William Poole, President of the St. Louis Fed, nicely explains some facts about the trade deficit that too often are ignored or remain unlearned. (The emphasis is mine.)
The most widely cited measure of the U.S. external imbalance is the trade deficit—the difference between U.S. exports and imports of goods and services. More generally, it is useful to consider the broader concept of the current account, which includes current earnings on capital as well as trade in goods and services. A corresponding account on the other side of the ledger, known as the “Capital and Financial Account,” measures the international flow of capital assets. Putting aside errors and omissions in the data, a current account deficit is necessarily equal to a capital account surplus. A country in this position—like the United States today—is exporting more capital claims than it is importing. Put another way, international investors are bringing more capital to the United States than U.S. investors are sending abroad.
A common mistake is to treat international capital flows as though they are passively responding to what is happening in the current account. The current account deficit, some say, is financed by U.S. borrowing abroad. In fact, international investors buy U.S. assets not for the purpose of financing the U.S. current account deficit but because they believe these are sound investments promising a good combination of safety and return. Moreover, many of these investments
have nothing whatsoever to do with borrowing in the conventional meaning of the word, but instead involve purchases of land, businesses, and common stock in the United States. Foreign auto companies, for example, have purchased land and built manufacturing plants in the United States. Clearly, foreign auto producers have established these facilities because of the prospective returns from building vehicles in the United States and not for the purpose of financing the U.S. current account deficit. This simple example should make clear that a careful analysis of the nature of international capital flows is necessary before offering judgments about risks posed by the U.S. current account deficit.
Podcast RSS Feed
Full EconTalk Text
{ 13 comments }
This really is well done.
sounds like larry kudlow, "its the capital account SURPLUS, stupid!"
Help me out here because Im still an econ undergrad but what is to be made of the accusation that we are borrowing from foriegners oversees? Is that all just a bunch of nonsense? Why is it a perceived bad thing for the agregate some of money being invested in the U.S by foreigners being greater than the agregate some of dollars invested by Americans oversees?
to John: we had some discussion about this recently here at Cafe Hayek in the context of the article Two cheers (http://cafehayek.com/2006/02/two_cheers_for_.html) I would recommend you to read this to get some opposing opinions on this matter, although none of the participants of the discussion is in the position of criticizing the deficits as such.
The views on this issue indeed differ. My position is that you cannot say whether the deficit is good or bad – it is simply the choice of current American generation, which has chosen to consume more and invest less. The higher consumption is partially satisfied by imports. The lower domestic investment is partially offset by imported capital (investment from abroad, capital inflow). This is basically an intergenerational transfer, when current generation consumes more instead of saving for the future generation. But it is their choice, and since we assume rational agents, it should be optimal. So far so good.
The problem with this kind of thinking is that the current generation (rationally) ignores the development after their death, so they choose more consumption and less investment than what would correspond to an optimal long-term growth path. If the future generations were able to participate on the decision-process today, they would vote for less consumption and more investment. They can't, so the decision which is optimal for the current generation can be suboptimal from the long-term perspective.
Right now, the lack of domestic investment is partly offset by investment from abroad, which is positive for the current growth but not so positive for the wealth of future generations, since the profits made of these investments will belong to the foreigners. I don't think that this will cause a fall to poverty in the case of the USA, but for some smaller and less developed countries, it really matters (however, I don't want to go here into the discussion of poverty traps etc.).
Other people claim that the "optimal level of investment" is difficult to estimate and that it might be well the case that the USA overinvested in the past decades and we are now only getting back to the balanced level of investment. Also, other believe that after so many years of over-average economic growth, the generation has the right to enjoy the fruits of their work (remember, the whole question of consumption-investment decision and the trade deficit boils down to trading off utility intertemporally – do we want more utility today, or rather tomorrow). Also, some claim that the current situation does not provide enough profitable investment opportunities for the Americans, so consumption is a logical step (however, these opportunities might be still profitable enough for foreigners, so they invest here). These are valid points for discussion, and mitigate to some extent the strenght of my assertions.
Read the discussion I gave the link to, and make up your own mind. One thing has to be clear – Americans are not borrowing from abroad. There is no debt behind that (well, apart from the government, but that is a different issue). It is just a trade – Americans buy consumption and pay for it with the money they own (i.e. no debt), and foreigners bring the money back and invest it here.
I suppose it doesn't matter that foreign investment has to ultimately be redeemed, which means the inflows turn into even greater outflows of repatriated profits.
By the way, this forces down the dollar as well.
Also, it would be specious to suggest that all of the "capital account surplus" is going into free capital markets. In the past four years, two trillion dollars of the surplus have gone into treasury securities, which are essentially non-productive and I would be reticent to even classify them as "investments".
It is also worth pointing out that I am not making up the above distinction.
In fact, the latest report of the Council of Economic Advisors, which has the chapter on "The U.S. Capital Account Surplus", draws a distinction between "market-driven" and "policy-driven" capital flows.
Inasmuch as these policy-driven inflows do not reflect a free market, they are worrisome due to their recent magnitude. Accordingly, the report suggests that governments change their policies.
"I suppose it doesn't matter that foreign investment has to ultimately be redeemed, which means the inflows turn into even greater outflows of repatriated profits."
