Reducing the U.S. Current Account Deficit: Harder Than You Think
Reducing the U.S. current account deficit, which has ballooned in recent years, is easy in theory. Simply put, spending must grow slower than production going forward. However, drilling down into the structure of the deficit reveals that a significant adjustment may be difficult to bring about in practice. Exploding petroleum imports have accounted for one third of the increase in the deficit over the past decade. Unless oil prices come down significantly, which seems unlikely in the foreseeable future, the current account deficit will see little relief from imported petroleum products.
Consumer goods and automotive products are the two other categories that have contributed the most to the widening of the deficit. Econometric evidence suggests that import growth rates in these categories are very sensitive to overall U.S. GDP growth. The upshot is that growth rates of consumer and automotive imports likely will remain rather solid unless the U.S. economy slows significantly, which is not our forecast. Exports of industrial supplies and capital goods, which account for 65% of total U.S. exports, have grown at a decent clip over the past few years, and they should continue to do so as long as global growth remains strong.
However, export growth probably will not outpace import growth by a large enough margin to bring about a significant reduction in the U.S. current account deficit anytime soon. The bottom line is that the gaping U.S. current account deficit should continue to exert downward pressure on the greenback for the foreseeable future.
The Structure of the Trade Deficit Makes It Difficult to Reduce.
It is a well-known fact that the United States is incurring a sizable current account deficit. Indeed, the deficit widened from $125 billion in 1996, which was equal to 1.6% of U.S. GDP, to an all-time record of $857 billion last year, which was equivalent to 6.5% of U.S. GDP, also a U.S. record. The causes of the U.S.’s massive current account deficit are beyond the scope of this report, but it is reasonable to expect that the United States will need to reduce its deficit, or it will eventually face a backlash from foreign investors who finance the deficit.1 At a minimum, the United States will be exposed to the risk of sudden currency depreciation and volatility in long-term interest rates as long as the country continues to incur sizable current account deficits.
Reducing the current account deficit is rather straightforward, at least in theory. Because the United States has been spending more than it produces, it has been incurring current account deficits. Therefore, reducing the deficit simply means bringing spending back in line with production. Slower U.S. economic growth should translate into slower spending growth, and dollar depreciation can help shift production from foreign economies to the United States via changes in relative prices. It sounds simple, at least, in theory. However, drilling down into the structure of the trade deficit reveals that a significant narrowing of the deficit may be more difficult to achieve in practice.2
Exhibit 1 breaks down the trade deficit by principal type of good. It is readily apparent that the widening in the overall U.S. trade deficit that has occurred over the past decade is due entirely to larger deficits in three categories of goods—industrial supplies and materials, automotive vehicles and consumer goods. Let’s take each category in turn.
High Oil Prices Will Make Reducing the Deficit More Difficult.
The category of industrial supplies and materials includes crude products (i.e., raw materials) as well as finished and semifinished goods used in manufacturing processes. The deficit in this category widened from about $60 billion in 1996 to nearly $330 billion last year. Why did the deficit increase so much? In a word, oil. The value of petroleum imports shot up by $230 billion between 1996 and 2006, which represents a 300% increase. Because the volume of oil imports increased only 35%, the vast majority of the surge in import values occurred because of the sharp rise in petroleum prices.
A sharp reduction in petroleum prices would lead to a significant narrowing in the U.S. current account deficit. However, we expect global growth to remain rather solid for the foreseeable future, which will do little to reduce oil prices. Indeed, we expect that crude oil prices will remain near current levels for the next year or two.3 Therefore, about one-third of the U.S. trade deficit is not likely to decline significantly anytime soon.
If the U.S. current account deficit is to decline significantly in the next year or two, trade deficits in automotive vehicles and consumer goods will need to narrow, which could be a tall order. Exhibit 2 shows that imports of these goods, which together account for about 40% of total U.S. imports, have grown significantly faster than exports over the past 10 years. How reasonable would a significant deceleration in imports of automotive and consumer goods be?
Import Growth Will Remain Solid as Long as GDP Growth Does.
To shed some light on that question, we estimated a model of demand for automotive and consumer good imports. Most models posit that imports are a function of a domestic spending variable and a relative price, and we follow that practice in this report. Exhibit 3 plots the actual and the estimated quarterly growth rates of automotive and consumer goods imports.4 Although the model does not fully capture the volatility that characterizes quarterly growth rates in automotive and consumer goods imports, it does a decent job of representing the general pattern of import growth over the past decade.
We also use the model to project import growth rates over the next two years using our forecast of GDP growth rates over that period.5 If, as we expect, U.S. GDP growth remains relatively solid, U.S. import growth is not likely to slow markedly.
Indeed, our model suggests that automotive and consumer goods imports will grow around 2% per quarter in 2008 and 2009, which is essentially the average growth rate over the past 10 years. With imports growing at that rate, exports will need to accelerate significantly if a marked decline in the current account deficit is to occur.
Exports Probably Won’t Grow Fast Enough to Significantly Reduce the Deficit.
Let’s now turn to the export side of the equation. Exhibit 4 breaks down U.S. exports into principal categories of goods. The lion’s share of U.S. exports comes from two broad types of goods—capital goods account for 40% of total exports and another 25% come from industrial supplies and materials. Growth in industrial production and capital spending is sensitive to cyclical fluctuations, so the outlook for U.S. export growth should depend crucially on the outlook for global GDP growth.
Indeed, our model of export growth, which is spelled out more fully in the appendix, is very sensitive to real GDP growth in America’s largest trading partners.6 Because we believe global GDP growth will hold up fairly well over the next year or two, we project that U.S. exports of capital goods and industrial supplies will grow at a decent clip over that period as well (Exhibit 5). However, growth in exports is not projected to be sufficiently stronger than growth in imports over the next two years to bring about a significant decline in the trade deficit.
Significant decline in the nation’s trade deficit. Everything else being equal, our models of export growth (industrial supplies and capital goods) and imports (automotive and consumer goods) imply very little reduction in the U.S. current account deficit over the next two years.
A combination of strong U.S. GDP growth, rising energy prices and relatively slow growth in major trading partners, at least until the past year or so, have pushed up the U.S. current account deficit to unprecedented levels. Because the current account deficit must be financed by capital inflows from abroad, it subjects the U.S. economy to the risk of a financial shock. Foreign investors could liquidate U.S. assets if something happened to bring the creditworthiness of those holdings into question. In that event, long-term interest rates could spike, which could in turn bring about recession. Although the probability of such a scenario is rather low, it clearly is not zero either.
However, the underlying structure of the trade deficit shows how difficult it will be to bring about a meaningful adjustment. Petroleum accounts for about one third of the widening in the U.S. current account deficit that has occurred over the past decade. Unless oil prices come down significantly, which does not seem very likely in the foreseeable future, there will be very little relief on the current account deficit from petroleum products. And as long as overall U.S. GDP growth remains rather solid, imports of consumer goods and automotive products, which also have contributed significantly to the widening current account deficit, should remain elevated.