PROGRAM : MMS BATCH : 2010 - 12

Comment Form for Assignments – Semester II

Section One: Data on the Course and Assignment

Subject EEB

Title of Assignment: U.S. Current Account Deficit

Date of Submission : 15/03/2011

Student Details :

Div. Roll No. Name Div. Roll No. Name

A 201011 Avdhut Raut

A 201020 Anisha Saraf

A 201022 Asprita Pandey

A 201024 Suviksha Bhat

A 201038 Khushwant Jain

Section Two: Evaluation

Please note below the comments on the assignment in accordance with your objectives and evaluation criteria.

Professor………………………………………………………………..……………………..
Signature ……………………………………………………………………………………… GRADE
Date returned to Examination Office : ……………………………..
Q) What are the causes of the current account deficit?
1. US consumer spending has been rising rapidly due to a combination of

◦ Tax cuts
◦ Low interest rates
◦ Rising house prices (although this is now being reversed)
Therefore with rising consumer spending the US has been increasing the value of imports bought
into the economy. Furthermore the US has a high marginal propensity to import. Many luxury good
like electrical goods and cars tend to be imported. It is these kinds of goods which are bought when
incomes rise.
2)Decline in competitiveness. US manufactured goods have been losing comparative advantage to
Asian economies. The primary reason is that wage costs in US are much higher than Asian
economies.

3) Dollar Relatively High compared to current account deficit. Dollar has not devalued as much
as you would expect for an economy with a large current account deficit. The US has remained an
attractive location for Capital investment. In particular China has been buying a lot of US
government securities. Therefore this inflow of capital has financed the current account deficit and
encouraged America to keep buying imports. The inflow of capital has also enabled interest rates to
remain low. Because China has bought so many US government bonds the US has been able to
finance its national debt whilst keeping interest rates low. These low interest rates have encouraged
consumer borrowing and consumer spending; a major cause of the current account deficit. In the past
12 months the dollar has been in decline but to reduce the current account deficit it would need to
fall by more than 20%

Q2 ) Has it been the causes of the financial crisis in U.S.?

ANS) The way out of the financial crisis now appears to be leading to an even greater current
account deficit that will likely lead to a worse financial crisis in the future budget, an. C. Fred
Bergsten of the Peterson Institute for International Economics about the U.S. dollar and fiscal
deficits in which he encourages the U.S. to “launch new policies to avoid large external deficits,
balance the d adapt to a global currency system less centered on the dollar.”

Before diving into Bergsten’s analysis, a quick primer on current account deficits may be helpful to
anyone not well versed in international economics. Put simply, a current account deficit is like the
government maintaining a checking account with the rest of the world that is permanently
overdrawn. Instead of paying overdraft fees, the government borrows from the world to pay the
deficit. The deficit occurs because the U.S. buys more stuff from other countries (especially oil)
than it sells. Deficits are not necessarily bad, and some have argued that a sustainable current
account deficit may be healthy for the U.S. However, when the fiscal deficit blows up, like it did in
the years preceding the 2008 Financial Crisis due to leveraged buying by U.S. consumers and easy
U.S. monetary policy, it can become extremely dangerous. Again, the simple reason is that as the
U.S. tries to sell more of its debt to the world, the world will demand ever higher returns. At some
point, the world might stop buying U.S. debt, and then we’re in big trouble.

In order to stop the financial panic, boost the economy back to growth and return financial markets
to normal operating levels, the U.S. has returned to an extraordinarily easy monetary policy. The
federal funds rate is basically at zero, and the Federal Reserve Board and Treasury Department have
flooded financial markets with dollars. Other governments have followed suit, and it appears that a
worldwide economic recovery has begun. But there are still serious problems in the system, and
they seem to be exacerbated by the very policies that have ended the recession. And so, the Fed
finds itself in the unenviable position of needing to transition out of its easy monetary policy without
violently upsetting the recovery.

Q.3) Will the world keep funding U.S in the same manner as in the past?

In the past, the U.S current account deficits were accompanied by capital inflows from abroad as
foreigners financed U.S. spending in excess of income.
China keeps on investing in United States so as to keep the dollar strong and to support U.S
spending on Asian exports. Another reason is private investments by helping to finance innovation
and the productivity growth of the developed economies
Various countries will continue to fund the United States. Treasuries will be purchased by foreign
central banks. China would continue to buy billions of U.S. dollars in order to avoid a dollar collapse
that would undermine U.S. consumption and the global stability upon which the China’s economy is
dependent.
Another reason for foreign countries investing in the Unites States is that the U.S. has strong
communication and information technology. So by funding in to the States, the foreign economies
can get the technology in exchange for funding for the current account deficit.
In the future there is no guarantee as to whether the Asian Central banks would continue to support
the U.S. currency. There is trade imbalance between Asia and the United States that can pose a risk
to the global financial system.

