U.S. Current Account Deficit Likely the Cause of the Next Financial Crisis

A while ago, Raw Finance explained why the U.S. current account deficit caused the 2008 financial crisis, which led to a market panic that took down every asset class (see How Government Economic Policies Caused the Financial Crisis of 2008).  The way out of the financial crisis now appears to be leading to an even greater current account deficit that will likely lead to a worse financial crisis in the future.  C. Fred Bergsten of the Peterson Institute for International Economics about the U.S. dollar and fiscal deficits in which he encourages the U.S. to “launch new policies to avoid large external deficits, balance the budget, and adapt to a global currency system less centered on the dollar.”

Before diving into Bergsten’s analysis, a quick primer on current account deficits may be helpful to anyone not well versed in international economics.  Put simply, a current account deficit is like the government maintaining a checking account with the rest of the world that is permanently overdrawn.  Instead of paying overdraft fees, the government borrows from the world to pay the deficit.  The deficit occurs because the U.S. buys more stuff from other countries (especially oil) than it sells.  Deficits are not necessarily bad, and some have argued that a sustainable current account deficit may be healthy for the U.S.  However, when the fiscal deficit blows up, like it did in the years preceding the 2008 Financial Crisis due to leveraged buying by U.S. consumers and easy U.S. monetary policy, it can become extremely dangerous.  Again, the simple reason is that as the U.S. tries to sell more of its debt to the world, the world will demand ever higher returns.  At some point, the world might stop buying U.S. debt, and then we’re in big trouble.

This then brings us right into the heart of Bergsten’s article.  In order to stop the financial panic, boost the economy back to growth and return financial markets to normal operating levels, the U.S. has returned to an extraordinarily easy monetary policy.  The federal funds rate is basically at zero, and the Federal Reserve Board and Treasury Department have flooded financial markets with dollars.  Other governments have followed suit, and it appears that a worldwide economic recovery has begun.  But there are still serious problems in the system, and they seem to be exacerbated by the very policies that have ended the recession.  And so, the Fed finds itself in the unenviable position of needing to transition out of its easy monetary policy without violently upsetting the recovery.

Bergsten details what needs to be done:

1. Avoid large external deficits: “US policymakers, therefore, must recognize that large external deficits, the dominance of the dollar, and the large capital inflows that necessarily accompany deficits and currency dominance are no longer in the United States’ national interest. Washington should welcome initiatives put forward over the past year by China and others to begin a serious discussion of reforming the international monetary system.”
2. Balance the budget: “Balancing the budget is the only reliable policy instrument for preventing such a buildup of foreign deficits and debt for the United States. As soon as the US economy recovers from the current crisis, it is imperative that US policymakers restore a budget that is balanced over the economic cycle and, in fact, runs surpluses during boom years. Measures that could be adopted now and phased in as growth is restored include containing the cost of medical care, reforming Social Security, and enacting new taxes on consumption.”
3. Encourage personal saving:  “The only healthy way to reduce the United States’ external deficits to a sustainable level is to raise the rate of national saving by several percentage points. Such an increase could be achieved with a combination of increased private saving and a reduced federal budget deficit. Prior to the crisis, household saving in the United States was essentially zero; it has recently rebounded to the 5-7 percent range. This is presumably a reaction to the sharp decline in household wealth created by the fall in housing and equity prices during the crisis.”
4. Defeat the enemy within: “The root of the United States’ problem is domestic, however. As soon as recovery from the current crisis permits, the United States must implement a responsible fiscal policy. It should adopt new measures in the near future—while the economy is still recovering—that can be implemented over the medium and long terms, as growth resumes and the country can accommodate fiscal tightening without risking another recession. Enacting such measures now would work to generate confidence as the United States continues to emphasize recovery and thus minimize the risk that both US Treasury securities and the dollar will come under suspicion in the markets—something that could, if it happened, jeopardize the recovery itself.”

Raw Finance has always remained politically neutral in evaluating economic conditions.  I believe this is critically important to a proper analysis of economic conditions that will inform a prudent investment strategy.  In the wake of the financial crisis, Washington, D.C., has emerged as the most important influence on the U.S. economy, and it is likely to remain so for several years.  This will require constant analysis of unfolding events on Capitol Hill, and whatever the U.S. government chooses to do, I will analyze only the probable effects based on economic analysis and facts.  As Milton Friedman stated, the “brute experience” will always trump political ideology, and over the past year we have had more than our fair share of “brute experience.”

In conclusion, whatever goals the current administration and Congress outline and pursue, they cannot be fully achieved without first taking the steps that Bergsten describes.  Also, Bergsten describes how this economic issue also has implications for U.S. foreign policy and national security.  How can the U.S. gain cooperation and concessions on issues like climate change, financial regulatory reform and foreign military operations if it is deeply indebted, and thus dependent on for its financial life, on other countries?

To view Bergsten’s article, please click on the following link:  The Dollar and the Deficits: How Washington Can Prevent the Next Crisis