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AmericasFebruary 3 2004

Why the US deficit

Andrew Smithers argues that the US current account deficit is too small and its financial markets need to fall.
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In a world where nearly everything is disputed, the statement that the US current account deficit is too large stands out as being almost universally agreed as true [See Viewpoint p16]. Yet, paradoxically, there is a better case for arguing that the deficit is too small.

Two different assumptions underlie the belief that the deficit is too large. The first is a vague mercantilist feeling that current accounts should more or less balance, with no country importing or exporting large amounts of capital. There is, as far as I am aware, no justification for this belief either in history or economic theory.

A more reasoned approach is to argue that the growth in the foreign ownership of US assets, implied by the current deficit, is unsustainable due to the economic or political strains to which it will give rise. If the current account deficit of around 5.5% of GDP were maintained over the very long term, this is likely to be true, but there is no reason to assume that it presents a significant problem over the next 10 years, or certainly the next five.

Foreign ownership is low

The ownership of US assets by foreigners, after netting off US ownership of foreign assets, amounts to about 8% of US assets. Furthermore, the annual cost of this is tiny, as US investments abroad appear to earn more than foreigners’ investments in the country. If the current account deficit were to remain at 5.5% of GDP and the economy grows at 3% in real terms, with 2.5% inflation, then foreigners will own 15% of US assets in five years’ time.

The case for the deficit being “unsustainable” seems to be highly suspect, therefore. Furthermore, if the natural demand for funds for capital investment is considered, there is a strong case that the current flow, from Europe and Japan into the US, is too small rather than too large.

The growth rates of economies are determined by the growth in their labour forces and the rate at which labour productivity is improving. In mature economies, there should be little difference between countries in terms of rising labour productivity. If there are differences today, then the evidence favours the US as achieving more than either Europe or Japan. In practice, however, small differences in productivity changes are outweighed by the large differences in population changes. While Japan’s population of working age is already falling at around 0.5% a year and Europe’s is almost stable, that of the US is growing at 1.2% a year.

The result is that the prospective growth rate of the US is, on any reasonable estimate, at least twice that of Japan, with Europe falling between the two. However, the proportion of output taken by labour tends to be stable and similar in all developed countries. Therefore, for the return on capital to be the same, there will have to be more investment, as a proportion of GDP, in the US than in Europe and Japan. And this difference in investment will be large.

At the moment, however, Europe and Japan invest more of their GDP than the US does. It is reasonable therefore to argue that a greater, rather than a smaller, flow of capital is needed into the US from the other developed economies. As the flow of capital is identical to the current account balance, this implies that the US deficit is too small rather than too large.

Reluctance abroad

The problem is not that the US deficit is too large but that the foreign private sector is unwilling to finance it. The only buyers of dollars seem to be Asian central banks. Although the prospective return on real assets in the US is better than that on such assets in Europe and Japan, capital flows involve the purchase of financial rather than real assets, even if these are equities, which represent the ownership of real assets. The key disequilibrium today lies in the overvaluation of US financial assets, which renders them unattractive and inhibits the private sector from financing the US deficit.

What is needed for equilibrium is not a fall in the dollar but a fall in the US bond and stock markets.

Andrew Smithers is chairman of economic consultants Smithers & Co Ltd

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