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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.

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