The calculation of current account (CA) includes trade balance (exports less imports), net unilateral transfers and net income payments. Since 1982, U.S. has been experiencing a continuous CA deficit (other than in 1991). This is equal to the net inflows of foreign investment to U.S., and is simply an accounting identity because the balance of payments (BOP) must balance.
There are negative consequences from a CA deficit, and question on its sustainability. The general worry arises when the time comes for U.S. to finance its debt. In order to decrease reliance on foreign investments, U.S. must increase savings rate, resulting in a decrease in consumption spending from the public, and a reduction in private investments. In addition, tighter monetary and fiscal policies will take place to reduce the federal budget deficit. These measures to narrow the CA deficit will lead to a slowing-down of the economy, which ironically, is the same result (or perhaps a more serious recession) should the CA deficit be allowed in continuing to grow. Another cause for concern is the increasing amount of US capital owned by foreigners. Income payment diverted to foreign countries in the form of dividends and interest will weaken the US economy. Some argue that the CA deficit, which is sustained by foreign borrowing, will stimulate the economy through investments in domestic businesses. However, much of this money is not directly invested in R&D and capital investments, which improve the economy’s productivity. Instead, a large portion of this borrowed money is diverted to finance the government budget deficit (which includes the bursting Social Security payments) and war spending, which do not increase total factor productivity, or innovation. Thus, should this trend continue, the CA deficit will not be sustainable in the long run.
On the other hand, this problem may not be as bleak as it seems to be. For any reason (such as the U.S. Financial Crisis in 2008) should foreigners’ confidence in U.S. assets decline, the consequence is a decrease of capital inflow, followed by the depreciation of the U.S. dollar in the foreign exchange market. This will increase exports and decrease imports, thus improving the balance of trade. The resulting narrowing of the CA deficit offsets the decrease in the capital account, which results in no huge negative impact on the economy. Foreigners choose to invest in U.S. assets because of the higher rate of returns compared to those in their domestic markets. Using this larger capital stock (than if solely obtained from its domestic savings), U.S. currently generates a higher rate of return than the cost of its debt. In addition, the U.S. receives a large, positive, net investment income from the rest of the world. From, “Excess Returns on Net Foreign Assets: The Exorbitant Privilege from a Global Perspective” by Maurizio Habib, the estimated real rate of return from U.S. foreign assets is 3.1% more than its foreign liabilities. Hence, the CA deficit is seen to be beneficial to both the U.S. economy and the foreign investors who are financing this debt.
I stand on the bench of supporting the CA deficit because it does not weaken the exchange rate in a managed-floating market. However, should there be a long-term decrease in confidence of U.S. assets, resulting in the dollar depreciating, the Federal Reserve must raise interest rates to allay the fears of investors. The rising interest rates will increase the vulnerability of the CA deficit, making it unsustainable. The key to sustaining the U.S. CA deficit is the continued confidence of foreigners in U.S. assets, a constant growth in the total factor productivity (in the U.S. economy), and a positive net income from U.S. investments from the rest of the world to the U.S.
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