A study in the dynamics of international flows… #2
In part #1 of this series on international flows, Norway’s trade deficit of the 1960’s was associated with foreign investment coming into their country. So the net trade deficit of the Current Account was matched by the net foreign investment surplus of the Capital and Financial Account.
There is a principle in international income accounting… A country’s Current Account balance is matched by Net Foreign Investment.
But we need to look at the relationship more closely. Which one is driving the other? Does a trade deficit simply determine the amount of net foreign investment? or does the desire of investors in general determine the amount of a trade deficit?
You might find someone saying that the US trade deficit is financed by the US receiving loans and investments from abroad. But we must realize that foreign investors want to invest their money in the US. Their desire can change the level of our trade deficit. The US is safe, even though the returns are lower. There is a risk-return relationship as to why foreign investors want to put their money in US stocks or real estate. And so we need to realize that the changing desire of investors, domestic and foreign, can determine the level of our trade deficit.
So what happens when China runs a Current Account surplus? China is taking the surplus and accumulating financial assets abroad. China could keep the surplus for themselves but what would happen to their currency? With too much demand for their currency from imports, their currency would appreciate making their exports most costly. They want to keep their exports cheap. So China puts that surplus into other countries through the foreign-exchange market. The other countries receive those funds.
If we don’t like receiving so many funds from China, what can we do about it? Well, we could change the Current Account balance that we have with China and other countries. How would we do that?
Savings and Investment
The Current Account balance is equal to the net savings and net borrowing, public and private, within a country. We have the equation…
Current Account deficit (net borrowing from abroad) = (G – T) + (I – S)
G = govt spending
T= tax revenues
(G – T) = net public borrowing
I = private investment
S = private saving
(I – S) = private net borrowing
So, if we wanted to change our Current Account deficit to a surplus, we would have to…
- raise taxes (kind of unpopular and there is a movement against higher taxes).
- lower govt spending (being done as we speak).
- raise private saving (hard to do when labor share of income is falling and returns are so low).
- lower private investment (but the Fed is trying their hardest to raise investment)
Companies like Walmart that rely on cheap imports want taxes to be lower. They want people to be paid less so that savings rates are lower. They want their employees to use government services to raise government spending. They want investment to be financed by money from foreign countries, and not domestic sources. It creates a bigger import market. Companies like Walmart perpetuate the US trade deficit because it increases their business.
You may be able to see that the US trade deficit is a result of lowering taxes and lowering the private saving rate over the years. A situation was created where we did not give ourselves enough domestic funds for govt spending and private investment. So we had to get those funds from abroad, which exacerbated the trade deficit.
But hold on… there are many ways to grasp this dynamic of a trade deficit…
Let’s look at this from an opposite perspective… Maybe the drop in tax revenues and the saving rate was the result of the trade deficit? Let’s face it, if all of a sudden you have these huge imports coming in at low prices, imports will increase. Then all of a sudden you have these foreign countries bringing back those dollars to invest in the US (by the dynamic of Balance of Payments and currency stabilization). Then we realize that the government can lower taxes because other countries are buying its bonds. Then we can suppress real wages, because savings from labor is no longer needed.
But then from another perspective, did imports rise because there was previously a big wave of foreign funds coming to the US?
Let’s go back in time a little further… the early 1980’s
In the early 1980’s, interest rates soared in the US thanks to Volcker. Yes, and returns to investment rose along with them. Foreigners wanted to invest in the US by the truckloads. Private saving was dropping. The US was safe and had long-term growth plans. Japan had money to invest. (I remember the house in Hawaii I was living in went from $130,000 to over $1 million.) Europe had troubles with unemployment and low growth. As more foreign money was being attracted to the US, the US trade balance (Current Account) started to turn negative.
