The unsustainability of the U.S. twin deficits.

• Author: Roubini, Nouriel

Global current account imbalances are increasing rather than decreasing. The U.S. current account deficit was about $665 billion in 2004 and rose to $791 billion (around 6.5 percent of GDP) in 2005, and it is likely to grow to more than $950 billion in 2006 and well above $1 trillion in 2007. Most other regions of the world--with the exception of Central Europe--are now running a current account surplus. Thus, with the exception of a few countries--Turkey, Australia, New Zealand, Iceland, Spain, Britain, and some Central European countries--most of the world is running a current account surplus and financing the U.S. current account deficits. Moreover, unlike some of these other countries running current account deficits, the United States is also running a large budget deficit that is growing--after a drop in 2005--at rates that are worrisome. Thus, the United States appears to be experiencing a twin fiscal and current account deficit whose medium- to long-term sustainability is doubtful.

The stability of this global current account disequilibrium is widely debated. According to some (Dooley, Folkerts-Landau, and Garber 2004, 2005), we are in a new Bretton Woods 2 (BW2) regime where Asia and most of the emerging world is now actively pegging its currencies to the U.S. dollar and thus following a mercantilist policy of undervalued currencies that lead to export-led growth. The resulting current account surpluses lead to an accumulation of official foreign exchange reserves that imply a cheap financing of the U.S. current account deficit. According to the supporters of the BW2 view, this is a stable disequilibrium that could last for a decade or two. In fact, this BW2 regime and the growing global imbalances are unsustainable and bound to unravel in the next couple of years. The U.S. current account deficits--bound to rise above 7-8 percent of GDP in 2006--07--imply an accumulation of foreign liabilities that will lead the U.S. net foreign debt to grow from the 25 percent of GDP level of 2004 to over 50 percent by 2010. Thus, the issue is whether foreign investors--both private and public--will be willing to accumulate U.S. assets at the net rate of $800 billion to $1,000 billion a year for the foreseeable future.

Those who believe in the sustainability of such trends point to the strength of the U.S. dollar in 2005 and to the low levels of U.S. long-term interest rates--the so-called bond market conundrum. They also argue that global imbalances are not due to the U.S. fiscal deficits but, rather, to other phenomena such as a global savings glut or foreigners' desire to accumulate U.S. assets (the "capital account surplus" interpretation of the current account deficit in the Council of Economic Advisers 2006 Economic Report of the President). However, a careful analysis of the data refutes the complacency of financial markets and the revisionist interpretations of the U.S. external deficit.

Why the Dollar Must Fall

The U.S. dollar did indeed appreciate in 2005 after falling relative to floating currencies in 2002-04, but the factors leading to such a dollar appreciation--in spite of a large and growing current account deficit--were all cyclical. In 2006, the laws of gravity--a growing current account deficit--will dominate the cyclical forces that lifted the dollar in 2005.

Such cyclical forces were several: (1) the increasing differential between short-term interest rates in the United States relative to Europe and Japan as the Fed kept on tightening while the European Central Bank (ECB) and the Bank of Japan (BOJ) remained on hold; (1) (2) the increase in the relative growth differential between the United States, Japan, and the European Union (EU) as the United States kept on growing around potential while Japanese and eurozone growth was sub par; and (3) the effects of the Homeland Investment Act (HIA) that led to the return to the United States of almost $200 billion of U.S. corporate profits that were kept abroad for tax reasons.

In 2006, instead, the issue will not be whether the dollar will be falling but rather when and how much as the gravitational forces that would weaken the dollar--a large current account deficit--will weigh with even greater force while the antigravitational forces that have lifted the dollar in 2005 will fizzle out over time. Specifically, one can expect the following factors to weaken the dollar in 2006.

First, the short-term interest rate differential will reverse against the U.S. dollar as the Fed will eventually stop its tightening cycle (and possibly reverse it if U.S. growth sharply slows) while the ECB will start its tightening phase and the BOJ will drop its zero interest rate policy.

Second, the growth differential factor will also turn against the U.S. dollar if the U.S. growth rate slows toward 2-2.5 percent (driven down by a shopped-out consumer with negative savings, high oil prices, high debt and debt servicing ratios, and a fizzling housing bubble) while Japanese growth may recover toward potential (2 percent) and even the anemic eurozone growth rate may recover toward a 2 percent potential level.

Third, the dollar boosting effects of the HIA will disappear as this profit-capital returning factor will be phased out by the expiration of this tax incentive.

Fourth, the relative returns in equity markets that already in 2005 saw the out-performance of European and Japanese equities relative to u.s. equities--may get reinforced if U.S. growth slows while Japanese and eurozone growth recovers.

Fifth, the relative yields on long-term bonds may also become bearish for the dollar as capital losses on U.S. dollar long-term fixed income assets coming from rising U.S. long rates may be--for a while--larger than similar losses on eurozone and Japanese bonds.

Sixth, the attractiveness of U.S. dollar assets may be reduced by a bursting--or even flattening--of the U.S. housing bubble compared with Japan and the eurozone where such an asset bubble did not materialize (apart from specific exceptions such as Spain). The capital gains from such a bubble have sustained, so far, the demand for U.S. dollar assets.

Seventh, the political factors that weakened the euro in 2005--the EU constitutional referenda failures, the EU fight over the budget, the mixed results of the German election, and the French riots--may not be as serious as in 2005, because some of those issues will be tackled by Europe and resolved. Conversely, the U.S. political factors may weaken the dollar because the Bush administration looks like a lame duck even this early in its second term; Iraq is becoming an increasing quagmire; and other serious domestic (Katrina and its fiscal effects) and international challenges (geostrategic stress points related to terrorism, Iran, Iraq, and North Korea) may fester and worsen.

Finally, China may decide to move its currency by about 5-10 percent in 2006, thus leading not only to a weakening of the dollar relative to the renminbi (RMB) but also to an appreciation of a wide range of Asian currencies (including the Yen) relative to the U.S. dollar. China would move for two reasons: (1) threats of U.S. protectionism as the Chinese trade surplus increases, and (2) the domestic need to cool down the overheated economy. The reduction in the...