The same is true of countries. Those that consume more than they produce must return the favor or get cut off. The “current account” describes whether a country is consuming more or less than it is producing. Countries with current account surpluses, like Japan, are producing more than they consume. The excess Japanese production is being sent to other countries in return for IOUs in the form of money. The current account is the broadest measure of a country’s consumption and includes everything from cars to movies, legal services, and investment income. Thus, the current account includes the trade deficit and all other international transfers.
FIGURE 6.1 The United States Consumes Far More Than It Produces
Source: U.S. Commerce Department
As shown in Figure 6.1, unlike Japan, the United States has a large current account deficit. We’ve had a deficit for so long that we show the negative current account deficit as positive numbers. Because we can’t imagine a world where the United States consumes less than it produces, we measure the amount of profligacy, not its existence. Residents in the United States consume far more than they produce. In return for Saudi oil, Japanese cars, and Canadian lumber, the United States sends the producers IOUs to the tune of about $500 billion a year.
How big is $500 billion a year? The short answer is: the biggest current account deficit in history. The longer answer is: The current account deficit is about 5% of the size of the U.S. economy, which still makes it one of the biggest current account deficits in history. How did we get here?
Current account imbalances are influenced by currency values. When Canadian lumber is made cheap by a strong dollar, for example, we import more logs from Saskatchewan. To understand the U.S. current account deficit we begin by looking at exchange rates.
When I was first learning about money, the British pound was always worth about $2.50. What I didn’t realize then was that currency prices were fixed by agreement between governments. Thus, the $2.50 was a government-mandated price, not a market price.
In 1944, governments decided that exchange rates were too important to be left to market irrationality. Economists put part of the blame for the Great Depression of the 1930s on wild fluctuations in the value of currencies. Toward the end of World War II, the major economic powers met in Bretton Woods and fixed the value of their currencies. The governments wanted to make sure that the excesses that led to global economic collapse would not reappear.1
In 1971, Richard Nixon devalued the dollar and destroyed the Bretton Woods pact. Freed from its fixed price, the dollar was free to fluctuate between irrationally low and high values, and to create current account imbalances. As seen in Figure 6.1, from the 1980s until now the dollar’s value has led to large and growing U.S. current account deficits.
Current account deficits are a form of borrowing. There’s nothing inherently evil about borrowing in general nor in running a current account deficit. College students borrow to further their education, companies borrow to expand factories, and countries borrow to undertake projects that may take years to repay.
For example, the Hoover Dam outside Las Vegas was built in the 1930s and now generates very low cost hydroelectric power. Only a curmudgeon would argue against borrowing for the Hoover Dam on financial grounds (there are, of course, legitimate environmental arguments against dams). Borrowing to develop something is often better than the alternative of no borrowing and no development.
While IOUs are nice, and loans can be good, eventually the piper must be paid. Notice that Wimpy in the Popeye cartoon says, “I’d gladly pay you Tuesday for a hamburger today.” He doesn’t say I’d gladly eat a hamburger on Tuesday for a hamburger today.
“Neither a borrower nor a lender be,” says Polonius to his son Laertes in Hamlet. While this advice appears sound, many scholars think Shakespeare wrote it as an example of a father droning on with obvious and unsolicited comments. In the case of borrowing, the advice is essentially empty. Debts must be repaid, so borrowing and lending are just different phases, not permanent states. It is impossible to go through life as a borrower (although I suppose Cheapskate did).
The implications are clear. Countries with current account deficits must at some point swing to surplus. Thus, the United States, currently the world’s biggest net consumer from other countries, will become a net producer. In the coming years we will be discussing the size of the U.S. current account surplus. Because the U.S. current account deficit is huge, the inevitable adjustment to surplus will have profound effects on the world’s economy and on individuals’ investments. Let’s look at how this is likely to play out and the implications.
A Euro for Your Thoughts
In November 2002 my wife and I visited Milan. Walking along the famous shopping street of Via Montenapolean, Barbara spotted a Bottega Veneta purse for the price of 700 euros. At the time, one dollar bought just over one euro so this purse was being offered at the price of about $680.
Both Barbara and I found this $680 purse price to be ridiculous but for different reasons. “Don’t you realize that I saw this same purse on sale in New York for over $800!” she said. Biting my lip and suppressing my horror, I said, “I think you should snap it up.” On our way back from Europe we flew out of the airport in Cologne. A young German woman about 23 years old was working the customs desk. She said, “You have declared an item worth 700 euros; may I see it?” I showed her the purse, and she gasped, “That’s it?” “Yes, isn’t it a ridiculous value?” I replied. We returned to the United States with Barbara’s beautiful bargain, thereby contributing $680 to the U.S. current account deficit.
Were we to go to Europe in 2004 we would find that purses costing 700 euros translate to a dollar-cost of $850. Costs to U.S. consumers have increased dramatically because the dollar has lost value relative to the euro. Currency devaluations change people’s purchasing decisions. Add up enough 700 euro purses not purchased, throw in a few Mercedes that Americans don’t buy, and pretty soon a falling dollar leads to a smaller current account deficit.
