The price of profligacy
Sep 18th 2003
From The Economist print edition
How bad is America's borrowing binge?
“I JUST think it's a meaningless concept.” That was the verdict of Paul O'Neill,George Bush's
plain-spoken first Treasury secretary,on the current-account deficit,Mr O'Neill reckoned it was
silly to worry about external imbalances in a global economy where capital flows freely,
Foreigners,he argued,put their money into America because it offered the best risk-adjusted
returns,A current-account deficit was merely the accounting consequence of these capital
inflows,
Mr O'Neill was pushed out last December and Mr Bush's current economic team may put things
less bluntly,but many of them are equally relaxed about the current-account deficit,Some
acknowledge that,over time,the deficit may need to shrink,but reckon that in large liquid
global capital markets,any adjustment will be gradual and benign,None of them appears to
lose sleep over the sustainability of America's external account,
Are they right to be so complacent? The current account is a tricky concept that reflects several
different balances at the same time (see article),From one angle,it is just the accounting
counterpoint to capital inflows,Viewed from a different perspective,however,it is the sum of
the trade deficit (showing how much more Americans import than they export),plus interest
payments to foreigners on previous borrowing,In other words,it reflects how much Americans
are borrowing to finance today's spending and to service yesterday's debt,If they are
borrowing too much,the deficit becomes unsustainable,
Just as an individual cannot pile on credit-card debt forever,so a country cannot increase the
burden of its foreign debt indefinitely,Eventually,interest on the accumulated debt would use
all the economy's resources,leaving nothing for domestic spending,In practice,however,the
current-account deficit would have to adjust much earlier,Just when depends on a variety of
indicators,the size of the accumulated debt; the rate at which new debt is piling up (the
current-account deficit); the speed of economic growth; and the interest rate paid on the
borrowed funds,
America's rate of borrowing is high and rising,At just over 5% of GDP,the current-account
deficit is the highest in the country's history,Even in the final decades of the 19th century,
after the Civil War,America's deficit was generally below 3% of GDP (though Canada and
Argentina ran deficits as high as 10% of GDP in that period),In the Reagan era,the current-
account deficit peaked at 3.4% of GDP,
Some of the recent rise may be a statistical quirk,According to official numbers,the world as a
whole runs a current-account deficit with itself,and one that has risen sharply since 1997,
Since the world does not,as yet,trade with Mars,the numbers must be wrong,so some of
America's current-account deficit may be more apparent than real,But not all of the recent
rise,or even most of it,can be explained this way,
In fact,America's current-account deficit is becoming worryingly large,Several studies suggest
that economies hit trouble when their current-account deficits reach 4-5% of GDP,Caroline
Freund,an economist now at the IMF and before that at the Federal Reserve,looked at 25
episodes of current-account adjustments in rich countries between 1980 and 1997 and found
that the current account typically begins to reverse after the deficit has grown for about four
years and reached 5% of GDP,
Another study at the IMF found only 12 episodes since 1973 where industrial countries have run
a deficit of over 4% of GDP for more than three years in a row,All of the countries involved
were relatively small and open economies,
Does it matter that America's current-account deficit is already an outlier by conventional
benchmarks? Optimists claim not,pointing out that America has seen a big rise in productivity
growth,That not only explains the higher borrowing (to fund the investment boom),but also
makes it easier to finance the debt,There is something in that,America's productivity growth
did rise sharply in the late 1990s,pushing the economy's trend rate of growth from about 2.5%
to 3-3.5%,But the current-account deficit has increased far more rapidly,Worse,it is still
rising,even though the investment boom is over,
America is different
Second,argue the sanguine,America has unique characteristics that allow it to run a larger
deficit,It can borrow in its own currency,which also happens to be the global reserve currency,
And it has the world's largest and most liquid stock and bond markets,Certainly these
advantages allow America to borrow more than others,They reduce the risk of balance-of-
payments crises of the sort that befall emerging markets,such as Argentina or Mexico,where
no one is willing to lend them money at almost any price,But they do not remove all limits,
A better reason to take comfort is that the stock of debt
is still relatively modest,America resembles a rich man
who has discovered credit-card bingeing late in life,At
the end of the 1970s,after decades of almost continuous
current-account surpluses,the United States was a
creditor country,with a net stock of foreign assets worth
about 10% of GDP,Persistent current-account deficits
turned the country into a net debtor in 1985,since when
it has been getting deeper and deeper into the red,At
the end of 2002,net external debt reached 25% of GDP
(see chart 4),
That is higher than the debt levels at which some Latin
American countries hit financial disaster in the 1980s
debt crisis,and on a par with the peak debt level
America reached in the 19th century,but it is not
especially high by the standards of other rich countries,
Many industrial nations have net foreign debts worth 40-50% of GDP,Australia's debt stock,for
example,reached 60% of GDP in the mid-1990s,and Ireland's peaked at over 70% in the early
1980s,The trouble is that on current trends,America's debt stock looks set to rise sharply,If
the current-account deficit remains at 5% of GDP,and the economy grows by 5% in nominal
terms (roughly its trend rate of real growth plus inflation of just under 2%),America's debt
stock will reach 40% of GDP by 2007 and 60% in a decade (see chart 5),
The bottom line
Can America afford this kind of indebtedness? That
depends on the interest rate it must pay,So far,it has
