Published daily by the Lowy Institute

The macroeconomic limit of American exceptionalism

There are hard rules to the forces driving the current account deficit, no matter how it is calculated.

A current account deficit can be sustainable as long as the rest of the world is willing to lend to or invest in the country (Max Sulik/Unsplash)
A current account deficit can be sustainable as long as the rest of the world is willing to lend to or invest in the country (Max Sulik/Unsplash)

Donald Trump was long obsessed with trade deficits and railed it was “very bad” whenever the balance ran against the United States. So, it’s not surprising to see one of Trump’s key lieutenants, former US Trade Representative Robert Lighthizer, also have a peculiar view of the forces driving the current account balance.

Lighthizer’s thesis, laid out in his book, No Trade is Free, boils down to the US current account deficit being a consequence of unfair practices by China and other countries subsidising their exports and underpricing their exchange rates. By providing the United States with cheaper products, he argues, these countries are forcing Americans to consume more, save less and run a large current account deficit.

Hence the solution, as Lighthizer see it, is to raise the cost of imports through tariff increases to offset the supposed advantage conferred by these unfair practices.

Now, to understand how he reaches this point, we need to delve into macroeconomics. Bear with me – this gets technical.

There is a fundament equation, known as an accounting identity, which means that the current account balance (exports less imports plus net foreign capital income) must equal the country’s saving less their investment. A floating exchange rate will adjust to balance these sides of the equation, while central banks have to buy or sell their foreign reserves to stabilise a managed or fixed exchange rate. This accounting identity tells us nothing about why a country has a large current account surplus or deficit, and so provides little insight into whether a deficit or surplus of any given size (measured as a share of GDP) is a good or bad thing.

When a country has a lot of young people and little capital, that country needs to run a current account deficit for their economic development. Similarly, countries with resources need foreign investment to bring capital (and knowhow) to be able to develop their resources. As countries develop and their populations mature, their savings tends to rise and investment needs decline relative to the size of their economy. These countries tend to have a period of current account surpluses, before the demographics shift and they need to draw down on past investments to fund the growing share of elderly.

A current account deficit can be sustainable as long as the rest of the world is willing to lend to or invest in the country. Export led growth is appealing to investors, who can see how their investments will be repaid over time. When investors are no longer willing to finance the deficit adjustment must come through raising savings or lowering investment to reduce the deficit and rebalance the equation.

So, where does this leave the Lighthizer logic?

Increasing US tariffs will reduce imports, but as tariffs raise the cost of inputs going into export production, they can also reduce the competitiveness of exports.

To Australians who lived through the 1980s when concerns about the current account deficit hitting 6% of GDP abounded, it must seem problematic. The “twin deficit” problem of a government budget deficit and current account deficit reflects the need for external borrowing (or an inflow of direct foreign investment) as domestic saving could not cover domestic private investment and the public sector deficit spending. The current account deficit mattered because, with a declining outlook for commodities, foreign investors got nervous.

Once investors get nervous about the ability of the country to repay loans or deliver a good return on investment the flow of capital slows. The market response to this slowing is for the exchange rate to depreciate. This raises the cost of imports and, unlike tariffs, improves the competitiveness of exports, helping restoring the balance to a sustainable level. But unless investors who are financing a current account deficit are convinced that their investments are safe, a once-off depreciation of the exchange rate is not going to be good enough.

In the 1980s and early 1990s, Australia had to convince investors that it would be able to service its debts in the future. Part of the adjustment was to reduce the government budget deficit. But much of the adjustment was to increase the productivity of the economy through structural reforms, which included a substantial reduction in tariffs and other forms of protection. This response, along with attention to the distributional consequences addressed by the Prices and Incomes Accord, served Australia well as productivity and incomes rose over the 1990s.

So, Australia’s solution to a persistent current account deficit was the opposite of that proposed by Lighthizer.

Is the United States exceptional, and do the rules that apply to small open economies, such as Australia, not apply?

It’s not possible to escape the fundamental equation. Increasing US tariffs will reduce imports, but as tariffs raise the cost of inputs going into export production, they can also reduce the competitiveness of exports. Unless tariffs reduce investment or increases savings, this will not shift the current account deficit. To the extent that protection reduces the growth in GDP and the United States becomes a less attractive place to invest, then a depreciation in the US dollar will reduce the current account deficit through the usual channels.

But this is where the United States is different. Tariffs and subsidies that protect US producers from competition can make the United States a more attractive place to invest. The strength in the US dollar reflects this “flight to safety” attitude of investors in the United States, as they shift to onshoring, as well as foreign investors as they seek to retain or establish a presence in the US market. This market reaction makes the US dollar stronger, which is the opposite of what Trump and Lighthizer are advocating for.

The twin targets of eliminating the current account deficit and a weaker US dollar, while consistent in themselves, are not going to be delivered by Lighthizer’s protection policies while foreigners are willing to finance US deficits.

The key to reducing the US current account deficit without a costly decline in investment (and consumption levels) is increasing the share of domestic income going to savings relative to consumption. Financial markets force this on most countries, but American exceptionalism lies in the willingness of foreigners to continue to fund the US current account deficit. While this willingness is tied to the reserve currency role that the US plays in the international financial system it is not guaranteed. Policies that make holding US dollar assets less attractive will ultimately rebalance the US current account deficit. It is just unlikely to be in a way that Lighthizer intends.

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