Risks of the U.S. Current Account Deficit

There are many projected scenarios for the outcome of the ever increasing U.S. current account deficit. The largest immediate risk appears to be the potential reduction of the very large net capital inflows that are required to finance it (Bergsten, 2007). This would lead to a decline in the exchange rate of the dollar that would push up the prices of imports and domestic goods. To check inflation, the Federal Reserve would most likely raise interest rates which would probably lead to recession. The economy is already softening, probably to growth of less than three percent for 2007, so increases in interest rates could push it into recession. Even if the current account deficit is sustainable for some time to come, critics are concerned that we have borrowed from our future and that the bill will have to be paid by the next generation of Americans.

Possible Solutions for the U.S. Current Account Deficit

Although trade balance is the largest component of the U.S. current account deficit, the U.S. should not attempt to limit free trade as a response to it situation. Free trade increases the global level of output because free trade permits specialization among countries so that a country can devote its scarce resources to the production of goods and services for which it has a comparative advantage (Free trade debate). The benefits of specialization, coupled with economies of scale, increase the global production possibility frontier so that the highest level of absolute quantity of goods and services are produced. and, the particular combination of goods and services actually produced will yield the highest possible utility to global consumers.

In the global economy, all economies are highly dependent on each other and must work together to resolve economic imbalances. Thus, there are a variety of recommendations not just for the U.S., but for its trading partners as well (the United States current account deficit and world markets):

The U.S....

should further depreciate the U.S. dollar to stimulate exports. Although this option may slow U.S. overall growth; this alternative is better than an outright and abrupt market correction. and, the U.S. should begin reducing its fiscal deficit by cutting spending and raising taxes. Higher interest rates as monetary policy could boost savings rates in the U.S.
Asian governments and central banks should ease fiscal and monetary policy to stimulate domestic spending, particularly in China. This will help Asian consumers absorb U.S. exports.

Europe should undertake a much needed program of microeconomic reform that leads to a large productivity and investment boost. In this way, dollar depreciation against the euro should have its intended impact.

World-wide investors should increase investment in Asian countries in addition to China. These areas are now more economically stable than in the past and investment will stimulate imports and bring current accounts into better alignment with that of the U.S.

Bibliography

Bergsten, C.F. (2007, February 1). The current account deficit and the U.S. economy. http://www.iie.com/publications/papers/paper.cfm?ResearchID=705

Current account balance - United States. http://www.fxwords.com/c/current-account-balance-united-states.html

Current account picture (2006, March 14). http://www.epi.org/content.cfm/webfeat_econindicators_capict_20060314

Free trade debate. http://en.wikipedia.org/wiki/Free_trade_debate#Economic_arguments_for_free_trade

Rajan, R. (2005, March 15).

Global current account imbalances: hard landing or soft landing. http://www.imf.org/external/np/speeches/2005/031505.htm

The United States current account deficit and world markets. http://www.brookings.edu/views/articles/mckibbin/200502.pdf

Weller, C.E. (2004, September 24). Underlying causes of trade deficit cast doubt on future improvements. http://www.americanprogress.org/issues/2004/09/b193700.html