Last year, for the third year in a row, the US current-account deficit set a record—this time at more than $400 billion.¹ Will this soaring deficit jeopardize the economy?

We don’t think so. There is nothing inherently good or bad about a current-account deficit—or surplus. The rapid increase in today’s deficit merely reflects the extraordinary economic growth of the US economy during the 1990s as compared with the rest of the world. But to understand why the present state of affairs shouldn’t be alarming, you must first understand its underlying cause.

Three explanations are commonly offered for the growth of the deficit. Each has different implications for the economy.

1. Consumption boom: A spending binge by US consumers has pushed the personal savings rate down to near zero. At almost every income level, the demand for consumer goods and the appetite for imports have surged. At the national level, borrowing from abroad finances the spending. According to the proponents of this theory, the borrowed money hasn’t been invested to enhance productivity, so future consumption and output may suffer as resources are diverted to service the foreign debt.
2. Safe haven: The financial crises that rocked emerging markets in 1997 and 1998 increased the flow of foreign capital into relatively safe US financial markets. That influx and the current-account deficit are two sides of the same coin. The overall effect has been a boon for the United States, since the inflow of funds has prompted interest rates to fall and investment to rise. The proponents of this theory add that an economic recovery in other countries could make foreign capital flow out of the United States abruptly, thus disrupting its financial markets and bringing a sudden—and painful—end to the import boom.
3. Technological change: Largely as a result of advances in computing and communications, the US economy recently underwent a huge technological restructuring that substantially raised productivity. This in turn has raised the demand for investment capital and stimulated an inflow of foreign funds. Since higher productivity makes it possible to service and repay higher levels of foreign debt, this explanation of the deficit generates less concern about the economy’s future than do the other two theories.

Which story best fits the data?

These three theories are not mutually exclusive; indeed, all explain part of what is happening. To identify the most important factor driving the current-account deficit and to assess its potential impact on the US economy, we examined the data.

Little evidence supports the consumption boom theory. Much of the trade gap is indeed due to imports of consumer goods, but the share of gross domestic purchases devoted to overall consumption has actually declined since 1991 while investment spending has risen (Exhibit 1). Industrial supplies and materials still represent a larger share of total imports than do consumer goods. Profligate consumer spending doesn’t seem to be crowding out productive business investment.

As for the safe-haven and technology arguments, their underlying mechanisms would have an opposite effect on interest rates. Since the safe-haven scenario suggests that more funds would be available for investment, interest rates ought to fall. Technological change, by contrast, would raise demand for those funds and thus cause interest rates to rise. How, then, have US interest rates behaved in the past few years? Exhibit 2 plots interest rates on ten-year Treasury bonds since 1990. Long-term rates declined from mid-1997 to late 1998. Thereafter, the trend was upward until they began to fall again in the most recent quarters.

Obviously, any number of developments affected these two movements. Even so, the general decline in rates through late 1998 seems to support the safe-haven theory. The subsequent rise—a sign of growing demand for investment capital—reflects the influence of technological change. Both the safe-haven effect and technological change attracted foreign capital until late 1998, when technological change started to dominate.

When the tide flows out

For the US economy, this is good news because it implies that a gradual adjustment is likely when the current-account deficit begins to contract. If the consumption boom argument had merit, consumer imports should decline along with economic output. A slowdown in consumer spending would have painful economic consequences overall, though the United States would start to run trade surpluses and to repay the foreign debt. But the consumption boom (or bust) theory is doubtful in view of the strong investment of recent years.

Under the safe-haven scenario, the economy is at risk of a sudden outflow of foreign capital and a plunge in the dollar’s value. Would this create the kind of financial crisis that has struck elsewhere in the world? Probably not, since the sheer size of the US economy is likely to mitigate both the magnitude and the speed of capital flight. The United States supplies 20 percent of the world’s economic output, so it enjoys a much steadier inflow of capital than does a small country. US interest rates will thus naturally adjust to slow any outflow of capital. More important, since 1997 most capital inflows to the United States have taken the form of direct investment: real estate, equity stakes of more than 10 percent in US companies, and corporate and municipal bonds with a maturity of at least one year. These investments hardly represent the kind of "hot money" that flows out of an economy with a few keystrokes on a currency trader’s computer.

Finally, in the technological-change scenario, investment in productivity-enhancing capital stock leads to an increase in economic output and then to a trade surplus, which would make it possible to repay the foreign debt. With greater investment and productivity, the United States could expect to reap income gains in the future, and the present US international deficit therefore reflects the country’s current and expected future prosperity. Over time, technology’s economic benefits would be transmitted to other countries, making investments in them more attractive and encouraging a current-account adjustment in the United States, which would find the process automatic and relatively painless.

The recent surge in the current-account deficit appears to reflect technological changes that have generated prosperity in the United States, and neither a continuation of the deficits nor the way they decline will have catastrophic consequences for the US economy. Either a US slowdown or an upturn in Europe or Asia would cut the flow of foreign capital to the United States and therefore the trade gap. And since foreign investments in the US economy are mostly for the long-term, a sudden flight of foreign capital is less likely than it would otherwise be. If there is an adjustment, we expect it to be relatively smooth and gradual.