In principle, we would expect a mature industrial economy such as the US, with high incomes and large accumulated endowments of capital, to be running a current account surplus, exporting capital to much less developed regions of the world such as China or Malaysia. Not so.
In practice, the US has been spending far more on imported goods and services than it earns, financing a shortfall of some 5% of GDP with substantial borrowings from foreigners around the globe. A small cottage industry has emerged within the international economics profession to explain this apparent anomaly. Economists have put forward a wide range of explanations:
- US budget deficits;
- the collapse of US private saving;
- rising oil prices;
- the boom in US productivity growth;
- lingering effects of the Asian financial crisis; and
- persistent intervention by many developing economies to keep their currencies competitive.
US assets as unusually attractive
In the past several years, a new explanation has been enjoying increasing prominence. The large US trade and current account deficits have been driven by capital inflows from foreign investors attracted by the prominent depth, breadth, and safety of US financial markets, combined with a highly entrepreneurial culture and supportive legal system.
Richard Cooper (2005) wrote that the “US has a revealed comparative advantage in producing highly attractive financial claims, to the mutual benefit of foreigners and American alike so long as Americans invest the proceeds productively.” Not to be outdone, Glenn Hubbard (2005) asserted that “the US financial system stands as a beacon for the possibility of a virtuous relationship between capital markets and sustainable economic growth.”
These days, as the global financial turmoil triggered by the subprime crisis continues, these paeans to the virtues of US financial markets strike a quaintly ironic tone. More worrisomely, if capital flows to the US were genuinely motivated by the apparent superiority of US assets, then, as Kristin Forbes notes in a recent Vox column, “anything that undermines the perceived advantages of US equity and bond markets could present a serious risk to the sustainability of US capital flows.” (Forbes 2008) In other words, she is suggesting that an event such as the subprime crisis could trigger a disorderly correction of the US current account deficit.
Is it true?
Have global investors really found US assets to be unusually attractive, and has this really been a major driver of the trade and current account deficits? Surprisingly, there have been few attempts to verify this view empirically even though it has achieved the status of conventional wisdom.
In a recent paper, my colleague Joe Gruber and I performed a number of tests of what we call the “superior US assets hypothesis.”
- Based on the panel data regression approach used by Chinn and Prasad (2003) and Gruber and Kamin (2007), we examined whether countries with better-developed financial systems – as proxied by such measures as the size of outstanding credit or stock market capitalisation relative to GDP – tended to run smaller (more negative) current account balances.
We found no evidence of such a relationship, and our models were unable to explain the large US deficits.
- On the premise that countries offering more attractive assets would command smaller risk premia and thus a lower cost of borrowing, we replaced our proxies for financial development with differences in sovereign bond yields relative to their cross-country average.
Consistent with our hypothesis, we found that lower bond yields were associated with larger current account deficits, but our model still failed to explain the large US current account deficit. The reason, to our surprise, is that, as demonstrated in Figure 1, US sovereign bond yields have not been significantly lower than those of other industrial economies. Nor have they fallen to a greater extent since the advent in the late 1990s of what Bernanke (2005) labelled “the global saving glut.”
Figure 1 Industrial economies’ bond yields
We verified that, even controlling for a broad range of macroeconomic determinants, bond yields throughout the industrial world have exhibited similar trends in the past decade.
We conclude from these findings that, contrary to the conventional wisdom, US financial assets have not been demonstrably more attractive than those of other industrial economies, and hence cannot explain the large US deficit.
- As investors did not hold inflated notions of the superiority of US assets before the subprime crisis erupted, this may help explain why subsequent foreign demand for US assets has held up.
- It is true that the dollar has fallen in foreign exchange markets since the eruption of financial turmoil a year ago, but that merely continues a downtrend since 2002.
- Much of the decline in the past year owes to reductions in US short-term interest rates relative to those abroad, as indicated by the differentials in overnight interest swaps shown in Figure 2 below.
- If global investors were shifting their portfolios out of US assets, we would be seeing increases in long-term sovereign and corporate interest rates, but as shown in Figure 3, that is not taking place.
Figure 2 The euro-dollar exchange rate and interest rate differentials
Figure 3 Long-term sovereign and corporate interest rates
Bernanke, Ben, “The global saving glut and the US current account deficit,” Homer Jones Lecture, St. Louis, Missouri, 14 April 2005.
Chinn, Menzie D. and Eswar Prasad, “Medium-term determinants of current accounts in industrial and developing countries: an empirical exploration,” Journal of International Economics 59 (2003):47-76.
Cooper, Richard N., “Living with Global Imbalances: A Contrarian View,” Institute for International Economics Policy Brief PB05-3 (2005).
Forbes, Kristin, “Why Do Foreigners Invest in the US?” NBER Working Paper 13908 (2008), April.
Gruber, Joseph W. and Steve Kamin, “Explaining the Global Pattern of Current Account Imbalances,” Journal of International Money and Finance 26 (2007):500-522.
Gruber, Joseph W. and Steve Kamin, “Do Differences in Financial Development Explain the Global Pattern of Current Account Balances?” International Finance Discussion Paper No. 923 (2008).
Hubbard, R. Glenn, “A Paradox of Interest,” Wall Street Journal, 23 June 2005.