1. NS3040 Winter Term 2015 Balance of Payments

2. Deutsche Bank: BP Misconceptions I General concerns at the time (October 2004) over U.S. BP deficits: Rising foreign indebtedness that might create financial difficulties over time A potential massive dollar depreciation needed to rectify the situation In an extreme case, a financial crisis as foreignenr refuse to finance U.S. deficits and switch their capital to other laces To assess situation need to examine key aspects of the U.S. balance of payments” The nature and underlying causes of the deficits The financing of the deficits Main characteristics of U.S. foreign debt and The role of the dollar in dealing with external deficits. 2

3. Deutsche Bank: BP Misconceptions II When assessing BP need to distinguish between cyclical and structural deficits Cyclical deficits non-controversial Result from the disparity in economic growth between the U.S. and main trading partners Last several decades U.S. has had stronger growth than most other industrial nations – will it continue? U.S. only major industrial country with growing population Technological revolution of 1990s most pronounced in U.S. Potential annual growth of U.S. still around 3.5% -- about 1% higher than Europe Cyclical factors suggest forces maintaining U.S. BP deficits with respect to industrialized countries 3

4. Deutsche Bank: BP Misconceptions III Structural deficits – long standing factors, unlikely to change in the near term U.S. income elasticity of imports higher than foreign income elasticity for U.S. exports Openness of U.S. market More competition domestically Proliferation of outsourcing – NAFTA, supply chains Products shipped abroad return to U.S. with value added Dollar’s role as main reserve currency Central banks accumulate reserves Interventions in foreign exchange markets by countries trying to prevent the appreciation of their currencies with respect to U.S. dollar 4

5. Deutsche Bank: BP Misconceptions IV Financing of U.S. external deficits Country can run a BP deficit only to the extent that it can finance it. U.S. in exceptional advantages situation – does not have to borrow in conventional sense Financing comes voluntarily because of attractiveness of U.S. as an investment destination Large capital market, low risk, low inflation Because of this attractiveness might argue that it is the capital inflow that causes the current account deficit Surplus may be driven by foreign demand for U.S. assets rather than any structural imbalance in U.S. economy Turns out that even though U.S. largest international borrower, still positive net inflows on portfolio U.S. has been acting as the global bank – takes in short term funds low interest, invests them at higher rate. 5

6. Deutsche Bank: BP Misconceptions IV Balance of payments and the dollar Controversial – many economists argue periods of increasing deficits cause weakening of dollar Plenty of evidence suggests this link is not very strong or does not exist at all Other factors more likely to affect value of the dollar 6

7. Deutsche Bank: BP Misconceptions V Conclusion: Should not be overly worried about the U.S. balance of payments deficits Primary cause of deficits is disparity of economic growth with U.S. growing faster than most other industrial countries Even disregarding growth differentials would run deficits for a number of structural reasons – U.S. dollar as a reserve currency a major factor here Even though U.S. has accumulated large external debt, it earns more on its portfolio than foreigners holding U.S. debt – much U.S. liabilities held by central banks 7

8. Post-Script While the Deutsche Bank paints a rosy picture, the U.S. BP deficits were seen by many as a cause of the global crisis in 2008 Controversial – did the U.S. run the deficits because it was a good place to invest or was the U.S. an irresponsible spendthrift, low saving country? High government deficits point to over spending, but if foreigners were willing to buy our paper at nearly zero interest rates, they must share some of the blame More after we develop a macroeconomic model -- 8

9. George Alessandria: Trade Deficits I George Alessandria, “Trade Deficits Aren’t as Bad as You Think,” Philadelphia Federal Reserve 2007 Gives standard free market interpretation of trade deficits – simply reflective of economic forces Pessimistic View Trade deficits evidence that American firms are unproductive and can’t compete with foreign firms Foreign governments are not playing fair in U.S. markets We are living beyond our means Optimistic view – trade deficits have benefits: Shift worldwide production to its most productive location Allow individuals to smooth out their consumption over the business cycle Smooth out consumption over lifetimes. 9

10. George Alessandria: Trade Deficits II Intertemporal trade Based on the idea that people’s purchases and income may not match up over time Similar to life cycle of typical doctor Borrows for schooling Education investment increases earning potential Pays back loans with additional income Income provides for retirement and dissaving In essence traded part of income stream when working for education young and higher standard of living when retired Countries act same way – sum of individual decision making – trade and capital flows facilitates consumption smoothing 10

