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You Can Safely Ignore Pundits Suffering from "Current Account Deficit Disorder"

As Milton Ezrati, Chief Economist with Lord Abbett & Company, noted in his December 27, 2004 commentary,1 many broadcast journalists are nearing apoplexy over the U.S. current account deficit. And quite a few investment managers seem to have the same malady.

We’ll show you why this agitation is needless. In the process, we’ll examine three key issues you need to keep in mind as you attempt to understand today’s current account deficit:

- Why the United States chronically runs a foreign deficit.
- Why the flow of red ink has become so much greater since the mid-1990s.
- Why dollar weakness is a corrective to the situation, though only a partial one.

Let’s start by looking at why the United States chronically runs a foreign deficit. The underlying problem for the U.S. current account deficit is the dollar’s unique status as the world’s reserve currency. That means that some 80 percent of the import-export contracts in the world today are written in dollars, even though many do not involve the United States or Americans.

Similar conditions prevail in banking and investment relationships. This requires economic agents to hold more dollars than are necessary for U.S. trade alone. Those special demands keep the price of the dollar higher than straightforward economic forces would require.

U.S. exports remain more expensive to the rest of the world than they otherwise might be, and imports appear cheaper to Americans. Foreigners, in other words, have a natural edge in the U.S. market, and American producers face an uphill battle on world markets and in competition with imports at home.

The situation has ensured that the U.S. current account has not been in surplus once in the last 30 years or more, and has averaged a deficit of about 2 percent of Gross Domestic Product throughout this time.

The current account almost came into balance in 1980 and again in 1991, but that was only because domestic U.S. recessions sharply curtailed American demands for imports. Current account deficits reached highs of roughly 3 percent of GDP in the boom times of the late 1980s and early 1990s, when rapidly growing incomes enlarged American demands for imports. In the early 1990s, Japan’s sudden slowdown compounded the problem for U.S. trade by causing a cutback on exports Americans were selling to Japan.

But why has flow of red ink become so much greater after 1997? First, U.S. exports suffered horribly when the Asian crisis of 1996-97 created sharp recessions that lingered long after the crisis had passed. American exports suffered still further when the Russian debt crisis blunted once-rapid growth there and in Eastern Europe.

At about same time, Western Europe, except the United Kingdom, seemed to exhaust the economic surge that had developed in the wake of the Maastricht agreement for the unification of European currency. The collapse of what at the time was called the European Monetary Union, a scheme to keep European currencies from fluctuating against each other, compounded the continent’s economic problems.

While all these economic setbacks cut deeply into demands for U.S. products in Asia and in Europe, American import demand remained strong, as a technology spending binge and rapidly rising equity markets kept the U.S. economy booming. As these opposing growth patterns developed differing appetites for imports here and abroad, the U.S. trade balance deteriorated.

Financial flows compounded the effect. Booming U.S. financial markets stood in stark contrast to the troubled Asian and European markets. Investment funds followed opportunities and flowed into this country at a fantastic rate, seeking what was effectively the only investment game on the globe. Foreign demands for dollars to make such American investments pushed the dollar’s foreign exchange value upward, even as the country’s trade and current accounts sank deeper into deficit.

For example, between 1995 and 1998, the dollar rose 77 percent against Japan’s yen and 35 percent against Germany’s deutschmark. This dollar appreciation made U.S. goods more expensive to foreigners ? and foreign goods cheaper to Americans. The effect exaggerated the impact of relative growth rates on the trade balance. The current account deficit slipped from 1.5 percent of GDP in 1997 toward 3 percent by 2000.

Even after the technology bubble burst in 2000 and the U.S. economy slipped into recession in 2001, it took a while for world funds flows and currency values to adjust. The preference for American investments continued the inflow of investment monies and with it, a growing demand for the dollar. Though the stock market bubble had burst, the historical comparisons on which many investors base their decisions still favored America. Under pressure from that investment demand, the dollar continued to rise. When the euro was introduced in 1999 at $1.18, the dollar’s strength quickly drove it down to $0.84 by late 2000, a spot where it hovered until late 2001. This continued dollar strength kept pricing U.S. goods out of world markets.

Meanwhile, though America’s boom had ended, relative world growth rates changed only marginally. The U.S. recession was so mild it had little effect on strong American demands for foreign goods. And since most foreign economies were still very weak, foreign demands for American goods remained comparably weak.

The net effect of these lingering trends pushed the U.S. foreign imbalance to unprecedented levels. As a result, the U.S. current account deficit widened toward 6 percent of GDP, where it stands today.

Now, that brings us to why the dollar has been getting weaker and why this is a good thing. By 2001, it had become apparent that the U.S. investment prospects had lost their former superiority. Foreign flows of private capital began to go elsewhere. The War on Terrorism convinced many overseas to curtail investing outside their own region, particularly in the United States.

Meanwhile, investment opportunities in Asia had improved. Not only did foreigners begin to redirect their investment flows away from the United States, but American investors also awoke to these same comparisons and began to invest abroad more heavily than they had in a long time.

