As early as the late 1990s, Federal Reserve officials from Alan Greenspan, the chairman, down have warned that the US external deficit is unsustainable. The Fed should be applauded for its analysis of the issues. But too many Fed officials are cheerleaders for the view that adjustment will be smooth.Even if one is confident that this will be the case, it is another matter to assert that a correction of the US external deficit will probably be benign in its effects on financial markets.
The Federal Reserve has been disingenuous in not stating that adjustment will require that the growth of total domestic demand - principally consumption and investment - slows dramatically. Assume that the US current account deficit will be halved over the next three to five years from its current 6 per cent of gross domestic product to 3 per cent. To accomplish this, the growth of demand - 4.4 per cent over the past year, and three-quarters of a percentage point faster than the 3.6 per cent growth of domestic output (GDP) - will have to be reduced by about 2 percentage points to three-quarters of a percentage point below the trend growth of potential output, which is about 3.2 per cent. In other words, to about 2.5 per cent or less.
This slowdown translates to $1,350 for every woman, man and child in the US. And the inevitable adjustment of dollar exchange rates, in the order of 30 per cent on average, will add an extra $1,000 per capita due to the adverse effects on the US terms of trade. The average price of US imports will rise relative to the average price of exports. No wonder politicians are staying away from this issue. The Federal Reserve does not have that excuse.
I don't think the Federal Reserve is going to take it upon themselves to half the current account deficit in 3-5 years but the foreign exchange market might.