A study in the dynamics of international flows… #3

Mr. Krugman said yesterday that the economy is “awash in excess savings with nowhere to go”. If we are awash in excess savings, why do we borrow from foreigners?

Let’s look at this equation to determine net borrowing from foreigners…

Current Account deficit (net borrowing from abroad) is… (M – X) = (G – T) + (I – S)

M = imports
X = exports
(M – X) = net borrowing from abroad
G = govt spending
T= tax revenues
(G – T) = net public borrowing
I = private investment
S = private saving
(I – S) = net private borrowing

For US data from the 2nd quarter of 2013, I get this equation… (in billions of $)

Current Account deficit $422 = $893 + $2529 – $3000

(M – X) = $422
(G – T) = $893
(I – S) = -$471
I = $2529
S = $3000 (labor and capital private savings combined)

We do not have enough domestic savings to cover domestic investment and net govt borrowing. Personal savings have fallen from over $646 billion per year in 1st quarter 2011 to $461 in 2nd quarter of 2013. So, we borrow from or sell assets to foreigners to the amount of $422 billion per year.

If we were awash in “excess” savings, would we be borrowing from abroad?

Weak labor income in the US contributes to the decline in personal savings, which makes the US seek foreign funds for domestic investment and government spending. For comparison sake, personal savings in 1972 was $467 billion and government spending was $1420 billion (2009 dollars). We still have the same personal savings $461 billion but government spending is double in real terms at $2900 in 2nd quarter 2013. We had a lot more personal savings back in 1978 relative to now. So again, why does Mr. Krugman say we are awash in excess savings? He must not be talking about personal savings.

And also, what does he mean that the savings have nowhere to go? US investors have been finding good returns on their money overseas. In fact, US investors find better returns on their money overseas than foreign investors find in the US.

The puzzle of paying less to foreign lenders

Our Current Account deficit is paid for by borrowing from foreigners or selling our assets to them. The US is a large debtor nation, so one would assume that we have to service this debt with large payments to foreigners. Those payments would include lots of interest and principal. However, there is a puzzle. The US actually receives more payments from its smaller investments overseas than it pays to service the larger investments by foreigners in the US.

This may be surprising to some people that the US actually has an “investment” surplus with foreign countries, in spite of the fact that we borrow more in total value $$. This surplus has normally run $20 to $30 billion per year in favor of the US. The reason for this is that US investors take on greater risk overseas, and get compensated better for that. Investing in the US is a low return, low risk venture.

So when Mr. Krugman says that the savings have nowhere to go, he must not know that overseas investments are paying relatively well.

Now, as long as US interest rates stay low, the US will pay out less principal and interest to foreigners. So there is reluctance in the US financial sector to raise interest rates, because payments to foreigners might end up being greater than what the US receives from overseas. It’s a profit thing. The US Current Account deficit is easier to tolerate if the financial sector is realizing a surplus. Ahem…

Foreigners are now investing overseas more…

We have seen the Current Account deficit of the US fall from over $800 billion in 2006 to $422 in the 2nd quarter of 2013. So the financial sector sees “progress” in minimizing payments to foreigners. Part of the explanation for this decline in the Current Account deficit is the depreciation of the US dollar which favors exports. and Part of the explanation for the depreciation of the US dollar is its declining share as a reserve currency. (see post at econbrowser)

Another explanation for the decline in the trade deficit is the increasing risk and greater returns from investing overseas. Even foreigners are finding it more profitable to invest overseas than in the US. Thus, there is less demand for US dollars, less net lending to the US from foreigners, and the result is a lower Current Account deficit. One can point to asset bubbles all around the world, Brazil, China, UK and other countries that seem to be attracting international flows of money.

So do we really need to borrow from abroad? Are domestic savings awash or not? Has the dollar just not depreciated enough? Is the US asking for foreign investment like Norway did back in the 1960’s in order to develop future productive capacity? Is the US investing in future productive capacity? How much of the international flow is “play” money? and how much of it is being invested in viable productive capacity for the future?

More to come in this series…