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04 November 2004

U.S. Will Pursue Growth, Savings to Lower Current Account Deficit

Treasury's Taylor describes policy initiatives to address imbalance

The United States is using three different economic approaches to deal with its growing current account deficit, according to John Taylor, under secretary of the Treasury for international affairs.

Taylor gave the keynote address at a November 4 conference on "Policy Challenges of Global Payment Imbalances" sponsored by the American Enterprise Institute. He attributed the growing imbalance in the United States' current account [the net flow of current transactions -- including goods, services, and interest payments -- between countries] to a gap between investment and saving.

"When investment in the United States is higher than domestic saving, foreigners make up the difference, and the United States has a current account deficit," he said.

A perception of high rates of return on U.S. assets, strong productivity growth, and a secure capital market made the United States an attractive place for foreign investment over the last decade, Taylor said. Such investment has contributed to an expansion in capital stock, technological development and increased output, and produced strong economic growth, he added.

"So far, Americans are still receiving more income from abroad than they are paying abroad, but at some time in the future Americans will need to pay a net return to foreigners," Taylor said. "The larger capital stock at their disposal producing more income than would otherwise have been the case will enable these payments."

The Bush administration recognizes that action is necessary to slow recent rapid growth in the current account deficit, which has risen from about 1 percent of the Gross Domestic Product (GDP) in 1990 to about 5 percent of GDP in early 2004, according to Taylor. GDP is the total market value of all final goods and services produced in a country in a given year.

Increased domestic saving in both the public and private sector is the first priority, he said. To achieve this, Taylor said the administration would work to reduce the U.S. fiscal deficit by controlling federal government spending, and would propose programs to encourage private savings for education, health care, and retirement.

"Next year the budget deficit is projected to be less than 3 percent of GDP," he said.

Second, Taylor said, the administration is pursuing policies to increase global economic growth. "These will ameliorate the deficit by raising U.S. exports and increasing investment opportunities around the globe," he said.

Taylor cited several international initiatives that have already been undertaken or spearheaded by the administration, including the Agenda for Growth adopted by the Group of Seven most industrialized countries (G7), the U.S.-Japan Partnership for Growth, the Partnership for Prosperity between the United States and Mexico, the U.S.-Brazil Group for Growth, and continuing efforts to promote the Doha Development Agenda of the World Trade Organization. The G7 comprises Canada, France, Germany, Italy, Japan, the United Kingdom and the United States.

Third, the administration will continue to promote market-based flexible exchange rates to smooth the path of global adjustment to economic shocks, Taylor said. He singled out China in particular as a focal point for such efforts.

"A flexible exchange rate is appropriate for China, not only in light of its growing international role but also in order to better manage domestic macroeconomic, particularly monetary, pressures," he said. "Regionally, the renminbi [Chinese currency] is an anchor currency and any movement toward flexibility should spread to other currencies."

While acknowledging that it will take time for a beneficial impact from such measures to be seen, Taylor stressed that there is no reason to expect that continued financing and adjustment will not be "adequate and smooth."

"I think the policies [the administration is pursuing] are the correct ones both for increasing growth and reducing the current account deficit," he said. "As we think about the future, there is great promise that the current global expansion will be a long lasting one, and this alone is good for the world economy as well as for the current account statistics."

Following is the full text of Under Secretary Taylor's remarks, as prepared for delivery:

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The U.S. Current Account: Recent Trends and Policies

John B. Taylor, Under Secretary of the Treasury for International Affairs

Keynote Address
American Enterprise Institute
Conference on Policy Challenges of Global Payment Imbalances
Washington, D.C.
November 4, 2004

It is a pleasure to participate in this conference on the adjustment of global payments imbalances and I thank Desmond Lachman for the invitation.

Balance of payments adjustment has long been a concern for international economists and policy makers. Indeed, 40 years ago, concerns that the balance of payments adjustment process was not working smoothly led to the creation of a special working party of international officials -- called Working Party 3 of the OECD [Organisation for Economic Co-operation and Development] -- to address these concerns. Working Party 3 (WP3) still exists today, and, as its current Chairman, I can tell you that global payments adjustment is still a major topic for discussion among international policy makers.

