iley & lewis - untangling the us deficit; evaluating causes, cures and global imbalances (2007)

3.2 Savings – investment imbalances and the current account 6.4 Foreign and US cross-border direct and portfolio 6.6 Components of changes in the net international investment 7.1 US gros

Edward Elgar

Cheltenham, UK • Northampton, MA, USA

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A catalogue record for this book

is available from the British Library

Library of Congress Cataloging in Publication Data

Iley, Richard A., 1970–

Untangling the US deficit : evaluating causes, cures and global imbalances / by Richard A Iley and Mervyn K Lewis.

p cm.

Includes bibliographical references and index.

1 Budget deficits—United States I Lewis, Mervyn II Title.

v

1.2 US net international investment position, 1980–2005 2

3.11 US non-financial corporations’ indebtedness, 1955–2006 643.12 US non-financial corporations’ liquidity, 1955–2006 65

3.14 US current account and government budget balances,

3.15 US and Japanese 20-year government bond yields, 1995–2006 81

4.7 Foreign exchange reserves of developing countries,

4.8 Foreign exchange reserves relative to import demand,

vi

4.9 US gross cross-border capital transactions, 1977–2006 115

5.1 Current account balances for selected countries, 2005–2006 124

6.2 US gross external assets and liabilities, 1976–2005 1506.3 US foreign direct investment out-performance, 1976–2005 1526.4 US net international investment position, 1976–2005 1596.5 US net foreign debt relative to export earnings, 1976–2005 1606.6 Movements in NIIP due to foreign exchange channel,

7.3 ‘Official’ inflows as a per cent of total gross inflows,

7.4 Asia’s invested funds, cumulative flows 1998–2005 1817.5 Investment in Japan, Germany and Switzerland, 1970–2005 1867.6 ‘Anglo-sphere’ consumption and residential investment,

8.3 Chinese ex-oil current account balance, 1995–2006 219

3.2 Savings – investment imbalances and the current account

6.4 Foreign and US cross-border direct and portfolio

6.6 Components of changes in the net international investment

7.1 US gross capital account flows by decade, 1960–2006 171

7.3 Global current account balances, selected years 1997–2006 1857.4 Holdings of US securities by foreign official institutions,

8.2 Decomposition of Chinese foreign exchange reserve

9.1 Summary of explanatory factors for US current account

viii

BIS Bank for International Settlements

CNCI capitalized net capital income

FDI foreign direct investment

Fed Board of Governors of the Federal Reserve System (Federal

Reserve)

FOMC Federal Open Market Committee

FRBNY Federal Reserve Bank of New York

GDP gross domestic product

GNP gross national product

MBS mortgage-backed securities

MEW mortgage equity withdrawal

NIID net international investment deficit (negative NIIP)

NIIP net international investment position

OECD Organisation for Economic Co-operation and DevelopmentPBOC People’s Bank of China

TIC Treasury International Capital Reporting System

ix

Writing a book on the US current account deficit was a challenge thatneither of us could resist With the United States absorbing four-fifths ofthe world’s cross-border savings, this imbalance is perhaps the biggest issue

in the international economy In addition, with the funds flowing fromsome of the poorest countries to the richest, the global imbalances take on

an extra dimension, as summed up by the view of another author that theflow is ‘fundamentally perverse’ Subject matter of such significance andportent could hardly be ignored

Both of us have been involved with the question of current account

deficits for some time One of us – a market economist immersed in thedaily ebb and flow of financial markets reacting to and affected by the US

deficit – welcomed the opportunity that the book offered, to sit back andtake a longer-term perspective The other, an academic, who was involved

in the debates on current account deficits in the Australian context somefifteen years ago, was glad of the opportunity to see how the literature hadchanged over the intervening years and to examine matters from the very

different vantage point of the US economy

As it turned out, one major difference from the past comes from the sheervariety of views that US academics and others have put forward to accountfor the phenomenon of the US external deficit One inspiration for thevolume came from the observation of ex-Federal Reserve Vice-ChairmanRoger Ferguson that there had been few attempts to evaluate the full range

of explanations advanced for the US deficit The first task we had was todevelop an organizing framework to deal with the different hypotheses,with the aim of producing the most comprehensive account to date of thevarious views and how they contribute to the story of the evolution of the

