Can the United States Continue to Run Current Account Deficits Ind.docx

Can the United States Continue to Run Current Account Deficits
Indefinitely?
The United States has benefitted from a surplus of saving over
investment in many areas of the world, which has provided a
supply of funds. This surplus of saving has been available to the
United States because foreigners have remained willing to loan
that saving to the United States in the form of acquiring U.S.
assets, such as Treasury securities, which have accommodated
the current account deficits. During the 1990s and the first
decade of the 2000s, for example, the United States experi-
enced a decline in its rate of saving and an increase in the rate
of domestic investment. The large increase in the U.S. current
account deficit would not have been possible without the
accommodating inflows of foreign capital coming from nations
with high saving rates, such as Japan, China, and Middle-
Eastern nations, as seen in Table 10.5.
For example, China has been the fastest growing supplier of
capital to the United States during 2001–2010. This is partly
because of China’s exchange-rate policy of keeping the value
of its yuan low (cheap) so as to export goods to the United
States and thus create jobs for its workers (see Chapter 15). In
order to offset a rise in the value of the yuan against the dollar,
the central bank of China has purchased dollars with yuan.
Rather than hold dollars, which earn no interest, China’s central
bank has converted much of its dollar holdings into U.S.
securities that do pay interest. This situation has put the
United States in a unique position to benefit from the
willingness of China to finance its current-account deficit.
Simply put, the
TABLE 10.5
FOREIGN HOLDERS OF U.S. SECURITIES AS OF 2007
United States can “print money” that the Chinese hold in order
to finance its excess spending. The buildup of China’s dollar
reserves helps to support the U.S. stock and bond markets and

permits the U.S. government to incur expenditure increases and
tax reductions without increases in domestic U.S. interest rates
that would otherwise take place. However, some analysts are
con- cerned that at some point Chinese investors may view the
increasing level of U.S. foreign debt as unsustain- able or more
risky and thus suddenly shift their capital elsewhere. They also
express concern that the United States will become more
politically reliant on China who might use its large holdings of
U.S. securities as leverage against policies it opposes.
Can the United States run current account deficits indefinitely
and thus rely on inflows of foreign capital? Since the current
account deficit arises mainly because foreigners desire to
purchase American assets, there is
Chapter 10 361
Billions of Country Dollars
Japan $1,197
Percent of World Total
12.2% 9.4 9.4 7.6 7.2 4.9 4.0
45.3
100.0%
China United Kingdom Cayman
Islands Luxembourg Canada Belgium Other 4,418
World Total $9,772
922
921
740
703
475
396

Source: U.S. Treasury Department, Report on Foreign Portfolio
Holdings of U.S. Securities as of June 30, 2007, April 2008, p.
8.
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to electronic rights, some third party content may be suppressed
from the eBook and/or eChapter(s). Editorial review has deemed
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362 The Balance of Payments
no economic reason why it cannot continue indefinitely. As long
as the investment opportunities are large enough to provide
foreign investors with competitive rates of return, they will be
happy to continue supplying funds to the United States. Simply
put, there is no reason why the process cannot continue
indefinitely: no automatic forces will cause either a current
account deficit or a current account surplus to reverse.
United States history illustrates this point. From 1820 to 1875,
the United States ran current account deficits almost
continuously. At this time, the United States was a relatively
poor (by European standards) but rapidly growing country.
Foreign investment helped foster that growth. This situation
changed after World War I. The United States was richer, and
investment opportunities were more limited. Thus, current
account surpluses were present almost continuously between
1920 and 1970. During the last 25 years, the situation has again
reversed. The current account deficits of the United States are
underlaid by its system of secure property rights, a stable
political and monetary environment, and a rapidly growing
labor force (compared with Japan and Europe), which make the
United States an attractive place to invest. Moreover, the U.S.
saving rate is low compared to its major trading partners. The

U.S. current account deficit reflects this combination of factors,
and it is likely to continue as long as they are present.
At the turn of the century, the United States’ current account
deficit was high and rising. By 2006, the U.S. current account
deficit was about six percent of GDP, the highest in the
country’s history. Even in the late 1800s, after the Civil War,
the U.S. deficit was generally below three percent of GDP.
During the budget deficits of President Ronald Reagan in the
1980s, the current account deficit peaked at 3.4 percent of
GDP. Because of relatively good prospects for growth in the
United States compared to the rest of the world, international
capital was flowing to the United States in search of the safety
and acceptable returns offered there. However, capital was not
flowing to emerging markets as in the 1990s. Europe faced high
unemploy- ment and sluggish growth, and Japan faced economic
contraction and continuing financial problems. Not surprisingly
in this setting, capital flowed into the United States because of
the relatively superior past performance and expectations for
future growth in the U.S. economy. Simply put, the U.S. current
account deficit reflected a surplus of good investment
opportunities in the United States and a deficit of growth
prospects elsewhere in the world. However, many economists
feel that economies become overextended and hit trouble when
their current-account deficits reach four to five percent of GDP.
Some economists think that because of spreading globalization,
the pool of savings offered to the United States by world
financial markets is deeper and more liquid than ever. This pool
allows foreign investors to continue furnishing the U.S. with the
money it needs without demanding higher interest rates in
return. Presum- ably, a current account deficit of six percent or
more of GDP would not have been readily fundable several
decades ago. The ability to move that much of world saving to
the United States in response to relative rates of return would
have been hindered by a far lower degree of international
financial interdependence. However, in recent years, the
increasing integration of financial markets has created an

