I have two basic disagreements with the formulation of the Rule Breaker column (from May 30th) regarding the significance of international trade deficits.
First, David implied that international services are not counted in the calculation of trade deficits. In fact, they are. This is only a technical point. The misconception involved in the Rule Breaker report's exclusion of services is not central to its thesis that U.S. trade deficits are healthy.
Secondly, and more importantly, investment inflows into the U.S. capital markets are good and healthy in some circumstances, but not all. This point has substantive implications.
The trade deficit is calculated by netting exports of goods and services against imports of good and services. The U.S. runs a deficit in its goods account and a surplus in its services account. Overall, since the deficit in its trade in goods is substantially larger than the surplus in its services account, the U.S. is said to run a "trade deficit."
Theoretically, in the absence of exchange conversion or central bank intervention, the payments position of any nation must be in balance. The trade deficit is matched by claims of foreigners on the U.S. The issue becomes how easily the trade deficit can be financed.
From an investor standpoint, the focus must be on when the deterioration of the U.S. trade deficit occurs at a rate that is unsustainable. Here sustainability connotes the ability of the United States to finance its trade deficit comfortably based on the anticipated demand of foreign investors to hold U.S. securities.
In hindsight, we can see that in 1972 and again in 1986 the U.S. trade deficit grew to a high percentage of Gross Domestic Product, leading to congestion in the U.S. financial markets. The trade deficit stands at even higher levels today.
However, this time it may be different. Formerly, there were substantial restrictions on the free movement of capital among nations. Arguably, the trade deficit tended to be the driver in the evolution of the balance of payments, with the capital account responding to the exigencies of trade. A high trade deficit was a surer sign that excessive U.S. domestic demand for goods and services was generating more U.S. debt than the market would be comfortable in holding.
More recently, with the opening of the capital markets, it is capital flows that appear to be the driver, and the trade balance responsive. How does this occur? A substantial inflow of investment into a nation creates investment demand for its currency. As its currency appreciates, that nation's trade terms are disadvantaged, contributing to its trade deficit. With a stronger currency, its exports are priced more dearly and its imports appear cheaper.
The Rule Breaker report assumed that attracting a capital inflow is always healthy. It is here that the report oversimplifies. If the capital inflow comes in the form of permanent investment, it is indeed healthy. If the inflow comes in the form of temporary investment, it may be potentially destabilizing and unhealthy.
We have seen this latter phenomenon most commonly when so-called less developed countries have attracted temporarily large inflows of funds, perhaps placed there on the false assumption of stability in exchange value of their currencies that proves ephemeral. The results can be unpleasant when foreign capital races for the exit.
The key in evaluating the health or malady of a trade deficit is the form of the flows into the debtor nation. Direct investment in business operations is good. A sharp buildup of funds in bank accounts, which may be withdrawn on short notice (and converted into foreign currencies), is probably a bad sign. In between, there are a whole variety of investments that are hard to categorize. Is investment in U.S. bonds, which are readily marketable, but may carry intermediate or long-term maturities, good or bad?
The mix of funds constituting the capital inflow into the U.S. may be healthier now. Bank accounts tend to account for less of the flows. In this sense, the U.S. trade deficit is better financed. The conclusion is consistent with the improved credit standing of the United States due to its balanced budget, higher productivity, and projected growth rate.
But, in the final analysis, the deterioration of the U.S. trade deficit may be seen as yet another window into the more basic question of whether the U.S. securities markets have been driven by irrational exuberance. As such, and given the globalization of markets, the U.S. trade deficit may be too narrow a fulcrum for resolving the issue. While the level of sustainable demand for U.S. securities may be critical at any juncture, the identity of investors as foreign or domestic is merely incidental.
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