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Zokirjon Abdusattarov, Institute for Law and Finance

US Current Account Deficit

What is a Current Account?

A current account is formulated as the sum of interaction between


plethora of economic factors, primarily, such as but not limited to, trade
balance (the spread between export and import of goods and services),
domestic ratings of saving and investment, economic growth, international
investment and capital flows, prices and rates of return, exchange rate, fiscal
and monetary policy. As we can see from the definition, a current account
deals with complicated interrelations of macroeconomic figures and cannot be
described as reflection of each factor taken separately on its own. If we
express the current account with oversimplified words, one can think of how
much a single household spends (clothes, food, car, apartment rent and etc)
and earns (salaries, dividends and interests from deposits, pension,
allowance and etc) each months.
The main components of the current account is published on
http://www.bea.gov on yearly or/and quarterly base.

Current account
Exports and Imports of goods and services and income receipts
* Exports of goods and services
* Goods, balance of payments basis
* Services
* Transfers under U.S. military agency sales contracts
* Travel
* Passenger fares
* Other transportation
* Royalties and license fees
* Other private services
* U.S. Government miscellaneous services
* Income receipts
* Income receipts on U.S.-owned assets abroad
* Direct investment receipts
* Other private receipts
* U.S. Government receipts
* Compensation of employees
Unilateral current transfers, net
* U.S. Government grants
* U.S. Government pensions and other transfers
* Private remittances and other transfers

Depending on the sum of the combination of the above factors, a


current account of certain country might be in surplus, in deficit or in perfect
balance, which is zero. A current account deficit can convey a message that a
country is living in debt because overall expenditure and investment go
beyond the overall savings of the country. Or it can also mean that economy
of the country is in such a constant high growth that enables to attract huge
amounts of foreign investment into the country at a high returns with relatively
low risks in comparison with in the other world countries. Obviously the latter
possibility is less likely since economies of the world countries cannot
maintain high economic growth for long term; there will always be fluctuations

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Zokirjon Abdusattarov, Institute for Law and Finance

in the rate of economic growth. Consequently, when country experience


normal (below normal) level of growth, it has to distribute large amount of
interest, dividend and other payments to foreign investors from the current
level of production of the economy, which might not be financially strong
enough to produce expected results.

What is the problem with current account in the US?

There are a number of reasons why this issue has recently started
having increasing overtone. The current situation in the US is appalling: the
current account deficit has hit its record, which is 7 % of the GPD or 900
billion dollars. This amount is greater than sum of GDPs of roughly 100
developing countries or almost 2 % of the Gross World Product (based on the
World Bank calculations for 2006). It is the amount of money that has never
been observed in the US financial history (see figure 1.). The current account
deficit also reflects the surplus of imports over exports in the international
trade of the US. This shows that the US is losing its competitiveness and the
US economy is suffering, and the employment opportunities are going down.
And finally the greater the deficit becomes, the more observers subscribe to
the view that correction must take place some time in the future with
significant affects on the US and world economy.
3500000

3000000

2500000
Exports of goods and services
and income receipts
2000000
Imports of goods and services
and income payments &
Unilateral current transfers, net
1500000
Years

1000000

500000

0
19 60
19 64
19 68
19 72
19 76
19 80
19 84
19 88
19 92
19 96
20 00
20 01
20 02
20 03
20 04
20 05
20 06

Figure 1.Current Account of the US during 1960-2006 in millions of


dollars.

Figure 1 illustrates that since the 1980s, the US trade balance has been in
deficit. The deficit significantly broadened during 1990ies when the US

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economy was experiencing boom and growing much faster than the world
economy attracting large stocks of international investments.
It should be noted that the international investment position of the US is
not an ingredient of the current account; nevertheless, it is immensely affected
by it since dividends and interests are, so to say, “exchanged” between the
US and world countries as a result of the foreign-owned assets in the US and
the US-owned assets abroad. In 1985 US foreign assets were almost equal to
foreign assets in the US. But due to high economic growth in 1990ies and
dramatic development of financial institutions globally, investing in the US
became very accessible and the latter was considered as “oasis of prosperity”
for foreign investors. In 2006 net international investment position of the US
spiked up to 2,5 trillion dollars. On this issue, Ferguson expresses the view
that “if current account deficits continue to boost the negative international
investment position, eventually the cost of servicing that position, which so far
has been quite modest, would rise to an unsustainable level”1. As a result the
US economy becomes very fragile and would be thrown to recession for
several years.