expanding class of foreigners who are willing and able to invest
in the United States.
The consequence of a current account deficit is a growing
foreign ownership of the capital stock of the United States and a
rising fraction of U.S. income that must be diverted overseas in
the form of interest and dividends to foreigners. A serious
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not be copied, scanned, or duplicated, in whole or in part. Due
to electronic rights, some third party content may be suppressed
from the eBook and/or eChapter(s). Editorial review has deemed
that any suppressed content does not materially affect the
overall learning experience. Cengage Learning reserves the
right to remove additional content at any time if subsequent
rights restrictions require it.
problem could emerge if foreigners lose confidence in the
ability of the United States to generate the resources necessary
to repay the funds borrowed from abroad. As a result, suppose
that foreigners decide to reduce the fraction of their saving that
they send to the United States. The initial effect could be both a
sudden and large decline in the value of the dollar as the supply
of dollars increases on the foreign-exchange market and a
sudden and large increase in U.S. interest rates as an important
source of saving was withdrawn from financial markets. Large
increases in interest rates could cause problems for the U.S.
economy as they reduce the market value of debt securities,
cause prices on the stock market to decline, and raise questions
about the solvency of various debtors. Simply put, whether the
United States can sustain its current account deficit over the
foreseeable future depends on whether foreigners are willing to
increase their investments in U.S. assets. The current account
deficit puts the economic fortunes of the United States partially
in the hands of foreign investors.
However, the economy’s ability to cope with big current
account deficits depends on continued improvements in
efficiency and technology. If the economy becomes more
productive, then its real wealth may grow fast enough to cover

its debt. Opti- mists note that robust increases in U.S.
productivity in recent years have made its current account
deficits affordable. But if productivity growth stalls, the
economy’s ability to cope with current account deficits will
deteriorate.
Although the appropriate level of the U.S. current account
deficit is difficult to assess, at least two principles are relevant
should it prove necessary to reduce the deficit. First, the United
States has an interest in policies that stimulate foreign growth,
because it is better to reduce the current account deficit through
faster growth abroad than through slower growth at home. A
recession at home would obviously be a highly undesirable
means of reducing the deficit.
Second, any reductions in the deficit are better achieved
through increased national saving than through reduced
domestic investment. If there are attractive investment
opportunities in the United States, we are better off borrowing
from abroad to finance these opportunities than forgoing them.
On the other hand, incomes in this country would be even
higher in the future if these investments were financed through
higher national saving. Increases in national saving allow
interest rates to remain lower than they would otherwise be.
Lower interest rates lead to higher domestic investment, which,
in turn, boosts demand for equipment and construction. For any
given level of investment, increased saving also results in
higher net exports, which would again increase employment in
these sectors.
However, shrinking the U.S. current account deficit can be
difficult. The economies of foreign nations may not be strong
enough to absorb additional American exports, and Americans
may be reluctant to curb their appetite for foreign goods. Also,
the U.S. government has shown a bias toward deficit spending.
Turning around a deficit is associated with a sizable fall in the
exchange rate and a decrease in output in the adjusting country,
topics that will be discussed in subsequent chapters.

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Editor
Stefan Schneider
+49 69 910-31790
[email protected]
Technical Assistant
Pia Johnson
+49 69 910-31777
[email protected]

Deutsche Bank Research
Frankfurt am Main
Germany
Internet: www.dbresearch.com
E-mail: [email protected]
Fax: +49 69 910-31877
Managing Director
Norbert Walter
October 1, 2004 Current Issues
The U.S. balance of payments: wide-
spread misconceptions and exaggerated
worries
• The U.S. balance of payments is by far the most confusing and
least
understood area of the U.S. economy. The confusion is centered
around the
large and rapidly growing deficits. Indeed, the deficit on the
current account of
the balance of payments rose to new records, both in absolute
and relative
terms.
• These developments created worries and fears regarding the
sustainability of
the external deficits. However, closer examination of the issue
shows that the
worries and fears are exaggerated and, most importantly, there
are no short-
and medium-term solutions because of a number of structural
reasons.
Mieczyslaw Karczmar, +1 212 586-3397 ([email protected])

