Why the U.S. external imbalance matters.

• Author: Cline, William R.

Last year the U.S. current account deficit (mainly on trade but including capital income and transfers) reached almost 7 percent of GDP, or about twice as large a share as in 1987, the peak of the previous episode of large external imbalances and dollar overvaluation. A major reason is that from 1995 to 2002 the dollar rose by 28 percent against other currencies, after taking account of inflation and weighting by trade. A strong dollar made U.S. exports expensive and imports cheap, driving up the trade deficit after about a two-year reaction time. With large and persistent external deficits, the United States has swung from being the world's largest creditor nation to its largest debtor, with net foreign liabilities now at about one-fourth of GDP.

The dollar has corrected somewhat and is now about 13 percent lower on a trade-weighted basis than its average in 2002, based on the Federal Reserve's broad real exchange rate index. Without that partial correction the trade deficit would now be even larger. It will likely require a decline of an additional 15 to 20 percent in the dollar to cut the current account deficit back to about 3 percent of GDP. That rate would be consistent with limiting net foreign liabilities to 50 percent of GDP in the long term. Exceeding that ceiling would seem imprudent for both the U.S. and global economies. It will be crucial that China, Japan, and much of the rest of Asia participate in realignment of their currencies against the dollar, because the decline of the dollar so far has been heavily concentrated against the euro and other industrial country currencies except for the Japanese yen. Dollar correction will also need to be accompanied by fiscal adjustment. Otherwise much of the competitive effect of the dollar adjustment would be offset by higher inflation and a dollar rebound from higher interest rates. Fundamentally the external deficit is the excess of resources used over resources produced, and with U.S. household saving near zero, the government cannot be a large net borrower without keeping the nation in large external deficit.

Why is the large external deficit a problem? After all, if the rest of the world wishes to finance overconsumption by the United States, why should we complain? There are three reasons. First, there is significant risk of a "hard landing" in which a shift in market confidence causes a plunge in the dollar, a surge in interest rates, and a recession for the U.S. and possibly global economies. Second, even with no such disruption the delay of adjustment until the current account deficit is even larger will impose a more severe burden on households a decade or more from now. Third, the trade deficit is especially punishing for the manufacturing sector, and can be expected to exert rising pressure for protection against imports, yet protection would be a highly inefficient way to narrow the trade gap.

Risk of a Hard Landing

...