Is the US current account de cit sustainable? Disproving some fallacies about current accounts

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1 Is the US current account de cit sustainable? Disproving some fallacies about current accounts Frederic Lambert International Macroeconomics - Prof. David Backus New York University December, 24 1 Introduction The US current account de cit has since long raised concerns about its sustainability (e.g. Mann 1999, Obstfeld and Rogo ). However fears seem to have recently worsened, as the size of the de cit is approaching 5% of the US GDP, a threshold above which, according to Freund (), adjustment is expected to take place. Papers advocating the need for the US to rebalance its current account and assessing the consequences of such a rebalancing on the dollar exchange rate or the US economic growth have thus multiplied while receiving a growing echo in the nancial press (see Roubini and Setser 24 for references). In a somehow provocative way, this paper questions the need for a rapid closing-up of the US current account de cit. Looking at the history of other industrialized countries, we provide examples of countries having sustained large current account de cits over very long periods of time apparently without any problems. We show that current account de cits do not necessarily imply real exchange rate depreciation, nor are they associated with future economic slowdown, thus disproving some widespread beliefs. The rest of the paper is organized as follows: Section 2 looks at evidence of industrialized countries running large current account de cits over very long periods of time without experiencing any di culties in nancing them. Sections 3 and 4 examine the relationship between current account balances and exchange rates and economic performance. Section 5 concludes. 2 The sustainability of current account de cits Many papers do not de ne precisely what they mean by "sustainability". The common wisdom seems to be that a de cit is sustainable as long as it is consistent with the intertemporal budget constraint, i.e. current de cits are o set by past or future surpluses so that over time a country does not consume more than it can pay. Sustainability so de ned is not very di erent from solvency. However, since the intertemporal budget constraint must hold in the very long run, this de nition is not very useful in practice to assess whether a de cit is sustainable or not. Indeed, one can nd several examples of countries sustaining large current account de cits over very long periods of time. Australia for instance has been running a current account de cit since 1861 except for 2 years. Nearly half the time (7 years out of 143), the de cit was even greater than 5% of the Australian GDP, and on 1

2 Figure 1: Current Account Balances as % of GDP 15% 15% 1 1 5% 5% 1 15% 2 5% 5% 1 15% 25% Australia Canada New Zealand United States average over the last 3 years, it amounted to 4.1% of GDP. This accumulation of de cits resulted into net liabilities (net international investment position - IIP) over 6 of GDP in 23. But the winner here is New Zealand, with net liabilities peaking at 87% of GDP at end- (around 77% at end-23). For the years for which data were available (196-23), the average current account de cit of New Zealand stood at 3.9% of GDP (5.1% over the last 3 years). Canada has also been running current account de cits for most of the 2th century, even if the situation has reversed over the past few years. The average de cit over the last 3 years was nevertheless a bit smaller than in the two previous examples, up to 1, of the Canadian GDP (2.5% if excluding the last 5 years when it has turned to a surplus) whereas Canada s net liabilities remained under 45% of its GDP. 1 1 A word of caution here. Canadian IIP gures are reported at book value, while Australian, New Zealand and US gures are supposed to be at market value. This might lead to an underestimation of the Canadian net liabilities, especially for components that are very sensitive to valuation e ects like FDI or portfolio investments. If it exists, the bias is however likely to be fairly limited here, as we are only comparing net gures for the total IIP. 2