Economic Adviser to DB Research
Guest authors express their own opinions, which may not
necessarily be those of Deutsche Bank
Research.
Economics 3
The U.S. balance of payments is by far the most confusing and
least
understood area of the U.S. economy. The confusion is centered
around the large and rapidly growing deficits. Indeed, the
deficit on
the current account of the balance of payments rose from USD
474
billion in 2002 to USD 531 billion in 2003 and is estimated to
reach
over USD 600 billion in 2004 (see table 1). In relative terms,
the
deficits amount to 4.5%, 4.9% and 5.3% of GDP, respectively,
in
those years. Both in absolute and relative terms, these are all-
time
records.
The sustainability of external deficits
Persistent and rising external deficits have attracted increasing
at-
tention of politicians, economists and the media. Needless to
say,

the deficits are generally viewed as highly negative for the U.S.
economy and U.S. financial conditions. The main points of
concern
are:
• Rising foreign indebtedness that might create financial
difficulties
over time.
• A potential massive dollar depreciation needed to rectify the
situation.
• In an extreme case, a financial crisis as foreigners refuse to fi-
nance U.S. deficits and switch their capital to other places.
The media, regardless of their political outlook, have been
commenting on the U.S. external deficits for quite some time,
spreading fear and predicting all sorts of calamities, which
apparently sells newspapers well. About five years ago, in the
fall of
1999, The New York Times ran an article with a pointed
headline:
“The United States sets a record for living beyond its means;”
and a
Barron’s article talked about a current account crisis and a
ticking
time bomb.
Had these scary predictions materialized, the U.S would have
been
bankrupt by now. But never mind, the fascination with the
rising
deficits continues. A Financial Times article a few weeks ago
was
headlined: “America is now on the comfortable path to ruin.”
The persistence of external deficits and their presumable
negative
effects have focused the economic debate on the key question.

Are
the deficits sustainable? A generally uniform answer is that not,
that
they are not sustainable. The Federal Reserve chairman Alan
Greenspan has repeatedly emphasized that he does not believe
the
deficits can go on indefinitely. But he confessed that he does
not
know when will they stop. And he admitted that so far the
financial
markets have coped very well with the global payments
imbalances.
The late Herbert Stein, a great economist with a great sense of
hu-
mor, had famously said that if something cannot go on forever,
it will
stop. The logic of this reasoning is unassailable. However, 2004
will
be the 29th consecutive year of trade deficits and (disregarding
the
statistical aberration in 1991 when foreign contributions to
finance
the Gulf war produced a small surplus) the 23rd consecutive
year of
current-account deficits. But during this period, the U.S.
enjoyed a
generally prosperous economy, especially during the decade of
the
1990s when the economy went through an unprecedented boom.
So maybe Stein’s saying should be reversed – if a trend goes on
for
a long time, and it not only does not have any harmful effects
but, on
the contrary, coincides with a period of prosperity, it may well
be
sustainable.

One-liners aside, there is an apparent conflict between theory
and
empirical evidence. To address the contradiction between
theoretical
and empirical considerations, it is necessary to examine the
Scary media predictions have so far
not materialised
-6.0
-5.5
-5.0
-4.5
-4.0
-3.5
-3.0
2000 2001 2002 2003 2004
-700
-600
-500
-400
-300
-200

-100
0
Current account
USD bn
(right)
% GDP (left)
-600
-500
-400
-300
-200
-100
0
100
70 75 80 85 90 95 00
Current account &
trade balance
Current account
USD bn
Trade balance

Current Issues October 1, 2004
4 Economics
following key aspects of the U.S. balance of payments: a) the
nature
and underlying causes of the deficits, b) the financing of the
deficits,
c) main characteristics of U.S. foreign debt, and d) the role of
the
dollar in dealing with the external deficits.
Main characteristics of U.S. external deficits
When analyzing the external deficits, it is essential to
distinguish
between cyclical and structural deficits. The cyclical deficits
are
non-controversial and easy to understand. They result from the
disparity in economic growth between the U.S. and its main
trading
partners, with the U.S. showing stronger growth. This generates
increased demand for imports while U.S. exports are hampered
by
slower growth abroad.
Over the past 20 years, the U.S. has shown generally strong
eco-
nomic performance (except for two brief and shallow recessions
in
1991 and 2001), superior to most other industrial countries. It
is,
therefore, not surprising that this coincided with rising trade
and
current-account deficits. Indeed, while in 1983 the current-

