People, including self-styled experts, need something to worry about. In the United States, they have found it in the large trade and current account deficits. To be fair, there is some reason for concern over chronic sizable current account deficits, but this is based on the experience of the typical developing country. The United States has many characteristics of a developing country, but it is also very different.
The Nature of Developing Countries
A developing country generates more investment opportunities than its residents can take advantage of with their own savings. Developing countries with rapidly increasing investment opportunities run current account deficits since they buy from the rest of the world more goods and services, often including inputs for the goods that they produce, than they sell to the rest of the world. The current account deficit by definition equals the net capital inflows that finance investment in excess of domestic savings plus any changes in foreign exchange reserves by the country's monetary authority.
For rapidly developing countries such as the Asian tigers or the Latin American stars, the capital inflows are viewed as a sign of strength--a testimony to the attractiveness of investment opportunities inside the country. The big problems that traditional developing countries face are emerging currency overvaluation and rising domestic inflation. As capital surges into a developing country, its currency tends to appreciate, thereby undercutting its ability to sell its goods in the global marketplace.
The monetary authority may intervene to mitigate the currency appreciation by purchasing foreign exchange, often dollars. The intervention results in an accumulation of foreign exchange reserves and a rise in domestic liquidity and inflation pressure. To mitigate the higher inflation pressure, the monetary authority can "sterilize" the impact of capital inflows on the domestic monetary base by selling bonds to the commercial banks. Put another way, the central bank borrows the capital inflows back from the commercial banks so that they cannot add to domestic liquidity and domestic inflationary pressure.
The problem with sterilizing capital inflows is that the underlying condition, a need for more domestic liquidity, remains undisturbed by capital inflows, which therefore continue. Eventually, the capital inflows may overwhelm the ability or the willingness of the monetary authority to sterilize them; in that case, avoiding currency overvaluation involves allowing more domestic inflation. In turn, the domestic inflation eventually undermines the currency since imports rise and exports tend to fall under conditions of rising domestic excess demand. In these circumstances, a currency crisis often ensues as it did late in 1994 in Mexico and, more recently to varying degrees, in Thailand, the Philippines, Indonesia, and the Czech Republic.
The fundamental problem that results in a currency crisis and devaluation for most traditional developing countries is the surge in domestic absorption (spending), relative to domestic production, that results from much faster, investment-driven growth. As spending growth accelerates in a traditional developing country, the current account deficit rises faster than the capital inflows, thereby creating incipient pressure for the currency to depreciate. The currency depreciation, in turn, causes capital inflows to dry up and perhaps even to become outflows as local capitalists seek to protect the purchasing power of assets accumulated in the country's boom era.
Monetary authorities in developing countries are forced to raise interest rates sharply and usually to devalue in order to reduce domestic absorption sharply until output exceeds expenditure. Under this condition, capital outflows are matched by a current account surplus, the exact opposite of the heady experience of having been a favorite developing country in a liquid world, where investment funds are searching for higher returns and creating a surge in capital inflows that allows domestic expenditure to exceed domestic output.
The idea that it is developing countries that are supposed to have current account deficits, together with the usual progression toward a currency crisis and a need for sharp reversal of expansionary policies, makes trade deficits and current account deficits somewhat suspect in the eyes of global market players, not to mention global monetary authorities. Current account deficits have come to carry the connotation of a temporary high that one later regrets. The initial effect of a second or third martini, compared with the next day's hangover, comes to mind.
If global market players and monetary authorities are ambivalent about current account deficits for developing countries, which are supposed to have them, they are doubly ambivalent about current account deficits for advanced industrial countries such as the United States. According to the textbooks, advanced industrial countries are supposed to run current account surpluses so that they generate excess savings to finance investments abroad in the more spritely developing countries of the world.
The model of England in the nineteenth century comes to mind. England was a traditional mature developing country that generated far more production and income than it could absorb and so shipped the resulting savings abroad to accumulate claims on foreign assets to enhance future consumption.