3 Hence it is not the size nor the persistence of current account de cits that should matter when assessing their sustainability. So why do people worry about the US de cit? Compared to Australia or Canada, the US has been running a current account surplus over a large part of the past century (66 years over 135 for which we got data). The US de cit is recent and it is only since that it went beyond of the US GDP. Net liabilities stand then around 2 of the GDP at the end of 23, a level that seems reasonable compared to Australian and New Zealand ones. It is often argued that the problem with the US de cit comes from its origin. While at the end of the nineties the US current account de cit was due to excess private investment over private saving, the federal budget being in surplus, the situation has changed since. 2 Today, it is mostly the growing government de cit that accounts for the current account de cit, whereas private investment has shrunk (private saving has shrunk too, so the aggregate impact on the current account is small). Since the recent increase in government expenditures does not correspond to an increase in productive investment, fears are that external debt is growing faster than debt service capacity (i.e. capacity to repay the debt by generating higher income in the future). However, both Canada and New Zealand have been running large government de cits leading to large current account de cits over quite a long period of time (from to for Canada and from to for New Zealand), so again the US situation does not look exceptional in this respect. Mann (24) provides a more general (and maybe more operational) de nition of sustainability. A current account imbalance is deemed sustainable whenever it "generates no economic forces of its own to change its trajectory". According to this de nition, a large depreciation of the domestic currency triggered by the current account de cit may thus be interpreted as a sign of its unsustainability. At least that is how some economists have analyzed the dollar decline over the past three years. However that link between current account de cits and exchange rates is weak. 3 Current account de cits and exchange rates According to a popular view, the current account and the exchange rate are considered to be closely related. For instance, a real exchange rate appreciation is expected to have a negative impact on the trade balance, as domestically produced goods become relatively more expensive than goods produced abroad, thereby undermining the competitiveness of domestic rms (Krugman, 1985). On the contrary, a real depreciation should improve the current account balance. However, this argument generally ignores individual rms behavior. Both domestic and foreign producers often try to adjust their pro t margins to movements in the exchange rate to keep their prices constant and retain their market shares. Hence the di culty to establish a strong empirical link. A rapid examination of the US recent experience illustrates that di culty (see Figure 3). Between 1981 and 1985, the dollar appreciated as the US current account de cit widened, a trend that the Plaza Agreement - aimed at driving the dollar down - failed to revert. Thus the de cit carried on increasing until 1987 despite the large depreciation of the dollar. More recently, the growing current account de cit did not prevent the dollar from appreciating between 1995 and, while the fall of the dollar since then has not (yet?) helped to close the de cit. Looking at the graphs for Australia, Canada and New Zealand is not more convincing. In Canada, if the recent rebalancing of the current account has been accompanied by a real depreciation of the 2 From the accounting identity CA S I, net current account de cits can be broken down into excess of private investment over private saving and public dissaving (government de cit). See Figure 2. 3

4 Figure 2: Current Account Balances and Saving and Investment as % of GDP 1 Public Saving Investment Private Saving Investment Current Account Balance Australia Public Saving Investment Private Saving Investment Current Account Balance Canada 1 1 Public Saving Investment Current Account Balance Private Saving Investment Public Saving Investment Current Account Balance Private Saving Investment New Zealand United States 4

5 Figure 3: Current Account Balances and Real Exchange Rates Current Account Balance (AUD million lhs) AUD Trade Weighted Real Exchange Rate Index (rhs) Current Account Balance (CAD million lhs) CAD Trade Weighted Real Exchange Rate Index (rhs) Australia Canada Current Account Balance (NZD million lhs) NZD Trade Weighted Real Exchange Rate Index (rhs) Current Account Balance (USD million lhs) USD Trade Weighted Real Exchange Rate Index (rhs) New Zealand United States 5

6 Table 1: Relationship between Changes in the Current Account and Exchange Rate and GDP Growth Dependent variable Change in Exchange Rate Index GDP Growth Rate 1.4E E-7 (.2) (-.92) Number of observations R-squared.7.11 Note: Both regressions include country xed-e ects. T-statistics are shown in parentheses. Canadian dollar, this was not the case at the beginning of the s when the current account de cit went from -4.1 to.61% of the Canadian GDP in. In Australia, the current account de cit widened between and while the Australian dollar was depreciating in real terms, but also between 21 and 23 while it was appreciating. In New Zealand, the current account balance improved along the real appreciation of the New Zealand dollar between and 1987, but it got worse between and 1997 as well as between 21 and 23. These observations are con rmed by some basic econometrics. By estimating a simple xed-e ect regression equation linking changes in current account balances and changes in trade-weighted real exchange rate indexes since in the four above mentioned countries, we found no evidence of any signi cant relationship between the two variables (see Table 1). 4 Current account de cits and economic performance It is a well-established fact in the literature that current account balances are countercyclical: countries usually run de cits during periods of high growth and surpluses in low-growth periods, a behavior consistent with risk-sharing. However nothing in the theory says that long-lasting current account de cits imply poor economic performance in the future. Indeed, the growth performance of Canada and Australia has not been worse than the average performance of OECD countries since, in spite of their running persistent current account de cits (this is not true for New Zealand, whose annual growth rate over the period -23 is both more volatile and on average lower than the OECD average). In particular, over the last few years (-23), the Canadian growth rate remained very close to the OECD average whereas the current account de cit switched to a surplus, thereby contradicting the argument that current account adjustment in industrialized countries is usually followed by a slowdown in GDP growth (Freund, ). Using again simple econometric techniques, we found no signi cant relationship between changes in the current account and GDP growth. If rebalancing the current account does not necessarily imply slower growth, it may in theory lead to lower private consumption growth, as saving needs to increase (assuming investment and government expenditures stay constant). 3 It is indeed what seems to happen in Canada in, when the current account de cit closed up and private consumption dropped. However private consumption also fell in the US in and it slowed down in Australia in 1983, while current account balances did not change much in those two countries. In fact, the cross-country correlation of consumption growth rates tends to be higher than the correlation between consumption growth rates and changes in the current account 3 Recall the accounting identity: CA (Y C G) I = S I. 6

