How Scary Is the Deficit?

Our Money, Our Debt, Our Problem

Brad Setser and Nouriel Roubini

The U.S. current account deficit -- the gap between what the United States earns abroad and what it spends abroad in a year -- is on track to reach seven percent of GDP in 2005. That figure is unprecedented for a major economy. Yet modern-day Panglosses tell us not to worry: the world's greatest power, they say, can also be the world's greatest debtor. According to David Levey and Stuart Brown ("The Overstretch Myth," March/April 2005), "the risk to U.S. financial stability posed by large foreign liabilities has been exaggerated." Indeed, they write, "the world's appetite for U.S. assets bolsters U.S. predominance rather than undermines it."

But in fact, the economic and financial risks that arise from the U.S. current account deficit (and the resulting dependence on foreign financing) have not been exaggerated. If anything, they have received too little attention -- and are set to grow in the coming years.

Levey and Brown make three basic arguments. First, they claim that foreign central banks will probably continue to finance U.S. deficits. Second, they predict that even if foreign central banks do pull back at some point, private investors will step in. And finally, they assume that even if this financing does not materialize, a dollar crash would hurt Europe and Japan more than it would hurt the United States. Unfortunately, there is a good chance that all of these assumptions will prove false. Foreign central banks may well stop financing growing U.S. deficits, private equity investors might not take their place, and the resulting adjustment process would prove quite painful for the United States.

DEBT DYNAMICS

U.S. external debt is now equal to more than 25 percent of GDP, a high level given that exports are a small fraction of U.S. GDP. More important, the United States is adding to its debt at an extraordinary pace. The U.S. current account deficit is now comparable to those of Thailand and Mexico in the years leading up to their financial crises.

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