The twentieth-century version of the United Kingdom as a well-behaved developing country was Japan, at least until 1990. Japan ran a rising current account surplus and invested heavily abroad. It is probably no accident that both Japan and England were advanced industrial countries that fit the traditional pattern of current account surpluses. Part of the reason turned out to be the ease with which domestic savings exceeded domestic investment opportunities because domestic investment opportunities were not plentiful. Japan and England are both, after all, small island nations without large stocks of natural resources.
In the late 1980s Japan proved that a nation can invest too much. Overinvestment in Japan drove the rate of return on savings so low that excess capacity emerged and ultimately developed into a major deflationary crisis. Simultaneously, the deflationary crisis caused the currency to appreciate, thereby causing Japanese investors to lose heavily on their accumulated foreign investments. Somewhat remarkably, the Japanese experience in the 1990s has not produced a radical change in the attitude of global market players and monetary authorities toward the intrinsic desirability of current account surpluses, even in advanced industrial economies.
The Criterion and the United States
By the criterion of the level of domestic investment opportunities relative to domestic saving opportunities, America is a developing country. This fact, highlighted by a string of American current account deficits that since 1981 have surpassed $1.5 trillion (still only one-fifth of one year's gross domestic product) has been the subject of much hand wringing. America's twin deficits--its current account and budget deficits--have long been decried as signs of inadequate savings in the United States, with the clear implication that continuation of such behavior would not be in the best interest of the United States. The 1990s, somewhat inconveniently for America's twin-deficit Cassandras, has brought virtual elimination of the federal budget deficit, so that now America's current account deficit--which reached a record of $167 billion last year--is largely a reflection of the shortage of domestic savings relative to private investment opportunities.
Actually, the rise since the early 1990s of the American current account deficit to a level equivalent to about 2 percent of GDP is a sign of rising strength of the American economy. American savings have not risen sharply in this expansion, but American investment opportunities have. America's climbing current account deficit, financed by increasing private and official foreign capital inflows from abroad, still leaves many market players and policy makers uneasy. Deprived of an ability to complain about the budget deficit, America's saving-shortage doomsayers now complain that our current account deficit is partly financed by rising purchases of U.S. Treasury securities by foreign central banks. While this was true until about the middle of 1996, and continues to a lesser degree, it is another sign of U.S. strength. The rising purchases of U.S. Treasury securities by foreign central banks is the mirror image of a desire on the part of those foreign central banks to avoid dollar depreciation since a weaker dollar would render many producers in Asia and Europe unable to compete with U.S. producers. In that sense, the desire of foreign central banks to shore up the dollar is a sign of U.S. strength, not weakness.
More recently, private capital inflows into the United States have risen while purchases of dollar assets by foreign central banks have been reduced. Still, the dollar has appreciated, in no small part because of signs of increasing excess capacity in emerging markets and steady atrophy of the Japanese "growth scare" (the Japanese economy was supposed to achieve self-sustained growth during 1997; that would, in turn, require higher interest rates from the Bank of Japan). This latter scenario is becoming increasingly doubtful as Japan struggles under the weight of continuing fiscal drag, 14 percent trade-weighted appreciation of the yen, and competitive devaluations within Asia by countries such as Thailand, the Philippines, and Indonesia to gain a competitive edge against Japanese goods in global markets.
The dollar has also strengthened against European currencies. The election of socialists in France has enhanced the inclusion of Italy, Spain, and Portugal in the new European Monetary Union, thereby suggesting to markets that the new currency, the Euro, will not be as hard as the deutsche mark. Most European producers fervently hope for this outcome.
Good News about America
These rosy reasons for the strength of the dollar have created an aura of nirvana for the outlook of the U.S. economy, which by definition makes most observers nervous simply because it is difficult to imagine the economy getting much better. Given all this, the attitude of the rest of the world toward America's good fortune does not appear to be totally benign, as demonstrated at the recent Denver summit. In the Mile-High City, it was fashionable to grumble about U.S. boasting, and President Clinton and Treasury Deputy Secretary Summers probably did lay it on a bit thick. What was really galling to Europeans and Japanese was the truth of the situation. Except for its Anglo-Saxon coconspirator, the United Kingdom, America is currently the only G-7 nation where attractive high-yield investment opportunities exceed domestic savings, thereby creating the ambivalently viewed symbol of American success, the current account deficit.
