (OCRA). A strong result of the theory is that the OCRA is the same for all investors with access to the same menu of assets, regardless of their attitudes toward risk and their level of wealth. That is, the share of each asset in the OCRA depends only on the distribution of asset returns. Another strong result of the theory is that the weights that mean-variance investors assign to the risk-free asset and the OCRA depend only on their risk aversion and the distribution of asset returns. They do not depend on the investors' wealth.(5)
Moving from the optimal investor portfolio to the average or country portfolio requires an additional assumption, namely, that the average risk aversion and the distribution of asset returns are both independent of wealth. This is a strong assumption, and its validity is an empirical issue that is far from settled. …