Friday, December 08, 2006

A Day's Pay

A Day's Pay

Over the last decade, current account balances across the world have shifted dramatically. The United States’ current account has swung into a deep and accelerating deficit while Japan and developing Asia have moved to large current account surpluses. Accompanying these swings in current account balances has been the United States’ movement to the status of a net debtor and developing Asia’s emergence as a net creditor, amassing claims on Americans in the form of treasuries, corporate equities, and direct investment. Both Latin American and Middle Eastern countries have also run significant surpluses, but they will be fleeting, as factors that affect those regions, such as rising commodity prices, are temporary and likely to be volatile in the future. The rising U.S. current account deficit is a perplexing topic for economists, as the American economy is rather mature and growing at a slow but consistent rate. The popular press frequently blames the massive imbalances on Americans’ aggressive spending habits and unwillingness to save a larger portion of their income. This “Made in the U.S.A.” argument derives from an interpretation of the macroeconomic accounting identities, but is utterly inconsistent with the data, and will be discussed later. Alternative explanations of the current account deficit have focused on blaming China as a currency manipulator, as the People’s Bank of China holds down the value of the yuan in order to gain an unfair trading advantage at the expense of the American manufacturing sector. Both the “Made in the U.S.A” and currency manipulator argument espoused by American legislators reek of sensationalism and fail to fully explain the recent trend in global current account balances. The most plausible and consistent explanation of the imbalances in current accounts across the world comes from an examination of savings and investment activity worldwide, international economic conditions, and the attractiveness of the United States’ highly liquid and well-regulated financial markets. This analysis of the global imbalances begins with an explanation of the current state of the imbalances, followed by an examination of each major region of the world and an assessment of the impacts felt in the United States.
Since the mid-1980s, the United States’ current account balance has fallen into a deep and accelerating deficit. With a brief return to surplus during a recession in the early 1990s, the excess of imports from foreigners over exports to the world has consistently risen, amounting to an annualized figure of roughly $870 billion or 6% of GDP.[1] Using the macroeconomic accounting identity, the U.S. current account can be explained by the equation, Sp + CAD = I + (G-T), which simply states that private investment and the government budget deficit must be financed by either private domestic savings or by importing foreign savings through the current account. In a closed economy, a country’s savings and investment must be equal by definition, but because of the globalization of financial markets and capital flows, a country’s savings and investment during a period need not be equal, enabling deficits and surpluses on the current account. In the United States, private savings amounts to roughly 15% of GDP, with investment and the government budget deficit weighing in at about 20% and 1% of GDP respectively, and the current account deficit at 6%.[2] As national savings is less than capital investment, the U.S. must run a current account deficit in order to finance the excess of investment over savings. Foreign savings must be imported in order to fill the gap between what Americans save and what private firms invest.
Through this savings and investment perspective of the current account, the “Made in the U.S.A.” hypothesis can be explained and ultimately refuted. As capital investment by firms has consistently outstripped savings, the need for a current account deficit has persisted. In explaining the dramatic swing to deficit during the American technology boom of the 1990s, the national accounts model is powerful. During the 1990s, productivity growth in information technologies boosted investment, and an exuberant stock market lifted household wealth, increasing consumption and reducing savings. Foreigners were also eager to participate in the investment boom, offering much needed capital to the overheating American economy in the form of the current account deficit. This explanation of the rise in the current account deficit as a result of robust investment demand outstripping savings is satisfying. The early 2000s, however, are more difficult to explain, as the current account remained in deficit despite the 2001 recession and productivity slowdown in the United States. Investment demand certainly cooled after the bubble burst, yet the current account deficit continued to widen.
Many analysts attribute the yawning deficit to a lack of savings in the United States, citing declining propensities to save because of increasing home prices and a ballooning government budget deficit. Since the 1980s, the savings rate for the United States has fallen from 18% to nearly 15% of GDP, and the household savings rate has precipitously declined to almost zero.[3] Given the accounting identity, as savings declines, the current account must fall into deficit if no other variable changes. This explanation derives itself from how the current account is defined. With the government deficit absorbing domestic savings, private investment requires financing from abroad and contributes to the current account deficit. The twin-deficit idea is theoretically valid, yet with government borrowing so low, only a small portion of the increasing current account deficit can be explained. In a recent study of the current account, researchers Menzie Chinn and Hiro Ito calculate the coefficient on the budget balance variable to be 0.21 for industrialized countries, statistically significant at a 10% level.