I remember a similar comment by the late David Brinkley on his Sunday morning show about 18 years ago. He said we Americans are so stupid… we buy things from the Japanese (then the nation of concern) and give them dollars for our purchases. They then turn around and buy our debt, which means in 10 years we would owe them twice the money. Which was approximately true, given a 7% interest rate and the rule of 72.
Was the dollar depressed 8-10 years ago because our creditors' securities matured?
To quote from Poole's speech: "My answer is also based on a simple observation, which I believe is not widely understood. For the United States, unlike almost every other country in the world, a hard-landing process is inherently self-limiting. U.S. assets owned by international investors are predominantly denominated in dollars and a large fraction of U.S. assets held abroad are denominated in foreign currencies. Dollar depreciation, should it occur in a hard-landing process, will be self-limiting because the dollar value of U.S. assets abroad will rise, thus improving the U.S. net international investment position. Market participants, knowing this fact, are therefore unlikely to drive down the foreign currency value of the dollar in a rapid and disruptive fashion."
Poole's comments are a bit confusing. He somehow claims that US ownership of non-dollar-denominated assets will slow depreciation, when in fact, it would seem they should have the opposite effect.
But anyway, I agree that the landing will be relatively "soft" in terms of dollar depreciation, because foreign holders of dollar treasury securities don't want to see them become valueless.
I do worry, however, about this effect combined with other elements of the re-balancing equation. What we've got set to happen at about the same time are:
- harder money (credit)
- no more easy money in real estate
- construction jobs set to decline
- rising prices on goods (the other side of the trade re-balancing coin)
- stagnating wages
- a larger public sector
- rising energy prices
It seems if all of these effects are by themselves "soft", the sum of the effects will still be anything but.
Jaroslav,
Thank you for a very balanced review of opinions.
Is it possible that a nation's optimal level of investment changes as its industry changes? Rather than claim that the U.S. overinvested in prior decades, I would suggest that the mix of industry in the U.S. has grown less capital intensive. Is it possible that former methods for calculating the rate of capital formation are not as valid in a knowledge-based and service-based economy as they are for an economy where manufacturing is growing faster? I am not all that familiar with the methods used, so I'm not sure my argument is valid.
Is the lack of savings in the U.S. truly an intergenerational transfer? If 30-somethings choose not to save for retirement, they will suffer more than their children when they're 70. If U.S. business today offers attractive investment opportunities, the funds can be imported, the businesses expanded, and the same future jobs created. U.S. workers tommorrow may have to serve international consumers more in the future, if tomorrow's retirees have less money to spend. But I don't see how that's a major problem. It seems possible that the U.S. economy may become more productiv if fewer 55-year-olds have the savings to retire early .
Mr Poole had this to say about the current state of financial affairs: "To be sure, no country can permanently incur rising levels of net external obligations relative to GDP. If sustained indefinitely, service payments on ever-increasing obligations would ultimately exceed national income. Long before that situation of literal insolvency occurred, however, market forces would drive changes in exchange rates, interest rate differentials and relative growth rates in such a way to move the economy toward a sustainable path." If that be the case, why are such changes absent today? Why is there no discernable shift in trend? Where is this gradual softening toward equilibrium? Mr Poole would have us believe that capital flows like ole' man river. He sounds like the captain of the Titanic, reassuring us that there are lifeboats for all. Let's hope so.
Your nation is on a gold standard. Your central bank expands the money supply and stimulates expenditures. Imports increase directly, and higher local prices also result in more imports and fewer exports. A trade deficit develops. The local currency loses value in the exchanges. If transport costs are covered, there will be a flow of gold to foreign nations and a loss of central bank reserves. This will eventually cause the central bank to reverse course.
But, because the decrease in the exchange rate is temporary, this creates the possibility of a speculative gain on securities. The result is a capital inflow that finances the trade deficit. The process requiring reversal is dampened by stabilizing speculation.
So, not to worry. The capital inflow matches the trade deficit. No! We must demand responsible behavior by the central bank (reversing the initial expansion.) Otherwise, the speculators will lose confidence, the capital would back flow out, the gold outflow will be worse, a drastic contraction will be needed, or worse yet, we will leave the gold standard and be left floating with an effective fiat standard–hyperinflation is on the way!
Obviously, that approach doesn't apply to the U.S. today in any exact sense. Does it apply in any sense?
During the classical gold standard, large amounts of capital funds flowed from Europe to the U.S. without endangering the gold standard or what passed as monetary stability at the time.
Still, we developed this conventional wisdom about what would happen when there was monetary irresponsibility, with pressure being felt at the foreign exchange and the final pressure for maintenance of stability being avoiding suspension of gold payments.
Alex Tabarrok quotes Brad DeLong:
The late Rudi Dornbusch said that one of the infallible warning signs that we are near the collapse of an overvalued currency associated with an unsustainable trade deficit is when highly intelligent and respected economists begin evolving plausible theories that–this time–the trade deficit is sustainable.
This quote disses Monsieur Boudreaux twice – first, by disagreeing with one of his favorite pet peeves and second, by failing to include him as a member of the set of "highly intelligent and respected economists."
Is there actually real dissent at econ@gmu?
That quote by Delong:
The late Rudi Dornbusch said that one of the infallible warning signs that we are near the collapse of an overvalued currency associated with an unsustainable trade deficit is when highly intelligent and respected economists begin evolving plausible theories that–this time–the trade deficit is sustainable.
When exactly was it NOT sustainable?
The larger dis is on Alex Tabarrok, whom I like reading, by his quoting Delong.