How Do US Current Account Deficits Arise?
One hears little today of the US “twin deficits,” a phrase familiar during the 1980s when the US had consistently run both federal budget deficits and international trade deficits. Economists hypothesized at that time that there was a theoretical and/or empirical relationship assuring the two deficits’ increasing or decreasing together.
How Do Federal Budget Deficits Arise?
Annual federal budget deficits exist whenever federal spending exceeds annual tax revenue. The US has consistently run these deficits in most of the postwar period, except during the Clinton administration in the 1990s. Fiscal year 2001 was the last time the US federal budget was in surplus.
The fiscal year 2023 budget deficit was $1.7 trillion, with tax revenue at $4.4 trillion and federal spending at $6.1 trillion. The deficit through the first half of fiscal year 2024, which ends September 30, was $1.1 trillion, with receipts at $2.2 trillion and outlays at $3.3 trillion. In order to finance these budget deficits, the US Treasury issues massive amounts of US Treasury bonds, adding every year to the total outstanding federal debt.
How Do US Current Account Deficits Arise?
Annual current account deficits occur when the US sends more funds abroad than the country receives from sources abroad. The largest item in the current account is trade (exports and imports), in which the US has run a deficit every year since 1975.
The other item in the current account is non-trade-related income flows between US residents and residents of other countries. These income flows include remittances from Americans and immigrants to entities abroad, as well as Americans’ tourist spending abroad. Mexico, China, India, and Philippines are the leading destinations of US remittances.
The US trade deficit was nearly $1 trillion in 2022, but then fell to $773 billion in 2023. This deficit varies every calendar quarter, and from year to year, often because of irregularly-timed exports of big-ticket items such as Boeing jets, and large regular imports of items such as oil, foreign machinery, pharmaceuticals, industrial supplies and car parts.
The largest US trade deficits are recorded with China, Mexico, Vietnam, Canada, Germany, Japan and Ireland. The largest trade surpluses are with the Netherlands, Hong Kong, Brazil, Singapore, Australia, and the UK. The US’s top trading partners are Canada (15 percent of total US trade), Mexico (14 percent of total, and China (13 percent of total).
The Twin-deficits Significance in the 1980s
The twin deficits hypothesis arose to explain the experience of the US during the 1980s. Observers noted that federal budget deficits and trade deficits rose and fell together, although whether there were a causal relationship in the movements of the two deficits was unclear.
At that time Americans were particularly concerned about federal budget deficits as Congress enacted the Economic Recovery Tax Act in 1981 but the Reagan administration did not cut federal spending commensurately. Some economists at the time wondered if the observed twin deficit model might assist countries control their government budget deficits. The thinking was that reducing the US trade deficit could also lower budget deficits, assuming a genuine linkage between the two deficits.
Note, however, that by the 1990s the Clinton administration brought the federal budget into surplus territory, yet the current account deficit continued into negative territory, calling into question the twin deficits hypothesis.
The Twin Deficits Narrative
The twin deficits explanatory narrative runs thusly: persistent current account trade deficits since 1975 have caused US trading partners to accumulate large amounts of US dollar-denominated foreign exchange, which were then invested in assets such as US Treasury bonds, land and other US real assets, producing capital account surpluses to offset current account deficits.
US trading partners have historically been comfortable investing in US Treasury debt, which is AAA rated, the highest level given by ratings agencies such as Moody’s and Standard & Poor. China, Japan, UK, Belgium and Luxembourg are the leading foreign countries holding US Treasury debt.
Might the Twin Deficits Provide Policy Guidance Today?
With today’s concern again over large federal budget deficits and all-time high federal debt, could the twin deficits hypothesis apply today? That is, would reduced current account trade deficits enable the US to constrain its federal budget deficits?
When the US runs both federal budget deficits and current account deficits, in effect the US federal government is borrowing from foreigners (who buy US Treasury bonds and other US assets) in exchange for imported foreign-made goods. Phrased another way, the US exports bonds (IOU pieces of paper) and imports foreign-made goods for domestic consumption.
While this exchange of pieces of paper (bonds) for foreign-made goods can be sustained, many Americans are probably quite satisfied with the results. As a nation, Americans love to consume, including imports, whether it’s $5,000 Hermes handbags from France or cheap knickknacks from China. They treat shopping as a national pastime, their motto being “Shop till you drop,” they often find it difficult to save some of their incomes for retirement or other distant future events, and readily incur personal debt (for example, on credit cards) in order to indulge their consumerist urges.
Americans’ Low Personal Saving Rate and Other Complications
But the mirror image of Americans’ consumerism is their low personal saving rate, which has hovered recently around 3 to 5 percent of GDP, and briefly as high as 32 percent in April 2020 during the pandemic when they received generous federal “stimulus” payments but had few opportunities to spend them. This contrasts markedly with China’s consistent saving rate of 40-50 percent of GDP, and Japan’s rate of about 25 percent.
Large continuing current account trade deficits are not sustainable in the long run if they increase foreign ownership of US federal debt. When foreigners own US federal debt, interest payments on this debt represent income flows leaving the country, adding to the current account deficit.
If the entire US federal debt were internally owned by US citizens, on the other hand, income flowing abroad would not be a major issue. Some Americans would simply owe US debt interest payments to other Americans, representing an internal redistribution of income from those US taxpayers who own no US bonds to other Americans who do own US bonds.
Beginning this year, the US has begun paying more interest on its federal debt than it spends on national defense. As interest rates are now more normalized at higher levels than a couple of years ago, these interest payments will only increase over time. And some portion of these interest payments flow to foreign owners of US debt. A larger debt, moreover, can be serviced only through more federal borrowing or higher net exports. And for net exports to rise, all else equal, the value of the dollar must decline and/or US workers must become more productive.
Is There a Future for the Twin Deficits Hypothesis?
Consider that one or more of the following structural or cyclical changes must occur for the twin deficits hypothesis to assist the US control its current federal budget deficits, and thus its ability to reduce its outstanding federal debt:
* Americans would uncharacteristically need to increase their saving rate, ideally providing sufficient domestic saving to purchase the new federal debt required to finance federal spending, thus reducing reliance on foreign investors.
* Tax revenues would need to increase, leaving Americans with less disposable income overall, likely causing politically divisive income distributional effects.
* Imports would need to fall, and/or exports increase, to reduce US trade deficits.
* The US dollar may need to depreciate relative to other currencies, raising questions about the Federal Reserve’s responsibility to support the USD’s stability.
A moment’s reflection reveals the limited prospect of these changes occurring. Underlying these potential changes, moreover, lurk possible immigration statutory or policy changes that might reduce current labor market tightness, thus inviting unemployment and recession that the Federal Reserve would feel obligated to respond to.
A Final Note on the Twin Deficits Narrative
This now-abandoned hypothesis from a bygone era is a reminder that economic models come and go. Yet conceivably it could emerge in some form during this current era of historically large US federal budget deficits.
Interestingly, there is no commentary in the literature about possible twin surpluses in federal budgets and trade balances. Perhaps that is because such joint surpluses have not existed in the US over any periods of time. Or perhaps it is because economists realize that there is neither a theoretical nor empirical basis for the twin deficits hypothesis, nor any basis for the existence of twin surpluses either.
If Americans are genuinely concerned about its federal budget deficits (and/or its current account trade deficits), they are well advised not to rely on the possibility of twin surpluses any time soon. Like the Easter bunny and the Tooth Fairy, twin surpluses are almost certainly a fantasy that wouldn’t absolve the US of the hard work required to clean its fiscal house and restore responsible federal spending.