In the 1960s, the current account deficit of the United States was a major focus. The same is true today. But the nature of the policy discussion has changed dramatically. The Bretton Woods system of fixed exchange rates is gone, replaced by a smooth-working system of market-based flexible exchange rates among the major currencies, though fixed exchange rates are still being used in some large economies. The policy analysis has also changed. For example, thinking of payments imbalances as a gap between saving and investment was unheard of in the WP3 discussions in the 1960s. In contrast, as I will emphasize in these remarks, the saving-investment gap is now the essence of both the explanations of the payments imbalances and the policy challenges today.

Today's Current Account Deficit

The U.S. current account deficit measured as a percentage of GDP has risen from about 1 percent in 1990 to about 4 percent in 2000 to about 5 in the first half of this year.

What explains this development? In my view the best way to think about the current account is as the gap between investment and saving. When investment in the United States is higher than domestic saving, foreigners make up the difference, and the United States has a current account deficit. In contrast, if saving exceeds investment in a country, then that country has a current account surplus as its people invest abroad.

Consider the first half of this year for example. The U.S. current account deficit was $594 billion (at a seasonally adjusted annual rate and on a national income account basis). This $594 billion deficit equaled the gap between $2,246 billion in investment and $1,652 billion in saving [including the relatively small statistical discrepancy]. That is, U.S. domestic investment was $594 billion more than domestic saving with net foreign investment making up the difference.

Viewed in these terms, the $112 billion increase in the U.S. current account deficit in the four quarters ending in the second quarter of this year (measured on a national income account basis), corresponded to a $335 billion increase in investment outstripping a $224 billion increase in saving. This increase in investment was a key factor in U.S. economic growth during this period. Over a longer period the increase in investment will expand the capital stock, which will raise potential output and increase wages. New technological processes are embedded in enhanced investment levels and will further raise productivity.

As this example indicates, the increase of the U.S. current account deficit over more than a decade has been linked to domestic U.S. capital formation increasing more than U.S. saving. Perceived high rates of return on U.S. assets, based on strong productivity growth relative to the rest of the world, combined with an efficient and secure U.S. capital market attracts foreign investment. Thus, sound, growth enhancing, economic policies are continuing to make the U.S. an attractive place to invest. There are parts of the world that currently have large savings rates and limited domestic opportunities. We would certainly not object -- in fact, we'd be very pleased -- if other countries strengthened their investment environment, their level of investment, and their economic growth performance.

A U.S. current account deficit implies that foreigners are acquiring more assets in the United States than Americans are acquiring abroad, and already foreigners own more assets in the United States than Americans own abroad. So far, Americans are still receiving more income from abroad than they are paying abroad, but at some time in the future Americans will need to pay a net return to foreigners. The larger capital stock at their disposal producing more income than would otherwise have been the case will enable these payments.

Economic Policy and the Current Account

In addition to helping to explain the trends, this view of the current account also tells us the kind of economic policies that will reduce the current deficit and at the same time keep the United States and the world economy strong. So let me now describe three types of economic policies that the Bush Administration is pursuing and will continue to pursue which relate directly to the current account.

Saving in the United States

Let me first turn to policies aimed at increasing saving of the public sector and the private sector. To be sure there is no one-to-one correspondence between the fiscal deficit in the United States and the current account deficit. For example, the decline in the current account deficit as a percentage of GDP increased by more in the late 1990s when there was a fiscal surplus than it has since the start of the economic downturn in 2000 -- when the deficit increased in part as a consequence of well-timed tax-cut policies to help mitigate and end the recession. Nonetheless, a reduction in the U.S. fiscal deficit now as the economy expands will reduce the current account deficit if private saving and investment do not change in a way to offset this reduction.

An important element of the Administration's fiscal policy is that as the economy continues to expand and the growth of government spending is contained, the fiscal deficit will decline substantially. Indeed one can already see evidence of this in the fiscal year that just closed. Because of the strong economic expansion, the federal budget deficit for fiscal year 2004 turned out to be less than either CBO [Congressional Budget Office] or the Administration forecast at the start of the year. The deficit is $108 billion less than the Administration's forecast. Next year the budget deficit is projected to be less than 3 percent of GDP, and continue to contract through the rest of the decade.