A current account deficit means that a country is consuming more than it is producing. A simple way to cut back is to raise the price of consumption. This can be accomplished almost magically by changing the value of the currency. Against the euro, the U.S. dollar has lost almost a third of its value over the last few years. As compared to the Japanese yen, the U.S. dollar has been in decline for decades. Thus, without any change in dollar wealth, U.S. consumers are now much poorer than we were a few years ago. This weakening of the dollar works to make us consume less from abroad. It also makes the American products cheaper, thus boosting purchases by foreigners.
A cheaper dollar decreases imports and increases exports, reducing the current account deficit.
Real and Nominal Exchange Rates
While exchange rates are a bit abstract for many people, for others they are of visceral importance. I learned this during a 1992 visit to Victoria Falls. I was staying in Zimbabwe across the Zambezi River from Zambia (Zimbabwe used to be called Rhodesia, and Zambia was Northern Rhodesia). One day I rented a bicycle and crossed a bridge into Zambia, intending to peddle a few miles to the museum in the town of Livingstone.
Two interesting things happened on the road to Livingstone. First, my bicycle got a flat tire. There was no place to fix the tire, so I decided to ride on the metal rim and pay the owner for any consequent damages. This meant that my already slow pace in the hot sun was further reduced.
Second, a group of Zambians descended on me. The Zambians were hungry to get their hands on some Zimbabwean currency. I found this interesting because I was able to get so much Zimbabwean currency for my U.S. dollars that I felt like a rich man in Victoria Falls. While the Zimbabwean currency was weak compared to the U.S. dollar, it was rock solid compared to the currency of Zambia. So motivated were these Zambians to get some “hard” currency that they chased after me for more than a mile—running beside my damaged bicycle in their street clothes and hard-soled shoes.
If o
ne were to visit Victoria Falls today, the situation would be reversed. The Zimbabwean currency is now extremely weak compared to that of Zambia. What happened? The current inflation rate in Zimbabwe is over 640%. By comparison, the Zambian rate of 18.5% looks positively tame.2 Because of the different inflation rates, the Zimbabwean currency is dropping on a daily basis. People who want to store their money in a stable currency are willing to work hard to avoid Zimbabwean currency.
Of the two currencies, the Zambian is now rock solid because of the difference in inflation rates. The lesson from this is that whenever we discuss exchange rates, we need to be sure to consider relative inflation rates. We care about the purchasing power of our money (the real exchange rate), not the number of bills we can get (the nominal exchange rate). The real exchange rate takes into account inflation rates.
With high inflation rates, the difference between nominal and real exchange rates can be enormous. In January 1913, one U.S. dollar converted into 4.2 German marks. In October 1923, the same dollar was worth over 25 billion German marks! Because German prices had risen even faster than the exchange rate, however, the purchasing power of these 25 billion marks was less than the 4.2 marks in 1913.3 The nominal value of a U.S. dollar in marks had gone up astronomically while the real value actually fell.
Wouldn’t it be nice if we could just ignore the difference between real and nominal exchange rates? Yes, and we will. Most of our discussion focuses on the three big currencies: the U.S. dollar, the euro, and the Japanese yen. All three regions have similarly low inflation rates these days. When countries have similar levels of inflation, it is okay to use nominal exchange rates.
Two Roads to Times Square
In The Out-of-Towners, the protagonists George and Gwen Kellerman (played by Jack Lemmon and Sandy Dennis in the 1970 original; Steve Martin and Goldie Hawn in the 1999 remake) make a hellish trip to New York City.
When their flight intended for New York is diverted to Boston, the Kellermans improvise and push on to Manhattan by train. After a very long night including a mugging, a police chase, and sleeping outdoors, the Kellermans run into one of their fellow passengers from the original flight. Unlike the frazzled Kellermans, their calm compatriot rested overnight in Boston and took a morning flight. Both parties ended up in Manhattan for breakfast, but by very different routes.
Similarly, there are various paths the world can take as we adjust from the United States having the biggest current account deficit in history to a future with U.S. current account surpluses. Two relevant and recent examples exist in North America. In these sagas, Mexico took a painful Kellermanesque path of adjustment, while Canada eased through its transition with many fewer aches and pains.
In the 1960s and 1970s my family used to vacation in Canada’s Point Pelee National Park. As an industrious child, I scavenged for discarded bottles with my sister Miranda to make money on the deposits. On good days, we would gather more than 100 bottles, which, depending on the brand, each carried a 2 cent or a 3 cent deposit. We were able to get our hot little hands on 2 or 3 dollars for a few hours of work. But there was one small catch; we earned Canadian dollars (now also known as “loonies”), not U.S. dollars.
When we began our bottle collecting, the loonie was worth slightly less than its U.S. counterpart.4 So we had a bit of disdain for the Canadian currency. Furthermore, because some of the coins were of similar size (particularly the quarters), people who lived in Detroit and the neighboring Canadian town of Windsor would often exchange the coins at an even rate. I was always happy if I could unload my Canadian quarters at full value, whereas I felt cheated when someone slipped me a Canadian quarter.
