The U.S. current account deficit - "The Perfect Storm",

January 11, 2006

Raghuram Rajan, the Research Director for the International Monetary Fund, recently gave a speech to the American Economics Association about the U.S. current account deficit. This deficit is by far the single greatest global threat to your ability to retire - - and the U.S. government's response is to blame the Chinese and everyone else for causing it.

The deficit is 6% of U.S. GDP. The EU does not allow its members to have a deficit above 3% of GDP. Our deficit is so large, it is 1.5% of the global GDP. To finance it, the U.S. pulls in 70% of all global capital flows -- that means 70% of all the money in the world that is being loaned or invested, is going to the U.S. to keep our lifestyle afloat.

What It Means:
This situation has been caused by a variety of factors:

• The Japanese asset bubble in the late 80’s. Many lenders were burned badly, and it has taken Japan this long to get out of a huge recession. Japan is the second largest economy in the world, so if investors can’t go there, they look to the U.S.
• A crash in emerging market investments in the late 80’s. As is the case now, everyone in the late 80’s thought that the “Tigers” - Korea, Malaysia, Indonesia, Singapore - were high growth investments. This crashed because of overspending, and it has taken this long for investors to return.
• Debt defaults in South America. Argentina and other Latin American countries defaulted on loans in the late 90’s, causing investors to flee this area.
• The high tech stock market crash. This made investors afraid of equities, and so U.S. Treasuries looked very safe.

To recover from all of these crashes, most countries lowered interest rates to increase spending. This meant lots of money in the world chasing too few investments. This all made U.S. Treasuries look good in comparison. Add an administration that is only too happy to spend for wars, tax cuts, etc., and you have the perfect storm -- our current account deficit.

The result is that most countries in the world, especially China and the emerging markets, are dependent on exports to finance their growth. They need to use the surplus they’ve acquired in the last five years and invest it in their own economies, boosting consumer spending.

This means, however, they will stop buying U.S. Treasuries, which means interest rates will go up, including mortgages. This will gradually slow consumer spending, which will lower the current account deficit. The risk is that this will happen suddenly, which cause a bust in the housing market. The other risk is that institutions which have bought emerging market funds, causing the 20-40% increase in these funds in the last few years, will pull out suddenly, causing another bust in these countries' economies.

The solution is for the U.S. to instill policies that encourage savings, and for other countries to instill policies that encourage consumer spending.

Action Steps:
What would you do if you knew that your cost of living was going to go up, while at the same time your ability to earn and to borrow was going to go down? Well, whatever it is, think about doing it now, because in five years you will find yourself in that situation. Most likely, the change will be gradual, and probably won’t start until after the elections this year, but given all we know, it seems inevitable.

Source: International Monetary Fund, "Financial System Reform and Global Current Account Imbalances", Remarks by Raghuram Rajan, Economic Counselor and Director of Research, January 8, 2006