[4] The statistically significant coefficient is evidence of the theoretical validity of the relationship between the budget balance and the current account, yet its low magnitude and a troubling adjusted-R2 for the equation are a signal that further investigation is required. The “Made in the U.S.A” explanation of the current account is grounded in theoretical validity, yet ignores the role of the rest of the world and is inconsistent with the behavior of interest rates. A decreased supply of savings in the United States because of a ravenous government and low savings rates would suggest an increase in the real interest rate, as the supply of savings decreased. This idea, however, is inconsistent with the behavior of interest rates, as the real interest rate has fallen consistently since 2000, suggesting an increase in the supply of savings.[5]
In contrast to the government budget deficit and consumer spending view, some economists argue that the United States actually saves plenty of its output for the accumulation of its capital stock. Acclaimed international economist Richard N. Cooper argues that in the modern knowledge-based economy, the traditional accounting identity does a poor job of describing an economy’s savings. National savings, which is measured as output less consumption and government expenditure, fails to account for savings in consumer durables, education, and research and development. Cooper explains, “The national accounts focus on productive physical capital plus housing. A broader and more appropriate concept must add at least three components of current output: consumer durables, education, and expenditure on research and development.”[6] Because investment in these three categories yields high returns in the future, they should be considered savings. Research and development, which generally yields large increases in productivity, is not even included in the national accounts, and considering education as part of consumption fails to recognize its capacity for future returns in an economy increasingly focused on information. Cooper estimates that when including these alternative forms of saving, the U.S. saves roughly one third of its GDP, which should be plenty for adequate capital accumulation to ensure future economic growth. If the United States is actually saving plenty of its output for capital accumulation and the government budget deficit cannot entirely account for the widening current account deficit, an explanation must lie outside the United States, particularly in developing Asia, Japan, and Europe.
Accompanying the dramatic rise of the U.S. current account deficit has been the movement of the rest of the world to surplus. The U.S. current account deficit is not the result of profligate consumption and a lack of savings by Americans, but is a result of savings and investment trends worldwide. From the 1980s to present, the world’s savings rate has remained relatively constant.[7] What has changed, however, are regional savings and investment rates, especially in developing Asia and the United States. Developing Asia’s savings rate has increased dramatically since the 1980s while the U.S. savings rate has declined. In the Middle East, savings has remained volatile, as it is primarily determined by changes in the price of oil exports. Both European and Japanese savings rates have remained relatively constant. Besides the shift in savings from the United States to emerging Asia, global investment rates have fallen steadily. With total world savings fairly stable and investment falling since the 1970s, the world has become awash with an excess of savings over investment, resulting in historically low real interest rates seen in the U.S. and large current account imbalances across key regions of the world.
The most dramatic change in savings and investment activity across the world has been the transformation of developing Asia from a net importer of capital to a net exporter. In 1994, developing Asia borrowed on net just over $40 billion to finance its current account deficit, yet by 2004 these countries were running large current account surpluses, amounting to nearly $180 billion, or about 3% of the region’s aggregate GDP.[8] Developing Asia’s dramatic swings in its current account balance are very noticeable in the data. Prior to 1997, investment activity made up roughly 36% of the region’s GDP, with savings weighing in at 33%, making the current account deficit 3% of GDP as noted above. 1997 marked a powerful swing in developing Asia’s current account balance, as investment dropped nearly 12 percentage points to 24% percent of GDP and the current account rose to an enormous surplus of about 7.5% of GDP.[9] This improvement in the current account is perplexing, given the scarcity of capital and its high marginal product in developing Asia relative to other regions of the world. In highly developed industrialized countries, where capital is more abundant, each additional unit of physical capital should be less productive because of the law of diminishing returns. As a larger capital stock is accumulated, the return on each unit of capital should fall, prompting investors to seek returns in countries with lower capital stocks. Also, where capital is scarce and labor is abundant, investments in capital should yield the largest returns. This theory of capital allocation seemed to play out empirically in the early 1990s, when developing Asia ran significant current account deficits, financing investment at home with savings from abroad. Indeed, profit-maximizing investors should have turned to developing Asia as the return on capital, defined as the value paid to capital owners divided by the total capital stock, was much higher than returns paid in the West, with the return in East Asia coming in at 14.4% compared a return of 9.9% in the United States.[10] Given the difference in returns, capital should flow to developing Asia, rather than to the highly industrialized and capital abundant United States. This dramatic and counterintuitive shift in capital flows can be explained by the 1997 Asian currency crises, which is responsible for much of the global current account imbalances seen today.
