Is the Current Account Deficit Sustainable?

A shift in net imports of 5 or 6 percent of GDP ... implies a massive change in the relative price of non-traded versus traded goods, with non-traded goods becoming relatively cheaper in the United States and more expensive abroad.

Should policymakers be worried that the U.S. current account deficit is on track to set an all-time record in 2004, reaching a level near 6 percent of GDP? Though some believe that the issue is a relatively minor one, NBER Research Associates Maurice Obstfeld and Kenneth Rogoff argue that the risks may be even more serious today than they were a few years ago. With the United States today absorbing roughly 70 percent of the current account surpluses of China, Japan, Germany, and of all the world's other surplus countries, the increasingly popular view that the current situation is sustainable seems unlikely. This is all the more true when one considers that government deficits rather than high investment now account for the lion's share of the U.S. current account deficit.

In The Unsustainable U.S. Current Account Position Revisited (NBER Working Paper No. 10869), Obstfeld and Rogoff update their earlier work and extend it in a number of dimensions, including allowing for global transmission effects. These refinements, together with today's higher deficit (5.5 percent in 2004 versus 4.4 percent in 2000) lead them to conclude that a very gradual re-equilibration of global current account imbalances would imply a depreciation of 15-20 percent in the real trade-weighted dollar. A sudden rebalancing would involve overshooting, with a doubling or more of the dollar's long-term movement. The fact that dollar depreciation tends to favor the U.S. net asset position - because the bulk of U.S. liabilities are effectively indexed to the dollar whereas only roughly half of assets are -- turns out to be relatively unimportant to this calibration.

Taking into account the fact that equilibration of the U.S. current account will affect global demand everywhere -- not just in the United States --- does, however, make a big difference. Just as the United States must absorb considerably more non-traded goods and services relative to traded goods (these include both goods where the United States is a net exporter and goods where it is a net importer) when its current account deficit closes up, foreigners consumers must be induced to start consuming more of the global supply of tradable goods now that U.S. demand is shrinking.

Thus, the bulk of the short-run pressure for dollar depreciation is driven by the need to get U.S. residents to consume fewer tradable goods of all types and for foreigners to consumer more of them, with the opposite true for production. With traded goods comprising only 25 percent of GDP in most OECD countries, a shift in net imports of 5 or 6 percent of GDP (that is, a closing of the U.S. current account deficit by that amount) implies a massive change in the relative price of non-traded versus traded goods, with non-traded goods becoming relatively cheaper in the United States and more expensive abroad. It is true that the price of the goods the United States exports must also decline, and that U.S. import prices must rise. However, contrary to much analysis in the press, this effect is quantitatively much less important, and plays only a secondary role.

The requisite depreciation, of course, depends on the empirical parameters of the economy as well as on the nature of the shock leading to equilibration (a rise in productivity in the foreign non-traded goods sector will reduce global imbalances with somewhat smaller exchange rate effects than would be caused by a rise in U.S. savings). Obstfeld and Rogoff show that an exchange rate change alone (say, caused by appreciation of the Asian currencies) will have only a relatively limited impact on the current account, absent shifts in underlying savings behavior and productivity.

While the analysis does not give a definite timetable, it does point out a number of factors that suggest rebalancing will happen within the next few years. These include the open-ended security costs of the United States, high energy prices, the still expansionary stance of monetary and fiscal policy, and rising old-age pension costs. The authors note that global rebalancing could turn out to be relatively benign, as it was in the late 1980s. Then, despite a 40 percent drop in the trade-weighted dollar, the global economy was able to absorb the shock reasonably well. But post-9/11, the Iraq war, and a succession of tax cuts, the situation appears more nearly parallel to the early 1970s, when the results were far less satisfactory.

Obstfeld and Rogoff consider a number of possible economic developments that might lead to rebalancing, including changes in savings and productivity. Higher foreign productivity helps in the short run if it is focused in the non-traded sector of the economy (where the bulk of output lies). But if foreign productivity increases are disproportionately concentrated in the traded goods sector, the imbalances will get worse before they get better.

The overall conclusion here is that the global economy is more vulnerable today than it seemed four years ago, when it already looked worrisome. If the current account closes up under relatively benign circumstances, then the effects may not be too traumatic, even though there will still likely be a spectacular short-run depreciation of the dollar, 20-40 percent on a trade-weighted basis. But if it occurs concurrently with another major shock, say to security or energy prices, or to consumer confidence, then the global output ramifications could be considerable, with interest rates rising, vulnerabilities in Europe and Asia due to appreciation of their currencies, and risks of financial crises.