account
deficit amounted to 1.1% of GDP, it has risen to about 5% in
the last
two years.
How long this strongly rising deficit trend would last? It is
difficult to
predict with any certainty. Yet, although the trend has been
cyclically
driven, it has certain permanent characteristics rooted in demo-
graphic and productivity aspects.
First, the U.S. is the only major industrial country with growing
popu-
lation. The latest census in 2000 has shown that during the
decade
of the 1990s U.S. population grew by 13.2%, in contrast with
stag-
nating or shrinking populations elsewhere in the industrial
world.
Moreover, although the U.S. population is aging, it is aging less
than
in other main industrial countries – the census revealed, e.g.,
that
72.7% of U.S. population was below the age of 50, while the
number
of people in the 35-54 age range, the most productive and
highest
spending segment, increased by 32% in the previous decade.
Second, the technological revolution of the 1990s was most
pronounced in the U.S. as it was in America where the
Schumpeterian “creative destruction” took mostly place. This
led to
strong productivity gains, superior to those in most other
nations.
The combination of population and productivity growth resulted
in a
rising growth potential of the economy. Even allowing for the

most
recent slowdown in productivity growth, potential annual
growth of
the U.S. economy is still estimated at about 3.5%, i.e. about 1%
higher than in Europe.
To be sure, there has been an acceleration of the economic
expan-
sion in Japan (even allowing for the most recent slowdown) and
continuing strong growth in China and the Asian newly
industrialized
countries (NIC). This should boost U.S. exports and possibly
arrest
the inexorable widening of U.S. deficits. But eliminating them,
let
alone turning them around into surpluses, is out of the question
in
the foreseeable future. The reasons lie in the structural deficits.
The structural deficits draw much less attention than the
cyclical
ones, even though they are at least equally important. Even if
the
disparity in economic growth rates between the U.S. and the
rest of
the world were eliminated, the U.S. would still have trade and
current-account deficits for the following main reasons.
First, U.S. income elasticity of imports is higher than foreign
income
elasticity for U.S. exports. This phenomenon is rooted in the
general
openness of the U.S. market, which makes imported goods
readily
available and it makes them available at increasingly
competitive
U.S. has exceptionally high income
elasticity of imports

-600
-500
-400
-300
-200
-100
0
100
70 75 80 85 90 95 00
-4
-2
0
2
4
6
8
Current account & real GDP
Current account
(right)

USD bn
Real GDP
(left)
% yoy
-4
-2
0
2
4
6
8
10
90 92 94 96 98 00 02 04
Nonfarm productivity
% yoy
Economics 5

prices. Moreover, the development of industrial cooperation and
outsourcing has increased sharply income elasticity of imports,
as
some products or groups of products are no longer produced in
the
U.S. While traditionally the ratio of import growth to GDP
growth was
about 1.7, it is now closer to 2.5 –3.0.
Second, the proliferation of outsourcing, beginning with the
North
American Free Trade Agreement (NAFTA) 10 years ago, and
now
extended to India, China and other Asian countries, has almost
by
definition widened the U.S. trade deficit as US products shipped
abroad return to the US with value added; hence, the value of
im-
ports exceeds that of exports.
Third, the U.S. dollar’s function as the main reserve currency
makes
the current-account deficit inevitable because of (a) inflow to
the
U.S. of monetary reserves of foreign central banks due to the
normal
accumulation of these reserves, especially in countries with
current-
account surpluses, and (b) occasional interventions in foreign
ex-
change markets by countries trying to resist the appreciation of
their
currencies vis-à-vis the U.S. dollar.
Of course, this source of financing the U.S. current-account
deficits
is not guaranteed forever. It is hoped that eventually the euro
will
also become a main reserve currency, which would in fact fulfill

de
Gaulle’s idea of breaking the dollar’s hegemony that was at the
foundation of the concept of a single European currency. But
this is
not likely to happen in the near future. The dollar is still the
dominant
reserve currency as about 65% of global monetary reserves are
held
in dollars.
The financing of U.S. external deficits
It is an axiom of the foreign trade theory that a country can run
a
balance of payments deficit only to the extent it can finance it,
either
through borrowing or through depleting its foreign exchange
reserves.
In this respect, the U.S. is in an exceptionally advantageous
situa-
tion because it does not need to borrow in a conventional sense.
The financing comes voluntarily because of the attractiveness of
the
U.S. as an investment destination providing generally higher
rates of
return than obtainable elsewhere; because of the seize, scope,
openness and liquidity of the U.S. capital markets; and because
of
the dollar’s role as the world’s prime investment, transaction
and
reserve currency. Interest rates are determined by the conditions
in
the U.S. money and capital market rather than dictated by the
lend-
ers. And, unlike most other countries, the U.S. has the ability to
fi-
nance its external deficits in its own currency.