7 Figure 4: Annual Growth Rates AUS CAN NZL USA OECD Average Figure 5: Current Account Balances and Private Consumption Growth Current Account Balance (% of GDP) Private Consumption Grow th Australia Current Account Balance (% of GDP) Private Consumption Grow th Canada 1 1 Current Account Balance (% of GDP) Private Consumption Grow th New Zealand Current Account Balance (% of GDP) Private Consumption Grow th United States 7

8 Table 2: Current Account and Private Consumption Growth Cross-country correlation of private consumption growth Correlation between changes in the current account and private consumption growth Australia Canada New Zealand Australia -.1 Canada Canada -.1 New Zealand New Zealand -.17 United States United States -.19 within individual countries in our sample (see Table 2). Note that, as expected, the correlation between changes in the current account and private consumption growth is negative: private consumption growth decreases whenever the current account balance improves. Nevertheless, the impact of rebalancing the current account on private consumption is far from being obvious. 5 Conclusion This paper tried to question some popular beliefs about current accounts, namely that current account de cits cannot be sustained over a long period of time or that rebalancing a current account de cit usually implies a real exchange rate depreciation and a decline in real GDP growth. Looking at historical evidence on Australia, Canada, New Zealand and the US, we showed that those commonly assumed relationships between current account and other macroeconomic variables were not supported by the facts. Maybe the cases we examined are just special cases. All four countries belong to the Anglo-Saxon world and share the same type of institutions, a determinant factor for building country-trust and thereby reducing the countries vulnerability to external shocks according to a recent study by Caballero, Cowan and Kearns (24). However, the experience of Australia, Canada and New Zealand should at least partly challenge those who scream at the US current account unsustainability. 8

9 Appendix on data sources Current account balance relative to GDP ratios are computed from saving and investment rates taken from Taylor () for years before 196. Current account balance and GDP data from national statistics o ces were used for subsequent years. Data on private consumption are from national statistics o ces. International investment position and government budget balances data are from the IMF International Financial Statistics. Real GDP growth rates are from the World Bank Development Indicators. Trade-weighted real exchange rate indices are from JPMorgan. References [1] Caballero, R., Cowan, K., Kearns, J. (24), "Fear of Sudden Stops: Lessons from Australia and Chile", Reserve Bank of Australia, Research Discussion Paper, May. [2] Freund, C. (), "Current Account Adjustment in Industrialized Countries", Board of Governors of the Federal Reserve System, International Finance Discussion Papers 692, December. [3] Jacob, J. (23), "Current Account Imbalances: Some Key Issues for the Major Industrialized Economies", Bank of Canada Review, Winter. [4] Krugman, P. (1985), "Is the Strong Dollar Sustainable?" NBER Working Paper 1644, June. [5] Mann, C. (1999), "Is the US Trade De cit Sustainable?", Institute for International Economics. [6] Mann, C.(24), "The US Current Account, New Economy Services, and Implications for Sustainability", Review of International Economics, forthcoming. [7] Obstfeld, M., Rogo, K. (), "Perspectives on OECD Capital Market Integration: Implications for US Current Account Adjustment", Federal Reserve Bank of Kansas City, Global Economic Integration: Opportunities and Challenges, March, pp [8] Obstfeld, M., Rogo, K. (24), "The Unsustainable US Current Account Position Revisited", NBER Working Paper 1869, October. [9] Roubini, N., Setser, B. (24), "The US as a Net Debtor: The Sustainability of the US External Imbalances", New York University, Mimeo, November. [1] Taylor, A. (), "A Century of Current Account Dynamics", NBER Working Papers 8927, May. 9