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     Dec 20, 2006
EYE ON AMERICA 
US debt: Devil in the details 
By Peter Morici

On Monday, the US Commerce Department reported that the third-quarter 2006 current-account deficit was US$225.6 billion, up from $217.1 billion in the second quarter.

The current account is the broadest measure of the US trade balance. In addition to trade in goods and services, it includes income received from US investments abroad less payments to



foreigners on their investments in the United States.

In the second quarter, higher oil prices and surging imports of consumer goods from China drove the trade deficit. Also, the lack of exciting, reliable, fuel-efficient vehicles at General Motors and Ford weighed heavily as well.

In the third quarter, the current-account deficit was 6.8% of gross domestic product (GDP) and was financed largely by borrowing from foreigners, as opposed to foreigners investing in productive assets in the United States.

Anatomy of the deficit
The United States had an $18.3 billion surplus on trade in services. This was hardly enough to offset the massive $218.6 billion deficit on trade in goods and the $3.8 billion deficit on interest, dividends and other transnational income payments. The remainder of the current-account deficit came from US transfer payments to foreign individuals and governments, which was $21.5 billion.

The deficit on petroleum products was $75.2 billion, up from $71.4 billion in the first quarter. The price of imported petroleum rose 4.7% and the volume increased 3.4%.

The deficit on automotive products was $35.5 billion. This deficit will rise in the future, because as US production moves from the former "Big Three" to Toyota and other Asian transplants, the US content of vehicles declines - transplants use fewer US-made parts in their vehicles. Moreover, Korean auto makers will continue to make inroads, challenging both Toyota and other Japanese transplants, which are developing their own cost problems.

The restructuring programs announced at GM and Ford may provide a temporary return to profitability but will increase the automotive deficit further. Down the road, more cutbacks should be expected as the concessions offered by the United Auto Workers union and corporate restructurings announced are inadequate to redress the domestic industry's fundamental competitiveness problems.

"The Wal-Mart effect" was broadly apparent. The trade deficit with China was $63.9 billion, up from $54.5 billion in the second quarter.

Together, the deficit on petroleum and automotive products with China totaled $170.8 billion - 78% of the $218.6 billion deficit on goods and services. The trade deficits on petroleum and automobile products are not affected much by recent exchange-rate movements; therefore, the deficit on goods and services will not improve much, and in fact will likely worsen, until substantial progress is accomplished on China's currency and other protectionist practices.

The US dollar remains at least 40% overvalued against the Chinese yuan and other Asian currencies. China continues to peg against the dollar. Although China revalued the yuan from 8.28 to 8.11 in July 2005, and announced that it would adjust it to a basket of currencies, the yuan continues to track the dollar very closely. Currently it is trading at about 7.84 to the greenback.

Other Asian governments must ensure that their currency policies conform to China's, lest they lose competitiveness in US and European markets. To sustain undervalued currencies against the dollar, foreign governments purchased $80.8 billion in US securities. This created a 14% subsidy on exports to the United States.

If China were to revalue the yuan, the US bilateral deficit with China could shift to other Asian exporters. However, to maintain their resulting large trade surpluses with the United States, these Asian nations would have to replicate China's intervention in currency markets and transfer of buying power to Americans, which comes to 9% of China's GDP. That would prove a Herculean task, and ultimately the dollar would trade lower against all Asian currencies, and the US trade deficit would decline.

Financing the deficit
The current-account deficit must be financed by a capital-account surplus, by foreigners either investing in the US economy or lending Americans money. Some analysts argue that the deficit reflects US economic strength, because foreigners find many promising investments in the United States. The details of US financing belie this argument.

In the third quarter, US investments abroad were $223.8 billion, while foreigners invested $400.2 billion in the United States. Of that latter total, only $44.1 billion, or 11%, was direct investment in US productive assets. Most of the remaining capital inflows were foreign purchases of US Treasury securities, corporate bonds, bank accounts, currency, and other paper assets. In essence, Americans borrowed $356.1 billion to consume about 6.8% more than they produced.

Foreign governments lent Americans $80.8 billion, or 2.4% of GDP. That well exceeded net household borrowing to finance homes, cars, gasoline and other consumer goods. The Chinese and other governments are in essence bankrolling the US consumer.

The cumulative effects of this borrowing are frightening. The total external debt now exceeds $5 trillion and will likely exceed $6 trillion by the end of 2006. That will come to about $20,000 for each American, and at 5% interest, $1,000 per person.

Peter Morici is a professor at the University of Maryland School of Business and former chief economist at the US International Trade Commission.

(Copyright 2006 Peter Morici.)



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