There is no doubt that this relative easiness in financing is an
impor-
tant factor in sustaining the US trade and current-account
deficits.
Some economists go even further. They contend that it is the
financ-
ing side of the equation, or net capital inflow, that determines
the
current-account deficits. For example, Milton Friedman – in an
inter-
view earlier this year – when asked about the reason for the
U.S.
current-account deficit, responded that it is because foreigners
want
to invest in the U.S. This view was postulated by the Austrian
economist Böhm-Bawerk a good 100 years ago, stating that it is
the
capital account of the balance of payments which leads the
current
account.
This view is also represented by William Poole, president of the
Federal Reserve Bank of St. Louis. In a paper published in the
January/February 2004 issue of the Federal Reserve Bank of St.
Louis Review, Poole – drawing on research of Catherine Mann
from
the Institute for International Economics in Washington –
examines
2
4
6
8

10
12
14
16
80 82 84 86 88 90 92 94 96 98 00 02 04
10Y Govt. bond yields
%
USA
Germany
6 Economics
three different views of the U.S. international imbalance: (a) the
trade view, in which trade flows are the primary factors and the
offsetting capital inflows are secondary, (b) the GDP view, in
which
the current-account deficit is perceived as a shortfall between
domestic investments and domestic savings, and (c) the capital
flows view, in which the trade and current-account deficits are a
residual, the result of the capital-account surplus.
This surplus, in turn, is driven by foreign demand for U.S.
assets
rather than by any structural imbalance in the U.S. economy.
Needless to say, the capital flow view is the most amenable to
the

sustainability of the U.S. external deficits. There is a legitimate
concern voiced by some economists that – due to persistent
foreign
demand for U.S. assets – the U.S. has absorbed some 80% of
international savings in recent years. This may cause a U.S.
dollar
overweight in global portfolios. However, there is no solution in
sight
for this apparent asymmetry in portfolio allocations.
The financing of U.S. external deficits is an area of the greatest
mis-
conceptions. A popular view held by some economists and the
me-
dia is that foreign investors might refuse to finance the U.S.
deficits
and switch their capital to other places or invest in their own
coun-
tries, which could have dire consequences for the U.S.
This may indeed happen. But one should keep in mind that
foreigners invest in the U.S. because they view this as
advantageous for them, not to do America a favor. Granted, they
may decide to increase their domestic investments. But as long
as
the U.S. has a large current-account deficit and Japan, China
and
other countries have large surpluses, continuing capital inflow
to the
U.S. is assured.
It is also true that foreign countries may shift some of their
monetary
reserves to other places. But as long as the U.S. dollar remains
the
pre-eminent reserve currency, this is unlikely because of the
limited
size and scope of other monetary areas. The situation illustrates
the

“exorbitant privilege” – in de Gaulle’s words some 45 years ago
–
the U.S. derives from the dollar’s global role. This enables the
U.S.
to run “deficits without tears” as described by Jacques Rueff, de
Gaulle’s adviser.
In short, if someone argues that at some point foreigners might
re-
fuse to continue financing U.S. external deficits, a question
must be
answered – where would they go with their money. The
alternatives
to investing in the U.S. are very limited, indeed.
The U.S. international indebtedness
A very important issue in assessing the sustainability of the
U.S.
external deficits is the magnitude and structure of U.S. foreign
indebtedness, as reflected in annual Commerce Department
reports
on U.S. international investment position (see table 2).1
As can be seen, net indebtedness reached at the end of 2003
USD
2.4 trillion or USD 2.6 trillion (depending on the valuation
method of
U.S. and foreign direct investments), i.e. close to 25% of GDP,
up
from a rough equilibrium in 1989. This has caused widespread
lam-
entations that the U.S., the richest country in the world, has
become
within 15 years the biggest debtor in the world.
1 U.S. international investment position does not exactly

represent U.S. foreign debt,
since it also includes equities and physical capital, but it is a
good proxy of the U.S. in-
ternational indebtedness.
Current-account deficit can be
financed by a “structural surplus” in
the capital account
Lack of alternative locations for
investment
Economics 7
Such a sharp rise in foreign debt should not be surprising,
considering the piling up of current-account deficits in recent
years.
What is surprising, though, is that the investment
income/payments
balance has been in surplus (see table 1) despite the large and
rising debt. How to explain this apparent incongruity?
The main reason for the surplus in investment income despite
the
rising U.S. indebtedness is that U.S. investments abroad are, in
aggregate, more profitable than foreign investments in the
United
States.
This fact is primarily caused by a very large share of foreign
official
assets in the U.S. due to the dollar’s function as the main

