Back to the Future: Americans Still Consuming Too Much and Rest of World Still Consuming Too Little

The much-needed (and talked about) reduction in global imbalances is not happening. On the contrary, these imbalances are getting worse. U.S. domestic demand growth remains strong, while growth in other key economies (especially Japan and the Eurozone) has faltered. It is tempting, for some, to blame U.S. "profligacy" as the root cause of this predicament. But the growing U.S. current-account deficit and the corresponding rise in surpluses elsewhere are global problems, which have global roots and thus require global solutions. Without a more concerted and coordinated effort to slow domestic demand growth in the United States and boost it in other parts of the world, the downward pressure on the dollar is likely to intensify, notwithstanding its recent rally.

The Global Imbalances Keep Getting Worse. The fourth-quarter GDP numbers for the United States contained both good news and bad news. The good news was that the U.S. recovery continues at a sustainable pace. And even though, at 3.1%, growth was a little disappointing, recent data releases suggest this preliminary estimate will likely be revised up to around 3.5% or possibly higher. The bad news was that domestic demand continued to grow at a very rapid pace—4.7%—while net exports subtracted 1.7% from overall growth in the fourth quarter. This is exactly the opposite of what is needed to correct America's yawning external imbalance. The United States needs export-led growth or GDP growth that is faster than the growth in domestic demand.

Strong growth in U.S. domestic demand is only half the problem. With the exception of Asia, domestic demand growth in other key regions of the world continues to lag. In particular, at around 1.5–2.0%, domestic demand growth in Japan and the Eurozone is one-third to one-half the rate in the United States and much too slow to help bring the global imbalances under control. There is little relief in sight. Business and consumer confidence is fragile in both these economies. For example, the recent rise in German jobless rolls to 5 million—the highest since 1932—is likely to make consumers there even more cautious.

All this means that the U.S. current-account deficit will keep rising this year to around $750 billion, or just above 6% of GDP. Likewise, the long-hoped-for (and sustained) contribution of net exports to U.S. growth is likely to be postponed for at least another year.

A Global Problem That Requires a Global Solution. Many analysts unfairly blame high debt levels, low savings, and the widening budget deficit in the United States as the primary reasons for a world economy that is out of kilter. While all of these factors have certainly contributed to the problem, it takes "two—or more—to tango." To begin with, private- and public-sector debt levels in the United States are no higher than the G-7 average. If high private- and public-sector debt were the root causes of a country's external imbalance, then both Japan and Germany would have larger deficits than the United States—in reality, they both run surpluses. Moreover, there is no direct connection between the budget deficit and the current-account deficit. During the 1990s, the U.S. budget balance went from a large deficit to a surplus, while the current-account deficit steadily worsened.

Recently, Global Insight addressed this issue using its newly developed Global Scenario Model. Using the model, we looked at the impact on the U.S. current account of balancing the U.S. federal budget by 2014. The current Global Insight baseline projects the budget deficit to be around $150 billion in 2014, and for balance to be achieved only after 2020. Balancing the budget sooner would cut the current account by $50 billion in 2014. This small impact—less than one-tenth the size of the current-account deficit in 2005—is consistent with the closed nature of the U.S. economy. In other words, a reduction in domestic demand has only a small impact on imports.

While a necessary part of the solution, balancing the U.S. budget, alone, will not be enough. Domestic spending growth in the rest of the world will also have to accelerate—and ideally grow faster than domestic demand in the United States. This means that monetary and fiscal policies in the rest of the world (especially the Eurozone and Japan) should remain accommodative, if not become more so. Unfortunately, the prospects for such policy accommodation do not look promising. Already, the Japanese government is talking about raising taxes. Likewise, despite the much-talked-about demise of the Stability and Growth Pact in Europe, most governments are planning to tighten their budgets over the next year. Also, while Global Insight predicts that the European Central Bank will cut interest rates by 50 basis points sometime this year, there is a risk that the ECB will keep sitting on its hands.

Thus, the most likely scenario is for U.S. fiscal and monetary policies to maintain their pace of gradual tightening, while the rest of the world does little to help in the necessary rebalancing. The lack of cooperation on the part of the Asian economies will probably continue to manifest itself by an unwillingness to allow their currencies to appreciate. This means that the downward pressure on the dollar will intensify in the coming year, even though it has recently seen a mini-rally.

A Much Larger Depreciation of the Dollar May Be the Only Way to Force the Necessary Adjustments. So far, the 15% drop in the dollar since early 2002 has not been enough to put any dent in the U.S. current-account deficit. There are three reasons for this. First, exporters to the United States have, so far, not allowed their U.S. prices to rise by much (and swallowed losses in their profits) as they struggle to maintain market share in the large and lucrative American market. Second, the dollar has only fallen against some currencies (i.e., the euro, yen, Canadian dollar, and other "floaters"). China, which enjoys a large surplus with the United States, continues to peg its currency to the greenback. Third, given the size of the U.S. current-account deficit, a large drop in the dollar is needed under any circumstance. During the late 1980s, the dollar fell by 35% on a trade-weighted basis, in the face of a current-account deficit that, as a percent of GDP, was less than half what it is today.

To measure the impact of a large depreciation of the dollar, Global Insight ran a second scenario, using the Global Scenario Model, in which the greenback was assumed to fall by 30% over the next three years against all currencies (including the Chinese renminbi). This cut the U.S. current-account deficit by around $430 billion in 2014, bringing the current-account deficit down to around 2% of GDP—which most economists believe is a sustainable level (insofar as it would stabilize the external debt of the United States). In this scenario, GDP growth in both Japan and Eurozone would be cut by an average 0.5 percentage point for three years, assuming that policy makers in those economies took no action to boost their domestic demand.

One way or another and sooner or later, the large imbalances in the global economy will be corrected. The big (unanswered) question is will the correction occur because of deliberate policy action by the United States and (all) its trading partners, or will it be imposed (most likely painfully) by the markets.