Likewise, increased private saving can play an important role in reducing the current account and also supporting long-term growth in the U.S. economy. The adoption of education savings plans and health savings plans are two steps the Administration has already taken to promote private savings. Increasing saving for retirement is more and more important as the population ages. The Administration has made efforts to encourage and safeguard retirement savings in the workplace.

But more can and should be done. The tax reform and social security reforms called for by President Bush -- including the introduction of personal savings accounts -- are an opportunity to further reduce the disincentives to save and provide long-term benefits to the U.S. economy.

Policies to Boost Global Growth

A second group of economic policies are those that will raise global growth. These will ameliorate the deficit by raising U.S. exports and increasing investment opportunities around the globe. And of course strong global growth has other benefits as well. Indeed, the effects of recent policy efforts are already visible in increased economic growth and greater economic stability around the world. Global economic growth is as high as it has been for 30 years and there are no major recessions or financial crises.

Several international economic policy initiatives have been undertaken in recent years to promote growth. Last year the G-7, under U.S. leadership, adopted the Agenda for Growth, which has emphasized structural, supply-side policies, especially in Europe and Japan, to increase flexibility and boost productivity growth and employment. In 2001, the U.S.-Japan Partnership for Growth established by President Bush and Prime Minister Koizumi led to candid discussions on how to promote sustainable growth in Japan. Early in the Bush Administration, President Bush and President Fox of Mexico created the Partnership for Prosperity, a private-public alliance to promote investment in parts of Mexico where growth has lagged. More recently President Bush and President Lula created a U.S.-Brazil Group for Growth to review and assess strategies to raise productivity and employment in Brazil. All of these initiatives aim to promote long-term investment opportunities in these countries and U.S. export opportunities.

The reduction of trade barriers through the Doha Development Round is vitally important for increasing economic growth but also for opening markets for exports from the United States and other countries. And with the right policies there could be much more foreign private investment in the low-income countries. Programs such as the recently created Millennium Challenge Corporation (MCC) and the World Bank's Doing Business initiative are keys to supporting low-income countries that are undertaking economic reforms to promote economic growth.

Market-Based Flexible Exchange Rates

A third area of policy relates to exchange rate flexibility. For small open economies, a currency board, dollarization or being part of a currency union can contribute greatly to stable prices and sound macroeconomic management. But exchange rate flexibility among currencies of major economies provides important paths of global adjustment to economic shocks. We have discussed these issues extensively in meetings with G-7 finance ministers and central bank governors and in other international fora. At the recent G-7 meetings in Dubai, Boca Raton and Washington, we achieved strong consensus in support of flexible exchange rates. The Boca Raton G-7 communiqué, repeated in the Washington G-7 communiqué, emphasized that "...more flexibility in exchange rates is desirable for major countries or economic areas that lack such flexibility to promote smooth and widespread adjustments in the international financial system, based on market mechanisms."

China is a large and growing economy. In 2003 it had a GDP of $1.4 trillion or $6.4 trillion adjusting for purchasing power parity. China is continuing to grow strongly and has become an important source of global growth. It has become a regional processing hub, finishing imported products from other Asian countries for final export. Other Asian emerging market economies follow China's economic strides and exchange rate policy closely. A flexible exchange rate is appropriate for China, not only in light of its growing international role but also in order to better manage domestic macroeconomic, particularly monetary pressures. Regionally, the Renminbi is an anchor currency and any movement toward flexibility should spread to other currencies.

The Bush Administration has had an unprecedented level of engagement with the Chinese government on its exchange rate policy including a technical cooperation program. We have broadened our diplomatic strategy to include China's major trading partners through the G-7. In early October, G-7 Finance Ministers and Central Bank Governors met for the first time as a group with their Chinese counterparts and discussed these issues.