The developing world’s currencies were plagued by instability during the 1990s, reminding international investors of the risk and political uncertainty that accompanied their outsized returns for much of the decade. The 1994 devaluation of the Mexican peso following the Chiapas uprising and the assassination of a presidential candidate reminded investors of the risks of short-term portfolio investments in volatile areas of the world. The response was a rapid attack and devaluation of the peso, devastating the Mexican economy. Although the Mexican crisis left many investors with a bitter palate, they were eager to forget it as the Asian currency crisis erupted under similar circumstances involving a reversal of capital flows. Capital flows into Indonesia, South Korea, Malaysia, the Philippines and Thailand averaged more than $40 billion per year in the 1990s and were $70 billion in 1996 alone.[11] Large current account deficits, rising portfolio investments in speculative areas such as real estate, and a poorly regulated banking system gave rise to a mass exodus from Asian currencies. As investors realized that a real estate bubble burst was likely and that many of their portfolio investments were put to questionable and unproductive use, they prompted a bank run on the region. Central banks worked to protect their currencies by selling foreign exchange, resulting in an exhaustion of reserves. Large capital outflows also exposed weakness in the banking system, as under-regulated banks made long-term speculative investments in real estate on funds borrowed from depositors with a shorter maturity. Given a wealth-constrained investment function, the dramatic devaluation created a large contraction in domestic investment and output. As much of developing Asia’s debt was denominated in foreign currencies, such as the dollar, the real burden of debt taken on during the boom years increased dramatically, prompting bankruptcies and the deterioration of firms’ balance sheets. As leverage increased, investment fell, reflecting firms’ risk aversion. Following the currency crisis, investment in developing Asia fell to rates comparable to those of the 1970s as countries exported to strengthen their international indebtedness position and central banks sought to amass foreign exchange reserves to protect their countries against capital outflow. Developing Asia’s defensive export strategy required domestic savings to exceed investment, resulting in large current account surpluses. The high levels of savings relative to investment in developing Asia following the Asian currency crises is a striking feature of the global imbalances that will persist in the future, as current account surpluses are largely a defensive measure, generating credibility and foreign exchange for developing Asia as they export goods on net to the rest of the world.
Although China was left unscathed from the currency crises affecting developing Asia, it was not immune to the effects of devaluations or concerned about how rapid capital outflow could be a threat to its economy in the future. Governor of the Reserve Bank of Australia, I.J. MacFarlane, correctly predicted the movement of developing Asia’s current accounts to surplus when he wrote in 1998 that “a number of emerging market countries will take the safety-first policy of building up large international reserves--a new type of mercantilism.”[12] This “safety-first” policy requires countries to undervalue their currencies in an effort support export growth and run current account surpluses. Not only do countries such as China gain credibility through their exports, but they accumulate foreign exchange reserves, insulating themselves from capital outflow and providing a form of insurance for foreign direct investment. China’s $1 trillion war chest of foreign exchange acts as a form of security for Western firms that would otherwise be reluctant to invest directly in China for fear of political uncertainty and nationalization. In order to dispel investors’ qualms of financial distress precipitated by banking system weakness or a government usurpation of the private sector, China has followed Thailand and South Korea’s precautionary movement toward a surplus in the current account and an accumulation of reserves.
In contrast to the rest of developing Asia, both savings and investment have increased markedly in China, satisfying the government’s development strategy and need for foreign exchange reserves to hold down the value of the yuan. While China’s trend toward current account surplus overall has followed that of the rest of developing Asia, savings and investment in China have not. With an already high savings rate of nearly 40% of GDP in the 1990s, Chinese savings increased to nearly 50% of GDP in the early 2000s.[13] Household savings is high at almost 25% of income, reflecting individuals’ concerns over the availability of crucial services such as healthcare and housing, previously exclusively provided by the government. The high rate of savings is likely to continue as the economy shifts to a fully market-based system, introducing further volatility and uncertainty to an economy accustomed to central planning. Also, corporate saving has risen rapidly, reflecting both fatter profit margins in private corporations and a lack of functioning capital markets. Because firms cannot seek financing through domestic capital markets, Chinese companies are frequently forced to finance their own growth through their retained earnings, encouraging companies to save if they wish to make capital investments in the future. The ratio of investment to GDP has also risen substantially after the Asian currency crisis, being primarily concentrated in infrastructure and manufacturing.[14] China’s persistent trade surplus is partly a reaction to the need for foreign exchange reserves and stability following the Asian currency crisis, but is also an integral part of the country’s development strategy and method of absorbing the hundreds of millions of Chinese peasants who will migrate to the coastal areas in search of high wages over the next several decades.