America is an advanced developing country with delicious additions: the ability (willingness) to absorb over $ 160 billion worth of net capital inflows per year (over 2 percent of GDP); a stable currency with a tendency to appreciate; excellent and deep capital markets; and a relatively liberal attitude toward foreign investment. Contrast this with the downright nasty paranoia about foreigners exhibited by Thailand's government during its recent crisis and the difficulties of investing in Japan with its primitive domestic infrastructure. Why shouldn't more capital flow into the United States?
With all this good news about America as Europe struggles to reduce its budget deficits in the name of yet to be achieved structural reform and as Japan's growth prospects begin to melt away, the addition of American gloating to its G-7 partners about the richness of U.S. investment opportunities is a little like chuckling from an oasis at passing parched caravans that are too proud to ask for water: they do not want to be reminded of their problems by someone who does not have them.
On top of all these strong attractions of investment in real property and projects in America is another powerful one: investment is underpriced, in the sense that there is effective rationing of access to U.S. investment opportunities. The U.S. government rations access, especially for Japanese investors, by signaling its unwillingness to tolerate rising current account deficits, at least with Japan. Such rising current account deficits are the necessary mirror image of rising capital inflows. Complaining about America's trade deficit with Japan is one of the few foolish indulgences of U.S. economic policy makers.
Other governments restrict access to U.S. investment opportunities by attempting to create artificial incentives at home that eventually drive down returns on new investment and by raising uncertainty about exchange rates, as the Japanese government did in April and May of this year. By scaring Japanese capital into staying at home, Japan's economically inept government has only forced real returns on financial assets in Japan even lower. No one in Japan is investing in real assets.
The higher real returns so desperately sought by Japan's investors, including its rapidly aging population, cannot simply be mandated, as many of Japan's politicians have urged. Rather, they can be induced only by broad deregulation that reveals clearly the economic redundancy of Japan's doddering nontraded goods sector. Then, after some considerable transitional pain, Japan would experience a strong investment boom as it built a modern nontraded goods sector, thus bringing over two-thirds of its economy up to modern industrial standards. Foreign capital would surge in, and Japan might even experience the delights of a current account deficit. Dream on.
The American post-cold war investment boom flowered in the early 1990s, once military needs ceased to absorb the cutting-edge resources in our technological sector. How would Microsoft, Intel, and the creators of the modern computer revolution have flowered if the Pentagon had been hogging all the best technology and technological minds for itself in a continuing cold war? The remarkable, noninflationary investment-led boom of the 1990s is a strong reminder of the heavy cost of five decades of obsession with military technology. Allowing the energy that went into developing proprietary military technology to refocus has given wing to the American economy but not yet to the G-7 free riders that grew soft under the American defense umbrella.
Now, in 1997, we still have the old thinking that the 2 percent of America's GDP represented by net capital inflows, our current account deficit, is a sign of weakness--a sign that the dollar needs to grow weaker. If we manage to mark down the dollar as in the recent dollar-yen episode, our current account deficit will rise because investment in the United States will become even more attractive while U.S. saving will be largely unaffected.
We could, if we wished, eliminate the current account deficit by having foreign governments truly remove all constraints on capital outflows, as Japan claims it will do on April 1, 1998. The resulting surge of capital inflows would push up the dollar until investment in the United States became too expensive for foreign investors and U.S. production locations became too expensive for American companies. The latter would be forced to begin to relocate production facilities abroad for exchange rate reasons, just as the Japanese did during the early 1990s. Then, America's heavy demand for imported goods would fall. America's traded goods sector would be relocated outside its borders, a situation not likely to be permitted by our nervous trading partners.
Alternatively, as the dollar appreciates, the Federal Reserve, like the central bank of a developing country, could lower interest rates and ease monetary conditions to increase U.S. domestic absorption. The result, provided that domestic absorption did not rise too rapidly, would be a tendency to dull the deflationary pressures being exported to the United States by countries seeking to weaken their currencies against the dollar. This line of thinking suggests the possibility that, rather than tightening over the next year, the Fed may actually ease because of global excess capacity and the attendant tendency of the dollar to appreciate. While this path seems unlikely in view of the strong growth of demand in the United States and some modest reflationary efforts in Europe and Japan over the next several years, the failure of faster growth in the United States to excite inflationary pressure is probably due to rising global excess capacity.
