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Will There Be A Debt Crisis?

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The U.S. produces roughly one-third of the world's output with less than 5% of the world's population. U.S. GDP will be about $12.5 trillion in 2005. Moreover, over the next 10 years, the U.S. will produce roughly $145 trillion worth of goods & services. Yet, the U.S. consumes more than it produces through current account deficits. In 2005, the U.S. will consume over $600 billion more than it will produce.

Current account deficits are offset by capital account surpluses (to keep the balance of payments balanced). The U.S. will export over $1.2 trillion of output, to the rest of the world, while the U.S. will import over $1.8 trillion of output, from the rest of the world. The over $600 billion deficit is offset by U.S. net capital inflows by our trading partners, or net foreign investment in the U.S.

The NeoKeynesian Consumption Function is Y = C + I + G + NX (or C = Y - I - G - NX); where Y is output, C is consumption, I is investment, G is government, and NX is net exports. The U.S. economy has been able to expand with large negative net exports, while U.S. trading partners need export-led growth to expand their economies. Consequently, the U.S. economy is relatively stronger than the rest of the world's economies.

One reason for the massive U.S. current account deficits is the differences in economic policies between the U.S. and its trading partners. For example, in Germany, full employment is maintained through wage rigidies and labor immobility (e.g. union contracts), and in Japan, lifetime employment is another economic stabilizer. Consequently, Germany and Japan need U.S. consumption to maintain acceptable levels of employment. However, the U.S. economy has far fewer restrictions, and is able to shift resources, including labor, into emerging industries more easily. However, there's a wide-range of value disparities between the U.S. and its trading partners, particularly in the social arena, that cannot be easily reconciled.

Foreign central banks need a strong U.S. dollar to maintain export growth. If foreigners exchanged U.S. dollars for their currencies, then their currencies would appreciate (i.e. receive fewer and fewer units of their currency per dollar). Consequently, interest rates would rise above the world rate in the foreign country to compensate for a stronger currency. Higher interest rates slow output growth, which lowers export growth. So, foreign central banks exchange their currencies for U.S. dollars, to appreciate the dollar, and then use those dollars to buy U.S. Treasury Bonds, which help finance U.S. federal budget deficits.

U.S. consumption has been the engine pulling the rest of the world's economies, and U.S. consumption of foreign goods has been at the expense of U.S. production. However, the Law of Comparative Advantage shows trade is a net benefit. Consequently, the gains of U.S. consumers outweigh the losses of U.S. producers. Moreover, the U.S. net gain is larger than its trading partners, in part, because a stronger dollar or cheaper imports force U.S. firms to become more efficient. So, U.S. trading partners need the U.S. more than the U.S. needs its trading partners, although the U.S. benefits more from international trade.

Over the past two years, U.S. real GDP expanded at a 3.9% annual rate, while U.S. real consumption expanded at a 3.7% annual rate. So, U.S. consumption grew roughly in parallel with U.S. output or income. However, real private fixed investment expanded at an 8.7% annual rate over the past two years, which indicates Americans are using debt to invest rather than consume. I suspect, a great deal of debt has been used in the housing market, and to a lesser extent in the stock market, because interest rates have been low.

The massive U.S. current account deficits cannot continue indefinitely. The U.S. has responded appropriately in the form of "Cournot Duopolies," against the rest of the world, in deriving the greatest gains from trade. It's inevitable that U.S. trading partners will either choose or be forced to accept slower growth, either in the form of gradually muddling through for years or suddenly through deep recessions. However, the U.S. should continue to target sustainable growth, where there's neither strain nor slack in the economy, which is optimal growth.

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