reserve
currency. (Private capital flows, as mentioned before, have an
oppo-
site characteristic as foreigners generally enjoy a higher return
on
their investments in the U.S.)
As can be seen from table 2 (item 18), foreign official assets in
the
U.S. reached USD 1.5 trillion at the end of last year, i.e. 60% or
55%
of U.S. net indebtedness (depending on the valuation method of
direct investments). In allocating their monetary reserves,
foreign
central banks are primarily motivated by safety and liquidity
rather
than by the rate of return. They invest these reserves mostly in
U.S.
Treasury bills, which bring them relatively low returns.
In addition, U.S. currency owned by foreigners, which is
practically
costless, reached USD 318 billion last year (item 27), bringing
the
total of low- or no-cost U.S. liabilities to about 70% of net U.S.
debt.
Moreover, foreign official assets and currency have, by a large,
a
permanent character, similar to demand deposits at commercial
banks, further easing the burden of U.S. foreign indebtedness.
The balance of payments and the dollar
One of the most controversial issues of the U.S. international
economy is the relationship between the balance of payments
and
the dollar exchange rate. Many economists believe that it is the
widening of the U.S. current-account deficit that is responsible
for

the dollar decline during the past 2-3 years. Some even go
further
by saying that it would be impossible to eliminate the deficit
without
a massive, prolonged devaluation of the dollar.
These views are highly questionable. They ignore historic
experi-
ence and they are based on an obsolete theory. If the weakening
dollar is mainly the result of rising external deficits, how to
explain
the fact that between 1995 and 2001, when the U.S. current-
account
deficit nearly quadrupled, the dollar was on a strongly rising
trend.
Going back another 10 years to 1985, the Plaza Hotel
Agreement
was a major international event aimed at pushing the dollar
down,
with the main underlying objective of shrinking and eventually
eliminating the U.S. current-account deficit. This did not
happen,
however, and the deficit rose to new highs.
The main underlying reason for the weak response of trade
flows to
the dollar devaluation is the relative low price elasticity of both
sides
of the U.S. trade balance. On the import side, for the dollar
devalua-
tion to have a full effect on trade flows, two conditions must be
ful-
filled: a) foreign exporters have to raise their prices to offset
the cur-
rency loss, and b) domestic producers competing with imports
have
to keep their prices constant in order to increase their market
share

and shift demand away from imports to domestic production.
None of these conditions is fulfilled to the full extent. Foreign
exporters are reluctant to raise their dollar prices in order not to
jeopardize their competitive position in the huge and lucrative
American market. They often cut their profit margins and
sometimes
-25
-20
-15
-10
-5
0
5
10
15
76 81 86 91 96 01
Net international investment
position
% GDP
0.00
0.25

0.50
0.75
1.00
1.25
70 75 80 85 90 95 00
Balance of investment income
% GDP
-600
-500
-400
-300
-200
-100
0
100
80 84 88 92 96 00
70
80
90

100
110
120
130
140
Current account & USD
Current
account
(right)
USD bn
USD nominal
trade-weighted rate (left)
2000=100
8 Economics
even run temporary losses, all in order to keep their market
shares.
Labor Department data on import prices clearly show this
phenomenon. For the past two years non-oil import prices have
risen only marginally.
Moreover, even when foreign exporters raise their prices,

domestic
producers competing with imports often raise prices, too, under
the
umbrella of higher import prices, thus defeating the macro-
economic
purpose of devaluation. This had happened on a massive scale
in
the 1985-1995 period when U.S. auto makers did not bother to
go
for higher market shares; they raised their prices, knowing that
Americans will buy Japanese cars anyway because of their
superior
quality.
Interestingly, these are not new phenomena, they have been
known
for decades. Weak macro-economic effects of currency
devaluation
were particularly visible during the devaluation of the British
pound
in 1967. Since that time, if anything, devaluation effects have
be-
come weaker still as trade flows shifted further away from
commod-
ity-type trade toward capital equipment.
Similarly, on the export side, currency changes and the
associated
changes in relative prices have had diminishing results on the
trade
balance. This was especially clear during periods of the dollar
ap-
preciation in the 1980s and 1990s. It did not hamper U.S.
exports,
as theoretically expected. On the contrary, exports were running
strong since U.S. trade partners were willing to pay higher
prices for
the U.S. technology, know-how and sophisticated capital goods.