got away lightly,Until 2001,more income was generated
by America's investments abroad than was paid out from
the United States to foreign investors,even though the
country became a net debtor in the mid-1980s,Even in
2002,America's net payments on foreign investments
were less than $4 billion,a relative trifle,
No one is sure why America pays so little for its
borrowing,One factor is the difference in returns on
foreign direct investment,Americans have tended to
earn higher returns on their FDI than foreigners have
earned on direct investment in America,This may be due
to different tax treatment,or to the age of the investment,American investments in foreign
factories are usually older and generate a bigger stream of dividends than foreigners' more
recent purchases in America,The difference in returns earned by foreigners and Americans on
portfolio investment,in contrast,is much less marked,
More important,the returns—both to Americans and foreigners—have been falling,Wynne
Godley,an economist at Britain's Cambridge university,in a paper published by the Levy
Economics Institute of Bard College,in New York state,has calculated a crude,quasi-interest
rate” earned on America's external financial assets and liabilities,by dividing the payments
received [and made] in one year by the stock of assets [and liabilities] at the end of the
previous year,For the past two decades,both rates of return have closely tracked the yields on
Treasury bills (ie,fallen sharply),Last year this quasi-interest rate fell to just over 1%,Falling
borrowing costs have,so far,masked the rising external debt,
That is unlikely to continue,In the years ahead,America faces a sharply rising debt stock and,
quite probably,higher interest rates,so net interest payments to foreigners could become
much more significant,If the average interest rate paid on external debt goes up to 3%,for
instance,and the debt stock rises to 40% of GDP in 2007,as current trends suggest,Americans
will be paying out close to $150 billion in interest,the equivalent of 1.2% of GDP,That would
mark a huge increase from the current $4 billion,and could start to hurt,
Add all these factors together,and the trend in America's indebtedness will become
unsustainable,but not for a while yet,More debt could be built up through a few more years of
large and rising current-account deficits before the costs of borrowing start to have a dramatic
effect on the economy,
But long before that happens,foreigners may become less willing to hold yet more American
assets,Foreign investors' decisions are affected by two,sometimes conflicting,factors,the
risk-adjusted returns that American assets offer,and the desire for a diversified portfolio,If
American assets offer high returns,then investors may be prepared to buy more of them,But
at some point the desire for a diversified portfolio will impose a limit,
Got enough greenbacks,thanks
Investors' recent behaviour suggests that foreigners'
appetite for American assets may already be beginning
to flag,In the past couple of years,the composition of
capital inflows has changed significantly,and in a
worrying direction,Private investors,who in the late
1990s were snapping up American shares,bonds and
factories,more or less stopped buying anything but
bonds in 2001,Foreign direct-investment flows,which
reached a peak of 1.6% of GDP in 2000,have turned
negative,And as purchases of American securities by
private foreign investors have fallen,the current-account
deficit has risen (see chart 6),According to Jim O'Neill,
head of economic research at Goldman Sachs (and no
relation to Paul),private portfolio flows and direct
investment in the first three months of 2003 were worth
only 1.4% of GDP,The remainder of the current-account
deficit of 5.1% of GDP was funded by short-term speculative capital flows and official purchases
of bonds by foreign central banks,
This lack of enthusiasm for American assets clearly shows up in the fall in the dollar since the
beginning of 2002,to entice buyers,their relative price had to fall,Some of this drop may have
been temporary,caused by low bond yields and a sluggish stockmarket,Indeed,as bond
markets temporarily rallied in the second quarter of 2003,portfolio flows picked up,And as
America's economic prospects have brightened in recent months,part of the dollar drop has
been reversed,But there are also good reasons to believe that foreign investors have got
enough dollar assets in their portfolios,
Every three months,The Economist asks a group of global portfolio investors about their asset
allocation,The most recent figures show that American stocks make up 53% of the typical
investor's equity portfolio and American-issued dollar bonds around 44% of the typical bond
portfolio,Those proportions are slightly lower than at their peak in 2001,with 54% and 50%
respectively,In the mid-1990s,in contrast,global investors allocated only around 30% of their
assets to American dollar assets,In the late 1990s,therefore,the typical investor hugely
increased the average share of American assets in his portfolio,In order to raise the average so
quickly,the marginal investment in American assets must have shot up,
Catherine Mann,an economist at the Institute for International Economics in Washington,DC,
who has pioneered the portfolio-based analysis of current-account sustainability,calculates that
in 1998-2001 the typical investor allocated an average of 80% of his increased wealth to
American assets,The question is whether this can continue,Ms Mann calculates that if the
current-account deficit is to remain sustainable,foreigners will have to go on allocating 80-90%
of their marginal investments to American assets over the next couple of years, That is not
inconceivable,but it seems unlikely.
In sum,even if America could afford to take on more debt,foreign investors appear
increasingly unwilling to hold it,True,foreign central banks,whose asset-allocation decisions
are based on political as well as economic criteria,could continue to pick up an ever-increasing
share of the burden,But,as a later section of this survey will show,central banks cannot
underwrite America's current-account deficit indefinitely,The chances are that an adjustment is
close,It will not be easy,
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