The current account balance is a commonly misunderstood economic statistic. And we're not just talking by you and the guy next door but professional economists, too. We'll admit it is hard not to think the "massive" US current account deficit is a harbinger of disaster considering the play it gets in the media. The story usually goes that foreigners are (out of the goodness of their hearts) funding American consumers' profligacy. At some point, foreigners will stop this altruism and take away their capital, leaving the US financial system teetering on the edge of collapse. But the reality is quite different. A large current account deficit does not portend disaster nor does it ever have to be corrected.
First, let's break apart balance of payments accounting, which records all transactions made between countries. The current account and the capital account are the two major subsets of the balance of payments. The current account is dominated by the trade balance (exports minus imports), while the capital account measures financial flows like investments. These two components must net to zero. That is, a current account deficit is exactly offset by an equal capital account surplus.
The US current account deficit stands at $838 billion in the four quarters ending June 2006, or approximately 7% of GDP. This may seem like a gigantic number, but it is misleading. Balance of payments methodology is flawed and does not tell the true story. The easiest way to show this is through an example.
Whether in a cubicle or at home surfing the Internet, chances are good that there is a Hewlett-Packard (HP) computer in front of you. HP is the world's largest PC maker, designing everything in its Northern California headquarters and outsourcing production and manufacturing to countries like Mexico and China. This is a fairly common business model these days.
Say HP sells a PC in the US for $500 that costs $300 to manufacture in China. The $300 import from China would be a debit to the US current account (a $300 deficit), but HP makes somewhere around $200 in profit while the Chinese manufacturer is lucky to keep $50 since margins on manufacturing are much smaller (these numbers are not exact but are probably pretty close to reality). While production costs are properly accounted for in public figures ($300), the profits from those products are not ($200 vs. $50). This means the current account balance does not properly account for the value-add in an economy, making a large part of the deficit an illusion of murky accounting.
Okay, most economists say, but surely the deficit is unsustainable at current levels. Turns out they're wrong on that one, too. There's no reason to think the deficit cannot continue indefinitely or even increase from today's levels. By definition, the US runs a capital account surplus that equals its current account deficit. This means foreigners are investing large amounts of money in US financial assets, or "funding" the US current account in common parlance.
But foreign investors aren't stupid nor are they charitable. They seek to maximize profit like any good capitalist. US innovation offers a better return on investment while other countries are more efficient with manufacturing. And there is no reason this has to end. This kind of trade is mutually beneficial and sustainable. Demand for US financial assets can continue indefinitely as long as innovation continues to spur higher returns on investment—something US corporations have done consistently over time.
If you still don't believe us, here's one last example. Over the past 20 years, the US has consistently run a current account deficit while Japan has had a current account surplus. Which country would you rather invest in? Japan, which is just now coming out of a 15-year bear market and recession? Or the US, which has seen tremendous economic growth and multiple bull markets over the same period?
Do yourself a favor and ignore the prognosticators who say our current imbalances are dangerous and unsustainable. It's one less thing to worry about.