Why debt hasn’t killed us yet

By Diana Farrell and Susan Lund

The US current account deficit—the broadest measure of the trade gap—could rise from 5 or 6 percent to 9 percent of GDP, or $1.6 trillion, by 2012 as long as foreigners are eager to invest there.

For nearly a decade, many economists have warned that the US trade deficit cannot keep swelling indefinitely. At some point, they insisted, it would have to start shrinking, perhaps so sharply that it will shake the economy. Last year, when the gap narrowed a bit, some observers speculated that the turnaround might have begun. Not necessarily. On the contrary, the downtick in 2007 could have been a mere breather in the run-up of a deficit that can grow much larger, quite comfortably. According to research by the McKinsey Global Institute, the US current account deficit—the broadest measure of the trade gap—could rise from 5 or 6 percent to 9 percent of GDP, or $1.6 trillion, by 2012 as long as foreigners are eager to invest there.

The pessimists failed to foresee three key developments in global capital markets. First, Asian manufacturers, oil exporters and other commodity producers are flush with surplus capital to invest. Second, there is growing interest in cross-border investing—and technological advances have made it easier and cheaper to do so. Third, the strength of the United States as a magnet for foreign investment has defied expectations.

The current account deficit measures the shortfall on all trade and investment income between a country and the rest of the world. Back in 1999, when the US deficit first climbed to 3 percent of GDP, many economists warned that it was unsustainably large. Policymakers scrambled for ways to avoid a painful correction. The gap grew steadily to over $800 billion in 2006, around 6 percent of GDP, with no crash. Finally, in 2007, the deficit fell (to a 5.1 percent annualized rate through the first nine months of the year). But that improvement may prove fleeting.

The US deficit is rising because US businesses, consumers and governments spend more than they save. In 2006 foreigners bought $1.9 trillion in US assets, and Americans bought $1.1 trillion in assets abroad, leaving the $800 billion deficit. If it continues to grow at the rate it has since 2002, it would double to $1.6 trillion in 2012, or 9 percent of US GDP. The resulting level of US net foreign debt—46 percent of GDP—would be large but hardly unprecedented. Australia's net foreign debt has been above this level since 1990. The net interest payments the United States would pay on that debt would be easily affordable, at less than 1 percent of GDP.

The deficit can grow as long as foreigners are willing to fund it, and so far they are. In the past, developing economies had little spare capital to invest abroad, but now they have more money than they can absorb at home. As of 2006 the world's capital account enjoyed a surplus of $1.4 trillion, or 3 percent of world GDP, up from 1 percent during most of the 1990s. The bulk of that surplus is held by Asian and oil economies, who invest heavily in the United States. All told, the United States absorbed about 60 percent of net global capital investment in 2006.

Over the next five years, foreign surpluses will grow even larger. Oil exporters' revenues will keep climbing whether crude stays near $100 a barrel or slides to $50 a barrel, or even $30. The Asian nations' export engines look likely to keep humming. Adding it up, we project that the surpluses around the world could total $2.1 trillion by 2012—more than enough to fund the larger US current account deficit.

The big question is whether foreign appetite for US investment will wane. If their currencies continue to gain strength against the dollar, it will be harder for foreign investors to make money in the United States. Indeed, in the third quarter of 2007 (the latest for which data are available) foreign capital inflows to the United States slowed—perhaps deterred in part by the credit-market turmoil.

But the US economy remains a fundamentally attractive investment in the long term. US productivity growth, the key to rising incomes, is likely to remain solid. And the US population is younger and growing faster than those in many other developed countries. US financial markets also are the largest, most liquid and most developed in the world. That's why investors from Asia and oil-exporting countries have invested tens of billions of dollars into struggling US banks and other types of financial institutions since the credit turmoil began in mid-2007. Plus, the US economy is still a major consumer of their exports, and they will be piling up dollars in any case.

We are not suggesting that the US current account deficit can continue to grow forever. Our analysis shows that the deficit could grow until 2020 before net interest payments reached 3 percent of GDP. But eventually it will need to stabilize and perhaps even decline. For that to happen, US households, companies and the government need to start saving more and consuming less. Stronger US export growth, creating well-paid jobs across the country, could also help shift the account picture. So could more robust consumption from new middles classes in Europe, Asia and other parts of the world—a shift we are already seeing.

The bottom line: don't count the US economy or dollar out of the game just yet. After the current business cycle ends, both may well pick up strength.

Diana Farrell is Director and Susan Lund is Senior Fellow at the McKinsey Global Institute.

This article originally ran in Newsweek International.

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