Is the U.S. Current Account Deficit Sustainable?

Publication Date: December 2005

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics

Type:

Abstract:

America's current account (CA) deficit (the trade deficit plus net income payments and net unilateral transfers) has been rising as a share of gross domestic product (GDP) since 1991. In the first half of 2005, the CA deficit reached a record high of 5.7% of GDP.

The CA deficit is financed by foreign capital inflows. Many observers have questioned whether such inflows are sustainable and expressed concern about the economic impact should foreign capital inflows decline rapidly. Some fear that a rapid decline in the CA deficit could cause a recession because, presumably, a decline in the CA deficit would trigger a sharp drop in the value of the dollar and a rise in interest rates (which could lower asset values). However, economic theory and empirical evidence suggest that should the CA deficit decline slowly, economic activity would not be greatly disrupted because production in the trade sector would be stimulated. Thus, the main issue of interest to policymakers may be whether a decline in the deficit would be gradual or sudden.

From 2000-2002, gross foreign private capital inflows declined sharply, from about $1 trillion to $600 billion a year. However, this reduction did not result in a decline in the CA deficit for two reasons. First, gross private capital outflows also declined. Second, private inflows were replaced by official inflows, as some foreign central banks increased their foreign reserve holdings.

One long-term consequence of a large CA deficit has been the growing foreign ownership of U.S. capital stock. A large CA deficit is not sustainable in the long run because it increases U.S. net debt to foreigners, which cannot rise without limit. A larger debt can be serviced only through higher borrowing or higher net exports. For net exports to rise, all else equal, the value of the dollar must fall. This explains why many economists believe that both the dollar and the CA deficit will fall at some point in the future. To date, debt service has not been burdensome. Because U.S. holdings of foreign assets have earned a higher rate of return than U.S. debt owed to foreigners, U.S. net investment income has remained positive, despite the fact that the United States is a net debtor nation.

Most episodes of a declining CA deficit in industrialized countries since 1980 were associated with slow economic growth. Only two episodes were associated with a severe disruption in economic activity. Because most of the episodes involved small countries, these cases may differ fundamentally from similar episodes in the United States. Historically, a few other countries have had a higher net foreign debtto-GDP ratio than the United States has at present; however, if CA deficits continue at current levels, the U.S. net foreign debt could be the highest ever recorded within a few decades.

This report reviews studies on the CA deficit's sustainability. The studies suggest that a dollar depreciation of 10% to 56% could eventually be required to restore sustainability. This report will be updated as events warrant.