Will Hambly Writing Sample--global Imbalances

Will C. Hambly Economics 495 Professor McIntyre Writing Sample Global Imbalances and the U.S. Current Account Deficit: Domestic and International Effects Over the last decade, current account balances across the world have shifted dramatically. The United States’ current account has swung into a deep and accelerating deficit while Japan and developing Asia have moved to large current account surpluses. Accompanying these swings in current account balances has been the United States’ movement to the status of a net debtor and developing Asia’s emergence as a net creditor, amassing claims on Americans in the form of treasuries, corporate equities, and direct investment. Both Latin American and Middle Eastern countries have also run significant surpluses, but they will be fleeting, as factors that affect those regions, such as rising commodity prices, are temporary and likely to be volatile in the future. The rising U.S. current account deficit is a perplexing topic for economists, as the American economy is rather mature and growing at a slow but consistent rate. The popular press frequently blames the massive imbalances on Americans’ aggressive spending habits and unwillingness to save a larger portion of their income. This “Made in the U.S.A.” argument derives from an interpretation of the macroeconomic accounting identities, but is utterly inconsistent with the data, and will be discussed later. Alternative explanations of the current account deficit have focused on blaming China as a currency manipulator, as the People’s Bank of China holds down the value of the yuan in order to gain an unfair trading advantage at the expense of the American manufacturing sector. Both the “Made in the U.S.A” and currency manipulator argument espoused by American legislators reek of sensationalism and fail to fully explain the recent trend in global current account balances. The most plausible and consistent

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explanation of the imbalances in current accounts across the world comes from an examination of savings and investment activity worldwide, international economic conditions, and the attractiveness of the United States’ highly liquid and well-regulated financial markets. This analysis of the global imbalances begins with an explanation of the current state of the imbalances, followed by an examination of each major region of the world and an assessment of the impacts felt in the United States. Since the mid-1980s, the United States’ current account balance has fallen into a deep and accelerating deficit. With a brief return to surplus during a recession in the early 1990s, the excess of imports from foreigners over exports to the world has consistently risen, amounting to an annualized figure of roughly $870 billion or 6% of GDP.1 Using the macroeconomic accounting identity, the U.S. current account can be explained by the equation, Sp + CAD = I + (G-T), which simply states that private investment and the government budget deficit must be financed by either private domestic savings or by importing foreign savings through the current account. In a closed economy, a country’s savings and investment must be equal by definition, but because of the globalization of financial markets and capital flows, a country’s savings and investment during a period need not be equal, enabling deficits and surpluses on the current account. In the United States, private savings amounts to roughly 15% of GDP, with investment and the government budget deficit weighing in at about 20% and 1% of GDP respectively, and the current account deficit at 6%.2 As national savings is less than capital investment, the U.S. must run a current account deficit in order to finance the excess of investment over savings. Foreign savings must be imported in order to fill the gap between what Americans save and what private firms invest. 1

Federal Reserve Economic Data. The second quarter U.S. current account balance amounted to -$218.41 billion on run-rate GDP of $13.2 trillion. 2 Cooper, Richard N. Living with the Global Imbalances: A Contrarian View. Institute for International Economics. November 2005.

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Through this savings and investment perspective of the current account, the “Made in the U.S.A.” hypothesis can be explained and ultimately refuted. As capital investment by firms has consistently outstripped savings, the need for a current account deficit has persisted. In explaining the dramatic swing to deficit during the American technology boom of the 1990s, the national accounts model is powerful. During the 1990s, productivity growth in information technologies boosted investment, and an exuberant stock market lifted household wealth, increasing consumption and reducing savings. Foreigners were also eager to participate in the investment boom, offering much needed capital to the overheating American economy in the form of the current account deficit. This explanation of the rise in the current account deficit as a result of robust investment demand outstripping savings is satisfying. The early 2000s, however, are more difficult to explain, as the current account remained in deficit despite the 2001 recession and productivity slowdown in the United States. Investment demand certainly cooled after the bubble burst, yet the current account deficit continued to widen. Many analysts attribute the yawning deficit to a lack of savings in the United States, citing declining propensities to save because of increasing home prices and a ballooning government budget deficit. Since the 1980s, the savings rate for the United States has fallen from 18% to nearly 15% of GDP, and the household savings rate has precipitously declined to almost zero.3 Given the accounting identity, as savings declines, the current account must fall into deficit if no other variable changes. This explanation derives itself from how the current account is defined. With the government deficit absorbing domestic savings, private investment requires financing from abroad and contributes to the current account deficit. The twin-deficit idea is theoretically valid, yet with government borrowing so low, only a small portion of the