In the early 1970s something magical happened. The Canadian dollars that we earned from our bottle work became worth more than a U.S. dollar.5 Although the adjustment was quite small, the movement to more than a buck was accompanied by tremendous pride. Instead of shyly sliding my Canadian dollar across the counter at Harry’s hobby shop and hoping I wouldn’t get yelled at, the crisp Canadian bills became something that I could proudly display.
Were I to earn some Canadian dollars today they would be worth far less than a U.S. dollar. In late 2001, the loonie dropped to 63 U.S. cents. What happened to my beloved loonie?
For many years, particularly in the 1980s, Canada ran a large current account deficit.6 In the post-1973 world, without governments controlling exchange rates under Bretton Woods, Canada’s current account deficits were among the largest for an industrialized country. In other words, Canada in the 1980s was consuming more than it produced to a degree almost as extreme as the United States in 2004.
In the 1980s, Canada was enjoying its Wimpy burgers with the promise of repayments on Tuesdays to come. The decline of the Canadian dollar indicated that it was Tuesday and time for repayment. The subsequent fall in the value of the Canadian dollar made Canadians less able to import products from abroad. The cheap currency also made Canadian products into excellent values. In short, Canada went through a textbook process. Years of consuming more than it produced were followed by repayment; this repayment, in the form of a current account surplus, was accompanied by a cheap currency.
Canada consistently runs a current account surplus, and the adjustment process was gradual.7 Over a quarter of a century, the Canadian dollar fell from just over 1 U.S. dollar in 1976 to a low of 63 cents and has remained below 75 U.S. cents for almost 10 years.
Canada’s adjustment process was not painless, but it was relatively gradual and did not involve any panics. In contrast, Mexico took the Kellermans’ route.
In the mid-1980s, my buddies and I used to make surf trips from San Diego down to Mexico’s Baja peninsula. Along the way we saw advertisements for Mexican investments “guaranteed” to return 40% per year. This seemed like an amazing deal, and some of my friends took up the offers.
For a time, my surf friends earned high interest rates on their Mexican investments. The process was very simple: Convert some U.S. dollars into Mexican pesos and invest the pesos for a year. Earn 40% on your pesos in a year, get them back, and convert your pesos into dollars. A $1,000 investment returned $1,400 just 12 months later. Not too shabby! Furthermore, the deposits were guaranteed to return 40% more pesos than invested.
There are few things more expensive than free lunches, especially in the investing world. The catch is that the Mexican deposits were guaranteed to return 40% more in pesos. The dollar value of those pesos was not guaranteed. Not to worry, though, how much can a peso devalue in a year?
As you might expect, this story involves the Mexican current account. In the early 1990s, Mexico was running a current account deficit that was 7% the size of its economy. As we have learned, such deficits are unsustainable and the road to repayment usually includes devaluing the currency.
In late 1994, a Mexican peso was worth about 30 U.S. cents. One year later it was worth about 12 cents.8 Now consider the 40% guaranteed return on your peso investment. Your $1,000 still earns 40% in pesos, but when the proceeds are converted back into dollars the investment returns about a total of $500. Rather than earning a 40% positive return, this “guaranteed” investment lost half its value in one year.
While the Mexican peso devaluation was bad for foreign investors, it was a crisis for Mexicans and many others. In simplest terms, the adjustment from current account deficit to surplus requires a change in wealth. Both Canadians and Mexicans became poorer because of their currency devaluations. The speed of the Mexican decline caused panic and severe readjustment costs.
The U.S. current account deficits will end. The adjustment path can be rocky or smooth. The U.S. situation is different, and in many ways better, than either the Canadian or the Mexican current account deficits. These differences lead many pundits to confidently predict a smooth path. Because the U.S. current account deficit is the largest in history, however, there is no precedent. Therefore, predictions of the adjustment path are simply speculations, some well grounded, but speculations nonetheles
s.
The Country with the Golden Brain
Since the United States is in a dominant economic position, perhaps the best predictor of the coming current account adjustment lies neither north nor south of the border, but in our own history. In the early 1980s, the U.S. current account deficit reached then record highs (although Figure 6.1 shows that these deficits pale in comparison to more recent deficits).
What happened after record U.S. current account deficits in the early 1980s? Well, the most common effects of large current account deficits are clear in this case. First, the current account deficits shrank. Second, the move away from deficit was accompanied by a substantial weakening of the dollar.9
This 1980s’ bout of U.S. current account adjustment was very smooth; much more like the Canadian experience than the Mexican peso crisis. Should we then infer that the coming adjustment will also be relatively smooth? Perhaps, but the current situation differs for two reasons. First, the current U.S. deficits are much larger than those in the 1980s. Second, in the last few decades the United States has moved from being the world’s biggest creditor to the biggest debtor.
The protagonist in Alphonse Daudet’s “The Legend of the Man with the Golden Brain” is born with a skull full of precious metal—his brain is literally made of gold. Throughout his life, he spends his birthright to help his parents and then his beautiful wife. He is particularly lavish with his spouse and spoils her with gifts paid for by depleting his finite supply of metal. For each purchase, he must remove part of his brain and sell the precious supply for cash.
Mean Markets and Lizard Brains Page 14