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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO JUNE 1995 NUMBER 94 Chicago Fed Letter The U.S. trade deficit: Is the sky really falling? on future real resources of the for U.S. investment abroad, payments to eign country. A U.S. im port from a foreigners derived from foreign in foreign seller reverses the transaction. vestment in the U.S., and unilateral transfers. The capital account reflects If a country’s goods trade is in bal After a lapse of some years, the U.S. net acquisition or sale of financial trade deficit is in the headlines ance during a specified period, resi again. In January 1995, the deficit in and direct investment assets by U.S. dents of that country have exchanged or foreign parties. goods trade increased to a near real resources of equal value. Over record $16.9 billion before backing any given period, however, only an An “individual” (private, corporate, off to $14.2 billion in February. In unusual set of circumstances would or governm ental entity) with com1994, the annual excess of goods produce such a result. Rather, a mittable funds faces a num ber of im ports over exports was a record country’s goods trade would normally alternatives. It may 1) purchase $166.6 billion, over $7 billion more be expected to be in “surplus” (sold goods and services domestically or than the previous 1987 record. A more abroad than purchased from 2) from abroad, 3) invest the funds record positive balance on trade in in real or financial assets domestical abroad—i.e., acquired net claims on services of $60.0 billion tem pered ly or 4) abroad, or 5) some com bina the future production of foreigners) the size of the overall deficit; none or “deficit” (sold less abroad than tion of the above. The choice of theless, the overall deficit on interna alternatives will depend on the indi purchased from abroad—i.e., as tional transactions (including sumed net liabilities against future vidual’s assessment of num erous unilateral transfers and investment domestic production in favor of for factors, including relative cost, ex incom e payments) stood at $155.7 pected return, risk preference, and a eigners) . A similar example could be billion in 1994, the second largest constructed for trade in services. broad range of utility preferences since 1987 and up sharply from the Again, only rare circumstances would including time preference. Because 1993 deficit of $103.4 billion. time preference is particularly im por result in a zero balance between ser vices exports and imports. Is the sky really falling, or are there no tant in shaping the balance between a country’s capital account and cur worries? Most recent commentary on The examples above essentially as rent account, I will spotlight that the subject has implied the former— sume instantaneous offsetting trans that a trade deficit is a problem. Many factor in the examples that follow. actions. However, as noted, a zero people believe that foreign capital balance at any given time is highly inflows (“foreigners buying up the The transactions unlikely. Thus we expect a positive or United States”) are also a problem. In negative balance on the goods trans Consider a situation in which a for fact, neither is necessarily the case. actions, and an offsetting capital ac Trade deficits or surpluses are neither eign buyer purchases goods from a count flow that U.S. exporter. In the transaction, the Indeed, implicitfinances them. trade inherently good or bad. The same is in unbalanced foreign buyer gives up funds and true for net inflows of foreign capital transactions are offsetting capital receives goods. That seems simple or net outflows of U.S. capital. This account transactions (see figure 1). enough, but what has really hap article puts trade deficits into sharper In reality, then, the trade balance and pened? The foreign buyer has ex focus by sketching the economic the capital account balance are two framework within which international changed funds (a general claim sides of the same coin. against future resources) for a specif one causes the other to To claim that trade takes place.1 some ic and current real resource (goods). misrepresents the underlying degree process. On the other side of the transaction, Current accounts and capital accounts the U.S. exporter has given up real resources (goods) in return for funds, The process The relationship between current ac which represent a general claim count transactions and capital account When trade transactions do not bal transactions is one of the more confus against the future resources of the ance, a net capital inflow or outflow foreign country. In sum, there has ing aspects of international trade. takes place. If there is a net im port of been a transfer of current real re The current account is made up of goods, i.e., a trade deficit, then by sources from the U.S. to the foreign international trade in goods and ser definition there are fewer funds recountry in exchange for a U.S. claim vices, net income from foreigners on Source: U.S. Departm ent of Comm erce, Bureau of Economic Analysis, National Income and Product Accounts database, various years. ceived from exports than funds paid for imports. That difference must be financed (borrowed) from abroad. In this sense, a negative balance in trade must be financed by an infusion of funds from abroad through the capital account. This would seem to suggest that trade flows drive the capital accounts. But capital account transactions may take num erous forms not intentionally related to trade transactions. Recognizing the various forms of capital transactions helps place in perspective the interre lationship between the trade and the capital accounts. Thus emerges a second basis for capi tal flows: investment. Taking invest m ent into consideration, one might conclude that capital flows drive the trade balance. Such capital transac tions could include the acquisition or