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July 20, 2005
Are American Consumers Responsible For The Large Trade Deficits?
Professor Hamilton, continuing to bat 1.000 with his posts, thinks that, yeah, they are:
I agree very strongly... that net foreign borrowing is not in and of itself a bad thing. In my mind, it really all depends on why we're doing the borrowing. If businesses were using the borrowed funds to do additional investing in plant and equipment, then even though we'd be owing more to foreigners, we'd also be creating the additional productive resources with which to pay them back and provide for our own future as well. Or if there was some good reason why we temporarily have a great need to borrow and would be in a better position to pay for what we now want at some point in the future, it might be a good idea to sell off some of our assets or go more deeply into debt to those in other countries.
But I see neither of these as a good description of our current situation. Investment has actually declined as a fraction of GDP over this period, and I don't see why it's going to be that much easier for either the government or private households to pay off that debt in the future. Instead to me it has more the appearance of a consumption binge.
I certainly agree that our large current account deficits -- the flip side of a lot of net foreign borrowing -- cannot be attributed to an extraordinary investment boom. And I am, for the sake of argument, willing to accept the proposition that there is not a "good reason why we temporarily have a great need to borrow." I think that this is at least arguable, but as I hope will become clear I believe it to be beside the point anyway -- to me, our current situation does not feel like a consumption binge.
Here's why. What would I expect the world to look like if borrowing from foreigners was indeed being driven by an autonomous decision by consumers to save less and spend more? To answer that, let's start by assuming that there is no rest of the world -- that is, assume that in any given year U.S. consumption, investment, and government purchases must sum to the amount of goods and services produced during the course of that year.
Now suppose everyone arises one fine morning and decides it's a good day for a consumption binge. Assuming that we hold the government's behavior fixed, the eventual effect will be that consumption spending "crowds out" investment spending by firms. By what mechanism does some investment spending drop out of the picture? Rising interest rates.
Things don't really change if we allow some amount of the consumption binge to be financed by borrowing from foreigners. The pressure on domestic investment and interest rates will certainly be mitigated by the "safety valve" of imported goods and services -- which, at the end of the day, are paid for by borrowing -- but the basic qualitative effects are the same.
To put it short: I find it hard to reconcile the "conundrum" of low market interest rates with an explanation of large current account deficits and net borrowing from foreigners that hinges primarily on an exogenous increase in desired consumption spending by U.S. households (which is how I am, perhaps incorrectly, interpreting the phrase "consumption binge").
What I don't find hard to reconcile is a story that is fundamentally about low saving rates being driven in large part by low interest rates, which themselves are a result of some third (or fourth or fifth) source.
What are my candidates for this source? I'll start with the global saving glut. Or if that term turns you pale because it does not sufficiently distinguish between private and public (read central bank) sources of foreign funds, call it the global dollar demand glut. In either case, a willingness by foreigners to absorb U.S. debt ultimately corresponds to a willingness to export goods and services to the United States. Absent a desire by U.S. consumers to automatically absorb those exports, prices adjust to stoke those desires -- lower interest rates, for example, that do the work of stimulating consumption spending.
I'll add to the list the oddly muted desire on the part of firms to invest in plants and equipment. Although investment demand over the past four quarters has been reasonably good, I would still characterize it as restrained. Here's an update of a picture I posted many months back:
Although the ratio of cash-flows to investment has fallen off of its peak, by historical standards the ratio is still quite high. This is not a picture that suggests a full-throttle investment environment to me. All the more reason to suspect that low interest rates, and the resulting stimulus to consumption spending, would be the order of the day.
Does this mean that our current account deficits are completely benign? No, not at all. But if my interpretation of things is the right one, it does suggest that we would be better off asking -- and formulating answers to -- questions like "Why aren't firms investing?", or "What is the appropriate policy response to a global dollar demand glut?", rather than "Why won't households save?"
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