There is a consensus among almost all observers on imminent


adjustment or correction of the US current account deficit but few scholars
agree when it will happen on how it will take place.2 Very crucial remains the
issue of what triggered all these changes in the current account and shifts in
the international investment position of the US. If the reasons lie behind the
monetary policy of the state then focus must be drawn on the improvement of
the economic regulations. Or if it was the market which has given the root
causes, then let the market to correct those trends. If it is an external cause,
maybe the US economists should think of new strategies to cope with the
issue. Or if it is the result of the combination of all the factors then massive
changes in the economic regulations must be made.

In analyzing these issues one should be very careful in distinguishing


the causes and responses to that, and of course, the surrounding matters
which has no direct link. For example, the current account deficit is not a
cause in itself. Or it is the same with the depreciation or appreciation of the
dollar. A value of the currency cannot change automatically. Causes or factors
have different sources and must be investigated independently. The following
chapter will discuss what might be the potential causes.

1
U.S. Current Account Deficit: Causes and Consequences: Remarks by Vice Chairman Roger
W. Ferguson, Jr. To the Economics Club of the University of North Carolina at Chapel Hill,
Chapel Hill, North Carolina, April 20, 2005
2
Ibid.

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Zokirjon Abdusattarov, Institute for Law and Finance

Causes of the US current account deficit

In a very complex and highly interconnected field as the contemporary


financial environment, there is a plethora of existing factors that may have
triggered in larger or in smaller part the US account deficit. Among the
economists and the researchers though, the focus is put on 6 different causes
that can be categorized as domestic or international: the fiscal deficit, a fall in
private saving rates, an increase in productivity growth, deterioration in foreign
domestic demand, the apparent increase of financial intermediation and the
ongoing rise in oil prices.
The first three factors are linked to the domestic economic background,
whereas the last three are internationally driven.
Let us view each one of them in more detail:
1. Expansion of the fiscal deficit

The view that the US current account deficit stems from the parallel rise of
the US budget deficit is commonly addressed by the so called “twin deficits
hypothesis”, primarily a development of the 1980s. The basis that forms this
theory is the accounting identity that the current account balance equals
saving – investment:
CURRENT ACCOUNT BALANCE= S- I
Then it states that taking into account that the increase in the fiscal deficit
lowered public saving, this means that it also caused the national saving to
lower, thus leading to an analogous increase of the current account deficit. Of
course, this hypothesis presupposes that private saving and investment
remain constant and only public saving alters, which is something that hardly
happens in the real world, where all these factors constantly change and
adjust to changes.
A more complex version of the “twin deficits hypothesis” contends that
the increased fiscal deficit causes domestic demand to rise, then domestic
demand in turn drives interest rates higher relative to foreign interest rates.
This spread leads of course to increased investments from abroad, thus
raising the value of the dollar, which affects the current account deficit by
widening it.
While this hypothesis is valid in terms of theory, the empirical data
shows otherwise: The expansion of the fiscal deficit contradicts with the data
of 1990’s when the US was confronted with a simultaneous rise of the trade
deficit and budget surplus instead of deficit. Moreover, in an international
level, empirical data taken from the economies of Japan and Germany,
suggest the same that account surpluses can coexist with budget deficits.
Thus, we can conclude that the expansion of the fiscal deficit had rather little
contribution to the expansion of the account deficit of the USA.