11. George Alessandria: Trade Deficits III International Production Shifting Want to take advantage of good investment opportunities rather than waiting until domestic resources available Over time production opportunities change Some industries make technological advances while others become obsolete. Norway a good example In 1960s rich petroleum deposits discovered in North Sea Development required resources beyond Norway’s capabilities Norway financed development by borrowing abroad – Norwegian investment grew substantially 1969-77 Once oil came on line, Norway trade balance improved dramatically – loans paid off. 11

12. Norwegian Investment and Trade Balance 12

13. George Alessandria: Trade Deficits IV Has production shifting and consumption smoothing taken place over business cycle to produce corresponding trade account figures? Finds: Fluctuations in consumption generally smoother than fluctuations in output Fluctuations in investment are much larger than fluctuations in output Means when output is growing fast, both investment and consumption are also growing Since investment is more volatile than output, investment grows much faster than output Implies trade balance should be declining In fact trade balance negatively correlated with output so during expansion trade balance tends to decline. 13

14. U.S. Business Cycle Statistics 14

15. George Alessandria: Trade Deficits IV Summing up Concludes trade balance reflects Optimal response of individuals, firms, investors and governments to changes in productive opportunities and needs world-wide If true, trade deficits not a problem because self-financing Alternative view Trade deficits may result from irrational behavior – individuals borrowing to spend beyond their means May feel richer than they are because of inflated asset values If true, trade deficits a problem, because not enough resources generated for debt servicing. Thinks empirical work suggests trade deficits simply reflect rational decisions and thus sustainable 15

16. Allison Butler, US/Japan Balances I Allison Butler, “Trade Imbalances and Economic Theory: The Case for a U.S.-Japan Trade Deficit,” Federal Reserve Bank of St. Louis 1991 Looks at large imbalances between the U.S. and Japan in the 1980s Common belief at the time was that Japan was not playing fair and that the U.S. should be more aggressive in opening up Japanese markets. If only look at the U.S. and Japan argument seemed plausible. However, if one looks at the bigger picture a completely different interpretation is in order. The trade imbalances are caused by macro-economic imbalances and have very little to do with actual trading practices 16

17. Allison Butler, US/Japan Balances II 17

18. Allison Butler, US/Japan Balances III Macroeconomic Framework National Income Accounts Y = C + I + G – (E-M) Supply/Demand Balance E-M = Current Account = CA Y = C + S + T Income Generated and Disposed of C + S + T = C + I + G + CA S + T = I + G + CA (S – I) + (T – G) = CA Current Account = Private Imbalance (S-I) + Government Fiscal Balance (T-G) 18

19. Allison Butler, US/Japan Balances IV 19

20. Allison Butler, US/Japan Balances V Policy Implications If the U.S. wants to close its trade or current account deficits the solution is simple Save more Invest less Tax more Less government spending or combination of all four One reason U.S. often runs large current account deficits is none of these adjustment mechanisms are popular or painless 20

21. Interpreting Trade Data I New OECD and WTO data set released early 2013 reveals much different patterns of trade than traditional gross figures Value added approach assess the actual contribution of various economies to the value embedded in a final sale export Example: Apple’s iPhone – although assembled in China only 4% of value of product attributed to China itself –rest being imported – physical components, or technical services For the United States new data suggests: BRIC economies are more important that conventionally thought Strong interest in seeing the euro-crisis resolved 21

22. Interpreting Trade Data II New dataset reveals interesting bilateral patterns: The U.S. deficit with China is 25% smaller than suggested by conventional gross trade figures Japan runs a larger surplus with the United States than it does with China – contrary to conventional data Japan’s surplus with the United States is 60% larger than suggested by gross trade figures Brazil is a larger exporter of services than previously thought Over 40% of Brazil’s value added in exports are in the form of services Brazil’s large exports of commodities to China means its true value added is smaller than suggested by gross trade figures 22

23. Interpreting Trade Data III For the United States: 45% of its non-NAFTA exports were consumed in euro- area economies as of 2009 Excluding NAFTA, the top consumer of US exports is Germany – on basis of VA data China distant second and equivalent to France, the UK and Japan Contrasts with gross trade figures which have China as top consumer and Germany as fourth-rank Brazil drops off the top-ten list when using VA data. 23

24. Interpreting Trade Data IV 24

25. Interpreting Trade Data V 25