What Does a Current Account Deficit (Surplus) Mean Lecture

What Does a Current Account Deficit (Surplus) Mean? • When foreigners start purchasing more of our assets than we are purchasing of theirs, the dollar becomes more costly in the foreign exchange market • U.S. goods more expensive to foreigners, declining exports; • foreign goods become cheaper to Americans, increasing imports. What Does a Current Account Deficit (Surplus) Mean? • Is Trump’s Trade Doctrine Misguided? • President Trump wants revised NAFTA to reduce America’s trade deficits with Canada and Mexico • Bilateral trade deficit matters little for country’s aggregate (global) trade balance • America’s imports would move from Mexico to other countries as production of relevant products shifts, or America’s exports would move to Mexico from other countries with negligible net impact on overall balance What Does a Current Account Deficit (Surplus) Mean? Table 10.4 Global Production and Manufacturing Cost of the iPhone Of the $179.02 wholesale cost of an iPhone in 2009, components came from many countries to be assembled in China. Here’s the breakdown: Manufacturing Cost (Labor and Components) Japan In U.S. Dollars $60.60 Percentage of Total Manufacturing Cost 33.9% Germany 30.15 16.8 South Korea 22.96 12.8 United States 10.75 6.0 China 6.50 3.6 Other 48.06 26.9 179.02 100.0 Source: Yuqing Xing and Neal Detert, How iPhone Widens the U.S. Trade Deficits with PRC, National Graduate Institute for Policy Studies, Tokyo, Japan, November 2010. What Does a Current Account Deficit (Surplus) Mean? • Is a Current Account Deficit a Problem? • Current account deficit arises because domestic economy spends more than it produces • Excess of demand met by net inflow of foreign goods and services, leading to deficit • Problem? Not necessarily • Foreign capital inflows augment domestic capital sources and keep domestic interest rates lower than would otherwise be • Benefit of deficit is ability to spend more than produce • Cost is debt service that must be paid on borrowing What Does a Current Account Deficit (Surplus) Mean? • Is a Current Account Deficit a Problem? (cont’d) • Is it good or bad for country to incur debt? • Depends on whether deficit used to finance more consumption or more investment • If used for investment, burden slight • If used for consumption, no boost to future productivity; and to meet debt service expense, future consumption must be reduced • In 1980s, U.S. saving decreased; U.S. used foreign borrowing to increase current consumption • In 1990s, deficits driven by increases in domestic investment, made possible by foreign lending What Does a Current Account Deficit (Surplus) Mean? • Business Cycles, Economic Growth, and the Current Account • Rapid growth of production & employment associated with growing trade & current account deficits • Slow output & employment growth associated with growing surpluses • During recession, saving & investment tend to fall; current account balance tends to rise; trade balance improves • Opposite occurs during periods of boom What Does a Current Account Deficit (Surplus) Mean? • How the U.S. Has Borrowed at Very Low Cost • In past 4 decades, U.S. current account moved from small surplus to large deficit, financed by borrowing from or selling assets to foreigners • U.S. has become large net debtor; must make larger payments of interest & principal to foreign lenders • In past 2 decades, paradox: U.S. residents earned more from foreign investments than foreigners earned from U.S. investments • U.S. has been large debtor without bearing negative debt-service cost; suggests current account deficits might be less burdensome than portrayed What Does a Current Account Deficit (Surplus) Mean? • How U.S. Has Borrowed at Very Low Cost • What accounts for paradox? • Asymmetric investment returns; rate-of-return advantage generally 1–2% points; given political and economic instability of other countries, U.S. firms take greater risks investing in foreign firms; higher risk/reward • U.S., by contrast, seen as safe haven; foreign investors more likely to buy U.S. assets that offer low risk, return • Future U.S. borrowing may be less favorable • If interest rates rise, U.S. will pay higher rates • Could swing U.S. investment income balance from surplus to deficit What Does a Current Account Deficit (Surplus) Mean? • Do Current Account Deficits Cost Americans Jobs? • U.S. employment statistics don’t fit expected pattern of negative relationship between current account deficit and employment • Trade deficit may hurt employment at some firms & industries as workers displaced by imports, but economy-wide, deficit matched by equal inflow of foreign funds sustaining investment spending • Current account deficit produces jobs as result of higher employment in investment-oriented industries and indirect effect of higher investment What Does a Current Account Deficit (Surplus) Mean? • Can the U.S. Continue to Run Current Account Deficits Indefinitely? • Foreigners have remained willing to buy U.S. assets such as Treasury securities • Large increase in U.S. current account deficit not possible without inflows of foreign capital from nations with high savings, such as Japan & China • China a major supplier of capital to U.S. • China has followed exchange-rate policy of keeping value of yuan low to export goods to U.S. & create jobs for its workers What Does a Current Account Deficit (Surplus) Mean? • Can the U.S. Continue to Run Current Account Deficits Indefinitely? (cont’d) • China’s central bank has converted its dollar holdings into U.S. securities that pay interest • Enables U.S. to benefit from willingness of China to finance current account deficit • U.S. can “print money” that Chinese hold in order to finance its excess spending • Some analysts concerned that