Econ 101: Trade Deficits, another Bite

Some years ago my friend Moritz Schularick and I were walking down a street in what is now called midtown Berlin (the former Eastern zone). Moritz asked me if I could explain why capital was flowing into the U.S. from developing countries when economic theory suggested it should flow in the other direction. At the time I didn’t have a very good answer. This note offers a better one.

We expect investors to put their money where the risk adjusted return is highest because that would maximize their profits. Wealthy countries like the United States have large capital stocks as a result of many decades of investment. Poor countries—especially the emerging economies—have much smaller capital stocks. Under those circumstances, the return to investing in more capital where it is relatively scarce is normally higher than where large investments have already been made. Economists call this the declining marginal return to capital. So the capital intensive, wealthier countries should have a lower return on investing in still more capital than would the poorer capital scarce countries. If the return to capital (interest rate) in emerging market economies is higher than in the U.S., capital should flow from the U.S. to promising developing countries.

I told Moritz that it must be that because of stronger institutions and property rights (rule of law) in the U.S. compared to many developing economies, investment in them was riskier to such an extent that the risk adjusted return was actually lower in developing economies. That may explain part of the reverse flow of capital into the U.S.

But two other factors might be even more important.

First we need to understand how capital flows from the U.S. to another economy. Consider American investments in Chile, a rapidly growing emerging economy with relatively good institutions and rule of law. American investors must buy Chilean pesos in the amounts to be invested. This will appreciate the peso some (one peso will be more dollars than before making American goods cheaper). Those pesos might be used to buy shares in a growing Chilean company. The purchase of these shares by an American might simply be a change in ownership (portfolio investment) or might finance new investment (Foreign direct investment—an actual increase in capital).

But what does the Chilean who sold her pesos for dollars do with those dollars? It simplifies without fundamentally changing the story to assume that the Chilean firm selling its share to an American acquired those dollars. The firm might buy U.S. treasury securities with these dollars (this is the simple swap of asset ownership of portfolio investments). But more likely it buys American machinery and equipment for its new investment. The U.S. “enjoys” a trade surplus as a result of these capital outflows. This is the traditional relationship assumed between the developed and undeveloped world. Capital flows from the U.S. to Chile.

Two additional very important factors have changed this story causing capital to flow backward from the Chiles of the world to the U.S. In my previous blog “Econ-101-trade-deficits” I explained the following relationship:

(M – X)   =   (I – S) +   (G – T),

which says that the trade deficit (imports-M- less exports-X) is equal to the savings deficit (investment-I- less saving-S) plus the government’s fiscal deficit (government spending-G- less its tax revenue-T). Uncle Sam has had a fiscal deficit every year since the Clinton administration surpluses (even currently when the economy is fully employed!) The rest of the world has helped finance our fiscal profligacy thus keeping US interest rates lower than they otherwise would have been and crowding out less of our private investment than such fiscal deficits would otherwise have caused. The rest of the world acquires the dollars to invest in the U.S. by selling more to us than they buy from us (i.e., via our trade deficit). So other things equal a smaller fiscal deficit or, god forbid, a fiscal surplus will reduce our trade deficit.

The other, often overlooked, cause of our trade deficits arises from the use of the U.S. dollar as the world’s primary reserve asset and thus the demand from foreign central banks to hold them in their foreign exchange reserves. They acquire these dollars via our trade deficit (and their trade surplus). Their demand for U.S. dollars appreciates the exchange rate of the dollar relative to foreign currencies making foreign goods cheaper in the U.S. and American exports more expensive abroad, thus creating our trade deficits and their surpluses (see my blog from last week linked above and/or this more extensive treatment; “Why the world needs a reserve asset with a hard anchor” Frontiers of Economics in China 2017, Vol 12 Issue 4,

It would be in our interest to replace the dollar’s use in foreign reserves with an internationally issued reserve currency, something I have been advocating for many years. The details for what this might look like and how it could be done are provided here: “Real SDR Currency Board”



About wcoats

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