Much of America’s current account deficit can be attributed to one single trading partner: China. Since the economic liberalization programs of 1980s, China has experienced impressive double digit growth. As China continues what Chinese President Hu Jintao characterizes as a “peaceful rise”, the Chinese economy has been booming at an average rate of 10% since 1990 and is projected to become the world’s second biggest economy within 15 years. How can America manage its current account deficit when we are so dependent on China?
First, let’s start with the definition of the “current account balance”. It is the difference between the amounts of “visible” goods and “invisible” services that America imports and exports. Currently, America is importing much more than it is exporting, resulting in a current account deficit of $800 billion last year. As a result, America has to issue IOUs to foreign debt holders, much of it to the Chinese. Twenty-one percent of the estimated trillion dollar exports coming out of China goes to the United States.
What can the United States do to reduce its account deficit? The economic textbook provides for three options to reduce the deficit. First, American domestic spending has to be curbed to reduce demand for foreign goods. Or second, foreign demand for American could rise, increasing demand for American exports. The easiest way to achieve these objectives is for the US dollar to plummet. This would make American exports cheaper relative to other countries exports. It would increase the demand abroad for US made goods. Unfortunately, a Federal Reserve Bank research paper found that significant reversals in the current account balance, led by a weakened dollar, and usually induces a moderate to severe recession.
Unlike unemployment or inflation, the current account deficit is not a categorically negative or positive situation. Many economists disagree on the severity or even whether the deficit has a negative impact on the economy. The former US treasury secretary, Paul O’Neill dismissed the account deficit as a “meaningless concept”.
Foreigners placed a lot of money into the United States because we offer the safest investment and the current account deficit is merely a symptom of that. History, however, suggests that the economic crisis of Mexico and other Latin American countries in the 1990s were preceded by a high level of current account deficit, as a percentage of the GDP. The Federal Reserve paper looked at 25 events of current account adjustment and found that the deficit decreased after four years and reaching 5% of the GDP. Economies usually hit trouble when the deficit reaches 4 to 5% of the GDP.
Other economists worry about the amount of interest the United States is going to have to pay. This is part of the fear about China’s involvement in buying up huge amounts of US debt. They fear that one day, the deficit is going to be so huge that the US would have to pay a significant amount of our income to other countries as “tribute”. It may even become so bad that the deficit could grow so huge that it would compound because we wouldn’t even be able to pay off the principal.
More worrying is the recent reversal of foreign direct investment flows into the country. It suggests that foreign investor’s appetite for American and dollar assets may be waning. In the 1990s, foreign investors were investing money into US stock, bonds, and factories. However, since 2000, most of the foreign money has been placed in only bonds. Since 2001, the flow of the foreign direct investment has turned negative, peaking at 2.1% of the GPD. This means that foreigners are not investing as much money into America as before and this affects the cash flow that finances the deficit. China and other Asian exporting tigers continue to buy up US Treasury securities because the have political in addition to economic considerations. The Chinese flood the market with RMB in order the keep the USD-RMB exchange rate low and make Chinese exports preferential. They do this through the Bank of China. The BOC continues to buy US Treasury securities as other federal reserve banks in other countries diversify their assets into EURO and YEN denominated assets.
The US current account balance deficit is one of choice. The US consumer has continued to spend money on foreign goods. But the longer the current account deficit lasts, the more severe the adjustment becomes. The Federal Reserve Bank has to curb consumer spending by raising the Fed Funds rate. It is not going to be easy but the United States cannot be in deficit for ever without consequences.
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