Apart from the Asian currency crisis, the trend toward an accelerating improvement in developing Asia’s current account can be explained with the Bretton Woods Revived thesis. In an effort to graduate their economies from the developing world, or the periphery, developing Asia has focused on export growth to boost economic performance and improve their capital stocks through foreign direct investment from the West. The development strategy requires large amounts of saving, undervalued currencies, and a thriving export sector. In an effort to upgrade their capital stocks and promote economic growth, countries in the periphery require Western technology in the form of physical and human capital. Importing this capital entails foreign direct investment by Western firms, which can only be seduced with large amounts of foreign exchange reserves as a form of collateral. Developing Asia’s role in the global imbalances is important not only because it makes up the largest part of the global imbalances, with a surplus amounting to nearly $180 billion in 2004, but because its export of capital flows the wrong direction, away from capital poor regions, to areas of significant capital saturation. Developing Asia’s status as a net exporter will likely persist until the region’s development needs are met, requiring continued savings and undervalued currencies.
In addition to developing Asia, both Japan and Germany have run significant current account surpluses in recent years. As individual countries, Japan and Germany have the largest current account surpluses, amounting to $172 billion and $104 billion respectively in 2004.[15] Both the savings and investment model from the national accounts and the demand model of the current account are useful in explaining the swelling current accounts in these industrialized countries. Common to both nations has been a prolonged economic downturn in recent years, structural difficulties in the economies, and rapidly aging populations. Since the crash of its soaring equity and real estate markets in 1989, Japan has been in a deep recession with creeping deflation.[16] Germany has been plagued with slow economic growth over the last four years, clocking in at less than 2% on an annualized basis and an increasing unemployment rate of over 10%.[17] Problems in Germany lie in its exorbitant tax rates and inflexible labor markets, as high marginal tax rates provide an obvious disincentive to do business in the country. More important in Germany is the high level of labor market inflexibility, with strong unions and governments dictating increases in the minimum wage and regressive employment laws that discourage hiring and keep unit labor costs elevated relative to its European peers.
Stagnant economic growth in both Japan and Germany has contributed to rising current account surpluses, increasing global imbalances worldwide. Using the demand model of the current account, the current account is a function of the nation’s income, foreign nations’ incomes, and the real exchange rate. Both Japan and Germany’s incomes have remained relatively constant while the rest of the world has seen output grow at a greater rate, contributing to current account surpluses. In addition, Japan has seen a significant depreciation in its currency, cheapening Japanese exports and making imports relatively more expensive. Furthermore, both Japanese and German demographics are posed to change dramatically. A larger proportion of each country’s population will be elderly in coming years, inducing them to save now. As individuals prepare for retirement, each society’s propensity to save should increase, making current account surpluses more persistent.[18] An additional factor contributing to persistent current account surpluses in Japan and Germany is set forth by Richard N. Cooper, who argues that since World War II, both Japan and Germany have built a psychological dependence upon strong export performance. If exports suffer and their current accounts become less positive, the countries will respond with additional savings, bringing them to surplus once again.[19] Using fiscal stimulus in Japan and Germany to reinvigorate the economy and stimulate import demand is not a viable policy option, as budget deficits in both regions are already high, amounting to 4% of GDP in Germany and nearly 8% of GDP in Japan.[20] For structural, psychological, and financial reasons, both Japan and Germany are likely to remain in surplus for the foreseeable future, contributing to the existence of the global imbalances.
Another prominent feature of today’s global imbalances is the large current account surpluses emanating from the Middle East. The recent increase in the price of oil over the last several years has dramatically altered the balance of payments between Middle Eastern countries, notably Saudi Arabia, and oil-importing countries. As the value of Saudi Arabian exports has risen, the country’s current account balance has correspondingly improved. The International Monetary Fund calculates Saudi Arabia’s 2005 current account surplus at over $100 billion, or about 30% of GDP.[21] Relative to the size of its economy, the Saudi current account surplus dwarfs East Asian current account balances. Current account surpluses in the Middle East, however, are likely to be transitory, as the price of oil has tended to be volatile and should not be a persistent contributor to the global imbalances.