Without strongly positive investment flows to support the dollar, it began to sink. So far, the dollar has dropped 60 percent against the euro from its lows of 2002, though it is still down only 15 percent from the euro’s original value when it was introduced back in 1999. The dollar has also dropped against the yen, about 22 percent from its 2002 highs; against the British pound-sterling, about 40 percent; against the Canadian dollar, about 32 percent; and against the Australian dollar, about 63 percent.

While these currency shifts should alter relative pricing in favor of American products and begin to stem the flow of red ink, the adjustment can only go so far, certainly not far enough to return the U.S. foreign balance to historic norms.

Part of the problem rests with the policies adopted by China and much of the rest of Asia in the late 1990s. All these economies have set out to promote their exports to America by keeping their currencies cheap relative to the dollar. China has set a rigid peg between its currency, the yuan, and the dollar. Other Asian nations ? such as South Korea, Taiwan, and Malaysia ? have resisted a rigid peg, but manage their currencies relative to the dollar’s value very closely anyway.2

While these currency policies might make sense to Asian development goals, they force these countries to buy dollars continually on foreign exchange markets. They cannot then sell the dollars, without undoing their objective of keeping their currencies cheap. As a result, these Asian policies block how far the dollar can fall, even against the euro or other currencies that are not managed against the dollar as they are. While this brings stability to currency markets, it limits how far a currency-based economic correction can proceed.

So what’s likely to happen and what will it mean for the global economy?

First, the U.S. economy has little reason to worry about a “run on the dollar.” Some people ask, “Aren’t we at risk when these Asian countries accumulate so much of our currency?” The answer is, “no.” While the monetary policies of China and the other Asian powerhouses interfere with market adjustments to the inordinately large U.S. current account deficit, they also make a “run on the dollar” highly unlikely. Of course, if the nations of Asia were to suddenly alter their policies and allow their currencies to freely float up on foreign exchange markets, the dollar would decline rapidly, perhaps fostering a “run on the dollar,” bringing with it rising inflation, high interest rates, and recession. But it is critical to realize that these Asian nations maintain their dollar support for their own self-serving reasons and not out of “good will” toward America, as one TV commentator foolishly suggested. A shift away from supporting the dollar runs counter to their fundamental economic growth strategy, which depends in large part on massive exports in general and exports to the U.S. in particular. It is, therefore, highly unlikely that Asia will remove its support, even if China were to allow some cosmetic adjustment in the direction of a floating yuan.

Second, the Asian economies are not likely to shift from a dollar base to a euro link. They have tied themselves to the dollar because the U.S. consumer market is such a reliable source of demand, and because U.S. policy makers always support the American consumer. The same cannot be said of the European consumer or European policy makers. Until Europe changes convincingly, such a dollar-euro switch by Asia seems improbable to say the least.

Third, what investors and managers should worry about when considering the global economic environment in the months ahead is a European recession. The euro’s rise is highly threatening in this regard. The continent is heavily dependent on exports. Some two-thirds of its growth in the last four years came from exports. Domestic economic growth there is anemic at best. Unemployment in Europe currently stands close to 10 percent. If a further rise in the euro impairs the price competitiveness of European exports, the continent could easily slip into recession. Aside from the hardship that would cause in Europe, a downturn there would stop the ongoing currency adjustment abruptly because it would redirect investment flows away from Europe, in part toward America, a change that would support the dollar relative to the euro, as it did between 1999 and 2002. Also, if Europe were to fall into recession, the European Central Bank would very probably cut interest rates. Since the Federal Reserve will likely continue to raise rates in the United States, rate comparisons would draw additional short-term funds to America, raising dollar demand and reducing demands for the euro. With a halt to the euro’s rise and the dollar’s fall, the adjustment to America’s huge foreign deficit would also halt, laying the groundwork for a more difficult and more painful adjustment at a later date.

Fourth, the way out of these global imbalances hinges on three changes, one in Asia, one in America, and one in Europe:

Asia should allow its currencies to rise against the dollar. Given the natural cost advantages in that area of the world, a rise in China’s yuan and other currencies in the region will not erase all the cost advantages their products have in the United States and elsewhere in the world. But some currency shift could reduce this disparity enough to permit world trade and especially American-Asian trade to move at least in the direction of balance.

The U.S. should shift away from consumption toward greater savings so that the country reduces its imports and America stops consuming more than it produces. We can expect any American effort along these lines to be done very gradually to allow an adjustment in the U.S. economy and in the economies of those nations dependent on exporting to the United States.

Third, Europe’s nations should contribute to the rebalancing of world trade flows by stimulating their domestic economies. Not only would that effort increase European demands for imports, helping to correct the balance of American trade, but progress on domestic economic growth would make Europe less dependent on exports, and therefore less likely to suffer so thoroughly from the euro’s rise.

References List :
1. To access Milton Ezratis article on the U.S. account deficit, visit the Lord, Abbett & Co. website at:www.lordabbett.com/insights/current_account_deficit.pdf2. To access Milton Ezratis article on Chinas currency policies, visit the Lord, Abbett & Co. website at:www.lordabbett.com/insights/revaluation_yuan.pdf

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