ANALYSIS OF THE US CURRENT ACCOUNT DEFICIT

A STUDY ON THE HISTORY, CAUSES AND CONSEQUENCES

OF THE US CAD
Section 1 Group 7

Nishanth A (DM15133)
Piyush Arora (DM15135)
Sandra Samuel (DM15148)
Swati Narayan (DM15161)
Sheikh Shadab (DM15150)
Shivam Rastogi (DM15151)
I. EXCHANGE RATE HISTORY
Timeline:

Gold Standard: For centuries the world currencies were backed by gold. That is the
currency issued by government had an equivalent real gold amount held in vault by the
government.
Bretton Woods System: In 1930s, U.S set the value of dollar as, 1 ounce of gold worth $35.
After World War II other countries pegged their currencies to dollar, while U.S still pegged it
to gold. As everyone knew how much gold U.S had they value their currency against dollar
depending on its value in gold. In 1928 Federal Reserve raised interest rates but could not
prevent the stock market to crash. In 1931 they again raised interest rates to defend gold
reserve. In the end in 1933 they withdrew from gold standard.
By 1971, the trade balance of U.S turned negative. America asked Germany and Japan, to
appreciate its currency, but they refused, as doing so would have increased their export
prices. Finally in 1971, U.S had to, take away gold standards all together. Which meant that
dollar no longer represented gold. Dollar was allowed to float- that is market forces
determine value of dollar. By 1973 U.S and other nations agreed to allow exchange rates to
float.
Today U.S dollar dominate the financial market and exchange rates are represented in terms
of dollar.
Twin Deficits of the 1980s
America was able to maintain a balance in CAD through the 1970s, achieving a surplus of
1.1% of GDP in 1975 to a deficit of 0.7% in 1977. After Ronald Reagan became the president
in 1981 course of current account changed. Post winning the election, Ronald Reagan cut
taxes in order to stabilize the US economy during the recession. His Fiscal Policy encouraged
public spending that in turn would increase the GDP. To curb the inflation the Monetary
Policy of the Federal Bank kept interest rates high. Foreign investors were attracted to make
investments in the US economy due to these high interest rates, due to which the dollar
dramatically appreciated. The US exports became expensive while their imports became
cheap, resulting in a wide trade deficit. Due to these factors the US trade deficit increased
from 0.1% of GDP in 1980 to 3.3% of GDP in 1986. The Budget deficit also increased from
2.8% to 4.8% of GDP during the same period. These changes of same magnitude and
direction became to be known as Twin Deficits.
The G5 (US, Japan, France, West Germany and UK) came together to intervene in the
currency markets to devalue the Dollar against the Yen and Deutsche Mark. The trade
weighted dollar fell over 40% over two years. The G6 (G% and Canada) then took steps to
halt the decline of dollar. By 1986, as a result of continued CAD, The US NIIP turned
negative, implying that US had net debtor to the world.
The Current account balance improved from a deficit of 3.4% of GDP in 1987 to 1.8% of
GDP in89.
US Economy in the 1990s
By late 1990s the twin deficits moved separately. The CAD widened while the budget deficit
moved into surplus. The wide use of information and communication technology further
accelerated the growth in productivity and the US stock market and other US equity returns
experienced a boom. The general public started believing in the government due to low
unemployment rates, growing wealth, and optimistic assessments of future income and the
consumer spending increased. The household saving rates dropped from 6.5% of GDP in 92
to less than 1% in 2000.
Due to demographic reasons the workforces in many advanced nations were slowly growing
or declining, and faced a dearth in domestic investment opportunities. The aging population
therefore chose to invest their savings in the US, attracted by rising equity returns. Foreign
capital inflows focused on private sector investments, thereby helping finance the innovation
and productivity growth of the US economy. The share of US assets in foreign portfolios of
the rest of the world increased to 35% with most investments in equity.