2. Fall in the private saving rate


The facts clearly depict a substantial decline in US private saving rates:
Since the mid-1990’s, the private saving rate has fallen from 5% of disposable
income to less than 2%, and the gross private saving (including corporate
saving) has also decreased from 16% to less than 15% of the GDP.
The lower saving rate implies higher private consumption, which in turn
causes a rise in the GDP growth, which then increases the interest rates. The

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Zokirjon Abdusattarov, Institute for Law and Finance

high interest rates account for the appreciation of the dollar and the resulting
decline in investment spending.
Yet, some researchers point out that various economic developments such
as the deterioration in private saving rates might just be an economic
response to big economic fundamental shocks. For example, a rise in the
value of housing combined with lower interest rates may lead to a shift in
household saving behavior and do not actually affect the US current account
deficit, at least to a large extent.

3. Increase in productivity growth


Both, the expansion of the fiscal deficit and the fall in the private saving
rates imply that the US current account deficit is the consequence of an
increased consumption of Americans relative to their income. The last
domestic factor that is suggested to have played a big part in the expansion of
the account deficit, appears to be the increase in productivity growth from
about 1-1,5% during 1975-1995 to 3% after 1995 onwards.
First of all, the higher growth increased the perceived rates of return in US
assets and investments, therefore increasing the foreign demand for those
assets and investments. This resulted in substantial increase in capital
inflows, the demand for dollars rose also and all these led to an appreciation
of the dollar.
Furthermore, the perceived increased rates of return on US assets and
investments had a considerable impact also on the domestic demand for
them, which also rose. This rise in domestic demand triggered a sense of
euphoria, which resulted in increased consumption and finally to a decline in
saving rates.
Indeed, the empirical data support this theory, as the above mentioned
fall in private saving rates and the 1990’s sharp increase in asset prices
suggest.

4. Deterioration in foreign domestic demand


In an international level, the fall of domestic demand due to other
factors that led to an increase in saving rates and a decrease in investment,
may be held responsible for affecting negatively the US account balance.
The deterioration of foreign domestic spending increased the supply of capital
to the US, caused a fall in US interest rates and resulted in appreciation of the
dollar.
In particular, in many parts of the developing world, as for example in
the South East Asia, following the major financial crisis of 1997, empirical data
show a clear decrease in investment rates even though the saving rates have
remained stable. This factual development led many State governments to
pursue lower exchange rates so as to enhance their exports in an attempt to
stimulate economic growth. This policy contributed in part to the further
increase in the US account deficit.
Once more, the empirical data proves this point: ever since 1999, the
developing countries overall have had account surpluses, forcing the
industrialized world countries and mainly the US to experience account
deficits.
Moreover, in general, the decrease in the foreign domestic demand
decreases the foreign GDP, which limits US exports. The limit in US exports

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Zokirjon Abdusattarov, Institute for Law and Finance

accordingly, leads to a decrease in US net exports, thus lowering the US


interest rates. The lower interest rates account for increased consumption
spending, which explains largely the rise of the account deficit since the mid-
1990’s.

5. Developments in the global financial markets.

During the past decades, the lift of significant barriers and constraints
in international flow and mobility of capital has resulted in an overall
enhancement of the outflow of funds from national saving to foreign
investments. The typical destination of these outflows is States that have a
steady financial and investor-friendly environment, that it ensures the
investors property rights and boasts good rates of returns. One of the most
popular destinations of the foreign capital fund is that fulfils all the above
criteria is the US,
The empirical data shows a reduced correlation between national
saving and investment rates which can be attributed to the fact that domestic
savings are vastly used to finance foreign investments.
The turn of the domestic capital towards foreign investment and in
particular, towards US assets, leads to a decrease in US interest rates that
represent the risk premium of the foreign investors for holding US assets.
The subsequent fall of the interest rates, increases the demand for US assets
and leads to a rise in the value of the dollar. Therefore, the current account
deficit expands.
6. The rice in oil prices
The on-going sharp rise in the oil price has had a major impact on US
economy. The US oil import bill has increased from 68 billion dollars back in
1999 to 180 billion dollars in just 5 years, an increase of 110 billion dollars
roughly.
Of course, part of this increase in oil bill, is due to an increasing
demand for oil, but most of it reflects increases in price than quantity of
imported oil. The consequence is an increase in the imports by 110 billion
dollars that puts negative pressure on the account balance.

