Why is the U.S. current account deficit so large? Evidence from vector autoregressions.

• Author: Bachman, Daniel David

1. Introduction

   Most observers consider large U.S. current account deficits to have been the main contributor to world macroeconomic imbalance in the 1980s. The implications of continuing U.S. current account deficits of 100 to 200 billion dollars per year are troubling. Other countries must adjust to the scarcity of capital as the United States acquires a significant portion of the world's savings. At the same time U.S. companies seek protection from "unfair" foreign competition as foreign companies increase market share in the United States. Determining the source of the problem, and designing the correct solution, are therefore major objectives of economic research.

   Policymakers and economists have suggested a number of reasons for the sudden jump in the current account deficit. Different schools of thought have therefore proposed different policy responses, ranging from doing nothing to radically altering the country's commercial policy. Debate has centered on the proposed policies, with little attention paid to comparing the explanatory power of the underlying hypotheses.

2. Theories of the Current Balance

   In the National Income accounts, the counterpart to the current account deficit is an imbalance of domestic savings and domestic investment. Two explanations of the current account deficit start from this uncontroversial observation. Martin Feldstein |11; 12~ popularized the conventional view held by many economists, sometimes referred to as the problem of the "twin deficits". (See also the 1984 Economic Report of the President |5, 54-7~.) In Feldstein's view, the large U.S. government deficits attracted foreign investment to the United States, thus causing the current account to move into deficit. This view's policy recommendations are clear. If Congress and the President do not reduce the budget deficit, the U.S. will continue to absorb a large portion of the rest of the world's savings.(1) Since the capital account determines the current account, policies that do not address capital movements will not alter the current account deficit.

   Supporters of the Reagan Administration's macroeconomic policy, including William Poole |23~, oppose this view. They believe that the savings-investment imbalance that caused the current account deficit reflected a shift in the demand for investment goods in the U.S., which occurred because of the 1981 investment tax cuts. (See also the 1985 Economic Report of the President |6, 102-106~.) According to this view the U.S. current account deficit does not present a policy problem. As the country accumulates debt to finance the current deficit, it accumulates capital and therefore the additional productive capacity to pay off the debt. Efforts to shrink the current deficit risk destroying the beneficial investment boom, so the government should take no action to reduce the current account deficit.

   Economists and politicians who are apprehensive about U.S. international competitiveness believe that the current account balance reflects falling productivity in the U.S. compared to its trading partners. (See Lovett |20~ for a defense of this view, and Carvounis |4~ for a detailed discussion of what he calls the "structural approach".) This view lacks a solid basis in macroeconomic theory, because it does not address the source of the savings-investment imbalance. Supporters of the productivity explanation nevertheless argue that the U.S. must adopt policies to support export industries and improve productivity. These range from reforming the U.S. educational system to adopting an industrial policy and protection of high-technology or infant industries. Many of these policies would require a radical change in how U.S. citizens view the relationship between government and industry, and proponents of this view indeed argue that such attitudes must change. Proponents of the competitiveness hypothesis argue, therefore, that reducing the current account deficit may require drastic changes in American society.

   Two hypotheses of the current account deficit focus on foreign exchange markets. One is the "safe haven" hypothesis, which suggests that U.S. assets became relatively less risky than foreign assets in the early 1980s. The resulting demand for U.S. assets drove up their price, (the international value of the dollar) and the high dollar then caused the current deficit. The second hypothesis assumes that the dollar's rise was not caused by market fundamentals, and that the expensive dollar caused the current account deficit. The "risk premium" in foreign exchange markets is a measure of both phenomena. The risk premium on home relative to foreign assets is the difference between the return on home assets and the return on foreign assets (where r is the log return on home assets, |r.sup.*~ is the log return on foreign assets, e is the log exchange rate, and e is the log expected exchange rate.

   r - |r.sup.*~ - e + e = |rho~ (1)

   Assuming covered interest parity, (r - |r.sup.*~ - f + e = 0), where f is the forward exchange rate), the risk premium is equal to the difference between the forward exchange rate and the expected future exchange rate. If expectations are rational, (the expectational error |epsilon~ has zero mean), the difference between the forward rate and the actual future exchange rate is an unbiased estimate of the risk premium:

   |f.sub.t~ - |e.sub.t+1~ = ||rho~.sub.t~ + ||epsilon~.sub.t+1~. (2)

   ||rho~.sub.t~ + ||epsilon~.sub.t+1~ is the forward bias which economists have attempted to explain for the last decade. (Hodrick |17~ and Boothe and Longworth |3~ have surveyed this extensive literature. Most researchers interpret the empirical results of forward bias tests as pointing to a time-varying, non-zero risk premium. The source of the risk, however, has not been established.

   I constructed a measure of the risk premium using monthly forward data averaged over each quarter for the U.S. dollar exchange rate of four currencies: the Canadian dollar, the German mark, the Japanese yen, and the British pound. This average risk premium was -0.0014 during the 1970s...