Sustainable Deficit - Essay Example

Sustainable Deficit In considering whether the U.S. current account deficit is sustainable, many factors must be examined. The amount of spending on foreign goods and foreign investment affect trade deficit or surplus which, in theory, directly affects the current account. Productivity affects the current account when investment occurs in order to increase future output. According to Economic Review, First Quarter 2001, “economic theory predicts that if a country experiences an investment boom as a result of increased productivity, while its trading partners do not, its current account deficit should widen.” Catherine Mann suggests that current account deficit can indicate that a nation is “living beyond its means,” or that a country is attracting global foreign investment due to higher returns and less risk. In the Economic Review article, Jill Holman defines current account as “the change Over time in the sum of three components: the trade account, the income account, and The transfer account.” Trade account is the difference in value of imports and exports. Income account is the difference in income payments made to foreigners versus payments Received from foreigners. Transfer account is the difference in value of private and government payments to and from other countries. The explanation on page 8 of the Economic Review summarizes a trade deficit that must be financed by borrowing from abroad. How this borrowing affect the U.S. current account deficit is more complicated than the trade deficit. The U.S. trade deficit has been widening since the late 1990s as we demand and consume more foreign goods. As we borrow from abroad, we must also make payments to foreign investors. Overall, deficits in both accounts are the result of U.S. participation in a global marketplace. As more U.S. firms invest in and manufacture goods overseas, we invest less in our own economies. More foreign owned firms in the U.S. mean less opportunity for our own firms to gain competitive advantage. t is easy to see why the current account deficit Sustainable Deficit 2 exists. The question of whether this deficit is sustainable is a bit more difficult to predict. An article appearing in the Journal of Economic Perspectives in the summer of 2003, By Catherine Mann, details the possibility of a sustainable current account deficit hinging on the condition that “neither it nor the associated capital inflows nor the net negative international investment position are large enough to induce drastic changes in economic variables.” Mann goes on to identify variables such as consumption, interest rate, investment and exchange rate. She concludes by explaining that the current account deficit in sustainable but only when certain conditions or policies are adopted. While Mann’s view is based on the prior activity of the current account, particularly within the past three decades, Jill Holman looks at the past decade since the early 1990’s to base her conclusions. Both economists conclude that as long the current account deficit stays on the same course or trajectory, with underlying factors remaining the same, it is sustainable. Holman focuses on foreign investment as the key to sustaining the account deficit. Foreign investors have quite a bit of confidence in U.S. investments, which help to finance the deficit. Foreign investments are mostly long-term in the U.S., which provides even more stability in financing. Mann suggests that even foreign investment changes will eventually reach their limit, creating a wider deficit that will not be sustainable. She also suggests some scenarios that will address the widening deficit. First, the depreciation of the U.S. dollar in response to the leveling off of foreign U.S. investment will serve to limit the deficit by decreasing consumption of foreign goods with a weaker exchange rate. Along with depreciation of the U.S. dollar, increasing interest rates occurring as a result of corporate attempts to attract foreign and domestic investment will limit U.S. investment in global economies. Mann also eludes to policy changes that encourage more household Sustainable Deficit 3 saving and increased fiscal responsibility which will also serve to narrow the deficit. Whether or not such policy changes actually take place, both economists suggest that increased productivity and wealth in the U.S. have since the early 1990’s have led to the widening current account deficit. Although Mann suggests solutions, Holman does not address a solution as she does not view U.S. spending and consumption as an underlying factor. While it is true that U.S. household savings and domestic investment have decreased drastically over the past decade, the issues of foreign outsourcing and off-shoring are not addressed. Incomes for blue collar workers have decreased as many are displaced into service sector employment, due to loss of U.S. production jobs. Many of the workers who were once able to contribute to company credit unions and savings accounts no longer have that option. There is also a loss of retirement account investment, either wholly provided by or subsidized by employers. When Mann suggests policy changes that limit foreign investment, she