Q.4) Will U.S. be able to sustain the current account deficit?

Large deficits in the can lead to macroeconomic adjustment that can be harmful not only for the
United States but also to the rest of the world. Large current account deficits can lead to global
imbalances represented by capital flowing from the developing to the developed countries.
If oil prices stay high and U.S. growth does not falter, the trade deficit will be even larger. Imports are
currently growing slightly faster than exports. Yet even if imports grew at the same pace as exports, the
large gap between the size of the U.S. import base and size of the U.S. export base would lead the U.S.
trade balance to deteriorate. The U.S. trade deficit is the counterpart to low U.S. savings. No matter what
their cause, the large ongoing deficits created when spending exceeds income have to be financed by
borrowing from abroad.
The rapid deterioration of US net external debt position implied by large trade and current account
deficits cannot continue for a long time. At some point, the interest rate that the U.S. needs to pay to
attract the external financing it needs to run ongoing deficits, slowing the U.S. economy and improving
the trade balance as higher interest rates increase the amount the U.S. must pay to its existing creditors.
The U.S. current account deficit grew throughout most of the 1990s and into 2000. But, clearly, the
U.S. current account deficit as a share of GDP cannot increase forever without disrupting the U.S.
economy or the global economy. Many economists gauge sustainability by examining the value of a
country’s external obligations. In this context, two commonly used measures of a country’s
international obligations are the ratio of the country’s current account deficit to GDP and the ratio of
the country’s net international debt to GDP. Although these two measures are not perfect indicators
of sustainability, they can provide some insight into the sustainability of a country’s current account
deficit. Both ratios, plus some additional evidence, suggest the U.S. current account deficit is
sustainable in the short run
1. avoid large external deficits: “US policymakers,
therefore, must recognize that large external deficits, the
dominance of the dollar, and the large capital inflows that
necessarily accompany deficits and currency dominance are no
longer in the United States’ national interest. Washington should
welcome initiatives put forward over the past year by China and
others to begin a serious discussion of reforming the
international monetary system.”
2. Balance the budget: “Balancing the budget is the only
reliable policy instrument for preventing such a buildup of
foreign deficits and debt for the United States. As soon as the
US economy recovers from the current crisis, it is imperative
that US policymakers restore a budget that is balanced over the
economic cycle and, in fact, runs surpluses during boom years.
Measures that could be adopted now and phased in as growth is
restored include containing the cost of medical care, reforming
Social Security, and enacting new taxes on consumption.”
3. Encourage personal saving: “The only healthy way to
reduce the United States’ external deficits to a sustainable level
is to raise the rate of national saving by several percentage
points. Such an increase could be achieved with a combination
of increased private saving and a reduced federal budget deficit.
Prior to the crisis, household saving in the United States was
essentially zero; it has recently rebounded to the 5-7 percent
range. This is presumably a reaction to the sharp decline in
household wealth created by the fall in housing and equity
prices during the crisis.”
4. Defeat the enemy within: “The root of the United
States’ problem is domestic, however. As soon as recovery from
the current crisis permits, the United States must implement a
responsible fiscal policy. It should adopt new measures in the
near future—while the economy is still recovering—that can be
implemented over the medium and long terms, as growth
resumes and the country can accommodate fiscal tightening
without risking another recession. Enacting such measures now
would work to generate confidence as the United States
continues to emphasize recovery and thus minimize the risk
that both US Treasury securities and the dollar will come under
suspicion in the markets—something that could, if it happened,
jeopardize the recovery itself.”
First, oil prices. High and rising oil prices have a nasty and quite unerring history of leading to economic slowdowns.
Reference the oil-price-driven slowdowns accompanying the 1973 Yom Kippur War, the early 1980s Iranian Revolution
and the 1990 first Gulf War.
High oil price/economic slowdown logic is straightforward. The gasoline, heating oil, aviation fuel, heavy oil, asphalt and
petrochemicals that are refined from oil are so essential to our way of life that we have no choice but to pay almost any
price for oil. In economist’s jargon, the demand for oil is inelastic with respect to price. The trouble is that as we pay more
and more for oil, we have less and less available to pay for things like homes and cars, the things that create jobs and
economic activity.
Rising oil prices have very much the same effect on an economy as a tax increase. Economists do not agree on much but
there is little disagreement that few things will slow an economy faster and with more certainty than a healthy tax increase.
Figure a slowdown in the global economy of about two thirds of one percent for each sustained ten dollar increase in the
price of oil. The key word is “sustained.” There is no doubt that my “best guess,” bullish outlook for Canada would be in
serious difficulty if oil persisted at 50 to 60 dollars a barrel or higher. Right now, I’m betting that oil will behave, but when
