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Americans Rely on Capital Flows from Abroad

In 2004, the U.S. economy ran large trade deficits, financed by substantial net capital inflows.

U.S. Account Deficit Set Record in 04

The U.S. current account deficit-the broadest measure of the nation’s trade balance-hit an all-time high in 2004, the government said Wednesday, raising fresh worries about the dollar even as other data showed the nation’s economy on track.

The Commerce Department said the current account showed a $187.9 billion deficit in the fourth quarter of 2004, and $665.9 billion for the ye~r. That’s 25.5% at.Te the 2003 gap of $530.7 billion. T’He deficit amounts to a record 5.7% of the economy.

The higher-than-expected numbers renewed concerns that the nation is too dependent on foreign investors, particularly Asian central banks, to finance the economy.

While foreign investment surged 51% in January to the second-highest level on record, funding needs are growing. Ethan Harris, chief U.S. economist at Lehman Bros. in New York, called the current account numbers abysmal.”The counterpart to this is that we’re asking foreigners, Don’t just lend us $600 billion this year. We’re asking for $700 billion.’ So it creates this funding problem,Harris said.Maybe they love to give us $300 billion or $400 billion, but you’re really stretching the boundaries.

The White House says the trade deficit reflects that the U.S. economy is growing faster than other nations. Federal Reserve Chairman Alan Greenspan expects the trade imbalance to gradually correct. Other economists and business leaders are concerned that if foreign investors were to suddenly move away from U.S. dollar-denominated investments, the dollar and stock prices could plummet and into rest rates and inflation could move higher.

Influential investor Warren Buffet, in this year’s letter to shareholders of Berkshire Hathaway, warned that the USA could become a sharecropper’s society.if it continued to transfer assets to foreigners.

This equation shows that a nation’s saving must equal its domestic investment plus its net capital outflow.In other words, when US. citizens save a dollar of their income for the future, that dollar can be used to finance accumulation of domestic capital or it can be used to finance the purchase of capital abroad.

This equation should look somewhat familiar. Earlier in the book, when we analyzed the role of the financial system, we considered this identity for the special case of a closed economy. In a closed economy, net capital outflow is zero (NeO = 0), so saving equals investment (S = I). By contrast, an open economy has two uses for its saving: domestic investment and net capital outflow.

As before, we can view the financial system as standing between the two sides of this identity.For example, suppose the Smith family decides to save some of its income for retirement. This decision contributes to national saving, the left side of our equation. If the Smiths deposit their saving in a mutual fund, the mutual fund may use some of the deposit to buy stock issued by General Motors, which uses the proceeds to build a factory in Ohio. In addition, the mutual fund may use some of the Smiths deposit to buy stock issued by Toyota, which uses the proceeds to build a factory in Osaka. These transactions show up on the right side of the equation. From the standpoint of US. accounting, the General Motors expenditure on a new factory is domestic investment, and the purchase of Toyota stock by a US. resident is net capital outflow. Thus, all saving in the US. economy shows up as investment in the US. economy or as US. net capital outflow.

The bottom line is that saving, investment, and international are inextricably linked. When a nation’s saving exceeds its domestic investment, its net capital outflow is positive, indicating that nation is using some of its saving to buy assets abroad. When a nation’s domestic invest men saving, its net capital outflow is negative, indicating that foreigners are financing some of by purchasing domestic assets.

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