foreign investors may view increasing U.S. foreign debt as unsustainable or more risky and shift capital elsewhere; U.S. also seen as politically reliant on China, giving latter leverage What Does a Current Account Deficit (Surplus) Mean? • Can the U.S. Continue to Run Current Account Deficits Indefinitely? (cont’d) • No automatic or economic reason why U.S. can’t sustain current account deficit indefinitely, if foreigners wish to purchase U.S. assets • Consequences of current account deficit are growing foreign ownership of capital stock and rising fraction of U.S. income paid as interest & dividends to foreigners • Serious problem could emerge if foreigners lose confidence in inability of U.S. to repay Balance of International Indebtedness • Balance of international indebtedness • Statement that summarizes fixed stock of assets and liabilities against rest of world; record of international position of U.S. at particular time • Shows accumulated value of U.S.-owned assets abroad • When accumulated value of U.S. owned assets abroad exceeds value of foreign-owned assets in U.S., U.S. is net creditor to rest of world Balance of International Indebtedness Table 10.5 International Investment Position of the United States at Year End (Billions of Dollars) Type of Investment* 1995 2000 2016 U.S.-owned assets abroad (U.S. assets) 3,406 6,168 23,917 Foreign-owned assets in the United States (U.S. liabilities) 3,906 8,010 32,027 Net international investment position −500 −1,842 −8,110 Relative share: U.S. net international investment position/U.S. gross domestic product 6% 15% 44% *At current cost. Source: From U.S. Department of Commerce, Bureau of Economic Analysis, The International Investment Position of the United States at Year End, available at http://www.bea.gov. See also U.S. Department of Commerce, Survey of Current Business , various June and July issues. Balance of International Indebtedness • Balance of international indebtedness (cont’d) • When reverse is case, U.S. is net debtor • Balance of international indebtedness breaks down international investment holdings into several categories • Policy implications can be drawn from each separate category about the liquidity status of nation Balance of International Indebtedness • U.S. As a Debtor Nation • In early industrial development, U.S. was net international debtor, relying on foreign funds to build its industries • After WWI, U.S. became net international creditor • By 1987, U.S. had become net international debtor and has continued in that position, with foreign investors placing more funds in U.S. than U.S. residents have invested abroad The Dollar as the World’s Reserve Currency • Dollar is main reserve currency in world today • Almost 2/3 of world’s official foreign exchange reserves held in dollars • 4/5 of daily foreign exchange trades involve dollars • Euro, second-most-important reserve currency, lags far behind dollar • Widening trade deficits & expanding foreign debt of U.S. have weakened prestige of dollar • Widespread use of dollar makes it difficult to displace as world’s main reserve currency The Dollar as the World’s Reserve Currency • Benefits to the United States • Americans can purchase products at marginally cheaper rates than nations that must exchange their currency and pay a transaction cost • Americans can borrow at lower interest rates for homes & autos, & U.S. government can finance larger deficits longer and at lower interest rates • U.S. can issue debt in its own currency, pushing exchange-rate risk onto foreign lenders • Fall in dollar’s value could wipe out their returns The Dollar as the World’s Reserve Currency • Benefits to the United States (cont’d) • But rising concern about continuing role of dollar as world’s main reserve currency • China fears U.S. digging hole with economy based on huge deficits & massive borrowing • Worries about volatility of dollar & destabilizing effect it can have on international trade & finance • Critics claim credit-based reserve currency (dollar) inherently risky; promotes spread of financial crises The Dollar as the World’s Reserve Currency • Benefits to the United States (cont’d) • Alternatives to the U.S. dollar • not British pound (past) • not Chinese yuan (far in future, if ever) • not euro (weakening) The Dollar as the World’s Reserve Currency • Will the Special Drawing Right or the Yuan Become a Reserve Currency? • In 2009, China proposed overhaul of international monetary system in which special drawing rights (SDRs) would replace dollar as world’s main reserve currency • Objective to adopt reserve currency disconnected from single country and stable in long run The Dollar as the World’s Reserve Currency • Will the Special Drawing Right or the Yuan Become a Reserve Currency? (cont’d) • SDR now based on euro, yen, pound, and dollar • China proposed currency basket be expanded to include all major currencies, including Chinese yuan and Russian ruble The Dollar as the World’s Reserve Currency • Will the Special Drawing Right or the Yuan Become a Reserve Currency? (cont’d) • SDR would be managed by IMF • Benefit: currency risk would be diversified • Pitfall: SDR backed only by good faith and credit of IMF; dollar, by contrast, backed by goods and services produced by Americans and people’s willingness to exchange those goods and services for dollars The Dollar as the World’s Reserve Currency • Will the Special Drawing Right or the Yuan Become a Reserve Currency? (cont’d) • For U.S., loss of reserve currency position costly • Americans would pay more for imports as dollar depreciates, since foreigners would no longer buy dollars as they did when dollar was reserve currency • Interest rates on private and governmental debt would increase, since foreigners, holding fewer dollars, will purchase fewer dollar-denominated assets