Borrowed Savings A nation's capital account is the other side of the current account coin. Basically, it measures the difference between saving and investment. When a nation's personal income, business net income, and government revenue (federal, state, and local) are insufficient to fund its consumer spending, business investment, and government spending, then it must attract foreign capital to cover the difference.
This creates a capital account surplus, which means a country sells more of its capital assets (for example, government bonds or shares of American companies) to foreign countries than it buys of theirs.
Countries like the United States that have current account deficits necessarily have capital account surpluses of exactly the same magnitude; the two accounts must balance. Viewed from one angle, the United States must sell some of its assets to pay for the fact that it imports more goods than it exports.
RISING FAST: The United States' current account balance, which includes trade and investment flows, is running a growing deficit that represents more than 6 percent of GDP.Indebted to the World Viewed from another angle, we have a trade deficit because we are spending more than our income and have to import savings to close that gap.
To some, this all seems like a virtuous circle: (a) the United States has not been saving nearly enough to finance its consumption, investment, and government spending; (b) investors in other countries like to invest in our country; so (c) we borrow the needed savings from abroad, thereby running a capital account surplus and a trade deficit.
Over the last several years, however, private investors have mostly pulled back. The trade deficit remains unchanged, though, because a second virtuous circle appeared. First Japan, then China (along with other economies that concentrate on exports), wanted the United States to continue importing their manufactured goods, so they worked to keep their currencies from appreciating against the dollar. Their central banks bought dollar-denominated assets, mainly U.S. Treasury securities.
Now, the very notion that developing countries would lend their savings to finance spending in the most developed nation on earth ought to give us pause. It is unprecedented. And, it can't continue forever.
Central banks accumulating U.S. dollars are taking on ever-greater currency risk. If the dollar were to depreciate, their losses would be large. Thus, they have an incentive to diversify their holdings rather than relying so heavily on dollar-denominated assets. But this could itself cause the dollar depreciation they fear.
This situation is a risk to the United States as well. While there has been no hint, as yet, that nations with large dollar reserves would use such holdings for economic or political leverage, that is a possibility.
Time For Action The greater fear has as much to do with mathematics as it does with economics. Even gradually increasing trade deficits can lead to accelerating current account deficits. Today's borrowing abroad means a further outflow of income (the interest on that borrowing) tomorrow, over and above the trade deficit itself. In the extreme, such a "debt trap" very quickly spirals out of control, producing the dreaded hard landing—at a minimum, economic recession coupled with sharply higher interest rates, rising bankruptcies, and flat or even declining house prices.
The "soft landing" is no picnic either. It means some combination of greater personal savings (lower personal consumption), higher taxes, lower government spending, lower investment and a still-weaker dollar. And you can count on considerably higher interest rates as one of the principal means of achieving such ends.
Such a scenario may seem remote. And it may be, at present. But the longer we wait to resolve the problem, the more likely such outcomes become.
To be sure, faster economic growth in Europe (and elsewhere) would help, as would revaluing the Chinese currency upward. Still, it is hard to construct an end game that doesn't involve sacrifice on the American home front.
Part of the solution surely involves reducing the federal budget deficit—a policy with merit even apart from its impact on the trade deficit. (For more background on federal budget matters, see Multifamily Executive, February 2004, p. 64.) Unfortunately, there is, as yet, no political consensus on how this should be done, making substantial improvement unlikely in the short term.
And there's another side to the needed adjustment. As Federal Reserve governor Ben Bernanke pointed out at a March lecture in Richmond, Va., much of the capital inflow in recent years has resulted not in more business investment with corresponding improvements in productivity, but rather in more houses and higher house prices, both of which have encouraged greater consumption.
Mark Obrinsky is chief economist for the National Multi Housing Council in Washington, D.C. "The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be," Bernanke said.
Here's another way to say this: we've largely wasted the huge capital inflow of recent years on a binge of house buying and consumption. It's time to right this ship and get it moving forward again.