But when did imports start to increase? Imports started to increase in the second half of 1982 into the first half of 1983… as the high interest rates of the Volcker recession were coming down. Coincidence? Not really. The dynamics for equilibrium in the international flows encouraged growth in import markets from tremendous foreign investment in the US. At that point, the US had to find a way to return those foreign investments by way of the Balance of Payments. The money was there to develop the import markets. And the development of those import markets was rapid, as is the beauty of capitalism.
A case can be made that Volcker is to “blame” for triggering the trade deficit by attracting large amounts of foreign investment in US assets. We have had 30 years of rising bond prices and many think the end of that is now. Will foreigners continue to invest in US assets? Will companies like Walmart be able to influence politics in order to sustain low domestic saving, private and public?
The dynamics that created the US deficit and to this day sustains it are thoroughly logical. There is no inherent problem with a trade deficit, but the US trade deficit has its advantages and its risks.
Low interest rates should themselves encourage domestic investment over foreign holdings and have some feedback into the account deficit/surplus.
There is some point/line/transition area though, where a carry is encouraged too. Borrowing here, investing there. All relative to other countries of course.
What is the impact of carries on account deficit? Does it appear to be investment in the nation of borrowing?
J.
In tomorrow’s post I will point out that investments overseas give good returns. And I will point something out which you might not expect. We need to keep our eye on that carry trade.
What I meant by the first item was probably more opaque than I intended.
Let’s ignore what country we are talking about because the US has some issues that are working counter to the normal world (IMHO). A multinational company has capital that is effectively locked in different countries by tax and other capital controlling rules, they are generally encouraged to spread operations to different geographies instead of just producing and selling all in one location, in part due to these tax related effects which are strongly related to international transfer pricing (some countries attempt to enforce relatively strong rules on this like India, other countries have large holes in their enforcement because of historical trading patterns related to colonial attachments (Netherlands). However, those capital flow related restrictions continue to exist.
The company is collecting revenue in a country and effectively in many cases the flow of the related cash out of that country is one or another way restricted. The company then has options on what to do with that cash. They can sock it away in government securities, invest it in company controlled productive assets, invest it in a liquid fashion in other companies (short term commercial paper), or move it out of the country (taking whatever the penalty is).
Interest rates drop, the company’s WACC hurdle rate for that country declines, investment inside the country becomes preferential to holding cash because more projects become “viable” from the management perspective.
As rates decline domestically, domestically captured resources should be tapped for cash generating projects.
J.
That transfer pricing is so hard to prove. How much of that is really being caught?
Are you suggesting that rates will decline in other countries? Do you see a problem with money being locked in a country? Don’t you think there needs to be some measure of insured stability?
Borrowing from abroad does not directly cause a trade deficit. Suppose I go to a German bank and borrow 100 euros.
Then U.S. holdings of foreign assets rise by 100 euros (deposit account) but foreign holdings of U.S. assets also rise by 100 euros (loan). So the capital account is unchanged.
If I withdraw the euros, then I am merely exchanging one foreign asset (deposit) for another (hard euros). So the capital account is still unchanged.
If I then exchange the euros for dollars, then U.S. holdings of foreign assets fall by 100 euros, but foreign holdings of U.S. assets also fall by an equal value of dollars. So the capital account is still unchanged.
Now, if the German bank decides it needs more dollars to make up for the ones it traded me, then maybe the dollar rises, making American made goods more expensive and Euro-zone goods less expensive. As agents respond to the changes in relative prices, this increases the trade deficit– imports rise and exports fall. But for every dollar by which the balance of trade shifts is balanced by a change in the capital account. (Say, a dollar increase in imports sends a dollar abroad, so that’s an increase in foreign holdings of U.S. assets. Or if we pay in euros, that’s a decrease in U.S. holdings of foreign assets.)