US current account deficit

Because the United States occupies such a central position in the worldorder, an analysis of the US deficit necessarily overlaps with global geopoli-tics and the United States’ relationships with China, Japan, the EuropeanUnion, oil exporters and others While we have not deliberately sought toemphasize such international geopolitical factors, they cannot be ignoredand we have certainly not tried to interpret everything solely in eco-nomic terms There is consequently coverage of some matters that mightnot be expected in such a volume, especially China’s global ambitions and

x

governance problems that, to us, condition its economic relations with theUnited States.

How the authors came to work together may seem something of a puzzlebut has a simple answer since they are son-in-law and father-in-law, andthere is a precedent for such a connection in the form of two earlier Elgarvolumes with another son-in-law Mother and daughter were on hand tobring things to a close by setting an unbreakable deadline for the book’scompletion of end-November 2006 Without this, it might still be in theprocess of draft and re-draft! To them we owe considerable gratitude, espec-ially since one of them bore almost entirely the brunt of typing the manu-script and keeping the references under control In fact, this is now theeighth book that the Lewis family connection has with Edward ElgarPublishing, an association that we are glad to acknowledge and continue

We thank Frank Warnock of Darden Business School, University ofVirginia, for supplying us with the data series for Figure 4.10 ChristianUpper and Nikola Tarashev of the Bank for International Settlements verykindly supplied us with the data for Figure 7.4

Finally, although this project was undertaken with the blessing of BNPParibas, the views expressed here are entirely our own and we alone areresponsible for the content

1 The essence of the problem

THE PUZZLING DEFICIT

The US current account deficit is undoubtedly one of the most significant,and at the same time puzzling, events of our age The magnitude andsignificance of the US deficit seems clear Figure 1.1 shows that from a situ-ation of near zero in 1991, the US current account deficit in 2006 had grown

to $811 billion, or 6.1 per cent of GDP, an unprecedentedly high level Itdominates global financial flows, with the world’s largest economy buyingimports and other services from abroad far in excess of its exports, andfinancing the difference using funds borrowed from the rest of the world,including some of the poorest countries – a flow of capital described as

‘fundamentally perverse’ (Cline, 2005b, p 2) Moreover, according to someexperts the imbalance is set to widen Forecasts by various commentatorsare that, with unchanged policies and exchange rates, the US currentaccount deficit will continue to grow and range between 8–12 per cent ofGDP by 2010 (Mann, 2004; Roubini and Setser, 2005; Truman, 2005).Obstfeld and Rogoff (2005) regard the US deficit ‘as a sword of Damocleshanging over the global economy’

1

1980 1985 1990 1995 2000 2005

–7 –6 –5 –4 –3 –2 –1 0 1

US current account balance, $ billion

US current account balance, as a % of GDP (RHS)

Figure 1.1 US current account, 1980–2006

Some consider that a US current account deficit even of this size is tainable and can be continued indefinitely at such levels Most observers, bycontrast, accept that some correction must inevitably occur Yet, there is

sus-no apparent urgency on either the lending or the borrowing side for thepresent, seemingly anomalous, situation to change Alan Greenspan inNovember 2003 saw little evidence of stress in funding the current account

deficit Two years later, in December 2005, with the deficit and the fundingconsiderably larger, he (along with other policy-makers) could only ‘marvel

at the seeming ease with which the United States continues to finance itscurrent account deficit’ (Greenspan, 2005e, p 1)