Given developing Asia’s concerns about future risk and volatility, and Japan and Germany’s poor investment opportunities, it is not surprising that nearly all of the world’s current account surpluses flow to the United States, allowing the U.S. to run a large current account deficit. Through the international capital flows lens, CA + KA + ORT = 0, it becomes apparent why the United States runs such a significant current account deficit. Because of foreigners’ strong demand for our financial assets, including bonds, corporate stock, and private equity, the United States is able to run a large current account deficit. Demand for U.S. assets abroad induces countries to pay for American financial assets with their exports, making the U.S. capital account rise and the current account fall into negative territory. Because the United States has the most sophisticated and liquid capital markets in the world, offering a vast array of any type of security and derivative imaginable, it is a particularly attractive location to place one’s savings. Furthermore, well defined property rights, low political risk, and acceptable returns attract foreign capital to the U.S., enabling it to run a significant current account deficit. The current account deficit will continue indefinitely until foreigners no longer perceive U.S. financial claims as highly desirable assets and refuse to purchase them. In this view, the deteriorating U.S. current account position is perfectly sustainable for the immediate term. Furthermore, as development in East Asia is dependent upon the accumulation of U.S. assets, demand for the dollar will likely persist. The leading authority on the U.S. current account position, Catherine Mann, however, explains that prolonged current account deficits and a deteriorating international investment position is associated with a depreciation of the exchange rate.[22] While an ever-increasing supply of American assets abroad may eventually cause a depreciation of the dollar, because dollar is the preferred unit of account internationally, an adjustment via dollar depreciation seems unlikely with the current account deficit at only 6% of U.S. GDP. The centrality of the U.S. dollar and its importance in developing nations’ export strategies make a significant dollar depreciation and reversal of the current account improbable.
An alternative explanation of the U.S. current account deficit focuses not on the abundance of Asian savings, but seeks to explain the decline in U.S. savings and increasing propensity to run a current account deficit by examining the decline in U.S. business cycle volatility. Fogli and Perri estimate that 20% of the current account deficit can be attributed to the lower volatility of U.S. GDP relative to other nations.[23] As the standard deviation of output growth in the U.S. economy has fallen over the last century, known as the Great Moderation, Americans have reduced their precautionary savings and increased foreign indebtedness. This explanation of the current account is also consistent with the experience of developing Asia. As country specific risk has increased because of GDP fluctuations, precautionary savings has risen and foreign indebtedness has declined for many of these countries. Fogli and Perri explain that a portion of the U.S. current account deficit is easily explained and is a natural reaction to the decline in volatility seen in U.S. GDP growth.
While many commentators cite the rising U.S. current account surplus as a threat to the U.S. economy and a sign of weakness, the rising trade deficit has actually been a boon to U.S. consumers, businesses, and central bankers alike. Because of a decrease in investment abroad, particularly East Asia, and the attractiveness of U.S. financial assets, the supply of savings available to the United States has increased. Not only is the current account deficit a sign of the attractiveness of U.S. assets and the dollar, but the supply of savings offered by the rest of the world has lowered real interest rates, fuelling a great boom in housing demand and enabling more Americans to obtain homes and extract wealth from existing residential investment. Also, increased exports from low cost areas of the world, such as East Asia, have made central banking in the United States much easier by lowering the trade off between inflation and unemployment. The increased supply of low-cost goods from Asia can be viewed as a favorable supply shock, shifting the Phillips curve inward and improving the classic trade off. Essentially, the increasing U.S. current account deficit has been a benefit on net and will likely continue unless the improbable case of a dollar depreciation causes an increase in inflation via exchange rate pass through-effects.
Much of the attention placed on the global imbalances in the business and financial press focuses on its origins in the U.S. government budget deficit and American consumers’ willingness to spend. This analysis of the current account has, however, demonstrated that while domestic savings and the budget balance do have an impact on the global imbalances, a more meaningful and appropriate analysis of it must begin abroad, specifically in developing Asia. Because of the Asian currency crisis and the region’s development strategy, the Asian surpluses will continue. Both Germany and Japan face major obstacles in moving to a current account deficit but may do so as economic growth accelerates and their populations age. Middle Eastern surpluses will likely be ephemeral as energy prices drop and investment demand in the region increases. The current state of the global imbalances will continue in the immediate future, but over the long run, the United States will have to become a net exporting nation to repay the debt owed to foreigners. The global imbalances will ultimately be resolved as developing Asia satisfies its development strategy and economic growth accelerates in Japan and the Euro Area.

