Meet the Author

Owen F. Humpage |

Senior Economic Advisor

Owen F. Humpage

Owen Humpage is a senior economic advisor specializing in international economics in the Research Department of the Federal Reserve Bank of Cleveland. His current research focuses on the history and effectiveness of U.S. foreign-exchange-market interventions. In addition, he has investigated the Chinese renminbi peg, quantitative easing in Japan, and the sustainability of U.S. current-account deficits.

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Meet the Author

Michael Shenk |

Research Assistant

Michael Shenk

Michael Shenk was formerly a research assistant in the Research Department of the Federal Reserve Bank of Cleveland. His work focused on international topics and housing-market indicators.

01.03.07

Economic Trends

Current Account Sustainability

Owen F. Humpage and Michael Shenk

The dollar has softened a bit since early October, largely because of changing beliefs about the probable course of monetary policies here and abroad. Market participants seem to believe that the Federal Reserve will move to lower the federal funds target sometime this year and that the European Central Bank and the Bank of Japan are likely to raise their target rates.

Leveraging the impact of changing beliefs about monetary policy, however, is the longer-held expectation that the dollar must depreciate to correct what has become an unsustainable U.S. balance-of-payments pattern. The United States has financed a nearly unbroken twenty-year string of current account deficits by issuing financial claims in unprecedented amounts. Many observers fear that the market is becoming saturated with dollar-denominated assets. They warn of portfolio diversification accompanied by sharp dollar depreciation and higher U.S. interest rates. Projections of a hard landing have been around for a number of years now, but so far the landing has been nothing if not soft. Current account deficits are likely to persist for the foreseeable future, and their financial burden will set the general tone for the dollar.

Foreign Exchange Indexes*

*The Major Currency Index includes large industrialized countries; the Broad Dollar Index includes these plus the important developing countries.
Source: Board of Governors of the Federal Reserve System, “Foreign Exchange Rates,” Federal Reserve Statistical Releases, H.10.

Foreign Exchange Rates*

*Foreign currency units per dollar.
Source: Bloomberg Financial Information Services.

The United States has run a current account deficit every year save one since 1982; this is likely to continue for the foreseeable future. Although the current account incorporates more than trade in goods and services, our propensity to import more goods than we export largely explains the current account deficit.

Current Account Balance*

*Data for 2006 are quarterly data shown at an annual rate.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.

Components of Current Account*

*Data for 2006 are authors' estimates.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.

The United States pays for its surfeit of imports by issuing financial claims (for example, stocks, bonds, Treasury securities, and bank accounts) to the rest of the world. Private individuals and organizations hold most of these claims, but foreign governments, their central banks, and international agencies own a significant share. Governments such as China, Japan, and the oil-producing nations often add a substantial portion of these claims to their official foreign exchange reserves.

Net Financial Flows*

*Data for 2006 are authors' estimates.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.

Since 1986, foreigners have held more financial claims against the United States than U.S. residents have held against them, giving us a negative net international investment position. In 2005, the last year for which we have complete information, foreigners’ net claims against the United States equaled approximately $2.7 trillion, mostly held by the private sector in a relatively liquid form. Official reserves, for example, amount to 17 percent of foreign financial claims on the United States, and direct investments, which presumably are relatively illiquid, amount to 15 percent of these claims.

Net International Investment Position*

*Data for 2006 are authors' estimates.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.

Composition of Foreign Claims

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

Because these ultimately are claims on future U.S. output, we typically gauge their size relative to GDP. In 2005, the net stock of outstanding foreign claims against the United States amounted to 22 percent of GDP. Given projections for this year’s current account deficit, our negative net international investment position could reach $3.5 trillion (approximately 27 percent of GDP) this year.

The ratio has increased sharply since 1999, but it cannot rise indefinitely. As foreign portfolios become saturated with dollar-denominated assets, global investors will become increasingly reluctant to hold additional dollar-denominated assets without compensation for the risk of doing so. They may eventually begin to diversify their portfolios out of dollars. Should we reach this point, the dollar will depreciate and U.S. interest rates will rise. The dollar depreciation will help reduce the current account deficit by raising the dollar price of foreign goods, lowering the foreign-currency price of U.S. goods, and shifting worldwide demand towards U.S. markets. The rise in interest rates will reduce investment in the United States and encourage saving.

Economists are fairly certain about the nature of these adjustments. Nevertheless, no one knows when they might commence, how long they might take, or how disruptive they may be.

Net Savings and Investment

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

Net Savings: Private and Government

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

A change in investment and savings patterns is a necessary, but often forgotten, aspect of the adjustment pattern. A country’s savings and investment pattern corresponds to its current account position. A nation, like the United States, that maintains a current account deficit also invests more than it saves. Foreign savings, channeled into the country when foreigners buy U.S. financial instruments, makes up the difference between domestic investment and savings.

The pattern of investment and savings in a deficit country often has implications for the sustainability of its negative net international investment position. Throughout most of the 1990s, for example, foreign savings went to support an investment boom in the United States. Both investment and savings rose as a share of GDP. The added capital seemed to boost the pace of our long-term economic growth, making it easier—in terms of foregone domestic consumption—to service and repay foreign financial claims on the United States. Since 2000, however, investment has fallen along with domestic savings. Inflows of foreign savings have financed consumption spending—notably government spending—in the United States. This pattern is not likely to foster the economic growth necessary to repay our foreign obligations without a drop in private domestic consumption.