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Zokirjon Abdusattarov, Institute for Law and Finance

Putting it All Together

As we have described throughout our paper, there is no single factor


that is responsible for the all the trouble with the current account balance. The
current account balance is sensible to the above mentioned changes in the
causes at various levels. Figure 23 demonstrates the degree of contributions
of each cause.

As one can observe from the chart, no single cause makes up


prevalent contribution to the whole changes. However, we should always
keep in mind that in highly osmotic economies, the various causes and
developments are always interrelated to a bigger or lesser extent, and this
consideration urges us to put more emphasis on two out of the above
mentioned six causes, that seem to play a bigger role in the widening of the
US account deficit than the others.

Those two main causes have to be the increased productivity growth


that has attracted substantial amounts of foreign saving and the decreased
foreign demand, which boosted saving in these foreign economies.
Nonetheless, one should not at any point conclude that the rise in current
account has been the result of various distinct developments within the global
economy, because the historical data point to the worldwide enhancement of

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The graph is taken from
http://www.federalreserve.gov/boarddocs/Speeches/2005/20050420/default.htm#fig_6

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Zokirjon Abdusattarov, Institute for Law and Finance

the financial intermediation, due to the ongoing globalization, liberalization


and technical innovation that embraces and affects not only the highly
developed western economies, but mainly the whole global economy, and the
developing economies even more. In fact, many scholars suggest, that it was
in the first place, the assurance that the US economy could easily finance its
budget deficit from the global financial markets that triggered the expansion of
the budget deficit itself and, thus, led to the subsequent expansion of the
current account deficit as well.

Possible remedies

This consideration has many important implications on the possible


remedies than can be applied to the problem. Taking a more holistic approach
to the issue, as we did so, suggests that the problem could and should be
corrected by the way of self –remedy. Many causes of the account deficit can
be reversed by the natural course of things: foreign domestic demand could
rebound, US private saving could increase and the continuing increase in
foreign productivity growth will eventually lead to these countries running
themselves account deficits, thus narrowing the US deficit accordingly.

Notwithstanding, there is room for government driven actions that


facilitate the process of reducing the account gap. The public sector must
actively engage in policies that will reduce the budget deficit. Then, the net
exports could be enhanced, without having to cut back on investment along
the process of reducing the account deficit.

Indeed, the G7 forum explicitly stated that persistent action should be


undertaken by governments and states to cope with the global imbalances
and ensure perpetual growth. Of course, one can easily understand that these
adjustments are slow and time-consuming and therefore, there are bound to
be short or mid term fluctuations in asset prices, interest rates and exchange
rates as the private investors re- evaluate their investment strategies.

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Zokirjon Abdusattarov, Institute for Law and Finance

The paper is prepared based on the following sources:

1. The Current Account Deficit and the US Economy by C. Fred


Bergsten, Peterson Institute, Testimony before the Budget
Committee of the United States Senate, February 1, 2007
2. U.S. Current Account Deficit: Causes and Consequences:
Remarks by Vice Chairman Roger W. Ferguson, Jr. To the
Economics Club of the University of North Carolina at Chapel
Hill, Chapel Hill, North Carolina, April 20, 2005
3. Analyses of the widening of the deficit include, among others,
Catherine L. Mann (2002), "Perspectives on the U.S. Current
Account Deficit and Sustainability," Journal of Economic
Perspectives, vol. 16 (Summer), pp.131-52
4. Implications of the U.S. Current Account Deficit, David H.
Howard, The Journal of Economic Perspectives, Vol.3, No.4.
(Autumn,1989 ), pp.153-165.
5. http://www.bea.gov