Once Again On Investor Nationality

by Don Boudreaux on February 27, 2006

in Trade

An editorial writer for the Washington Times yesterday made a fundamental error — although, in his or her defense, it’s a mistake more common than pigeons in Central Park.

Worrying about the so-called ‘twin deficits,’ this editorialist wrote that ""rising trade deficits, as a simple arithmetic fact, exert a negative effect on the economic growth rate."

This assertion is wrong, and the fact that it is wrong should be obvious upon just a bit of reflection.

I know (I think) what the editorialist means — namely, that GDP is calculated by subtracting any excess of imports over exports from domestic consumption and investment expenditures.  So, in the familiar equation [GDP = Consumption Expenditures + Investment Expenditures + Government Expenditures + (Exports - Imports)], the greater the excess of imports over exports, the lower the calculated GDP figure.

But whatever dollars foreigners don’t spend on American exports, they invest in dollar-denominated assets.  So ask: why would such investment (which is the flip-side of the so-called ‘trade deficit’) hamper economic growth?  Isn’t such investment likely to promote economic growth?

Put differently, if we correctly recognize that American economic growth is likely enhanced if Mr. Davis of Dallas saves and invests this savings in dollar-denominated assets, why do we suppose that if Mr. Shi of Shanghai does the very same — spends his dollars not on consumption goods but, instead, invests them in dollar-denominated assets — economic growth is hampered?

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Pankaj February 27, 2006 at 11:33 am

I wonder,
are we coming a full circle.

Michael Giampaoli February 27, 2006 at 12:00 pm

Mr. Shi's investment is likely to produce economic growth but, is it possible that Mr. Shi's investment is not included in America's Investment Expenditures?

Mike February 27, 2006 at 12:57 pm

Mr. Shi's Government may be forcing a reinvestment in USD – and perhaps here is where any imbalances could be stewing ???

Joe P. February 27, 2006 at 1:53 pm

I'm not an economist, but: say a country did not export anything, but had to import [only] all wheels or computers in order to make its ecomomy work. Why would this trade deficit necessarily create a net negative effect on its economic growth?

Rising trade deficits might "cause" growth?

Gary Schiller February 27, 2006 at 5:00 pm

Most journalists probably take the standard, albeit misguided, Keynesian cross as their econ model. Sadly, vague memories of what they learned in econ1 forms the basis of their public policy analysis.
In that framework, a fall in net exports reduces GDP and national savings. The increase in international savings exactly offsets the fall in national savings, leaving investment fixed.

krd February 28, 2006 at 4:46 am

Unfortunately, cross border "investment" into the U.S. does not necessarily increase the productive capital stock of the domestic economy. Worse, such "investment" can create an illusion of "excess savings" which reduces real rates and contributes to asset inflation for whichever class of assets is driven by credit expansion. In our present case, it is probably no coincidence that the largest buyer of home equity loans globally in the past few years has been the Bank of China.

While geopolitically deficit finance is not neutral, it is also a mistake to assume that our deficit is funded by independent private investors who consider real returns in the U.S. superior to their alternatives. In reality, foreign central banks are printing their own currencies and using the proceeds to buy U.S. dollars. This is anything but a free-market exchange of preferences. Both Japan and China have seen the explosion of their central bank balance sheets to battle their own domestic deflations (weak bank balance sheets) – this is in fact a purposeful government intervention to prevent the market from liquidating bad debts in their own economies. As such, this is not private foreign savings being invested in attractive U.S. investments. It is excess money created by the Fed being leveraged within foreign banking systems to battle deflationary forces arising from past lending mistakes.

In this analysis, the savings of U.S. investors are being diluted by excess money creation which is then further leveraged by foreign central banks to create money growth in their own domestic banking system which is a coersive seizure of the purchasing power their own private citizens. The U.S. exports inflation which is counterbalanced by the deflationary forces of foreign economies facilitated by the interventions of central banks.

Everybody is happy as long as the mark to market of the collateral (housing) is rising. The problem for U.S. citizens is that they cannot, en masse, realize the mark to market gains on their houses to fuel consumption through the sale of housing to foreigners. They can only gain access to these gains by borrowing against them in the form of loans which are then sold to foreigners. These liabilities remain after the gains in mark to market have been consumed. Socialist would gladly harp "but we owe the debts to ourselves" but 1) we don't and 2) the market pricing of this debt is not free of government intervention (Fed and GSEs).

In effect, the foreign central banks have substituted a bad loan situation domestically for a potentially bad loan situation in their foreign investments. From an investment perspective, it is not such a bad trade since they delay the day of reckoning but politically it is better to foreclose on a foreigners mortgage than to shut down poorly-performing state-owned companies employing hundreds of thousands.

The savings-offset theory does not hold in a fiat currency regime. The funding of the current account at currenly low real interest rates is not the result of the free market pricing of investment alternatives by foreigners. It is the result of excess money creation aimed at keeping inflation positive even when a benign deflation would result (productivity, low-cost labour supply shock, etc.).

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