The 2005 Current Account Paradox

How big will the US’s current account (CA) deficit be in 2005? The best forecasts of the CA deficit for 2005 are in the neighborhood of $750-$800bn. That would be roughly consistent with the pace that the US ran during the end of 2004. But because of an interesting paradox that exists about the 2005 CA deficit, I’m starting to wonder if it won’t be significantly smaller than that rather alarming estimate.

The reason that I throw out this possibility is because the US’s CA deficit needs to be financed, which means that individuals and companies around the world must be willing to hold more dollar assets. If the US runs a CA deficit of $800bn in 2005, that is only possible if it can persuade people around the world to hold $800bn more dollar assets during the course of the year.

In recent years, the task of persuading the world to hold dollar-denominated assets has been made significantly easier by the fact that some foreign central banks have been purchasing huge quantities of dollar assets, as Brad Setser points out in a post today. That has meant that the US has not had to attract much capital from the private sector. The following chart shows the total inflows of private capital into the US over the past decade, with the figure for 2004 estimated. The figures are simply the difference between the US’s total borrowing needs (the US CA deficit) and the increase in dollar holdings by central banks around the world (as reported by the BIS).

Even with 2004’s record CA deficit, only about $250bn of private capital flowed into the US, thanks to a phenomenal $400+ billion in demand for US dollars by foreign central banks. However, by definition, those private-sector capital flows were enough.

But think about what this implies for 2005. I would like to suggest three possible scenarios, each of which is rather unlikely, but one of which must be true.

Scenario #1: The US CA deficit is indeed about $800bn, financed roughly equally by the private sector and foreign central banks. This implies that private capital flows must surge to $400bn or more. Compare this to the chart above, however. I would argue that simple historical context makes this scenario unlikely. Such massive capital flows from the private sector would be even greater than the investments made in the US by foreigners during the peak of the internet bubble, the stock market boom, and the US economy’s expansion. Unless one believes that something dramatic will happen in the US economy this year that suddenly makes it far, far more attractive to foreign investment — in fact, even more attractive than it was in the year 2000, when the world was in a veritable frenzy of investing in the US — it seems that private capital flows will be substantially lower than $400bn in 2005. A more reasonable guess would be that they will remain roughly unchanged from 2004 levels.

Scenario #2: The US CA deficit is indeed about $800bn, while private capital flows remain roughly unchanged from 2004 levels. This implies that foreign central banks must increase their breathtaking rate of dollar accumulation in 2004 by almost 50%. Instead of accumulating $400+ billion in dollar assets, as they have done for the past two years, foreign central banks massively increase their purchases of dollars to almost $600bn per year. I find this scenario unlikely simply because it would represent central banks making a “double or nothing” bet on something that they know they will lose on — an eventual dollar depreciation. That is why numerous people have suggested that central banks are more likely to want to reduce their purchases of dollar assets this year, not raise them tremendously as this scenario requires.

Scenario #3: The US CA deficit will be closer to $500bn than $800bn. This would of course imply either a dramatic (unprecendented, in fact) surge in US exports or a dramatic (and also unprecedented) drop in US imports this year. What would cause such things to happen? Short of a major US recession, it’s not at all clear to me.

None of these scenarios is impossible, of course… but neither does any of them seem very plausible to me. And yet one of them must actually happen. It’s a delicious paradox… but one with very high stakes.