Background
The nature of current account deficit in the United States is a widely researched topic. Besides, it is the most misunderstood area in the economy of the US. The external deficit of the country has continuously risen over the past years. The deficit can be dated back in the 1820. During this period, the economy was not developed. Therefore, the country relied on external sources of funds between 1820 and 1875 as a major source of finance. The deficit balance grew rapidly during this period. Also, the whole economy also grew at a faster rate. After the First World War, the economy of the U.S. was performing well and instead of having a deficit, the country had surpluses. This situation persisted between 1920 and 1970 (Carbaugh, 2011). However, after 1970, the country reverted back to the current account deficits. This situation has been a major concern to all players in the economy and they wonder if the country will continue to have the deficit indefinitely (Carbaugh, 2011). In the recent years, the deficit balance seems to be growing exponentially and the worries are mounting. For instance, the debt balance rose from $474billion in 2002 to $521billion in the following year. It rose further to $600billion in 2004 (Deutsche Bank Research, 2004).
Cause of the deficit
There have been a number of postulations that attempts to explain the persistent nature of the US current account deficit. The growing nature of the US current account deficit is caused by excess supply of foreign capital from all over the world. The United States has gained from excess saving in other countries. Further, these savings are considered to be highly liquid and deeper than in the earlier years. This can be attributed to the high speed of globalization. These countries are willing to provide their excess savings as loans to the US because of the increasing demand to own the US assets, especially from countries that have a high rate of savings. Further, the foreign investors are not doing America a favor by investing, but are rather attracted to other factors such as political stability, a rising labor force, safe property rights, and stable monetary markets among other factors (Deutsche Bank Research, 2004). These factors make investors willing to provide the US with cash inflow even at lower interest rates. Therefore, analysts are of the opinion that the deficit will persist as along as these factors are present. It is estimated that the United States absorbs over 80% of the total capital inflow. The deficit in the US can be grouped into two. The first category is the cyclical deficit (Carbaugh, 2011). It arises from the differences in the level of economic growth. When compared to other trade partners, the US is at a superior level of growth. This puts an upwards pressure on the US to import and slows down the export business. The second group is structural deficit. It arises from a number of factors such as outburst of outsourcing, the function that the US dollar plays as a key reserve currency, and the differences between the elasticity of import and export.
Sustainability of the deficit
One area that concerns many analysts and other players is the sustainability of the deficit. Several players are worried about the negative impact of this trend in the economy. One major consequence of the foreign ownership of capital stock of the US is that the country must part with a proportion of their income to pay interest and dividends to the foreign investors. The players are of the opinion that the US may experience financial difficulties in the future because of the persistent debt. (Deutsche Bank Research, 2004)
The players in the economy are of the opinion that in order to correct the current situation, the value of the dollar should drop significantly. The connection between the balance of payment and the USD exchange rate cannot be ignored. Some analysts hold the view that the large deficit explains why the USD is depreciating. However, this view is unjustifiable because there are periods when the deficit rose significantly yet the value of the dollar was still very high. Therefore, the assumed positive correlation between the value of the dollar and the current account deficit does not hold. Some of the main factors that contributed to the loss in value of the dollar are the different interest rate between the US and trading partners, terrorist attacks, and different political regimes. Past analyses have indicated that the devaluation of the dollar has no effect or connection to the deficit. Therefore, devaluation cannot be used to resolve the problem of the deficit (Deutsche Bank Research, 2004).
The participants in the economy are scared of the fact that the foreign capital providers may shift to other economies and this will cause an extreme financial crisis in the US. In the event that the players lose confidence in the capability of US to produce adequate resources that can repay the funds borrowed, then the investors will reduce the amount of capital they provide to the country. The immediate effect of this action will be a swift fall in the value of dollar because the supply of the currency will rise in the market. Besides, the United States will experience a substantial increase in the interest rates. This will affect the solvency of debtors because the rise in interest rates will result in a decline in the value of debt securities, and a consequent decline of prices in the stock market. Thus, the ability of the country to sustain the current account deficit depends on the inclination of the foreigners to increase capital inflow and enhancement of technology and overall efficiency. Increase in efficiency leads to the creation of more real wealth. The fear of foreign investors shifting their savings to other countries is real, but it is not likely to occur in the near future as long as the dollar remains the most popular reserve currency. This position of the dollar gives the United States undue advantage over other countries in the world. Besides, the foreign investors have limited areas to invest in.
Based on the analysis above, it is difficult to estimate an appropriate level of debt that is required by the US. However, there is the need to reduce the current level of debt. This cannot be achieved without having some amount of undesirable impact on the economy. There are a number of approaches that can be used to reduce the amount of the deficit. First, the country should facilitate faster growth on investments made abroad than concentrating on slower growth rate in the country. Secondly, the debt can be reduced by raising the level of national saving. This option is better than decreasing the amount of investments made locally because an increase in savings leads to lower interest rate. The lower interest rate will lead to domestic investment. From an economic point of view, it is better to borrow externally and finance the investment opportunities than not to borrow completely (Carbaugh, 2011).
Reference
Carbaugh, R. (2011). International Economics. Mason, OH: South-Western, Cengage Learning.
Deutsche Bank Research. (2004). The U.S. balance of payment: wide-spread misconceptions and exaggerated worries. Web.