The Overstretch Myth

David H. Levey and Stuart S. Brown

From Foreign Affairs, March/April 2005

Summary:  The United States' current account deficit and foreign debt are not dire threats to its global position, as would-be Cassandras warn. U.S. power is firmly grounded on economic superiority and financial stability that will not end soon.

David H. Levey recently retired after 19 years as Managing Director of Moody's Sovereign Ratings Service. Stuart S. Brown is Professor of Economics and International Relations in the Moynihan Institute of Global Affairs at Syracuse University's Maxwell School of Citizenship and Public Affairs.

These estimates, however, fail to consider that future dollar depreciation and market adjustments in interest rates and asset prices will likely check the increase of the NIIP. Dollar depreciation against the euro and the yen in 2002 and 2003 kept the NIIP flat despite large current account deficits. The same result is likely for 2004 (final numbers will not be available until the end of June). Thus, although the NIIP will surely continue to grow for many years to come, its increase will be far less dramatic than many economists fear.

FALSE ALARM

The real question is just how much the United States' deteriorating NIIP threatens to undermine the economic foundations of U.S. hegemony. The precise answer depends on whether you explain current account deficits in terms of trade, domestic savings and investment, or the composition of global wealth. In each case, though, the risks are far less dire than they are made out to be. And in many ways, chronic current account deficits reflect strong economic fundamentals rather than fatal structural flaws.

A trade-oriented approach to current account deficits views them as a byproduct of robust economic growth, reinforced by a still overvalued currency and the U.S. economy's powerful structural import bias. In this view, the U.S. has a stubborn current account deficit because it grows faster than its trading partners and spends a disproportionate share of its growing income on imported goods and services.

An alternative perspective takes as its point of departure the accounting identity that equates the current account deficit with the difference between total investment in the United States and U.S. domestic saving. Low domestic saving, according to this view, is to blame for deficits. The fear is that a sudden reluctance by foreigners to continue exporting their excess savings to the United States would choke off the investment needed to sustain economic growth, sending the U.S. economy into crisis.

This explanation becomes less alarming, however, when you consider that both savings and investment are seriously undervalued in U.S. economic accounts. Capital gains on equities, 401(k) plans, and home values are excluded from measurements of personal saving; when they are added, total U.S. domestic saving is around 20 percent of GDP--about the same rate as in other developed economies. The national account also excludes "intangible" investment: spending on knowledge-creating activities such as on-the-job training, new-product development and testing, design and blueprint experimentation, and managerial time spent on workplace organization. Economists at the National Bureau of Economic Research estimate that intangible investment grew rapidly during the 1990s and is now at least as large as physical investment in plant and equipment: more than $1 trillion per year, or 10 percent of GDP. Consequently, the size and growth rate of the U.S. economy have been seriously underestimated. In fact, when tangible and intangible investment are both counted, the apparent (and much decried) increase in consumer spending as a share of GDP turns out to be a statistical artifact.

A third approach to the current account deficit focuses on the growth and composition of global wealth. In this framework, international capital movements drive the current account balance, rather than vice versa. With the United States expected to grow faster than Europe and Japan over the next several decades and wealth growing rapidly in Asia--especially in China and India--it makes sense that foreign investors will continue to flock to U.S. financial markets. This could generate a sequence of U.S. deficits as high as 5 percent of GDP, causing the NIIP to balloon. But such an increase would not mean an end to the foreign appetite for U.S. assets; NIIP ratios that appear dangerously high relative to U.S. GDP would be sustainable because of the rapid growth of global wealth.

U.S. financial markets have stayed strong even as the financing of the U.S. deficit shifts from private investors to foreign central banks (from 2000 to 2003, the official institutional share of investment inflows rose from 4 percent to 30 percent). A large percentage of the $1.3 trillion in Asian governments' foreign exchange reserves is in U.S. assets; central banks now claim about 12 percent of total foreign-owned assets in the United States, including more than $1 trillion in Treasury and agency securities. Official inflows from Asia will likely continue for the foreseeable future, keeping U.S. interest rates from rising too fast and choking off investment.

In a series of recent papers, economists Michael Dooley, David Folkerts-Landau, and Peter Garber maintain that Asian governments--pursuing a "mercantilist" development strategy of undervalued exchange rates to support export-led growth--must continue to finance U.S. imports of their manufactured goods, since the United States is their largest market and a major source of inward direct investment. Only a fundamental transformation in Asia's growth strategy could undermine this mutually advantageous interdependence--an unlikely prospect at least until China absorbs the 300 million peasants expected to move into its industrial and service sectors over the next generation. Even the widely anticipated loosening of China's exchange-rate peg would not alter the imperatives of this overriding structural transformation. Ronald McKinnon of Stanford argues that Asian governments will continue to prevent their currencies from depreciating too much in order to maintain competitiveness, avoid imposing capital losses on domestic holders of dollar assets, and reduce the risk of an economic slowdown that could lead to a deflationary spiral. According to both theories, there should be no breakdown of the current dollar-based regime.