II. CAUSES FOR RISING CAD
One of the key reasons for the US current account deficit being sustained is the continual
willingness of countries to invest in dollar assets.
In order to sustain its CAD, the US tries to maintain an unlimited line of credit with the other
countries. As a result of this, it can also borrow in its domestic currency. The NIIP (net
international wealth position) of the US has resulted in negative figures.

The American economy is more fragile due to low levels of domestic savings. Personal
savings have now reduced to 4% of the GNP while fiscal deficits are at 7% of the GNP. As
compared to China, the savings rate in China is increasing.


Other causes include:
1. Increase in oil prices
2. High levels of trade deficit in the manufacturing sector

3. There was increase in productivity levels in the US from 1990 onwards, which
resulted in excessive investment spending or in Investment Boom. This increased
household incomes and consumer spending.

4. Increasing imports of capital goods.


5. Also, the pace of increase in the economies of other countries have been relatively
slower as that compared to that of USA. This has resulted in rapid increase of imports
but a slow increase in exports. There has been a decrease in the international domestic
demand.
6. Downward pressure of the US Dollar due to rising inflation expectations

III. CONSEQUENCES

1. Increasing reliance on foreign borrowings increases the rate of deindustrialization in
America. This has resulted in a shrinkage of the manufacturing sector and increasing
unemployment. As households became wealthier, people tend to prefer more services
over goods.
Year Manufacturing
Output (% of
GNP)
Employment (%)
Mid-1960s 27 24
2004 13.8 10.1

2. High levels of savings deficiency.
3. If the imports were reduced drastically as a sudden measure to reduce deficits, there
would be a credit crunch scenario. This happened in 1991-92, where current account
deficit reduced but affected Japan and Germany, and had an adverse impact on
American citizens. This is also known as hard landing.


IV. MEASURES TO CONTROL US CAD

1. Soft Landing Scenario
Increasing the propensity to save of the American households would be a
favourable measure to improve the deficit position of the economy. Direct
increase in taxes or decrease in government expenditure would not be a feasible
measure since this would have adverse effects on the economy. US public
finances can be improved by enhancing the savings potential of the American
consumers. This can be done by providing tax incentives and increasing down
payments for home and automobile purchases.
2. U.S needs to cut down on credit financed spending.
3. Stop global currency manipulation (can reduce trade deficit by estimated $190
billion to $400 billion in 3 years)
4. Promote foreign markets and remove foreign trade barriers. U.S industries need to
improve productivity and product quality, to have grater competitiveness.
5. Introduce economies of scale to reduce the per unit overhead expense.
6. Also, as Europe, one of the largest importer of U.S goods, starts recovering from
the slowdown the U.S exports will increase and the deficits will contract.
Taking into consideration some macro-economic measures like the International Debt-GDP
ratio and CAD-GDP ratio, it has been predicted that the US CAD is sustainable and can
rectify itself in a non-detrimental and orderly manner.

USA as a Geopolitical Superpower
USAs position as a geopolitical super power has been weakening in the current global
context. Post its World War II victory, USA has been instrumental in the creation of various
security institutions like the NATO and United Nations. It also constituted various plans like
the Marshall Plan, General Agreement on Tariffs and Trade and the Bretton Woods system to
promote trade and economic prosperity.
However, this established power of the USA has been a threat to its national security as well
due to increased terrorist attacks.
IMF predictions suggest that China will become the largest economy by 2016. In
manufacturing, China leads over USA in areas such steel, textiles, etc. It also has a large
stake in the US economy since it is the largest holder of US foreign reserves like treasury
bonds. China is home to the largest consumer population resulting in increased domestic
demand and energy consumption.
Other factors include:
1. USA has minor military liaisons while China has trade agreements with bigger
countries like Japan and South Korea.
2. USA drains its economy to meet its military expenditure while China helps in
boosting its economic by active use of its energy resources.
3. USA engages in wars in the Middle East while China invests in countries like Africa.
US policies should be formulated to ensure active involvement in international institutions
and a strong foreign policy. It can also build soft power in areas like education and research.
Immigrant-friendly policies will attract labour force that would help improve the productivity
of the nation.