Our Capital Account Surplus

A recent Associated Press headline was, "Current Account Trade Deficit Posts Unexpectedly Large Improvement." It fell by 6.5 %. But why assume that was an improvement? After all, the current account deficit "improved" during every recession, and even moved into surplus during the worst recessions of 1975 and 1980-81.

The Economist’s survey of world forecasters estimates the current account deficit will reach 7.3 % of GDP in Spain this year and 5.6 % of GDP in Australia. I think the U.S. current account deficit will be about 6.5 %, the flip side of which means that 6.5 % of GDP measures the difference between foreign investment rushing into the United States minus the amount of U.S. investment flowing abroad. We have a large capital surplus, otherwise known as a current account deficit.

What do countries with large capital account surpluses have in common? Economic growth over the past year was 3.1 % in Australia, 3.5 % in Spain and 3.6 % in the United States. The expected current account deficit is smaller in the United Kingdom (2.7 %), yet British economic growth is also slower (2.2 %). India’s current account deficit is running about 2.5 % of GDP. By contrast, Germany has a perpetual current account surplus and a pathetic economic growth rate that has long been stuck close to 1 %.

Since the third quarter of 2003, U.S. exports of goods alone have increased at a 9.7 % annual rate in real terms — more than double the 4 % growth of real GDP — while real imports of goods increased at a 9.2 % rate. The United States is a big exporter of plastics, aircraft, specialized industrial machinery, scientific instruments, corn, cotton and soybeans. But producing and shipping such products requires importing oil and natural gas.

In April 2006, imported oil and natural gas accounted for 34 % of the U.S. merchandise trade deficit. That was not because we guzzled more oil. The quantity of imported crude oil was 7 % smaller than a year earlier, yet the cost was 18 % higher.

One of the most persistent myths about semi-free trade or globalization is the idea that countries with trade deficits must be losing manufacturing jobs to countries that run trade surpluses. Japan and Germany have run chronic trade surpluses for many years, particularly in manufactured goods, making it easy to find out if this theory works.

From 1992 to 2005, according to the Bureau of Labor Statistics, the number of manufacturing jobs fell by 16.3 % in the United States, from 20.1 million to 16.3 million. But the number of manufacturing jobs fell by 24.1 % in Germany (from 10.7 million to 8.1 million) and by 27.2 % in Japan (from 15.7 million to 11.4 million).

Chronic trade surpluses were a sign of capital flight, not industrial might. Since 1992, industrial production has increased 11.5 % in Japan, 18.9 % in Germany and 59.7 % in the United States. People in Japan and Germany sold goods to the United States in order to get the dollars they must have to invest in the stronger U.S. economy.

As long as people are free to invest wherever they like, global balance is literally impossible. Yet several economists have made careers out of fretting about "global imbalances." They never define current account surpluses as "imbalances," which puts all the emphasis on belt-tightening among vigorously expanding economies, rather than pro-growth policies among the laggards.

In the process of advocating a Federal Reserve policy "predisposed more toward tightening," Stephen Roach of Morgan Stanley frets, "There is always a chance it’s too late — that America’s imbalances are so advanced, the only way out is the dreaded hard landing."

A hard landing means lower stock and housing prices, yet lower asset prices is precisely what Roach wants the Fed to accomplish. In a startling confusion of cause and effect, he worries the United States must "run massive current account and trade deficits in order to attract foreign capital." Investors are attracted to countries because of their current account deficits?

In the words of that previously mentioned AP report, "The concern is that the current account deficit could grow so high that foreigners would become less willing to hold U.S. assets. If they began dumping their U.S. holdings, it could depress stock prices, send U.S. interest rates higher and cause the dollar’s value to fall sharply."

That "hard landing" mantra seems to be the equivalent of the phrase "Hare Krishna" for some economists, who never tire of repeating it. But what does it mean? If foreigners "dumped" U.S. stocks and bonds, who would they sell to and how would they be paid? If they could somehow sell U.S. assets only to Americans, then foreign investors would suffer a capital loss at the expense of American bargain-hunters.

Regardless of where the buyers lived, those foreign sellers of dollar-denominated assets would be paid in dollars — they would have dollar cash and the buyers would have dollar assets. Why would the dollar fall? Not because of the current account deficit, because the hard landing argument insists that if the current account deficit could not be financed then it could not exist. Besides, if there were any connection between current account deficits and exchange rate movements, then it would be child’s play to make billions by speculating on exchange rates.

Why would those who supposedly rushed to liquidate U.S. assets in exchange for dollar cash be eager to swap those greenbacks for euro or yen? That might make sense if they wanted to invest in European or Japanese stocks and bonds, yet those markets always collapse whenever U.S. markets merely tumble. In any case, dips in the prices of U.S. stocks make them cheaper and more attractive to world investors, not less attractive.

What about foreign governments? Official capital inflows declined by 48.6 % from 2004 to 2005, yet nothing noteworthy happened as a result. The inflow of foreign official money invested in the United States dropped from $147.6 billon in the first quarter of 2004 to just $19 billion a year later, but the hard landing crowd did not even notice. When foreign central banks stop buying U.S. Treasury bills and bonds, somebody else buys them. The demand for U.S. bonds is huge, as proven by their low yield.

There are doubtless many things worth worrying about. But the interminable bleating about current account deficits, global imbalances and hard landings is once again sounding remarkably similar to fearing the sky is falling.