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Bernanke, Ben. The Global Savings Glut and the U.S. Current Account Deficit. Virginia Association of Economists. March 2005.

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increasing current account deficit can be explained. In a recent study of the current account, researchers Menzie Chinn and Hiro Ito calculate the coefficient on the budget balance variable to be 0.21 for industrialized countries, statistically significant at a 10% level.4 The statistically significant coefficient is evidence of the theoretical validity of the relationship between the budget balance and the current account, yet its low magnitude and a troubling adjusted-R2 for the equation are a signal that further investigation is required. The “Made in the U.S.A” explanation of the current account is grounded in theoretical validity, yet ignores the role of the rest of the world and is inconsistent with the behavior of interest rates. A decreased supply of savings in the United States because of a ravenous government and low savings rates would suggest an increase in the real interest rate, as the supply of savings decreased. This idea, however, is inconsistent with the behavior of interest rates, as the real interest rate has fallen consistently since 2000, suggesting an increase in the supply of savings.5 In contrast to the government budget deficit and consumer spending view, some economists argue that the United States actually saves plenty of its output for the accumulation of its capital stock. Acclaimed international economist Richard N. Cooper argues that in the modern knowledge-based economy, the traditional accounting identity does a poor job of describing an economy’s savings. National savings, which is measured as output less consumption and government expenditure, fails to account for savings in consumer durables, education, and research and development. Cooper explains, “The national accounts focus on productive physical capital plus housing. A broader and more appropriate concept must add at least three components of current output: consumer durables, education, and expenditure on research and development.”6 Because investment in these three categories yields high returns in 4

Chinn, Menzie and Ito, Hiro. Current Account Balances, Financial Development and Institutions: Assaying the World “Saving Glut”. Portland State University. October 2006. 5 Bernanke, Ben. 6 Cooper, Richard N.

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the future, they should be considered savings. Research and development, which generally yields large increases in productivity, is not even included in the national accounts, and considering education as part of consumption fails to recognize its capacity for future returns in an economy increasingly focused on information. Cooper estimates that when including these alternative forms of saving, the U.S. saves roughly one third of its GDP, which should be plenty for adequate capital accumulation to ensure future economic growth. If the United States is actually saving plenty of its output for capital accumulation and the government budget deficit cannot entirely account for the widening current account deficit, an explanation must lie outside the United States, particularly in developing Asia, Japan, and Europe. Accompanying the dramatic rise of the U.S. current account deficit has been the movement of the rest of the world to surplus. The U.S. current account deficit is not the result of profligate consumption and a lack of savings by Americans, but is a result of savings and investment trends worldwide. From the 1980s to present, the world’s savings rate has remained relatively constant.7 What has changed, however, are regional savings and investment rates, especially in developing Asia and the United States. Developing Asia’s savings rate has increased dramatically since the 1980s while the U.S. savings rate has declined. In the Middle East, savings has remained volatile, as it is primarily determined by changes in the price of oil exports. Both European and Japanese savings rates have remained relatively constant. Besides the shift in savings from the United States to emerging Asia, global investment rates have fallen steadily. With total world savings fairly stable and investment falling since the 1970s, the world has become awash with an excess of savings over investment, resulting in historically low real interest rates seen in the U.S. and large current account imbalances across key regions of the

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Dooley, Michael P. et al. Savings Gluts and Interest Rates: The Missing Link to Europe. National Bureau of Economic Research. July, 2005.

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world. [For the purposes of the writing sample, this essay has been truncated. The remaining portion is available upon request.]