Sustainability and the US Current Account: Dark Musings

1. Sustainability and the US Current Account: Dark Musings Maurice Obstfeld University of California, Berkeley FRBSF, February 4, 2005

2. 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.

3. 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 world’s 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?

4. The United States as a Startup • The U.S. has not yet made net investment income transfers on its growing foreign debt

5. How Can This Be? Simple Algebra • Let NFA = A L. • Net investment income is

6. 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 > .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.)

7. … 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 Fed’s leadership going forward?

8. 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 Japan’s intervention has slowed). • (Unclear whether Japan’s intervention has much exchange rate effect, given the 0 interest rate.) • For BW, problems began soon after European convertibility in 1958.

9. 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 don’t 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.

10. 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.

11. 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 -- China’s 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 isn’t enough.