How Does It End?

A recent OECD working paper by three economists at the OECD poses the following question: how might the US’s massive current account deficit be reduced? For a decent summary of the paper, you can take a look at a piece in this week’s online Economist.

The main conclusions of the paper are straightforward: two major problems loom over the eventual correction of the US current account deficit. First, it will be very difficult to achieve. In order to bring the US’s current account back into balance, a huge change in the value of the US dollar will be required. A 5 or 10 percent decline in the value of the dollar will do little to improve the CA deficit; what will be needed is probably a 25 to 50 percent drop in the value of the dollar. Furthermore, this will probably need to be combined with a return to fiscal discipline in Washington, the likelihood of which you can judge for yourself.

Note that it makes intuitive sense that a large fall in the value of the dollar is needed. To reduce the CA deficit Americans have to stop buying so much from the rest of the world. But they won’t do that until they start feeling significantly poorer compared to the rest of the world than they do currently. Well, that’s exactly what a large depreciation of the dollar would accomplish. (A massive recession would do the same thing, but with many more negative side-effects.)

The second big problem is that, even if a significant reduction in the CA deficit can be achieved, we will then need to worry about the serious negative consequences that it would have. In particular, countries that are flirting with deflation (e.g. Japan, Germany) could be pushed over the brink by a large fall in the dollar and a large drop in US demand for their goods.

So where does that leave us? How will the US’s current account deficit be resolved? Chances are that it won’t, at least not for a while. The US will probably keep running large CA deficits for the next several years. This is not necessarily bad. Borrowing money from the rest of the world through CA deficits can actually be perfectly fine, depending on what the borrowed funds are spent on.

But under the Bush administration, the US has been spending nearly all of the money it has borrowed from other countries to finance the budget deficit. And that’s where the real problem lies. Borrowing money from the rest of the world would worry me less if the US wasn’t spending it to fund government services and tax cuts to the wealthy, and was spending it instead on business investment. Borrowed money should ideally be spent on things that increase your ability to repay your loans in the future. By and large, that was true of the US current account deficits the 1990s, which was indeed spent on business investment. Today it is not.