Is the Current Account Deficit Bad?

A commenter over the weekend posed this important question, so I thought I’d take a stab at answering it. The Current Account (CA) deficit represents the total borrowing that a country is doing from other countries. As with individuals, if a country as a whole is consuming more than it is producing, then it needs to borrow from another country to make up the difference. The way a country borrows from abroad is by importing more than it exports. It pays for those imports by either increasing its debts to the rest of the world or by selling off its assets. Either way, the country’s “net worth” goes down by the amount of the current account deficit every year.

This sounds bad – but it’s not, necessarily. It can be either good or bad, just as it can be good or bad when individuals or firms borrow money. When individuals borrow to buy a car or a house it’s often a good thing. When firms borrow money to expand a profitable business it’s often a good thing. But of course, individuals and businesses can also borrow for frivolous purposes, which we would consider “bad” borrowing. In the same way, a current account deficit is good or bad depending on how it’s spent. The crucial criterion is whether the things being purchased with the borrowed money will make it easier to repay the loan in the future. Wisely spent borrowed money should increase the borrower’s ability to repay debts.

So what’s the US spending its borrowed money on? That’s actually changed significantly over recent years. It’s useful to break down the sources of borrowing into two categories: the private sector and the government sector. The private sector borrows if it spends more than it earns – that is, if the spending done by consumers and businesses is more or less than their income. The government sector borrows if it runs budget deficits. The current account deficit – national borrowing – is the sum of the two.

The following chart shows the US’s current account balance split into these two components. The green line shows the private sector balance. The most prominent feature is the huge private sector deficit in the late 1990s, which was due to a combination of extremely high business spending on capital investment and extremely low saving by households. In recent years this imbalance has been nearly eliminated, as businesses have cut back sharply on their spending (though households still aren’t saving much).

The red line shows the government sector balance, including federal, state, and local levels of government. The remarkable feature about that series is the dramatic move from surplus to deficit in the past 3 years. The blue line is the sum of the two other lines – i.e. the CA balance. The graph illustrates that in the 1990s, the US was spending its borrowed funds on much higher business investment spending and somewhat higher consumption. By contrast, today the US is spending its borrowed money on government spending and higher consumer spending enabled by the tax cuts.

So, back to the question of whether the CA deficit is bad. My own opinion is that in the 1990s the CA deficit was not necessarily harmful – the money that businesses borrowed in the 1990s was spent on investments that are the crucial ingredient to today’s rapidly increasing productivity, which is essential to sustainable income growth. I’m not sure the same could be said about the higher consumer and government spending that is the cause of today’s CA deficit. Will the higher defense spending, new cars, and renovated kitchens that the US has bought with its borrowed funds over recent years help future income growth? Perhaps, but I’m skeptical.

One last point about the CA deficit: notice that it is a reflection of national borrowing and saving, and thus is not the result of “excessive” or “unfair” trade. If the US were somehow magically able to reduce its imports from China by $100bn, the US’s CA deficit would remain unchanged. Why? Because the US would still be demanding more products than it produces, so US imports from other sources would have to increase by $100bn to make up that gap. If the US were magically able to reduce its overall imports by $100bn, then the US’s CA deficit would still be unchanged, because as imports fall so would exports; in order to satisfy its excessive demand with fewer imports, the US would have to consume more of what it used to export.

The only way that the US economy can improve its current account balance is if it produces more but doesn’t spend more. In other words, private and government saving needs to improve. There’s absolutely no other way.