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May 11, 2005
The U.S. Current Account Deficit: How Big Is Sustainable?
The U.S. trade deficit narrowed unexpectedly in March on a surge of exports of capital and consumer goods and farm products, the Commerce Department said Wednesday.
The deficit narrowed by 9.2% in March to $55 billion. This is the lowest trade deficit since last September and the largest monthly decline since December 2001. The narrowing of the trade gap was unexpected. The consensus forecast of Wall Street economists was for the deficit to widen to $61.2 billion...
The trade gap in February was revised down to $60.6 billion compared with the initial estimate of $61 billion.
The timing was great for the latest Chicago Fed Letter, penned by staff economist by Michael Kouparitsas, titled "Is the U.S. current account sustainable?". Michael starts by noting that, when talking about the current account deficit you may as well be talking about the trade deficit. In fact, you may as well be talking about the deficit in manufactured goods:
With that in mind, here is the definition of sustainability:
When economists want to assess sustainability of the current account, they begin by calculating the net exports to GDP ratio that would be required to maintain the current net foreign assets to GDP ratio, NFA*. I refer to this as the critical net exports to GDP ratio, NX*. Net exports to GDP ratios above NX* will increase the nation’s net foreign assets to GDP ratio above NFA*, while net exports to GDP ratios below NX* will decrease it.
NFA refers to the U.S. net foreign asset position: The value of assets owned by U.S. residents held abroad (A) minus the value of U.S. liabilities to the rest of the world (D) is called the U.S. net foreign asset position (NFA). If its net foreign asset position is positive (NFA > 0), the U.S. is a net creditor to the rest of the world. Conversely, if NFA is negative (NFA < 0), then the U.S. is a net debtor because its outstanding liabilities to the rest of the world exceed its claims on the rest of the world.
The connection between the current account deficit and our net foreign asset position is pretty straightforward. The important thing to recognize is that foreigners do not provide us with more goods than we provide to them out of the goodness of their hearts. They do so because they expect to be paid back sometime in the future, and they collect promises to do so in the form of financial assets – like Treasury securities -- that pay off in dollars. A current account deficit therefore means that U.S. citizens are increasing their indebtedness to foreigners.
The article contains a detailed explanation of the Kouparitsas' calculations, but here is the punch line:
Regardless of the method used to calculate it, the size of the net exports deficit that would allow the U.S. to maintain its current level of international indebtedness as a percentage of GDP is well below that of the current net export deficit. My estimates suggest that the U.S. net export deficit must fall by 3% to 3.5% of GDP to maintain the current net foreign asset to GDP ratio. However, I also note that if the U.S. continues to enjoy relatively high rates of return on its foreign assets, the resulting net foreign income surplus would allow it to run relatively large net export deficits without much change in the net foreign asset to GDP ratio.
It's an excellent and timely article -- I highly recommend it.
UPDATE: You will certainly want to check out pgl's critique at Angry Bear, as well as Brad Setser's in the comments section. (Brad also has his own post on the trade news.)
Kash has a post of his own at AB (all of the above being noted by Calculated Risk). Michael Mandel has his say too (although pgl tries to straighten him out as well).
Elsewhere: The Prudent Investor smells a rat.
UPDATE, THE SEQUEL: William Polley decides, quite sensibly, that the confidence interval around his trade-deficit point estimate has increased.
UPDATE, THE THIRD: The Capital Spectator parses the report.
UPDATE, THE FOURTH: General Glut smells something fishy, which I guess is something like smelling a rat.
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More on trade deficits
David Altig has a nice piece about the sustainability of the trade deficit. He fails to note, however, that the deficits are sustainable as long as U.S. wealth, net of debts to foreigners, continues to grow--which it has been doing... [Read More]
Tracked on May 11, 2005 6:11:20 PM
Trade deficit: good or bad?
David Altig says the trade deficit is bad. “[F]oreigners do not provide us with more goods than we provide to them out of the goodness of their hearts. They do so because they expect to be paid back sometime [Read More]
Tracked on May 13, 2005 1:19:36 PM
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