So it’s not
(Rising Foreign Lending = Rising Capital Account) -> (Falling Current Account = Rising Trade Deficit)
but rather
Rising Foreign Lending -> Rising Dollar -> (Rising Trade Deficit = Falling Current Account = Rising Capital Account)
Note that the real broad dollar went from 88.9 in January 1980 (trade was more or less in balance in 1980) to 108.5 in July of 1982 and 110.8 in May 1983 all the way to 128.4 in March 1985 (record deficit of 18 percent of total trade by year’s end)
So yeah, Volker’s high interest rates interested foreigners who *bought dollars* to purchase, say, bonds, and the high dollar tanked the trade balance AND grew the capital account surplus.
But it’s the dollar movement– not a need to restore the BoP (which must happen with precisely zero lag as a matter of accounting)– that resulted in the current account deficits.
DR,
Yes… I realize there is not a one way causation. There is an ebb and flow causation and the exchange rate gets caught in the middle. The post already scheduled for tomorrow touches upon these things.
I don’t understand. There is no “ebb and flow” in the BoP. The current and capital accounts either move simultaneously as the result of a transaction, or neither moves at all.
A change in the capital account cannot cause a change in the current account because once the former has changed, the latter has already changed. There is no time for anyone’s behavior to change. There is no exchange rate getting caught in the middle. The exchange rate does not mediate the BoP. Nor do interest rates balance the payments. Why? Because there is literally no “middle” in which to get caught.
But perhaps I just don’t understand your point.
DR,
Could we say that the exchange rate is an equilibrium between supply and demand that is determined by market forces? and that market forces have an ebb and flow? and the BoP flows with those market forces?
Not sure where you are going with this, but…
1. The exchange rate is a price, not an equilibrium. Do you mean that the exchange rate is (the?) price when supply and demand of all currencies are in equilibrium? I don’t understand your question.
2. Do market forces ebb and flow? Well, they are not static. So… yes?
3. Does the BoP (ebb and?) flow? No. The BoP is always zero. Do the current and capital accounts ebb and flow with market forces. Well, I suppose, accepting a certain lack of rigor yes those do, but they move simultaneously and the changes share exactly the same magnitude but opposite signs. A change in one cannot cause a change in the other except that the latter has already changed and will not change except that the former will also again change.
I don’t see where that gets us. Do we yet need to resolve these questions, or are we ready to move on?
D R
Obviously, a balance is not a flow, but the payments are, so the balance of such flows should tell us something. But it can also hide a lot if we fail to examine the flows. My first impression of this exchange was that you were nit picking, but I agree that precision of language is important in such analyses.
Edward
You write:
“The dynamics for equilibrium in the international flows encouraged growth in import markets from tremendous foreign investment in the US. At that point, the US had to find a way to return those foreign investments by way of the Balance of Payments. The money was there to develop the import markets. And the development of those import markets was rapid, as is the beauty of capitalism.”
I think it’s important in such discussions to make explicit the mechanisms involved and not just the broad trends. By saying “the US had to find a way”, you are giving the impression that someone in Treasury or Commerce said “Yikes, what are we going to do with all this money”, and began developing a national import program.
Can’t we just say that the investment inflow caused interest rates to fall and the Dollar to strengthen, which made conditions favorable for US merchandisers to develop their import businesses?
Then what could the Fed or Treasury have done about this, if they wanted to make import conditions less favorable? The Fed could have increased interest rates, but that might have been inconsistent with domestic monetary policy (I can’t recall, but I suppose you will discuss this), and higher interest rates would presumably have attracted more foreign capital, at least until higher interest rates tanked the domestic economy.
What can be done to break such a vicious circle? Just accept the inevitable and enjoy cheap imports?
Money can/does become locked along national borders due to national policies.
Probably the best example (but working the other direction) is the overseas revenue of US HQed multinationals. Normal international practice would say that this revenue would be taxed, with an offset for taxes collected in other jurisdictions. Instead US tax policy prevents it from being taxed until it is on-shored.
As a result, these funds are in practice locked out of the US because it is cheaper to borrow in the US to fund US obligations than it would be to on-shore those foreign revenues/profits (hard to distinguish because of the vagaries of different companies transfer pricing policies).