liquidation of bank deposits, pur chase or sale of stocks or other private securities, direct investment purchas es or sales of plant and equipment, and the purchase or sale of govern m ent obligations. Emerging from this trade flow/capital flow relation ship is a framework of factors that determ ines the underlying “market clearing mechanism .” Underlying factors determining trade balances and capital flows During any given period, a constella tion of economic factors such as eco nomic growth, prices, interest rates, exchange rates, productivity, and governm ent policy interact such that a country may be a net im porter of real resources (and an im porter of capital), a net exporter of real re sources, or in balance. Residents of the net im porting (current-accountdeficit) country should understand that as a result of their country’s net real imports, the foreign exporter is acquiring claims against the net im porter’s future output. The goods im porter is in effect exporting claims against its future real production. It follows that when these claims are called, the form er net im porter be comes a net exporter; those future goods exported represent output that cannot be utilized in its home market. Looked at from the other side of the coin, the above situation may be de scribed as follows: Consider a constel lation of economic factors such that in the aggregate, residents of one country prefer to forgo current con sumption or domestic investment in favor of saving abroad (acquiring future claims on the real resources of a second country). Thus they “im po rt” foreign governm ent securities or possibly the ownership of foreign factories, rather than goods. If any of that constellation of economic factors change (e.g., relative interest rates, exchange rates, demographics, trade policies, or security holders’ views about the economic stability of the country whose securities are being exported), the change will feed into the time preference function of the securities importers. With an appro priate change in the relative mix of economic factors between countries, residents of the securities-importing country will choose to convert those future claims on foreign production (e.g., their holdings of securities is sued abroad) into claims on current foreign production. Thus an adjust m ent between the capital and current accounts may occur. Likewise, the time preferences of those who were formerly net im porters of real re sources may change as they look for ward to an environm ent in which the net acquisition of claims on future foreign production (positive net ex ports) appears preferable to the net im port of real resources. Now consider an example of a capital account transaction. A U.S. entity borrows funds by selling a security. After evaluating the options, a foreign entity decides to acquire the security as the best use of its available funds. The U.S.-originated security, in effect, is exported and becomes a claim by a foreigner against the future pro duction of the U.S. issuer. In this capital transaction, the foreign buy e r/ im porter has exchanged funds that represent a general claim against future real resources at home for a claim against the future real resources of the U.S. The foreigner has only changed the location of its claim against the future. As far as the U.S. is concerned, the sale (export) of the security represents an obligation to transfer real resources from the U.S. to the foreign country at some time in the future. An im portant difference between the current account and the capital ac count is the timing of the transfer of real resources. In effect, it is the interaction of the two accounts that facilitates different time preferences between countries with respect to the intercountry transfer of real resources. That is, in the aggregate, a country may elect for a time to consume more and attract more investment than it could currently produce domestically, if it pursues an appropriate set of poli cies vis-a-vis foreign countries. This can be accomplished only if in the aggregate, foreigners are willing to currently consume less and invest more abroad in anticipation of revers ing that pattern at some later date. In perspective The critical economic issue from the perspective of the capital-importing country is, how is the im ported (bor rowed) capital to be used in the do mestic economy? This same basic question faces any borrower of funds. In the simplest terms from a consum er’s perspective, borrowed funds are used to increase current consumption at the expense of future consump tion. In business, however, borrowed funds used to invest in improved pro ductivity and increased output can be 2. The role of capital inflows percent Net foreign investment in U.S./ domestic investment demand -5 -------------------------------------------------------------------------------- ____i___i__ i___i___i__ i___i__ i___i___i__ 1985 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 Source: U.S. D epartm ent of Com m erce. serviced and paid back in the future out of the resulting increase in in come, with a balance rem aining that contributes to a net real increase in income to the borrower. Thus cur rent as well as future consumption may be increased. But if the bor rowed funds are used to finance cur rent consum ption or nonproductive endeavors, the borrower will have to service and pay off the debt by cutting into its unenhanced future earnings or its capital base. Clearly, a net inflow of capital (a trade deficit) is not inherently unde sirable. Indeed, it may result in an increase not only in the current level of living, but also in the future level of living for residents of the capital im porting country. Certainly im port ed capital has been instrum ental in building the U.S. economy. The key issue is, to what use is today’s im port ed capital directed? This question is no less valid in 1995 than it was in 1985. Unfortunately, the answer remains pretty much