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On January 7, the IMF published a report declaring that
the American current account deficit—which it deemed an
“unprecedented level of external debt for a large industrial
country”—represents a clear and present danger to the
world economy. The Fund also issued warnings about the
U.S. fiscal deficit, asserting that unfunded Social Security
and Medicare claims could generate a long-term
budgetary shortfall of $47 trillion, nearly 500 percent of
GDP.
The IMF report echoes other proclamations about the
perils of America’s twin deficits. New York Times
columnist (and eminent Princeton economist) Paul
Krugman likened the country’s financial straits to
Argentina’s. Warren Buffett opined in Fortune that
“America’s growing trade deficit is selling the nation out
from under us.” Robert Rubin warned that America’s
deficits were now so large that conventional
models—which predict a slow accumulation of the costs of
adjustment—no longer suffice, and that the social and
economic consequences of prolonged deficit spending
could be sudden and severe. Even the ardently pro-Bush
editorial page of the Wall Street Journal lambasted the
Administration for leading the U.S. into a “fiscal train
wreck”.
Alan Greenspan offered a less apocalyptic assessment.
Dismissing predictions of a looming financial crisis,
Greenspan expressed confidence that the international
financial system—whose sophistication and flexibility have
grown since previous financial bubbles—could readily
accommodate the U.S. deficits. “If no measures are taken
to adjust the current account deficit, the market will do it.”
Amid the cacophony about the American deficits, three
fundamental points warrant emphasis:
First, popular lamentations about the “twin deficits”
obscure the complex relationship between the internal and
external sides of America’s financial ledger. While the
recent increase in the U.S. current account deficit has in
fact paralleled the resumption of U.S. deficit spending, the
former long preceded the latter. The current account
deficit grew steadily during the flush years of the 1990s
when the internal budget was registering a surplus, rising
Copyright © 2004 Global Economics Company
from 1.5 percent of GDP in 1997 to 4 percent in 2000.
Indeed, the rise in the external deficit was largely a result
of the U.S. economic boom, reflecting the wide gap
between foreign demand for American exports and
domestic demand for imports in the more rapidly growing
U.S.. The current account deficit is certainly larger than
ever before ($530 billion in 2003, or 5 percent GDP). But
that deficit is the historical norm, reflecting the structural
imbalance in American exports/imports that represent the
principal components of the current account.
Second, as a share of GDP the U.S. current account
deficit now surpasses the limit (4 percent) traditionally
identified by economists as the threshold of sustainability,
beyond which adjustment mechanisms kick in and force a
correction of the imbalance. However, there are serious
questions about whether this self-correcting mechanism
applies to the United States, which enjoys a number of
distinctive attributes that relieve it of the adjustment
burden facing other deficit countries: Its immense
economy (larger than the next four countries combined);
the dollar’s status as the main reserve asset (still used for
most international transactions despite growing
competition from the Euro); and a singularly deep and
liquid capital market (offering a plethora of vehicles for
foreign investors to supply the funds needed to finance the
deficit). The continued rise of the American current
account deficit despite a steep dollar devaluation calls into
doubt the efficacy of the balance of payments adjustment
mechanism in the U.S..
Third, the decisive issue concerns not the literal size of
America’s external deficit, but how it is financed. Here
there has been an alarming shift in the composition of the
U.S. capital account, a surplus in which is the necessary
complement of the current account deficit. From a record
$308 billion in 2000, foreign direct investment in the
United States plummeted to $30 billion in 2002. During
the same period, portfolio investment (far more prone to
capital flight than FDI) surged as the U.S. Treasury turned
to foreign bond investors to finance the budget deficit.
While FDI registered a partial recovery in 2003,
uncertainties persist about the capacity of the U.S. to
sustain the inflows of foreign capital need to service the
external deficit.