Fed Watch: On That Capital Flow Fallacy

Yesterday Paul Krugman chastised the White House over this quote from President Barak Obama’s press conference:

I do think that if the country as a whole sees Washington act responsibly, compromises being made, the deficit and debt being dealt with for 10, 15, 20 years, that that will help with businesses feeling more confident about aggressively investing in this country, foreign investors saying America has got its act together and are willing to invest. And so it can have a positive impact in overall growth and employment.

Krugman adds:

OK, so that’s the confidence fairy at the beginning. But the “foreign investors” thing is actually worse.

Think about it: U.S. interest rates are low; there’s no crowding out going on; we are NOT suffering from a shortage of saving.

I think it is worth trying to understand the Administration’s position in light of this morning’s trade release, which revealed an unexpected surge in the trade deficit.  The deterioration was in both the petroleum and non-petroleum balances, nominal and real.  I imagine the numbers will be another ding to the second quarter GDP forecast, although on net trade is still poised to make a significant contribution to growth.  So far, in real terms, the trade deficit for Q2 remains improved relative to Q1.

Still, the deficit was $50.2 billion, an outflow which requires an offsetting net inflow.  Annualized, this amounts to $600 billion a year of inflow, although note the decline in oil prices should take some of the pressure of the nominal deficit over the next couple of months.  I think it is protecting this inflow that concerns that White House.

The counter-argument is that that global investors appear to have plenty of cash to pour into the US, yielding very low interest rates.  Under such circumstances, it is counterproductive to fret about the need for foreign investment.  Indeed, that foreign investment, in the form of central bank dollar accumulation, has been a net drag on US demand, supporting the evolution of unsustainable patterns of trade.

It seems if you view the US as a sufficiently large country that the external accounts are simply a residual, the tail of the dog, so to speak, you tend to dismiss their relevance to policy making.  This strikes me as essentially a closed economy view.  On the other hand, persons working in international finance tend to have a less innocuous view of the external accounts, where sudden stops of capital in this “residual” have massive and destructive effects on the domestic economy.   In such cases, the tail wags the dog.

Of course, Obama’s chief economic advisor, Treasury Secretary Timothy Geithner, cut his teeth on financial crises, and thus I suspect this puts him in the latter group.  And where Geithner goes, Obama follows.

I have gone back and forth on this issue.  I don’t think I am alone in viewing the gaping and persistent US current account deficit as a potential disaster waiting to happen.  At the same time, it seems that nations most likely to suffer from current account/currency crises are those with some mix of overvalued exchange rates, inability to print domestic currency, and high levels of foreign currency denominated debt.

The US is free of these issues.  We can print our own currency, our debt is dollar-denominated, and US authorities are not actively strengthening the currency (such actions are directed by foreign central banks).  Under such circumstances, my tendency is to think that excessive focus on the confidence of foreign investors would tend toward inappropriately tight policy given the current economic environment.  Indeed, discouraging foreign central banks from accumulating Dollar assets would be the appropriate policy, especially as we are experiencing a significant current account deficit at the same time output is well below potential.

I should add this is not meant to imply that investor confidence (and not just foreign investors) is irrelevant.  I admit to a nontrivial concern that even for the US, the tail does wag the dog. But the much-feared Dollar crisis continues to elude us.  It appears that reasonable economic stewardship prevents those fears from being realized – with reasonable meaning acting to prevent economic collapse.  I think this means to push the concern for deficits a few years into the future, but having a credible plan in place to tackle the issue at that juncture.

With this in mind, I would not court disaster, by, for example, calling into question the sanctity of US government debt or putting the nation at risk of a major economic contraction in the second half of this year.  I think it would be appropriate for foreign investors to fundamentally reassess their confidence in US asset in the face of such recklessness.  Yet Republicans appear willing to take just such a risk to hold to the “no new revenues” pledge.

Indeed, we are now closer than I would have imagined to the ultimate test of the “expansionary austerity” argument because, come August 3, fiscal policy will quickly become very austere.  And somehow I don’t think this will boost investor confidence, neither foreign nor domestic.  Indeed, foreign investors may then be the least of our worries.

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