Works Cited
Bernanke, Ben. The Global Savings Glut and the U.S. Current Account Deficit. Virginia Association of Economists. March 2005.

Chinn, Menzie and Ito, Hiro. Current Account Balances, Financial Development and Institutions: Assaying the World “Saving Glut”. Portland State University. October 2006.

Cooper, Richard N. Living with the Global Imbalances: A Contrarian View. Institute for International Economics. November 2005.

Dooley, Michael P. et al. Savings Gluts and Interest Rates: The Missing Link to Europe. National Bureau of Economic Research. July, 2005.

Dornbusch, Rudiger and Park, Yung Chul. Contagion: How It Spreads and How It Can Be Stopped. World Bank. May, 2000.

Fogli, Alessanda and Perri, Fabrizio. The Great Moderation and the U.S. External Imbalance. Federal Reserve Bank of Minneapolis. September 2006.

Heading Down. The Economist. March, 2003.

International Monetary Fund. Global Imbalances: A Saving and Investment Perspective. World Economic Outlook. September, 2005.

Macfarlane, I.J. Payments Imbalances. China and the World Economy. 2005.

Mann, Catherine L. Perspectives on the U.S. Current Account Deficit and Sustainability. Journal of Economic Perspectives. Summer 2002.

Recycling the Petrodollars. The Economist, November 2005.

Squaring the Circle. The Economist. February, 2006.

[1] Federal Reserve Economic Data. The second quarter U.S. current account balance amounted to -$218.41 billion on run-rate GDP of $13.2 trillion.
[2] Cooper, Richard N. Living with the Global Imbalances: A Contrarian View. Institute for International Economics. November 2005.
[3] Bernanke, Ben. The Global Savings Glut and the U.S. Current Account Deficit. Virginia Association of Economists. March 2005.
[4] Chinn, Menzie and Ito, Hiro. Current Account Balances, Financial Development and Institutions:
Assaying the World “Saving Glut”. Portland State University. October 2006.
[5] Bernanke, Ben.
[6] Cooper, Richard N.
[7] Dooley, Michael P. et al. Savings Gluts and Interest Rates: The Missing Link to Europe. National Bureau of Economic Research. July, 2005.
[8] Bernanke, Ben.
[9] International Monetary Fund. Global Imbalances: A Saving and Investment Perspective. World Economic Outlook. September, 2005.
[10] International Monetary Fund.
[11] Dornbusch, Rudiger and Park, Yung Chul. Contagion: How It Spreads and How It Can Be Stopped. World Bank. May, 2000.
[12] MacFarlane, I.J. Payments Imbalances. China and the World Economy. 2005.
[13] International Monetary Fund
[14] International Monetary Fund
[15] Bernanke, Ben.
[16] Heading Down. The Economist. March, 2003.
[17] Squaring the Circle. The Economist. February, 2006.
[18] International Monetary Fund.
[19] Cooper, Richard N.
[20] The Economist. Economic Data and Indicators.
[21] Recycling the Petrodollars. The Economist, November 2005.
[22] Mann, Catherine L. Perspectives on the U.S. Current Account Deficit and Sustainability. Journal of Economic Perspectives. Summer 2002.
[23] Fogli, Alessanda and Perri, Fabrizio. The Great Moderation and the U.S. External Imbalance. Federal Reserve Bank of Minneapolis. September 2006.