A separate case is the possible revaluation of the Chinese yuan
by
eliminating its fixed exchange rate to the dollar. This is
strongly ad-
vocated by some economists and policymakers in view of the
rapidly
rising U.S. trade deficits with China. But it is dubious that this
would
really happen. The exchange rate of the yuan is a political issue
rather than an economic one; it is determined by the Chinese
Polit-
bureau, not by market forces.
The dollar decline during the 2001-2004 period cannot be
attributed
to any large extent to the widening U.S. trade and current-
account
deficits. The main contributing factors were a) exceptionally
wide
interest ride differentials between the U.S. and other industrial
nations as U.S. rates fell to their lowest levels in over 40 years,
b)
the September 11 events and constant fears of further terrorist
attacks, and c) a change in the attitude of the U.S. toward the
dollar
as clear signs emerged that the Bush administration is not
unhappy
with the weaker dollar, in contrast with the strong-dollar policy
of the
second Clinton administration.
All together, a dollar devaluation is not likely to solve the
deficit prob-
lem (if there is one), and may disappoint those who advocate it.
On
the contrary, from the policy standpoint, it may have a negative
im-
pact on the U.S. economy. Considering that it is capital flows

rather
than trade flows that determine the dollar exchange rate,
devalua-
tion might hamper the financing of the deficit without reducing
it to
any large extent.
Concluding remarks
The persistence of U.S. external deficits and the associated rise
of
U.S. international debt have led to widespread worries and fears
as
to how long this condition may last and how could it be
rectified.
Closer examination of this issue shows, however, that the
worries
are far from justified and the fears greatly exaggerated, for the
fol-
lowing main reasons:
-30
-20
-10
0
10
20
30
40

80 82 84 86 88 90 92 94 96 98 00 02
Exports & USD
Exports
% yoy
USD nominal
effective exchange rate
-20
-15
-10
-5
0
5
10
15
90 92 94 96 98 00 02 04
Import prices & USD
Import prices % yoy
USD nominal
effective exchange rate

Economics 9
• The primary cause of U.S. trade deficits is disparity of
economic
growth, with the U.S. growing faster than most other industrial
nations due to demographic and productivity factors. Sure, a
deep and protracted recession in America could possibly reverse
the rising deficit trend. But, obviously, the cure would be worse
than the disease. The U.S. is thus a victim of its own success.
The deficit is a reflection of U.S. strength not weakness.
• Even when disregarding the growth disparity, the U.S. would
still
run external deficits for a number of structural reasons, the most
important of which are: a) high income elasticity of imports, b)
spreading industrial cooperation and outsourcing, c) the dollar’s
function as the key global reserve currency.
• Although the accumulation of current-account deficits raised
U.S.
international debt to about one-quarter of its GDP, the structure
of the debt is highly advantageous as about 70% of it constitutes
liabilities to foreign central banks and U.S. currency owned by
foreigners. Both sources have pretty permanent characteristics
and, above all, very low cost of financing or are outright
costless.
• The depreciation of the dollar is not likely to change much the
balance of payments deficit but it may jeopardize its financing.
So, all together, does the U.S. have a problem with its external
deficits? If it does, the problem certainly pales in comparison
with

major long-term problems, such as the unfunded liabilities of
the
Social Security system in view of the forthcoming retirement of
the
baby-boom generation, the explosive rise in health-care costs,
and
the growing dependence on oil imports from volatile areas of
the
world.
Most important, as the paper was trying to demonstrate, if it is a
problem, there are no immediate solutions of the problem. And
to
quote another Herb Stein’s one-liner, “if there is no solution to
a
problem, there is no problem.”
Finally, an important mitigating circumstance is that it is mostly
economists and politicians who worry about the external
deficits.
The general public does not lose sleep over the issue, which
only
attests to the common sense of the American people.
Mieczyslaw Karczmar, +1 212 586-3397 ([email protected])
Economic Adviser to DB Research
10 Economics
Table 1: U.S. Balance of Payments
(in billions of dollars)

I. Current Account 2002 2003 2004*
Exports of goods 681.8 713.1 791.5
Imports of goods -1164.7 -1260.7 -1400.2
Merchandise Trade Balance -482.9 -547.6 -608.7
Income from services 294.1 307.3 334.3
Payments for services -232.9 -256.3 -283.4
Services Balance 61.2 51.0 50.9
Income from U.S. assets abroad 266.8 294.4 340.8
Payments on foreign assets in the U.S. -259.6 -261.1 -311.2
Investment Income/Payments Balance 7.2 33.3 29.6
Unilateral Transfers -59.4 -67.4 -78.8
Current-Account Balance -473.9 -530.7 -607.0
II. Capital (Financial) Account (private)
Foreign direct investment 72.4 39.9 85.8
Foreign portfolio investment 385.9 365.4 503.4
Bank borrowing 96.4 75.6 343.5
Other 99.5 100.7 85.0
Capital inflow 654.2 581.6 1017.7
U.S. direct investment abroad -134.8 -173.8 -216.7
U.S. portfolio investment abroad 15.9 -72.3 -93.7
Bank lending -30.3 -10.4 -436.0
Other -46.4 -32.5 -108.8
Statistical discrepancy -95.0 -12.0 57.3
Capital outflow -290.6 -301.0 -797.9
Capital-Account Balance 363.6 280.6 219.8

