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August 25, 2004

Is the US Trade Deficit Good or Bad?

I'm trying to puzzle out the implications of something suggested by Catherine
Mann in the Summer 2002 Journal of Economic Perspectives. She said that in 2001, if investors had simply "held the market portfolio", allocating their holdings
in proportion to the size of stock markets around the world, they'd have 57% in
US stocks and that global mutual funds do that.

A longstanding puzzle is why investors all over the world don't invest more in
foreign stocks than they do.

The main question in Mann's article is whether America's big current account
trade deficits can continue. Foreigners hold American wealth equal to about 20%
of US GDP. If the return on that is 5% per year, then that means foreigners earn
about 1% of US GDP each year, leaving us locals with the other 99%. If foreign
holdings double, they'll get 2% of GDP. It doesn't sound disastrous.

The real question, though, is whether the foreign investment is raising US GDP.
If it is, then foreign holdings could be 200% of GDP and we shouldn't worry,
because it won't make us any poorer. See this in an example. Suppose Country A
has 100 billion dollars worth of factories, none of it foreign owned, earning 5
billion dollars a year. Country B has 300 billion dollars a year, of which 200
billion is foreign owned, earning 15 billion dollars a year. Some politicians
scream that foreigners are extracting 66% of Country B's GDP, and contrasting
that with the 0% of Country A's GDP that is being lost abroad. But the two
countries' citizens are actually equally well off.

Of course, not all GDP is capital income. Country B's citizens will actually be
much better off, because the huge increase in capital will drive up wages, which
all go to the citizens and not the foreigners. Also, the factories will pay
taxes which will largely go as transfers to citizens rather than providing
extra government services (e.g., extra police protection so the factories
aren't burgled) to the factories.

But those are old thoughts. Back to two new ones:

1. What are the implications of most forms of capital being
Stocks are a form of equity easily traded, and
easily held by foreigners. This particularly applies to US stocks, since we have
much stricter corporate governance than the rest of the world, and foreigners
will get a fair deal here where they won't in Europe, Japan, or the Third

If someone in Italy wants to diversify his portfolio, he should hold mostly
foreign assets. It's too dangerous to hold real estate or small businesses, so
he'll hold publicly traded stock. 57% of that is American. Much less than 57% of
wealth is American. This means there will a lot of demand for that American
stock, resulting in capital inflows into America.

I'll try a numerical example to clear things up in my head. Suppose we have
two countries, America and Other. Capital consists of tradeable widgets and
nontradeable gizmos. America has 50 widgets, and Other had 50. America has 100
gizmos and Other has 400. Thus, total wealth is 150 in America and 450 in
Other. The return on American widgets and gizmos and foreign ones has the same
expected value. Within a given country, widgets and gizmos have identical
returns, but the return is independent across countries. There is no other
source of income but the flow from widgets and gizmos.

If all goods were tradeable, an investor would want to split his holdings 50-50
between US and foreign assets. This would drive up the price of American widgets
and gizmos, because they are more valuable for diversification. If new widgets
can be created, this would tend towards the creation of more AMerican widgets,
since they're more valuable if created in America. You might think this would
explain foreign investment in the US, but it's an artifact of the model, because
actually there aren't just two countries, and "Other" is standing in for lots of
countries with returns that aren't correlated with each other.

But remember that gizmos, which are the bulk of wealth, aren't tradeable. Thus,
in the attempt to split his holdings 50-50, our world investor is putting very
heavy demand on the 50 US widgets. Starting from the initial positions, the
American is wanting to trade some of his 100 American gizmos for the 50
Other widgets. America is small enough in this model that he can do so-- in
equilibrium, it gets complicated, but I suppose Americans will end up with
something like this: 0 American widgets, 60 Other gizmos, 100 American gizmos.

The Other investor is wanting to buy those American widgets-- ideally, he'd
like to buy all 50 of them, plus 175 American gizmos, but the Gizmos aren't
tradeable. So he'll bid heavily for those 50 American widgets, since they are
all that are available for him to use to diversify. This means the American
widgets will be worth more than the Other widgets. And if new widgets could be
created, the incentive is to create them in America, not in Other.

Here's the lesson for the real world. The US has a much
bigger share of the tradeable assets of the world than of total assets. Thus,
its tradeable assets are going to be more valuable to investors looking for
diversification. This should lead to capital flowing into America to create more
of those tradeable assets, and to pressure to convert US nontradeable assets
(e.g., land) into tradeable assets (e.g., real estate trusts).

2. I'm too tired to think this through now, but I thought on the question of whether the US trade deficit is good (it shows that foreigners want to invest here) or bad (it shows that Americans want to borrow to buy foreign goods), the movement of the exchange rate would be very important. Here's what its been, from the St. Louis Fed:

Price of a Euro in Dollars

2001 01 .94

2002 01 .89

2003 01 1.06

2004 01 1.26

2004 07 1.23

This looks bad. The Euro is going up; the dollar is going down.

Posted by erasmuse at August 25, 2004 10:27 PM

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