Why Debt Hasn't Killed Us Yet.(Davos Preview; Point of View)

Byline: Diana Farrell and Susan Lund; Farrell is Director and Lund Senior Fellow at the McKinsey Global Institute

For nearly a decade, many economists have warned that the U.S. 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 U.S. 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 U.S. 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 U.S. deficit is rising because U.S. businesses, consumers and governments spend more than they save. In 2006 foreigners bought $1.9 trillion in U.S. 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 U.S. GDP. The resulting level of U.S. 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 ...