III. Balance of Payments -110.3 -250.1 -387.2
IV. Official Reserve Transactions
Decline (+) /Increase (-) in U.S. official reserve assets -3.7
1.5 3.4
Increase in foreign official assets in the U.S. 114.0 248.6
383.8
*) Forecast
Source: US Department of Commerce, own calculation and
regroupings
Economics 11
Line Type of investment Position, Position
2002r 2003p
Net international investment position of the United States:
1 With direct investment positions at current cost (line 3 less
line
16)..........................................................................................
.....................................................-2,233,018 -2,430,682
2 With direct investment positions at market value (line 4 less
line
17)..........................................................................................
.....................................................-2,553,407 -2,650,990
U.S.-owned assets abroad:
3 With direct investment at current cost (lines
5+6+7)....................................................................................

...........................................................6,413,535 7,202,692
4 With direct investment at market value (lines
5+6+8)....................................................................................
...........................................................6,613,320 7,863,968
5 U.S. official reserve
assets......................................................................................
.........................................................158,602 183,577
6 U.S. Government assets, other than official reserve
assets......................................................................................
.........................................................85,309 84,772
U.S. private assets:
9+11+14+15)...........................................................................
....................................................................6,169,624
6,934,343
10+11+14+15).........................................................................
......................................................................6,369,409
7,595,619
Direct investment abroad:
9 At current
cost.........................................................................................
......................................................1,839,995 2,069,013
10 At market
value................................................................................... ....
........................................................2,039,780 2,730,289
11 Foreign
securities................................................................................
...............................................................1,846,879 2,474,374

12
Bonds.....................................................................................
..........................................................501,762 502,130
13 Corporate
stocks.....................................................................................
..........................................................1,345,117 1,972,244
14 U.S. claims on unaffiliated foreigners reported by U.S.
nonbanking
concerns............................................................................. .....
.............................................................908,024 614,672
15 U.S. claims reported by U.S. banks, not included
elsewhere................................................................................
...............................................................1,574,726 1,776,284
Foreign-owned assets in the United States:
18+19)....................................................................................
...........................................................8,646,553 9,633,374
18+20)....................................................................................
...........................................................9,166,727 10,514,958
18 Foreign official assets in the United
States......................................................................................
.........................................................1,212,723 1,474,161
Other foreign assets:
21+23+24+27+28+29)..............................................................
.................................................................................7,433,83
0 8,159,213
22+23+24+27+28+29)..............................................................

.................................................................................7,954,00
4 9,040,797
Direct investment in the United States:
21 At current
cost.........................................................................................
......................................................1,505,171 1,553,955
22 At market
value.......................................................................................
........................................................2,025,345 2,435,539
23 U.S. Treasury
securities................................................................................
...............................................................457,670 542,542
24 U.S. securities other than U.S. Treasury
securities................................................................................
...............................................................2,786,647 3,391,050
25 Corporate and other
bonds......................................................................................
.........................................................1,600,414 1,852,971
26 Corporate
stocks.....................................................................................
..........................................................1,186,233 1,538,079
27 U.S.
currency..................................................................................
.............................................................301,268 317,908
28 U.S. liabilities to unaffiliated foreigners reported by U.S.
nonbanking
concerns..................................................................................
.............................................................864,632 466,543
29 U.S. liabilities reported by U.S. banks, not included
elsewhere................................................................................
...............................................................1,518,442 1,887,215
p Preliminary.

r Revised.
Source: US Department of Commerce, Bureau of Economic
Analysis
Table 2: International Investment Position of the United States
at Yearend, 2002 and 2003
[Millions of dollars]
Current Issues
ISSN 1612-314X
Topics published on
The U.S. balance of payments: widespread misconceptions
October 1, 2004
and exaggerated worries
Japanese cars: sustainable upswing expected September 27,
2004
Asia outlook: cruising at a good speed September 14, 2004
Foreign direct investment in China - August 24, 2004
good prospects for German companies?
Germany on the way to longer working hours August 10, 2004
Steel market in China: Constraints check more powerful growth
August 6, 2004
Global outlook: above-trend growth to continue in 2005 July 27,
2004

Innovation in Germany - Windows of opportunity June 22, 2004
Consolidation in air transport: in sight at last? June 16, 2004
Privatisation and regulation of German airports
Credit derivatives: effects on the stability of financial markets
June 9, 2004
Demographic developments will not spare the public
infrastructure June 7, 2004
Infrastructure as basis for sustainable regional development
June 3, 2004
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