March 14, 2007

Falling oil imports improve U.S. current account deficit, but record investment outflows will be a drag on future income

by Robert E. Scott

As expected, the U.S. current account deficit improved to $196 billion in the 4th quarter of 2006. The $34 billion improvement was due mostly to a $23 billion decline in the goods and services trade deficit and a $9 billion quarterly rise in investment income balance. Most of the improvement in the trade deficit was caused by a $21 billion fall in U.S. oil imports.

In a closely watched development, the annual balance of net income on domestic and foreign investments was -$1 billion, making 2006 the first year on record with negative income flows (as shown in the chart below).  Interest payments on the rapidly growing U.S. net foreign debt, which reached -$2.7 trillion in 2005, will reduce U.S. income for present and future generations as these payments grow.

Despite the fourth quarter improvement, the annual current account deficit for 2006 increased to $857 billion, growing $67 billion (8.2%) over 2005.  The 2006 deficit also set a record measured as a share of U.S. gross domestic product, reaching -6.5%.  In effect, the United States consumed 6.5% more than it produced in 2006. The United States must borrow from foreigners to finance this deficit. Put more concretely, the United States borrowed more than $3 billion every business day in 2006 to finance its $857 billion account deficit.

U.S. private investments abroad soared to $1.1 trillion in 2006, an increase of $600 billion over outflows in 2005, and the highest level on record.  This outflow of private U.S. capital was matched by purchases of U.S. Treasury bills and other U.S. assets by foreign governments. Foreign central banks and governments have provided the capital inflows that have financed virtually the entire U.S. current account deficit since 2001. Foreign governments have also financed the entire $1.3 trillion increase in the U.S. federal debt in this period. A smooth unwinding of the U.S. current account deficit will depend on a reduction in these foreign inflows into the United States. This reduction will require the United States to make more of what it consumes domestically, and will require foreign governments to depend less on exports to the U.S. consumer market to sustain their own employment growth. This can be done, and the sooner the process starts, the better it will be for both U.S. and foreign economies.

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