Is the U.S. Current Account Deficit Sustainable? If Not, How Costly Is Adjustment Likely to Be?

Many analysts in academia, the private sector, and applied research institutions express increasing concern about the growing U.S. current account deficit. There is a general sense that current global imbalances are unsustainable and that adjustment must come sooner rather than later. The unprecedented magnitude of the U.S. current account deficit and the United States' growing net foreign indebtedness have fueled these worries, with many analysts arguing that, unless something is done, the world will move toward a major financial crisis.¹ Some have gone as far as to suggest an imminent collapse of the dollar and a global financial meltdown.² Underlying this view is the fact that, if the deficit continues at its current level, U.S. net international liabilities will eventually reach 100 percent of GDP, a figure widely considered to be excessively large.³

The source of financing of the U.S. current account deficit has also become a matter of concern. A number of authors have argued that, by relying on foreign and particularly Asian central banks' purchases of Treasury securities, the United States has become extremely vulnerable to sudden changes in expectations and economic sentiments.⁴

Robert Skidelsky recently argued in the New York Times that the value of the dollar is one of the most important sources of political tension between the United States and Europe. Arguing that "[U]nilateralism is not more acceptable in currency matters than in foreign policy," Skidel-sky points out that,

The United States is the only major country proclaiming itself indifferent to its currency's value. In countries running persistent current account deficits, governments normally-indeed must-reduce domestic consumption. But so far, the United States has relied on other countries to adjust their economies to profligate American spending. . . .⁵

There is, however, an alternative view. Some authors have argued that, in an era of increasing financial globalization and rapid U.S. productivity gains, it is possible—indeed, even logical and desirable—for the United States to run very large current account deficits for a very long period (say, a quarter of a century). In this view, growing international portfolio diversification implies that the rest of the world will be willing to accumulate large U.S. liabilities during the next few years, maybe even in excess of 100 percent of U.S. GDP. From this perspective, since the U.S. current account deficit poses no threat, there are no fundamental reasons to justify a significant fall in the value of the dollar.⁶

This paper analyzes the relationship between the dollar and the U.S. current account, with particular attention to the issue of sustainability and the mechanics of current account adjustment. I develop a portfolio model of the current account and show that, even under a very positive scenario where foreigners' (net) demand for U.S. assets doubles from its current level, the U.S. current account will have to go through a significant adjustment in the not-too-distant future. Indeed, one cannot rule out a scenario where the U.S. current account deficit shrinks abruptly by 3 to 6 percent of GDP. To get an idea of the possible consequences of such an adjustment, I also analyze the international historical evidence on current account reversals. The results of this empirical investigation indicate that significant current account reversals have tended to result in large declines in GDP growth.

The U.S. Dollar and the Current Account: A Thirty-Year Perspective

This section analyzes the behavior of the U.S. real exchange rate (RER) and current account since the adoption of floating exchange rates in the early 1970s.⁷ I begin by discussing the course of the U.S. RER and current account during that period and the changing nature of the U.S. trade-weighted RER index. I argue that the last thirty years of U.S. RER behavior can be divided into six distinct phases. Second, I discuss the most recent data on the U.S. current account, including its sources of financing. And third, I provide some...