Rakesh asks an interesting and important question: why has foreign
capital continued to flow into the US in recent months if the
"fundamentals" are so unsound? I certainly do not have a complete answer
to this question, but it seems to me that the continuing inflow of foreign
capital so far is due at least in part to the following causes:
1. FOREIGN INVESTORS DISAGREE ABOUT THE FUNDAMENTALS.
a. Mainly, investors DO NOT EXPECT THE US DEFICIT ON CURRENT ACCOUNT TO
CONTINUE TO INCREASE (or maybe a small increase this year and a turnaround
starting next year). The main reason for this optimism is that they think
that the Asian-global crisis is over (as has been proclaimed by the IMF
and many others) and hence that the demand for US exports will soon start
to increase again. But I think that the Asian-global crisis is far from
over, which would mean that the US current account deficit will continue
to worsen. Also, a factor which many people may not recognize is that
there has been a $50b negative swing in the "investment income / payments"
line item on the current account in the last 15 years: what used to be a
$30b surplus is now a $20b deficit and growing every year for the
foreseeable future, due to the increasing foreign indebtedness of the US
since 1982. This growing negative item will make it all the more
difficult to reduce the deficit on current account in the years ahead.
b. And/or investors DO NOT THINK THAT A SUBSTANTIAL DEVALUATION OF THE
DOLLAR WILL BE REQUIRED in order to reduce the deficit on current account
sufficiently. My answer here is somewhat more technical in nature
(involving export and import price elasticities and recent trends in
exports and imports), which I would be happy to get into if you wish. But
one important historical comparison is with the US in 1985. The deficit
on current account as a percentage of GDP in 1995 was approximately the
same in 1999 (about 3.5%), and the dollar declined over the next two years
about 40%. So I think that at least this much devaluation will be
required this time around.
c. Or investors might think that a 40% devaluation didn't do much damage
then, so why should it now? But I think the situation is very different
now, in at least the following respects:
- The STOCK MARKET IS OVERVALUED, rather than undervalued, with large
foreign investments. So this time around, a significant decline in the
dollar would almost certainly cause a major contraction in the stock
market, which in turn would have severe negative effects on consumer
spending and on the US economy in general.
- The foreign debt in 1999 is mostly PRIVATE debt, rather government
debt, and hence there is a greater risk of defaults, bankruptcies, crisis,
etc.
- HOUSEHOLD AND CORPORATE DEBT IS HIGHER, thereby increasing the chances
of defaults, etc.
- The SAVINGS RATE IS NEGATIVE, and hence an outflow of foreign capital
will have a greater negative effect.
- The WORLD ECONOMY IS IN A VERY WEAK CONDITION, and a devaluation of the
dollar would make things even worse in the rest of the world.
All in all, it seems to me that these differences suggest that a
significant devaluation of the dollar would have much more negative
effects on the US economy today than in the late 80s.
2. But mostly I think that FOREIGN INVESTORS THINK THAT THEY WILL BE ABLE
TO GET OUT OF THE DOLLAR IN TIME.
Even if foreign investors more or less agree about the "fundamentals";
i.e. agree that a substantial devaluation of the dollar will be required
in the not-too-distant future because of the increasing current account
deficit, they probably think that the devaluation will be gradual and
managed to at least some extent by government intervention, so that they
will be able to sell their dollar assets without too much of a loss when
the time comes. But the very fact that so many investors are poised to
get out and that most of them will try to get out at roughly the same time
once the decline of the dollar starts, means that the decline will more
likely be rapid and uncontrolled. Not everybody will be able get out in
time.
I think that US assets have been a relatively good investment in recent
years (due to higher returns, a booming stock market, a rising dollar, and
greater safety). But all this could change quickly with a declining
dollar. Maybe investors are waiting to ride the stock market up as long
as it lasts and get out when the dollar and the stock market (and the US
economy) head down.
And remember: it is not necessary for foreign investors to actually
WITHDRAW their capital in order to get a devaluation of the dollar
started. All that is required is an UNWILLINGNESS TO LEND MORE as the us
current account deficit continues to increase. But once the decline gets
started, then the withdrawals will likely begin and the decline of the
dollar will accelerate.
Rakesh, I will respond to your other question about the causes of the
partial recovery of the rate of profit since the 1970s in a subsequent
post.
Looking forward to further skeptical questions,
Fred