Domestic or global imbalances? Rising inequality and the fall in the US current account

This paper shows how the rise in individual income risk in the US since the 1980s might help explain the fall in its foreign asset position. The key to this result is endogenous financial deepening in an open economy with participation-constrained domestic financial markets. There, more volatile income makes individuals less inclined to default on financial contracts as this excludes them from future financial trade. This increases the insurability of income shocks and lowers the need for precautionary savings. The mechanism thus relies on an endogenous rise in financial depth in an open economy, not on exogenous financial advantage and capital account liberalisation as Mendoza et al (2007). To derive the results, I provide an analytical solution to the stationary consumption distribution in a small open economy with participation-constrained domestic markets. Across stationary equilibria, higher income risk can lower mean consumption and aggregate assets. But interestingly, consumption inequality turns out to depend almost entirely on world interest rates. A quantitative exercise shows that the observed rise in individual income risk in the US can explain a significant fall in net foreign assets. JEL Classification Codes: D31,D52,E21,F21,F41