This is the third in a series of papers we have written over the past five years about the growing U.S. current account deficit and the potentially sharp exchange rate movements any future adjustment toward current account balance might imply.1 The problem has hardly gone away in those five years. Indeed, the U.S. current account deficit today is running at around 6 percent of GDP, an all-time record. Incredibly, the U.S. deficit now soaks up about 75 percent of the combined current account surpluses of Germany, Japan, China, and all the world's other surplus countries.2 To balance its current account simply through higher exports, the United States would have to increase export revenue by a staggering 58 percent over 2004 levels. And, as we argue in this paper, the speed at which the U.S. current account ultimately returns toward balance, the triggers that drive that adjustment, and the way in which the burden of adjustment is allocated across Europe [End Page 67] and Asia all have enormous implications for global exchange rates. Each scenario for returning to balance poses, in turn, its own risks to financial markets and to general economic stability.
Our assessment is that the risks of collateral damage—beyond the risks to exchange rate stability—have grown substantially over the five years since our first research paper on the topic, partly because the U.S. current account deficit itself has grown, but mainly because of a mix of other factors. These include, not least, the stunningly low U.S. personal saving rate (which, driven by unsustainable rates of housing appreciation and record low interest rates, fell to 1 percent of disposable personal income in 2004). But additional major risks are posed by the sharp deterioration in the U.S. federal government's fiscal trajectory since 2000, rising energy prices, and the fact that the United States has become increasingly dependent on Asian central banks and politically unstable oil producers to finance its deficits. To these vulnerabilities must be added Europe's conspicuously inflexible economy, Japan's continuing dependence on export-driven growth, the susceptibility of emerging markets to any kind of global financial volatility, and the fact that, increasingly, the counterparties in international asset transactions are insurance companies, hedge funds, and other relatively unregulated nonbank financial entities. Perhaps above all, geopolitical risks and the threat of international terror have risen markedly since September 2001, confronting the United States with open-ended long-term costs for financing wars and homeland security.
True, if some shock (such as a rise in foreign demand for U.S. exports) were to close up these global imbalances quickly without exposing any concomitant weaknesses, the damage might well be contained to exchange rates and to the collapse of a few large banks and financial firms—along with, perhaps, mild recession in Europe and Japan. But, given the broader risks, it seems prudent to try to find policies that will gradually reduce global imbalances now rather than later. Such policies would include finding ways to reverse the decline in U.S. saving, particularly by developing a more credible strategy to eliminate the structural federal budget deficit and to tackle the country's actuarially insolvent old-age pension and medical benefit programs. More rapid productivity growth in the rest of the world would be particularly helpful in achieving a benign adjustment, but only, as the model we develop in this paper illustrates, if that growth is concentrated in nontraded (domestically produced and consumed) goods rather than the export sector, where such productivity growth could actually widen the U.S. trade deficit. [End Page 68]
It is also essential that Asia, which now accounts for more than one-third of global output on a purchasing power parity basis, take responsibility for bearing its share of the burden of adjustment. Otherwise, if demand shifts caused the U.S. current account deficit to close even by half (from 6 percent to 3 percent of GDP), while Asian currencies remain fixed against the dollar, we find that European currencies would have to depreciate by roughly 29 percent...