Despite arguments to the contrary, America’s current account deficit is a huge problem, says Kenneth Rogoff. But a decline in the dollar won’t solve it: a more sophisticated, multilateral, response is required –

Will America’s latest public and private borrowing rampage, already more than a decade old, end in tears? Should we expect the gaping current account deficit (the excess of what the country invests less what domestic savings provide) to continue indefinitely, with countries such as China, Brazil, Japan and Germany running huge offsetting surpluses? Or should we expect the gap (estimated at $600 billion in 2004) eventually to close, followed by a broad-based, and potentially disruptive, decline in the dollar? There is a raging policy debate, and whether or not decision-makers engage in a more intensive and balanced response will determine the future of international macroeconomic policy coordination.

Crisis? What crisis?

Basically, there are three schools of thought. The first is that there is no problem, as former United States Treasury secretary Paul O’Neill opined. Foreigners wanting to keep pouring money in is a sign of strength, not of weakness.

America accounts for a disproportionate share of the world’s tradable bonds and stocks, even beyond its 22% share of global income. As global portfolios expand, more and more American assets are inevitably bought. Emerging Asian economies, especially China, this view runs, also need to keep accumulating dollar assets to prepare for when their boom turns to bust. So don’t bother America about its pathetic savings rate. Don’t bother China about its inflexible exchange rate: everything’s fine.

A nice bedtime story, perhaps, but, like all such stories, there’s an element of fantasy. One delusion is that the US deficit still supports high real investment; it doesn’t. It increasingly mirrors open-ended government borrowing.

Investment in the real economy leads to growth, helping to repay higher debt. Government deficits just lead to higher taxes and lower growth. (Unless, perhaps, the funds are used to invest in high social return public infrastructure projects. Unfortunately, this is not the case today.) Usually, when a big current account deficit reflects a big government deficit, it is the beginning of the end.

A second fantasy is the notion that foreigners will continue to be satisfied with the miserable returns they have been getting on dollar investments. For complex reasons, foreigners have consistently earned stunningly low, often negative, returns in America. Japanese blunders are the stuff of legend (the purchase of New York’s Rockefeller Center at the peak comes to mind). But Europeans have not done much better. They invested heavily in bonds during the second half of the 1990s, until they switched into equities just ahead of the technology crash. Partly as a consequence of this asset depreciation, and also because of the fall in the dollar, America’s net indebtedness to the rest of the world has been more stable than one would expect given its heavy borrowing trajectory.

But this cannot continue. If foreigners don’t start earning normal returns, they will retrench. And if returns do rise, US net debt – currently around 25% of national income, a record – will start rising even faster. Then there is the much-ballyhooed accumulation of dollar reserves in China, Japan and rest of Asia, now approaching $2 trillion. Given the dollar’s vulnerability, and the low yields on Treasury bills, we are likely to see Asian central banks diversifying into other currencies. Lastly, most projections suggest that Japan’s savings rate will keep sinking as its population – which is ageing faster than any other in the developed world – retires.

‘It’ll sort itself out…’

So much for the “What me, worry?” school of thought. A second argument concedes that the current account is going to have to rebalance, but says it is no big deal and deep global capital markets can handle the adjustment easily. There is some history to support this. During the 1980s, after US president Ronald Reagan’s aggressive tax cuts, America was also running large simultaneous current account and budget deficits (although the current account deficit then was much smaller as a share of national income than it is today.) Sure, when the correction hit, the dollar crashed by 40% on a trade-weighted basis. But, this argument claims, the fallout wasn’t so bad except, perhaps, for helping set off the events that led to Japan’s decade-long recession. Unfortunately, there are growing holes in this logic which, perhaps, explains why some early adherents, including US Federal Reserve chairman Alan Greenspan, are now expressing growing concern.

‘…No it won’t’

First, a huge fall in the dollar would have unpredictable global effects, possibly triggering financial crises and probably suffocating global growth. Just because the world dodged a bullet once doesn’t mean it will again. The other problem is that this decade looks less like the 1980s than the 1970s, when the collapse of the Bretton Woods fixed exchange rate system also led to a fall in the dollar.

Today, as in the 1970s, America is engaged in aggressive monetary and fiscal expansion (then, particularly in advance of president Richard Nixon’s re-election in 1972). Today, as then, America is facing unlimited security costs. In the 1970s it was Vietnam. Today it is “homeland security” and Iraqistan. Last, but not least, in 1972 Congress passed a huge open-ended increase in social security pensions (again, conveniently timed to go into effect just before the election). Today, higher prescription drug benefits will have the same effect on the budget. And then there are oil prices, which exploded in the 1970s and are under pressure again today.

The 1980s might have led to the boom of the 1990s, but the 1970s were a growth disaster for industrialized countries. So, whereas a sudden rebalancing of the US current account might be benign, it won’t be if it occurs against the backdrop of other serious problems.

A bit of perspective on the numbers helps illustrate the gravity of the situation. Let’s compare the $600 billion current account deficit that the United States ran up in 2004 with a few benchmarks. Gross direct foreign investment flows to all developing countries in 2004, including popular destinations like China and India, were $166 billion in 2004 and are projected to be about the same in 2005.

Incredibly, if one adds up the surpluses of all the countries running current account surpluses – that is, generating savings that can be used by the rest of the world – America is eating up well over 70% of the total. When the United States wades into the global capital market, it pretty well empties all the water out of the pool. The $600 billion borrowing tab represents more than 5.4% of US income. Never, even as a developing nation in the 19th century or during wars, has America ever depended so much on the “kindness of strangers”. There are few enough examples of small countries borrowing such large fractions of income year in, year out, much less a large country like America.

A cheap dollar won’t be enough

So policymakers are right to be worried. But what, if any, action can be taken? The clearest advice is on what not to do. Policymakers should not try to engineer an unprovoked, broad coordinated decline in the dollar. Many people think a dollar decline is going to solve the problem. They are wrong. Even if one could be engineered, it would only take care of a part of the deficit. Indeed, according to my analysis with professor Maurice Obstfeld of the University of California, Berkeley, even a broad-based fall in the dollar of 20% would only knock 2% off the US’s 6% deficit.

But dearer money will help

A restoration of normal interest rate levels will help, of course, by encouraging savings and, more directly, by capping house price increases that have fuelled a mortgage refinancing and borrowing cycle. It would also help if the government were to reduce its own deficit.

Another positive shock would be for foreign countries to start catching up with US productivity gains in the non-traded sectors of their economies. Retailing, for example, is an area where America has enjoyed a productivity explosion in recent decades. A similar gain abroad would drive foreign demand for US goods. Of course, if the productivity gains were concentrated in foreign export industries, that would simply exacerbate the problem. Finally, while having more flexible exchange rates in Asia won’t turn around America’s deficit overnight, they will provide a more flexible global environment for imbalances to unwind.

Global imbalances have been cumulating for some time and are now a substantial risk to the world economy, especially if they unwind in an otherwise adverse scenario. Whereas there are limits to what policymakers can do to anticipate the correction, this does not mean they are helpless. Far better to try to move the global economy towards balance in a stable period than to wait for the current account imbalances to implode against a backdrop of 1970s-style problems. The global current account imbalances, and their potential consequences for exchange rates, offer the quintessential case for multilateral policy consultations. If we don’t see any coordinated response on this one, it won’t bode well for global financial governance over the next decade.

Kenneth Rogoff
Kenneth Rogoff is the Thomas D Cabot Professor of Public Policy and professor of economics at Harvard University. From 2001-2003, he was chief economist and director of research at the International Monetary Fund. He has also served as the director of the Center for International Development at Harvard.