If, however, enough deflationary pressure is exported to the United States by a rising dollar, the Fed will ease to avoid global deflation. This would constitute a complete reversal of the pressures on the Fed to tighten before August 1971, during the late stages of the Bretton Woods system of fixed exchange rates. Many policy makers, seeing America's rising current account deficit, mistake today's conditions as similar to those in the early 1970s. They are the reverse. Today we are flirting with disinflation, while in the several years before 1971 and thereafter we were experiencing rising inflation.
The incipient and actual strength of the dollar has already required active rethinking of exchange rate policies by developing countries. Pegging to a stronger dollar results in chronic overvaluation and deflationary pressures. The recent currency crises in Thailand and in other member-nations of the Association of Southeast Asian Nations, with the attendant float of the Thai baht, offer examples of the remedies necessary for countries pegged to an ascendant dollar. The investment boom, transforming the U.S. economy from the world's most technologically advanced military power to the world's most technologically advanced economic power, has made the United States into a developing country, albeit an advanced one. Developing, and developed, economies that try to run with America over the next half-decade will fall prey to deflationary crises if they do not avail themselves of some relief from a depreciation against the dollar. Japan, Thailand, Germany, and France are a few illustrations, each with varying degrees of intensity.
America could experience the usual plight of a developing country: a drift toward overabsorption or too much spending, which, in turn, creates inflation pressure. In the short run, however, the outlook is for a stronger dollar either way. If global excess capacity creates deflationary pressure, then countries in Asia and Europe, attempting to maintain adequate demand for their products, will be forced to depreciate their currencies. The resulting dollar appreciation will keep shifting demand away from U.S. productive capacity while imparting some disinflationary pressure to the U.S. economy, as we have seen since spring. Based on the comparison between yields on ten-year Treasury inflation index bonds and normal Treasury bonds, U.S. long-term inflation expectations have dropped by seventy-five basis points during the past three months.
Alternatively, if U.S. inflation does pick up later this year--as it could if the pressure on U.S. productive capacity grows excessive--inflationary expectations could rebound rapidly, and with them U.S. market rates would rebound as well. Under such circumstances, the Federal Reserve would likely act preemptively to raise interest rates. A preemptive Fed would raise U.S. real interest rates and thereby cause the dollar to continue to appreciate against the currencies of Europe and Japan that are likely to be experiencing slower growth over the balance of this year.
The United States should be less vulnerable to the eventual excess absorption that forces developing countries to devalue. A necessary condition for net capital inflows to result in devaluation is a rise in domestic expenditure that causes the current account deficit to rise more rapidly than net capital inflows. As long as U.S. investment opportunities continue to grow while U.S. demand growth continues to be moderate, there will be no need for dollar depreciation. In fact, the opposite--dollar appreciation--will persist.
Like most investment-led recoveries, the limits for the expansion of the U.S. economy will probably come with a temporary exhaustion of investment opportunities. As U.S. investment opportunities become fully exploited, the returns on investment in the United States will fall, thereby resulting in a reduction in desired capital inflows. Under those circumstances, even a slight increase in U.S. demand growth will require dollar depreciation and tighter U.S. monetary policy. The tighter policy would push up rates and slow down demand growth as earnings growth slackens. The combination of higher U.S. interest rates and more gradual earnings growth would result in a lower stock market and probably an end to the expansion phase of the U.S. recovery.
It is virtually impossible to pinpoint the time at which U.S. investment opportunities will stop growing. By that time, we can hope that rapid deregulation of heavily regulated economies such as Japan, Germany, and France will have created enough investment opportunities to keep global economic expansion on track. Then those nations will be able to enjoy a current account deficit as the world's newest group of developing countries.
John H. Makin is a resident scholar at the American Enterprise Institute.