does not mention particular policy that will limit outsourcing of U.S. manufacturers, as well as an increasing number of service providers. The chart below shows the increase in U.S. import consumption as a percentage of the GDP that occurred in the previous decade. Much of the consumption and spending on imports by the U.S. is done so for economic Sustainable Deficit 4 reasons. Foreign goods often cost less to manufacture, making them less costly To U.S. households. Roger Ferguson Jr., Vice Chairman of the Federal Reserve Board identifies the increasing lack of global competitiveness as the cause of income and job loss in the U.S. He further provides the view of some experts who “view the large current account deficit as an example of the profligacy of Americans,” with a decline in personal savings rate from five percent in the mid 1990’s to two percent by 2005. While he offers no definitive explanation of why this decrease in saving has occurred, Ferguson has offered some ideas, such as increase in housing investment and increased overall consumption. Ferguson offers three different explanations of what defines the current account. The difference between exports and imports, difference between savings and investment and the net inflow of foreign capital in the U.S. This is not unlike Mann’s threefold factor in defining the current account, though her formula combines the three factors together. What Ferguson mentions that Mann and Holman do not, is the recent increase in oil prices as a large contributing factor to the current account deficit. As Ferguson points out “it is worth noting that our oil import bill has risen by about $110 billion, from $68 billion in 1999 to $180 billion in 2004, and most of this increase reflects higher oil prices.” He is in agreement with the Holman that productivity growth and decline in savings rate are also contributing factors. Ferguson evaluates various opinions as to whether the current account deficit will narrow in the future by natural economic means, or whether corrective action in policy must occur. Widespread differences in opinion appear to correlate with view in the cause of the current account deficit. For those who believe that government policies such as budget deficit served to widen the current account deficit, change in governmental policy is the corrective action needed to narrow the deficit. Those who believe that Sustainable Deficit 5 private sector activities are a major contributor view the marketplace as the means for reducing the deficit. Jill Holman takes the approach that the deficit will naturally correct itself as gradual changes occur in reevaluation by current foreign investors in the U.S. marketplace. She further believes that the international dept-GDP ratio will not rise above levels that other industrial economies have experienced. Holman also argues against Mann’s benchmark four percent as the level of import consumption portion of the U.S. GDP being the cutoff for sustainability of the current account deficit. She points out the current deficit is above that level and believes the benchmark to be an inexact figure. Holman believes that any change in foreign investment, depreciation of the us dollar or increase in interest rates will be gradual enough for the account deficit to withstand such changes. She believes that “the current account deficit will narrow within the next few years in an orderly manner.” While such an occurrence is entirely possible, the views of the economists mentioned take for granted that particular events will not occur. For instance, Holman takes for granted that “there will not be a fire sale of U.S. assets.”(2001, p20). None of the views take account of the possible devaluation of U.S. assets due to political policy, as well as to fiscal or budget policy. Abrupt changes in policy such as in immigration or defense, if not acceptable at least in the views of other industrial nations, could potentially lead to sharp decline in foreign investments as the values of such assets are not held in as high regard, and therefore less marketable. Such changes could also bring about even less demand for US exports, and rising cost of imports. The question of whether the current account deficit in the U.S. is sustainable is a difficult one to answer, given the vast differences in economist views. I believe that if the current trajectory continues it will not be sustainable. However, I do not think Sustainable Deficit 6 that that budget or policy changes are necessarily the answer. Some policy changes that could be beneficial are export incentives and additional taxation to U.S. firms that practice foreign outsourcing. Without such changes, I believe the current account deficit will correct itself over time as Jill Holman theorizes. References Ferguson, W 2005, ‘U.S. Current Account Deficit: Causes and Consequences’, Retrieved October 9 2006 from http://www.federalreserve.gov/boarddocs/Speeches/2005/ 20050420/default.htm. Holman, J 2001, ‘Is the Large U.S. Current Account deficit Sustainable?’ Economic Review, First Quarter. Mann, C L 2002, ‘Perspectives on the U.S. Current Account Deficit and Sustainability’, Journal of Economic Perspectives, Vol 16, No3, pp. 131-152. Read More