Opposingly, FDI rules and policing of company transfer pricing impacts on tax particularly in “developing nations” tend to also prevent capital outflows from those countries (which can also be a barried to FDI).
Transfer pricing is a black art. I work frequently on trying to tie out and provide evidence supporting our internal service fees, and even transfer pricing on physical goods moving around a company can be really messy (we have more than one approach to this, and some of them that would be preferred by tax authorities which are set dynamically (basically the factory transfer prices are related to the prices that will be charged in the market of sale or the market of use (not always the same) instead of the factory cost plus a fixed rate) make the rest of your accounting life a major pain in the ass (just try to forecast what your inter company profit elimination is going to be on that, the complexity is gigantic because we have thousands of potential configurations for something as “simple” as an MRI machine, then after that you need to figure out the market and product mix impacts, configuration impacts, etc when you are trying to analyze the result versus forecasts, getting down to that balance sheet elimination impact that comes back into your P&L is just really difficult).
When you see a company that is much more straightforward like Google, Starbucks or MacDonalds (they really only sell labor and brand licenses, their cost of goods is practically a rounding error) that can get away with essentially never paying taxes anywhere, you occasionally find yourself blinking and wondering why you’re working so hard to try to produce something that doesn’t invade people’s privacy and make them obese. Secret: there’s more money in selling nothing and no one can prove it’s not priced right.
FRauncher,
I feel the need to be careful at the outset in response to EL’s questions because I have no idea where he is going with his line of inquiry and therefore have no idea if his argument hinges on one of these details.
For example, EL seems to conflate net foreign investment with the capital account and then again with foreign lending. To me, this makes things very difficult to process, because China can buy as many treasury bills as it likes but I fail to see how these purchases (swapping one U.S. asset for another U.S. asset) would budge the capital account. (Indeed, to be careful, they don’t need to pay in dollars, but the end result is just the same if you follow through on the bookkeeping.) So we’re already off on the wrong foot as EL sets up his post.
I would like to understand what EL is trying to say, but for that I require his assistance– either in comments or via email.
FRauncher,
Interest rates have been falling steadily for 30 years. But so has the savings rate and taxes too over that time. The result was less funds for domestic investment and government spending. Thus funds needed to be found abroad to make up the difference. The level to which funds abroad made up the difference contributed to creating an environment favorable for imports.
I would not say that investment inflow caused the interest rate to drop. There are too many other factors that influence that. But yes, the investment inflow strengthened the dollar which made our exports more expensive and imports cheaper.
What can the Fed or Treasury do? The Fed has put itself into a labyrinth and can’t find the exit. They really have a severe problem. They are stuck and can’t change anything they are doing.
The solutions would be to raise taxes and the savings rate in order to boost domestic savings. That will require higher wages, and higher interest rates. All these solutions are not likely for some years. The financial sector is pulling the strings to maximize its profit.
China will not be able to raise its domestic consumption fast enough. Their domestic investments are going to require stronger domestic consumption, but their labor share rates are still too low to be successful with that on a sustainable basis. They have a serious problem going into the future. Labor share has a long way to rise before they can balance their long-run growth.
For the foreseeable future, we have to accept cheap imports.
“I would not say that investment inflow caused the interest rate to drop… But yes, the investment inflow strengthened the dollar which made our exports more expensive and imports cheaper.”
Good. So we seem to agree the problem is the high dollar, which has remained high despite low interest rates. So… why not focus on the dollar? How is raising taxes going to lower the dollar? By reducing the supply of safe assets and thereby lowering interest rates, making U.S. treasuries even less attractive to foreigners? How would this work if the alternative is a policy of boosting domestic savings by increasing interest rates? This doesn’t seem consistent to me. Perhaps I’m not seeing the mechanism by which you think this would all work.
As for China, yes, they need to keep moving from export growth to increasing domestic demand. Yes, they need wages to rise. But I don’t understand your pessimism.