16 September 2005

**BORE ALERT** A Quick Macroeconomics lesson

Real World Economics
by Ed Lotterman

In modern economies, trade in physical goods is only one component in determining international money flows. Services also flow, whether it be a Minneapolis architectural firm designing a housing project in Korea or a German insurance firm selling variable annuities to U.S. households.

Then there are government payments. The United States gives some $3 billion per year to Israel. Tens of thousands of Social Security and military retirement checks go to U.S. retirees in Costa Rica, Mexico and Poland.

Personal remittances enter in, too. Philippine maids in Hong Kong send money back to their families.

All of these payments — trade, services, investment income, remittances, government payments — fall into a category called the "current account."

Investment income plays a big role. Dutch insurance companies get interest payments on U.S. Treasury bonds they hold. 3M sends profits from its Belgian subsidiary back to Maplewood.

All of these financial flows go into a category of the balance of payments called the "current account." This is the account in which we are running large deficits.

Capital flows are the other major category and are tabulated in a capital account. When the Dutch insurance company bought the T-bonds, that initial principal investment was booked in the capital account, as was 3M's spending in Belgium.

The flip side of a large current account deficit, as the United States currently has, is a capital account surplus. We are buying more abroad than we sell, or paying more income abroad than is received here, or remitting more money to foreign families and governments than they send to us.

But far more money is being invested in the United States than U.S.-based entities are investing abroad. Our capital account surplus is large.

This raises two "pushed or pulled" questions.

First, is capital flowing in because the U.S. is such a great place to invest, or because Japan, Europe and Latin America are such lousy, poor-return alternatives?

More important, are we on an import spree because all the foreign money pouring into the United States has to find a way out? Or is so much capital flowing in because our voracious importing is flooding the world with dollars that have to find a way back somehow?

The answers to these questions are not clear. But a recent Federal Reserve study confirms what economic historians have long known: Current account deficit binges reverse themselves eventually. The Fed found that this usually occurs about when the deficit hits 5 percent of GDP. We are reaching that point now.

It also found that the reversals usually lead to a fall in the exchange rate of about 40 percent. If this happens, Chinese-made clothes at the mall will be sharply higher in price. And Minnesota wheat in Rotterdam will be cheaper. Exporting producers will benefit but consumers will see higher interest rates and prices.

The tide reverses when foreign investors no longer want to risk spending large amounts of their currency to buy the expensive dollars necessary to invest in the United States.

As foreign demand for investing in the United States falls, so will the dollar in relation to other countries. When foreigners with existing U.S. investments see these assets fall in value in their domestic currency many will depart.

And as foreign investors reduce their U.S. holdings, there will be less available capital in the United States and this supply reduction will force up the price of capital — interest rates. Stock and bond prices will fall. The Fed could compensate by increasing the U.S. money supply, but this would feed inflation at a time when a weakening dollar was reducing the downward pressure cheap imports put on U.S. price levels.

© 2002 Edward Lotterman
Chanarambie Consulting, Inc

**YAWN** Are you asleep yet? Frick, economics was always such a bore.

1 comment:

Mrs The Experience said...

And to think, while you were posting this, I was having mad ferret sex. All along I could have been reading this!