The People's Bank of China's recent moves to increase its one-year lending and deposit rates are the latest examples of China's more systematic management of monetary policy. Such actions represent significant steps in support of China's move to a flexible and market based exchange rate.

Current Account Adjustment and Financing

In the last three-plus years, I have traveled throughout the United States and other countries meeting with a wide variety of international experts from the private and public sector to discuss the Bush Administration's economic policies. Questions about the adjustment or the financing of the current account often surface in these discussions, and, as I mentioned, I am currently chairing an international group whose main purpose is to examine questions about the adjustment and financing of the current account. I readily highlight the positive actions taken by the U.S. government, which will promote more growth throughout the world and reduce external imbalances. And I recommend strongly against actions that would be detrimental to the United States economy or the world economy even if one could argue that they would reduce the current account deficit. The beneficial impact of these positive measures may take time to materialize, but there is no reason to expect that financing and adjusting will not be adequate and smooth.

First, it is important to put the current account in the perspective of the total amount of financial flows crossing U.S. borders in large, open and flexible markets. The scale and scope of these capital flows represent a critical link for understanding the resources to fund the current account deficit.

Let me use an example from the most recent balance of payments statistics in the first two quarters of this year. From the first to the second quarter, the current account deficit increased from $147 billion in the first quarter to $166 billion in the second quarter, an increase of $19 billion. How was this increase financed? Net purchases of U.S. assets by the official sector actually fell by $54 billion; recall that intervention in exchange markets by Japan came to a halt on March 16. What about private purchases of U.S. assets? They declined too, by $126 billion from $317 billion to $191 billion. So where did the increased financing come from? The answer is a reduction in the purchase of foreign assets by U.S. residents, investors, and corporations. The net purchase of foreign assets fell by $188 billion. Note that in this example it was simply the reduction in the amount of purchases by Americans of foreign securities that did the financing. The stock of U.S. owned assets abroad continued to increase. Although data are difficult to obtain, our estimates indicate that the U.S. investment position represents a stock of capital of about $8 trillion.

This example also illustrates why certain ratios, such as "official sources of finance as a percentage of the current account," can be misleading. In the first quarter of this year that ratio was 92 percent. In the second quarter it fell to 50 percent. Yet the financing of the current account proceeded smoothly. Volatility in the markets remained low and long-term interest rates actually fell during the year. Some ask about the econometric models that are used to estimate the size of a currency adjustment that would be associated with a given current account adjustment. These models sometimes find large currency changes, but they sometimes also tend to look mechanically at the effect of an isolated exchange rate change. In reality many factors change simultaneously because the dollar and other major currencies are determined in markets. Further, it is important to keep in mind that, embedded within such model simulations, is an assumed U.S. current account at a certain given level.

Another question relates to a long-standing empirical observation that the U.S. income elasticity of demand for imports substantially exceeds trading partner income elasticity of demand for exports. This gives rise to pessimism that equally rapid growth at home and abroad would lead to an increase in the deficit. More recent research shows a significantly reduced asymmetry, however, particularly when data for the period since the 1990s are considered. As the world evolves, elasticity asymmetries, which may have been prominent in the 1960s and 1970s, are less present in more recent times. This more recent finding should not be surprising. As foreign countries grow and undertake structural reform, their income elasticity of demand for imports may rise. For example, Japan's import elasticity rose during the 1990s, confirming that the Japanese economy was moving to a more import-dependent structure than in the past. This is a manifestation of a shift in the industry mix of the Japanese economy, from the "full-set" structure of the past to a structure based on division of labor with East Asia. Structural reforms clearly had a role and will continue to have a role.

Conclusion

In sum, in these remarks I have tried to review the reasons for the recent current account trends in the United States, some of the related policies that the U.S. government is pursuing and will pursue in the future and some of the questions that people raise about financing and adjustment. I think the policies are the correct ones both for increasing growth and reducing the current account deficit. As we think about the future, there is great promise that the current global expansion will be a long lasting one, and this alone is good for the world economy as well as for the current account statistics.

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(Distributed by the Bureau of International Information Programs, U.S. Department of State. Web site: http://usinfo.state.gov)