The U.S. Current Account Deficit

Table of Contents

Summary of the Facts 3

Statement of the Problem 5

Causes of the Problem 5

Possible Solutions 7

Solution and its Implementation 8

Justification 9

References 10

Summary of the Facts:

The first section of the case study identifies the potential sources of the large deficits. Investors and policymakers throughout the world were confronted with the risk of painful economic consequences arising from the large U.S. current account deficit. Defying forecasts, the deficit continued to climb. By 2006, it was $811 billion, equivalent to 6.2% of GDP (HBR, page 1). In 2007, the U.S. current account deficit was $731 billion, equivalent to 5.3% of GDP. Much of the rise in the current account deficit over the past decade can be attributed to two major factors: first is the accelerating U.S. productivity and secondly there is a surge in household wealth driven by the stock market. The second section examines whether the U.S. current account deficit is sustainable in the near term. In this study, an unsustainable deficit is defined as one that triggers a sharp hike in interest rates, a rapid depreciation of the dollar, or some other domestic or global economic disruption.

The article concludes that, over the near term, deficits of roughly the current magnitude are sustainable and therefore unlikely to disrupt the U.S. economy. Explaining the rise in the current account deficit shown in Chart 1 below requires considering a range of other variables (HBR, page 12).

Many of these variables are part of the U.S. economy's external sector: the trade account, international financial flows, and the exchange rate. Movements in the current account deficit are due primarily to movements in the trade deficit. The current account deficits are financed by net capital inflows from abroad (HBR).

Finally, the exchange rate is related to the current account because international transactions including trade in goods, services, and financial assets generally require exchanging dollars for foreign currencies. A country's international trade in goods and services and international borrowing and lending are recorded in its balance of payments accounts.

The balance of payments consists of two main accounts: the current account and the financial account. The current account measures the change over time in the sum of three separate components: the trade account, the income account, and the transfer account. The trade account measures the difference between the value of exports and imports of goods and services. A trade deficit occurs when a country imports more than it exports (HBR).

The U.S. trade deficit is by far the largest component of the U.S. current account deficit. In fact, fluctuations in the trade deficit are the primary cause of fluctuations in the current account deficit. The income account measures the income payments made to foreigners net of income payments received from foreigners. For the United States, the income account largely reflects interest payments made by the United States on its foreign debt and interest payments received by the United States on its foreign assets. An income deficit arises when the value of income paid by the United States to foreigners exceeds the value of income received by the United States from foreigners. The transfer account measures the difference in the value of private and official transfer payments to and from other countries. The largest entry in the transfer account for the United States is foreign-aid payments (HBR).

Statement of the Problem:

Several of the main problems mentioned in the case study are:

* The appreciation and depreciation of the dollar: Appreciation against major currencies by 34% from December 1995 to February 2002, then depreciation by 31% from February 2002 to April 2005. Also, against the euro by 40% from December 1995 to March 2002, then depreciation by 39% from March 2002 to April 2005 (HBR, page 7).

* An increase in the U.S. demand for foreign goods. Partly higher U.S. growth, mostly relative demand shifts.

* An increase in the foreign demand for U.S. assets. There were a variety of different assets/investors since the mid-1990s, from equities to bonds and from private investors to central banks. Appreciation, triggering trade deficit, but then depreciation as the U.S. net foreign debt accumulates.

* Another problem is high consumer debt, the U.S. Federal budget deficit and debt, and high savings rates in Japan and China. If not addressed, these factors will eventually limit U.S. economic growth (HBR, page 7).

Causes of the Problem

History shows that United States was the largest creditor and is now the largest debtor in the world market. The creation of the euro currency in 1999 created a decline in the ability of the United States to finance its large and growing current account deficit. This imbalance involved from its external balances alone with its handling of critical internal transactions, one being, and the handling of foreign oil dependency.

The problems with the American dollar have been brewing since the mid-1800s during the time of rapidly industrializing. It was during this time that the U.S. current account deficit and NIIP close to their early 21st-century levels (Obstfeld and Rogoff, 2004). It was a period of time when large current account imbalances were common throughout the world. These loans were finance with long-term "development finance" capital tending to flow from already industrialized countries of Western Europe. These industrializing countries had current account surpluses of which they loaned to emerging economies that needed to fund major infrastructure projects (Obstfeld and Taylor 2002).

In 1879 the United States joined the global gold standard the gold standard acted as a "seal of approval" for countries issuing sovereign debt. This was time