Smith Faculty Opinion Article	March 14, 2007
By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

2006 Current Account Deficit Hits Sets Record
Chinese Government Could Purchase Five Percent of U.S. Stocks

Today, the Commerce Department reported the 2006 current account deficit was $856.7 billion, up from $791.5 billion in 2005 and setting a new record. The deficit was 6.5 percent of GDP.

In the fourth quarter, the current account deficit was $195.8 billion, down from $229.4 billion in the third quarter. The reduction was mostly attributable to lower oil prices during the latter months of 2006, and this situation reversed in the first quarter of 2007.

The current account is the broadest measure of the U.S. trade balance. In addition to trade in goods and services, it includes income received from U.S. investments abroad less payments to foreigners on their investments in the United States. Those net payments turned negative for the first time in many decades, and confirm that borrowing to finance huge trade deficits have reduced the worlds largest economy to the status of a debtor nation.

To finance the trade deficit, Americans are borrowing and selling assets at a net pace of $856.7 billion a year. Consequently, in 2007, the United States paid to foreigners more interest, dividends and profits than it received, recording a net deficit on income payments of $7.3 billion. Valuing the net investment position of the United States is difficult, but this negative flow of payments is the clearest evidence of the debtor status of the United States.

The Chinese government alone holds more than one trillion dollars in U.S. and other securities, and these could be used to purchase more than five percent of the value of publicly trade U.S. companies. This should give Americans real pause about Chinese government intentions to diversify its foreign exchange holdings.

The current account deficit imposes a significant tax on GDP growth by moving workers from export and import-competing industries to other sectors of the economy. This reduces labor productivity, research and development (R&D) spending, and important investments in human capital.

Anatomy of the Hemorrhaging Current Account

In 2006, the United States had a $70.7 billion surplus on trade in services. This was hardly enough to offset the massive $836.0 billion deficit on trade in goods and $7.3 billion deficit on income flows. Also, unilateral transfers contributed $84.1 billion to the overall current account deficit.

In 2006, the deficit on petroleum products was $271.0 billion, up from $229.2 billion in 2005; prices for imported petroleum rose about 23.9 percent from 2005, while the volume of imports rose 19.6 percent.

The American appetite for inexpensive imported consumer goods and cars was a huge factor driving the trade deficit higher. In 2006, the deficit on nonpetroleum goods was $547.0 billion, up from $538.3 billion in 2005.

The deficit on motor vehicle products increased 5.5 percent to $144.7 billion, as Ford and GM continue to push their procurement offshore and cede market share to Japanese and Korean companies offering better made and less expensive to own vehicles. Even when they assemble automobiles in the United States, Asian automakers import more parts than Ford and GM.

The Wal-Mart effect was broadly apparent. In 2006, the trade deficit with China was $232.7 billion, a new record. This was up from $201.7 billion in 2005.

This situation is likely to become worse in the months ahead. Crude oil prices are rising again, and an overvalued dollar continues to keep imported cars and consumer goods cheap. Announced production cutbacks at GM, Ford and Chrysler will result in more imported motor vehicles and parts. Rising gas prices are driving car buyers away from Detroits gas guzzlers and into the arms of Asian brands.

The dollar remains at least 40 percent overvalued against the Chinese yuan and other Asian currencies. Although China revalued the yuan from 8.28 to 8.11 in July 2005, and announced it would adjust the currency to a basket of currencies, the yuan continues to track the dollar very closely. Currently it is trading at 7.74

Other Asian governments must conform their currency policies to China, lest they lose competitiveness in U.S. and European markets. To sustain undervalued currencies against the dollar, foreign governments purchased $300.5 billion in U.S. securities in 2007. This created a 14 percent subsidy on their exports to the United States.

Financing the Deficit

The current account deficit must be financed by a capital account surplus, either by foreigners investing in the U.S. economy or loaning Americans money. Some analysts argue that the deficit reflects U.S. economic strength, because foreigners find many promising investments here. The details of U.S. financing belie this argument.

In 2007, U.S. investments abroad were $1045.8 billion, while foreigners invested $1764.9 billion in the United States. Of that latter total, only $183.6 billion, or 10.4 percent, was direct investment in U.S. productive assets. The remaining capital inflows were foreign purchases of Treasury securities, corporate bonds, bank accounts, currency, and other paper assets. Essentially, Americans borrowed $1.6 billion to consume 6.5 percent more than they produced.

Foreign governments loaned Americans $300.5 billion or 2.3 percent of GDP. That well exceeded net household borrowing to finance homes, cars, gasoline, and other consumer goods. The Chinese and other governments are essentially bankrolling U.S. consumers, who in turn are mortgaging their childrens income.

The cumulative effects of this borrowing are frightening. The total external debt now exceeds $6 trillion. That comes to $20,000 for each American, and at 5 percent interest, $2000 for each working American.

The Chinese government alone holds enough U.S. and other foreign reserves to purchase more than five percent of the shares of all publicly trade U.S. companies, and that figure increases by 20 percent each year. The U.S. trade deficit is the primary driver behind this phenomenon.

Consequences for Economic Growth

High and rising trade deficits tax economic growth. Specifically, each dollar spent on imports that is not matched by a dollar of exports reduces domestic demand and employment, and shifts workers into activities where productivity is lower.

Productivity is at least 50 percent higher in industries that export and compete with imports, and reducing the trade deficit and moving workers into these industries would increase GDP.

Were the trade deficit cut in half, GDP would increase by nearly $250 billion, or about $2000 for every working American. Workers wages would not be lagging inflation, and ordinary working Americans would more easily find jobs paying higher wages and offering decent benefits.

Manufacturers are particularly hard hit by this subsidized competition. Through recession and recovery, the manufacturing sector has lost 3.2 million jobs since 2000. Following the pattern of past economic recoveries, the manufacturing sector should have regained about 2 million of those jobs, especially given the very strong productivity growth accomplished in durable goods and throughout manufacturing.

Longer-term, persistent U.S. trade deficits are a substantial drag on growth. U.S. import-competing and export industries spend three-times the national average on industrial R&D, and encourage more investments in skills and education than other sectors of the economy. By shifting employment away from trade-competing industries, the trade deficit reduces U.S. investments in new methods and products, and skilled labor.

Cutting the trade deficit in half would boost U.S. GDP growth by one percentage point a year, and the trade deficits of the last two decades have reduced U.S. growth by one percentage point a year.

Lost growth is cumulative. Thanks to the record trade deficits accumulated over the last 10 years, the U.S. economy is about $1.5 trillion smaller. This comes to about $10000 per worker.

Had the Administration and the Congress acted responsibly to reduce the deficit, American workers would be much better off, tax revenues would be much larger, and the federal deficit could be eliminated without cutting spending.

The damage grows larger each month, as the Bush administration dallies and ignores the corrosive consequences of the trade deficit.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.