January 20, 2006,
When he served under President Reagan as chairman of the Council of Economic Advisors, Martin Feldstein called for a weaker dollar to reduce the U.S. deficit in the current account (or, in other words, to correct a situation of this country importing more than it was exporting). Though a “deficit” in this case merely speaks to foreign capital inflows into the deficit country, Feldstein saw the situation as unsustainable and wanted to correct it.
Nearly twenty years later, with the Dow Jones Industrial Average trading at levels nearly four-times higher than when Feldstein initially sounded the alarm, the U.S. economy is still somehow imperiled as a result of investor interest in our public and private assets. Although Adam Smith saw capital inflows as “the effect, not the cause, of public prosperity,” Feldstein apparently sees them in a reverse light. According to his January 10 op-ed in the Financial Times, they’re indicative of a looming dollar crash.
To begin, Feldstein opined that the “value of the dollar must fall by at least 30 percent to shrink the trade deficit to a sustainable level of 3 percent of GDP.” The problem here is that there’s no discernible correlation between the current account deficit and the value of the dollar.
The deficit rose throughout the 1970s, from $1 billion in 1971 to $24 billion in 1979 all this despite a dollar that mostly fell during that decade. The dollar strengthened throughout the 1980s, yet the trade deficit’s rise continued from $19 billion in 1980 to $93 billion in 1989. Between 1996 and 2001 (years of impressive dollar strength) the trade deficit rose 250 percent. Since 2001 the dollar has fallen pretty substantially against the pound, euro, and yen, yet Feldstein’s own statistics show that the current account deficit rose to $668 billion in 2004 and will rise above its current level of $790 billion in 2006.
Importantly, the U.S. has been forcing upward revaluations of foreign currencies since we left the Bretton Woods gold standard in 1971. During that time the yen alone has risen 68 percent against the dollar. At some point, a useful question to those who decry trade deficits might go as follows: How much deflation (and resulting economic dislocation) will we force on our trading partners before we admit that currency values and current account balances have very little to do with each other?
Of course, a lack of interest in U.S. assets would be a clear signal that we were in trouble, and this trouble would be reflected across all U.S. asset classes. All this raises another question for those who fear trade deficits: Since deficits signal investor interest in our country, why would be better off if the imbalances became surpluses? Assuming Feldstein is right that governments, including OPEC countries, account for a growing share of capital flows here, isn’t that a somewhat positive signal? Just as no one would remodel a house they’re about to tear down, would a government park its capital in a country that it had designs on invading?
Feldstein’s op-ed bemoaned the “nature of the current capital inflow,” as it’s “different from the experience as recently as five years ago” when a higher percentage of foreign capital inflow went into equity funds. While this may be true, it only serves to tell us that if foreigners became more bullish about U.S. equities, the current account deficit that has so many so afraid would only grow.
Feldstein also acknowledged that part of the foreign capital inflow has to do with governments seeking to accumulate U.S. dollars as a way to maintain a stable value for their currencies against the dollar. In short, lacking credible central banks, foreign governments seek to import our central bank’s relative credibility. Absent the credibility gained, it seems a safe assumption that even more in the way of foreign capital would reach our shores given legitimate fears of investing money in less stable monetary situations.
Finally, Feldstein made the point that it is the small interest-rate differential (U.S. interest rates are presently higher) between the U.S. and foreign countries that keeps capital flowing in our direction. The problem with this thinking is that he also believes that the “dollar must fall faster than these small interest differentials in order to prevent the current account deficit from increasing more rapidly than GDP.” This might be true if there were a correlation between the two, but if the dollar does go into freefall as Feldstein expects, U.S. interest rates will eventually rise to reflect the weaker currency. Notably, the current account balance nearly vanished when U.S. interest rates rose to double-digit levels in the early 1980s. Those who fear trade imbalances almost by definition wrap themselves in truly endless contradictions.
Feldstein is of the belief that the present level of foreign investment in the U.S. is unsustainable. Leaving aside how long the “sky-is-falling” crowd has been incorrect, what’s unsustainable is not the deficit itself, but the causes of it. Indeed, investment inflows are eminently sustainable if we avoid the currency devaluations and machinations that the trade-deficit worriers have been prescribing for so long. If we do so, the result will be a better economy along with those “awful” trade imbalances that give pessimistic economists something to complain about.
John Tamny is a writer in Washington, D.C. He can be contacted at email@example.com.