Untangling the US Deficit
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Untangling the US Deficit

Evaluating Causes, Cures and Global Imbalances

Richard A. IIey and Mervyn K. Lewis

As the US current account deficit has expanded to a record level of $811 billion in 2006, debate about the deficit’s causes and consequences has also grown. Is the deficit a product of American profligacy or a ‘glut of savings’ in the rest of the world? Is it a serious problem or essentially benign? Untangling the US Deficit charts a course between the competing explanations in a systematic and rigorous approach, incorporating the latest academic research and market data. Particular attention is given to the China–United States trade imbalance and to the special role of the US dollar and US capital markets in global finance.
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Chapter 5: Nature of the Adjustment Mechanisms

Richard A. IIey and Mervyn K. Lewis


THE NEW POLICY ENVIRONMENT With the onset of floating exchange rates in 1973, the current account position replaced the overall balance of payments as an indicator of the need for adjustment in a country’s macroeconomic policies. One point we make in this chapter is that in the new environment of financially integrated markets the distinction between internal balance and external balance made in the theory of economic policy may no longer be relevant: the latter balance, however defined, can no longer usefully or indeed reliably be targeted by traditional instruments such as monetary and fiscal policy. Policy-makers may also find themselves in the unfamiliar position of having the capital account drive the current account, rather than the reverse causation implied in old Keynesian models, and this can lead to policy confusion as we have seen with the debates about the causes of the US current account deficit and who bears the onus for its correction. A lack of utility in current account targeting is implicit in the intertemporal theory of the balance of payments, as expressed for example by Sachs (1981) and by Frenkel and Razin (1987). The process of global financial integration makes the essential assumptions of that theory more nearly realistic. From a policy viewpoint, the basic trouble is that the current account imbalances are being measured, and concerns about them assessed, at the wrong level. This conclusion is the message that emerges from Alan Greenspan’s analysis of the implications of the decline of home bias....

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