the price is so dependent on stability in the likes of Iraq, Iran, Indonesia, Nigeria, Russia, and Venezuela, who really
knows? Tell economists what the average price of oil will be for the next two years and they are a good way to telling you
what the economy will look like.
Second, the U.S. current account. The current account is the difference between what a country sells others and others
sell the country. A deficit must be financed internationally, meaning foreign savings must be imported and international
debt added. So long as current account deficits are moderate and offset periodically by surpluses, there is no particular
concern. That is not remotely the U.S. current account situation. The current account deficit of the world’s biggest
economy is pushing an astonishing six percent of GDP, meaning that the U.S. is adding six percent of its GDP to its
international debt every year, with debt servicing costs also increasing accordingly.
The risks in the U.S. current account situation are as straightforward as they are extreme: if foreigners, especially Asians,
become unwilling to keep funding the U.S. current account deficit, interest rates in the U.S. will rise significantly, taking
ours with them; at the same time, the U.S. dollar will decline against the Canadian dollar, and for that matter most other
currencies, making it harder for us to export goods into the U.S.; the falling U.S. dollar will come right out of the U.S.
standard of living, exacerbating our U.S. export difficulties. Rising interest rates and a declining U.S. currency are not a
recipe for prosperity for countries like Canada that have so tied their economies to U.S. exports.
The U.S. current account situation is not sustainable; it must be reduced dramatically; the only issues are whether the
reduction is orderly or disorderly and how far and how fast interest rates and exchange rates move; we have a huge
interest in an orderly and a not-too far, too-fast reduction. There is a huge jeopardy for Canada in the U.S. current account
situation.
Third, the U.S. federal government spending deficit. At close to five percent of GDP, the U.S. spending deficit is arguably
as unsustainable and worrisome for us as the American current account deficit. Because Americans save so little, their
spending deficit over time, if uncorrected, will put serious upward pressure on U.S. interest rates; again, where their
interest rates go, ours will more or less go too. At the same time, international investors will show their discomfort with the
U.S. spending deficit by pushing the U.S. dollar down, further hurting our U.S. export situation.
Financing the U.S. spending deficit requires a lot of world capital that could be more usefully employed elsewhere.
Causes of the U.S. spending deficit include aggressive tax cuts, rising entitlements, the war in Iraq, weak job creation and
an economy that needs to grow faster. Similar to the U.S. current account deficit, the U.S. spending deficit gets at Canada
with interest rates and a dollar that move in directions that damage our economy.
Fourth, the U.S. consumer. The engine pulling the Canadian economy and, to an extent, the world economy, is the
willingness of U.S. consumers to spend, spend and then spend some more. Up to their ears in debt, over-stocked with
consumer durables like cars and appliances and spending almost everything they take in, U.S. consumers, like energizer
bunnies, just keep on ticking. If the U.S. runs out of spending gas, look out! The economic fallout here will be huge and
immediate. Remove the U.S. consumer’s insatiable appetite for Canadian exports out of Canadian growth, and our
economy will look pretty anemic pretty quickly. There is no way of gauging just when U.S. consumers will dial it back but it
could be abrupt.
Fifth, China. China is the world’s number two economy on a purchasing-power parity basis. It is also incredibly overheated
– a fact recognized by the Chinese authorities who are using monetary and credit policies to slow things down in an
orderly fashion. The goal is a “soft landing” but if instead, China gets close to recession, that will be bad news for the big
commodity countries like Canada. It is Chinese demand that is behind the price increases in oil, copper, lead, zinc, and
aluminum that have so benefited the Canadian economy. A “hard landing” in China will hurt Canada. It will similarly hurt
countries in Asia like Japan, Taiwan, South Korea and Australia that have become so dependent on Chinese exports.
What the Chinese economy has accomplished in such a short period of time is nothing short of a miracle. It has also
sowed the seeds of economic jeopardy for Canada and others.
Sixth, inflation. Inflation is benign at the moment, held down by productivity growth, excess labour and plant capacity, low-
cost Chinese production, and brutal competition among producers. But lurking beneath the surface is the enormous
monetary expansion of the past few years, the pent-up wage demands of workers and the rising prices of commodities.
Each has a history of stoking inflation. If inflation significantly rises, then our authorities will have little choice but to
aggressively push interest rates up in response. That would slow our economy. Rising inflation and its effects on interest
rates is a risk for the Canadian economy.
Oil, the U.S. current account deficit, the U.S. spending deficit, interest rates, exchange rates, the U.S. consumer, China
and inflation. Each factor in its own way creates uncertainty for the Canadian economy. If enough break the wrong way,
the Canadian economy could get into trouble. Literally overnight, our economic outlook could deteriorate dramatically. I
would rate the probabilities fairly low but I sure do not rule it out.
My bet, therefore, is that nothing really unpleasant happens at least through the next year. With that said, it is a wise
enterprise that runs its affairs as if it might.