Cause of U.S. Current Account Deficit - Savings Rate or Pegged Exchange Rate?

Includes: CNY, CYB, UDN, UUP
by: Nikhil Raheja

Over the last few weeks, two Nobel Laureates, Paul Krugman and Joseph Stiglitz and another economist, Stephen Roach, have been engaged in a public debate about the causes of the US Current account deficit. This article offers my perspective on the argument.

Here`s the background, the current account is a combined accounting entity that measures the trade balance and the net income on investments from abroad. So, if money flows out in net imports (imports – exports), and interest payments on the investments made by foreigners within the country, the sum of those two would show us a current account deficit, conversely, net exports and income received from abroad would show a current account surplus.

A Current account deficit has been theoretically and empirically linked to a country`s Capital inflow. Capital inflow is the total amount of Capital that flows into the country from abroad during a certain period. Due to the increase in the quantity of capital, production and employment rise, leading to an increase in the total Net income of the country. As income rises, so does consumption, but this consumption is not supported by sufficient readily available final goods. As a result, prices may start to rise. However, historical data suggests that businesses seldom change their product prices so frequently. This concept is known as ‘Price Stickiness’. Price stickiness in this case would entail that prices must remain the same while consumption rises; such an event is possible only if products have been imported from abroad to support increased consumption. Thus, a capital inflow results in an equal sized current account deficit. It is possible that a current account deficit falls short of the capital inflow, but that would mean price increases.

The US has run consistent Current account deficits for the last few decades. The debate amongst the economists is focused on the varying causes of the persistent US Current account deficits. Krugman believes that the key reason for the current account deficits is the Chinese peg of its currency, Renminbi, to the US$. The peg ensures that China gains the ability to outcompete the US manufacturers and other global manufacturers based on price. According to Krugman, as long as the People`s Bank of China keeps recycling the Dollars back into the US and maintains the peg, the US will run a trade deficit while China would run a surplus.

On the other hand, Stephen Roach and Joseph Stiglitz believe that the key cause of the deficits is the lack of savings in the US. According to economic theory, if a country saves less than the quantitative demand for investment, then capital would be imported from abroad, leading to a Capital inflow. According to Roach and Stiglitz, unless the US increases its savings, capital inflows would continue, and hence result in current account deficits. They do not blame China for the US deficits since they assume that the Chinese are simply filling a void left open by the Americans themselves.

In addition, a higher savings rate would cause consumption to fall, leading to a lower trade deficit and a lower incentive for the Chinese to dump their products in the US.

My perspective on the argument:

The problem with the Roach and Stiglitz argument is the assumption that a country can realistically raise its savings rate to the level where it suffices all demand for money. Demand for money is difficult to quantify and is usually not satiated in any country to the level where the banks or other lenders realize that they must export capital abroad since it can no longer be lent domestically. It in no way means that demand is unlimited, but it is safe to say that demand for money is usually much higher than the supply of money, except during depressions. So the argument that an increase in savings will be sufficient to ward off foreign capital is faulty.

Also, receipt of capital is a privilege granted to only a few countries in the world. Capital flows to where the expectations of future profits are the highest. The reason why the US can borrow money is that its debt is considered the safest, and thus the US$ is the reserve currency for most. In addition, investors abroad believe in the ingenuity of the Americans and fund their private investments. As long as people round the world believe in the US economy as the best investment, capital will continue to flow in, leading to trade deficits. This is a problem that would be faced by every economic superpower, unless it places capital controls.

Hence, the problem with the argument made by Stiglitz and Roach is that they assume that savings can grow enough in the US to completely satiate all demand and diminish the need for capital inflows from investors abroad who love US investments.

But the other part of the argument is that a higher savings rate lowers consumption, so that reduces the incentive for a foreign exporter to export since demand is lesser. This aspect of a higher savings rate does help the trade balance. All in all, a higher savings rate would help the US since it would be able to fund production domestically, enriching the locals, and lower consumption would balance the trade.

Paul Krugman, on the other hand, agrees that the low savings of the US is one of the causes of the trade deficit. He, however, is one to believe that the chief cause of the Capital inflow into the US is the People`s Bank of China, which keeps recycling its US$ into the US, so as to cause a trade surplus in China. According to Krugman, without the manipulations of the Central Bank of China, the inflows into the US would be lower. In addition, China pegs the Renminbi to the US$, which gives China a competitive advantage. As a result, China forces the US to run a deficit, and benefits by running a surplus due to its competitive advantage.

Krugman also says that due to the current lack of demand in the US, exports to the US cause the consumption of US products to fall and lower the profits for the US manufacturers, while benefitting the Chinese manufacturers. This helps the Chinese economy create demand for its products, while worsens off the US economy.

There is no doubt that both the peg and the People`s Bank of China`s actions are increasing the deficit in the US. However, if the savings rate in a country is higher, it cannot run a trade deficit due to low consumption, so the actions of a foreign central bank would have little effect. This is exactly the problem faced by the Chinese. Despite high inflows into China, it cannot run a trade deficit because there is already low consumption in the country.

However, raising the Savings rate at a time of already low consumption would be hurt the cause, since the retailers would lose even more money. So, even though a higher savings rate is the panacea to the problems in the US, a higher savings rate is not the best medicine in the interim, as Krugman believes. This article agrees with Krugman`s view.

Disclosure: None