the same, that is, not very clear. Net foreign investment in the U.S. (capital inflows) continues to be an im portant source for meeting the U.S. aggregate dem and for invest m ent funds.2 Since 1973, net foreign investment in the U.S. has registered an inflow in every year except 1977, 1978, and 1991. Net foreign invest m ent inflows as a share of dem and for investment funds peaked in 1987 at around 19% (see figure 2). The net foreign investment inflow share of domestic investment dropped sharply in the late 1980s, and by 1991 there was a marginal net outflow of funds (net U.S. investment abroad). Since then, however, net foreign investment in the U.S. and the share of invest m ent funds dem and provided by net foreign investment has increased again. During 1994, net foreign in vestment rose to more than 12% of domestic investment demand. Is net foreign investment financing productive activity? W ithout ques tion, a substantial portion of it is. But if net foreign investment at the mar gin is used to finance nonproductive governm ent deficits or nonproductive private spending, the productive im pact of net foreign investment is weakened. W hether and to what extent this is happening is an open question. Further complicating the issue is the fungibility of domestic versus foreign investment funds. Should the U.S. be trying to reverse the current account/capital account relationship? This is a deceptively simple question with no simple an swer. However, if the present rela tionship between the current account and the capital account were re versed, the domestic economy would look quite different than it now does. In fact, at recent and current levels of economic output and private and governm ent “investment,” and given the composition of monetary, fiscal, trade, and administrative policies in place in the U.S. and abroad, the U.S. economy requires net foreign capital inflows and, in turn, a trade deficit. W hen an economy is structured such that, for better or for worse, it re quires net capital imports, it makes little sense to complain too loudly about trade deficits. The two are inextricably related. A change in that relationship would require larg er current exports of real resources than current im ports of real resourc es. If other things stayed the same, this would result in a lower level of living domestically than otherwise would be the case. So was Chicken Little right? No, the sky is not falling. But to assert that there are no worries overstates the case. There is basis for concern if borrowed foreign capital has been used to finance nonproductive en deavors, public or private. To ignore this aspect of the trade flow/ capital flow relationship risks placing addi tional pressures on unenhanced fu ture output when foreign creditors take their gains in real product. —-Jack L. Hervey Senior Economist This article draws in some detail on Jack Hervey, “The internationalization of Uncle Sam,” Economic Perspectives, May/ June 1986, pp. 3-14. Given the current state of debate about the trade deficit, this discussion seems as timely now as it was in the mid-1980s. Tor this article, a measure of the de mand for such “investment” funds is drawn from the National Income and Product Accounts database—the sum of 1) private gross domestic investment and 2) the excess of government expendi tures over receipts (federal, state, and local). Net foreign investment is the sum of net exports, net receipts of factor income from foreigners and payments of factor income to foreigners, and net transfer payments. Michael H. Moskow, President, William C. Hunter, Senior Vice President and Director of Research; David R. Allardice, Vice President, regional programs; Douglas Evanoff, Assistant Vice President, financial studies; Charles Evans and Kenneth Kuttner, Assistant Vice Presidents, macroeconomic policy research; Daniel Sullivan, Assistant Vice President, microeconomic policy research; Anne Weaver, Manager, administration; Janice Weiss, Editor. Chicago Fed Letter is published monthly by the Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ and are not necessarily those of the Federal Reserve Bank of Chicago or the Federal Reserve System. Articles may be reprinted if the source is credited and the Research Department is provided with copies of the reprints. Chicago Fed Letter is available without charge from the Public Information Center, Federal Reserve Bank of Chicago, P.O. Box 834, Chicago, Illinois, 60690-0834, (312) 322-5111. ISSN 0895-0164 ■ ■ ■ ■ ■ ■ ■ H I ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ Domestic light vehicle production strengthened in the first quarter on a seasonally adjusted basis. Car production rose to its highest quarterly level since the first quarter of 1989, and light truck output flattened out at high levels. New light vehicle sales reportedly weakened in recent m onths, how ever, and domestic vehicle output is currently scheduled to fall back some what in the second quarter. Some special factors played an im portant role in dam pening auto sales in early 1995, including incom e tax effects, redesigns of popular models, lower incentives, and higher interest rates on auto loans. Sources: The Midwest Manufacturing Index (MMI) is a composite index of 15 industries, based on monthly hours worked and kilowatt hours. IP rep resents the Federal Reserve Board industrial pro duction index for the U.S. manufacturing sector. Autos and light trucks are measured in annualized units, using seasonal adjustments developed by the Board. The purchasing managers’ survey data for the Midwest are weighted averages of the sea sonally adjusted production components from the Chicago, Detroit, and Milwaukee Purchasing Man agers’ Association surveys, with assistance from Bishop Associates, Comerica, and the University of Wisconsin-Milwaukee. IIIS"£S£ (2lg) PF80-06909 siouim ‘oSnaii^ P£8 xog O d J31U33 uop^imojuj ogqnj OOVOIH3 3 0 3NV9 3A33S33 3VH3CI33 JTTUT] poj (Xoi’diiy )