Sustainability and the US Current Account: Dark Musings

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Sustainability and the US Current Account Dark
Musings

• Maurice Obstfeld
• University of California, Berkeley
• FRBSF, February 4, 2005

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What is Sustainability?

• The Concept is Best Defined in Long Run
• Adherence to intertemporal budget constraint,
  without involuntary transfers from lenders or
  their governments.
• Involves willingness as well as ability to pay.
• What is sustainable for one country may not be
  for one with different wealth, politics,
  institutions.
• Emerging markets can encounter external financing
  problems long before industrial borrowers.
• Expectations and high interest rates may force
  the issue.
• Creates a demand for international liquidity.

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The Position of the United States

• For the U.S. an EM-style sudden stop seems
  unthinkable -- or does it?
• Even at net foreign liabilities equal to 100 of
  GDP, we might pay 5 of GDP per year, say, on
  interest -- quite high, but not totally crushing.
  
• Expectations, however, might complicate matters.
• On the other hand, the U.S. is currently soaking
  up some 70 of the worlds CA surpluses.
• It is running a large trade deficit which it will
  have to reverse to repay foreign debts. How?
  And with what expectations/asset-price effects?

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The United States as a Startup

• The U.S. has not yet made net investment income
  transfers on its growing foreign debt

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How Can This Be? Simple Algebra

• Let NFA A ? L.
• Net investment income is

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Exorbitant Privilege Still with Us ...

• Alan Taylor and I calculate that for the U.S. in
  recent decades, this has amounted to about a 2
  reduction in borrowing cost.
• So if we pay, say, 4 but earn 6, the preceding
  inequality will hold (.33 gt .25).
• For a privilege of 2, the inequality is more
  demanding at high nominal interest rates. So low
  rates are part of the story recently. (At high
  rates amortization is faster, but liquidity needs
  to be greater.)

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but for How Much Longer?

• If we have to pay 200 b.p. more on our foreign
  liabilities, cost is 2 GDP, even if NFA/GDP
  -.25.
• That cost will rise as NFA continues to fall.
• The much greater extent of international
  leveraging makes the U.S. (and other economies)
  more vulnerable to a loss in confidence.
• In part that is because it creates greater
  incentives for opportunistic policy behavior.
• Now the dollar has a credible competitor, the
  euro.
• We know that vehicle currency status depends on
  network externalities--could there be a tipping
  point given the current idiosyncratic course in
  American fiscal and foreign policies? Or the
  question of the Feds leadership going forward?

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Revived Bretton Woods?

• DFG point out BW survived for some 20 years.
• However, they also (February 2004) state For
  the next year or so we are comfortable that the
  official sector can succeed in its defense of
  exchange rates.
• The question is, how long is the horizon?
• Clearly Asian central banks currently have strong
  incentives to accumulate dollars (though Japans
  intervention has slowed).
• (Unclear whether Japans intervention has much
  exchange rate effect, given the 0 interest rate.)
• For BW, problems began soon after European
  convertibility in 1958.

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Why Did BW Break Down?

• The Triffin problem was secondary
• Need for a dollar devaluation.
• Worsened by deteriorating U.S. leadership
  position in world economy -- economic
  unilateralism. (Nixon I dont give a
  expletive deleted about the lira.)
• Strong currency countries were swamped in
  liquidity as speculation on revaluations spread.
• European countries tried capital inflow controls.
• U.S. got Smithsonian devaluation through
  aggressive trade policy -- import surcharge.
• Broke down in face of even larger attacks.

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Vulnerabilities Scenarios

• Trade warfare is one way of pressuring official
  Asia.
• There is a plausible financial scenario, too.
• World will not pay us unlimited transfers
  forever.
• Dollar must undergo a substantial depreciation to
  bring about U.S. current account adjustment--see
  Rogoff and my NBER paper (symposium website).
• If private agents anticipated this with
  certainty, they would massively short dollars,
  leading to virtually unlimited acquisitions by
  Asian central banks.
• The longer the U.S. deficit lasts, the longer the
  needed exchange rate adjustment.

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How Could It All End?

• At some point the potential losses of China et
  al. would break their government budget
  constraints.
• Of course, with uncertainty, and real-world short
  sales constraints, the potential attack is less
  extreme, but still, the danger rises the longer
  the current non-adjustment pattern continues.
• We should not be complacent -- Chinas controls
  help to shield it for now. But markets are much
  broader and deeper today than at the end of the
  Bretton Woods system.
• Basic problem How will US saving, investment
  change? Exchange rate alone isnt enough.