Sustainability of US External Imbalances

If you want to see a bleakly pessimistic picture painted of the sustainability of the US’s current account deficit, take a look at this paper by Nouriel Roubini and Brad Setser. They argue that, within a very few years, the US’s net international debt will be too large for the deficits to continue, and that the ensuing adjustment will be painful. They estimate that:

  • By 2008, the US’s current account deficit will be more than 7% of GDP (in the absence of major policy changes).
  • The adjustment in the US’s trade deficit required simply to keep the foreign debt/GDP ratio constant is 5% of GDP — i.e. imports will have fall by 1/3 or exports will have to double (or some combination thereof).
  • By 2008, the US’s net foreign debt will total 50% of GDP (up from about 28% today).

These factors will make foreign creditors unwilling to continue loaning the US money at current interest rates, Roubini and Setser argue. They therefore expect a large rise in interest rates along with a large fall in the value of the dollar to happen sometime in the latter part of this decade, at the latest. The picture below shows the US’s foreign assets and liabilities, and illustrates that the current large net foreign debt of about $2.5 trillion is a fairly new phenomenon.

But I disagree slightly with Roubini and Setser’s assessment of why these imbalances will end. As they note, for any other country, the grim statistics on the US’s external debt would raise all sorts of warning flags for investors. But the fundamental difference between the US and any other country is crucial: the US can repay its loans in its own currency, and its own currency will continue (for the forseeable future) to be widely demanded for many types of international transactions, such as the purchase of oil. Even with a massive external debt, I find it impossible to believe that creditors would start to consider default by the US government a real possibility.

So I think that there’s one key to understanding if and when the financial adjustment will occur, and it’s not the debt/GDP ratio: it’s how Asian central banks feel about lending the US money at the rapid pace that we’ve seen over the past year. Every time that the central bank of China or Japan buys dollar-denominated bonds, it necessarily increases its own money supply. Over the past year, for example, China has accumulated an additional $125 bn in foreign reserves, and its (narrow) money supply has risen from $950 bn to $1,100 bn, according to the IMF. As long as China and Japan are content to let their money supply expand at this rate, they will have no reason to stop buying US dollars.

That’s why I think that the endgame for the US current account deficit will have nothing to do with international investors starting to doubt the credit-worthiness of the US, as would happen with any other country in this situation. Rather, it depends completely on what happens in the domestic economies and central bank boardrooms of East Asia.