There are other puzzling aspects of the experience Figure 1.2 shows therecorded US net international investment position (NIIP) which followsthe path of the current account deficit, moving from a situation where theUnited States had net foreign assets in 1980 to one today where there aresubstantial net foreign liabilities Nevertheless, despite being a net debtorcountry since the early 1980s (indeed, the world’s largest debtor country)and, by definition, needing to service its borrowings, the United States,until the end of 2005 at least, had maintained the remarkable position ofreceiving positive net investment income from aboard In fact, the netincome in 2004 when the United States was a net borrower was almostexactly the same as in 1980 when it was a net lender, and the positionhas changed little since On this basis, it has been questioned whetherthe US deficit even exists in any meaningful sense – the so-called ‘dark

US NIIP, $ trillion US NIIP, as a % of GDP (RHS)

1980 1985 1990 1995 2000 2005

–25 –20 –15 –10 –5 0 5 10 15

Figure 1.2 US net international investment position, 1980–2005

(measured at current cost)

matter’ argument (Hausmann and Sturzenegger, 2005; Cline, 2005a; The Economist, 2006b).

Reasons for the growth of the current account deficit abound A highlyvisible component is the trade imbalance with China, which has more thandoubled in the past four years China exports five times as much to America

as it imports from that country Many Americans worry that China may bereplacing the United States as the powerhouse of the world economy Not

so long ago the ‘twin deficits’ theory was popular, based on the observationthat current accounts deficits and government budget deficits tend to gotogether Earlier this decade, when the US government budget deficitpeaked at 4.5 per cent of GDP in the third quarter of 2003, it was theobvious culprit to explain the rising external imbalance But rapid taxrevenue growth and the economic recovery of 2003–2006 have seen thefederal deficit shrink rapidly and, in the first half of 2006, it averaged lessthan 2 per cent of GDP This particular ‘twin deficit’ explanation for thewidening current account balance has inevitably faded, only to be replaced

by one involving the household sector

Imbalances seem increasingly concentrated in the private sector, larly the US consumer Paralleling the trend of the current account balance

particu-is the household sector financial balance – the difference between totalspending and income In the late 1990s, spending of US households inaggregate began to exceed income for the first time on a sustained basis andthe shortfall has accelerated to reach an unprecedented 4.5 per cent ofGDP in the first half of 2006 This household sector financial deficit andthe smaller, but still significant, government budget deficit together absorbthe small surplus of the corporate sector with the difference being the netforeign finance, which is the financial counterpart of the current account

deficit Concern has grown about the financing of the current account

deficit and how this requirement will build, in particular the United States’reliance on foreign central bank purchases (mainly China and in the recentpast, Japan) and the surpluses of oil exporters (especially Saudi Arabia,Russia and Iran)

For a long time the US deficit was viewed in purely domestic terms Tofinance a current account deficit there must be a matching inflow of funds(‘borrowing’) from abroad However, these international capital flows donot respond exclusively to what is happening on the trade front Althoughthe financing of the US deficit has been described by Larry Summers (2004)

as ‘international vendor finance’ (at least in the context of foreign mental purchases of US securities), many of those supplying the funds donot buy US assets solely (if indeed at all) for the purpose of financing USpurchases of goods from abroad but rather because US claims (such

govern-as securities, land, equity, direct investment) offer attractive characteristics

(safety, liquidity, prospective returns) An increasing number of studieshave seen developments in overseas capital markets as causal factors drivingthe US current account These developments revolve around an increasedwillingness to hold US assets due to globalization and an associated reduc-tion in home bias (Greenspan, 2005e) or because of a ‘global savings glut’

in countries outside the United States which have a large amount of savingseager to be put into safe dollar assets and insufficient investment to makeuse of those savings (Bernanke, 2005) Foreign government and centralbank purchases of US government bonds and bills are also attributed tocountries at the periphery of the international system adopting export-ledgrowth strategies by using capital controls and undervalued exchange rateslinked to the dollar, with China again the prime suspect, limiting the move-ment of the yuan vis-à-vis the dollar and making Chinese goods artificiallycheap Together, the export of savings and the accumulation of dollarreserves have combined to keep US interest rates low and have presented USconsumers with cheap finance and cheap goods that constitute a bargainthought to be too good to pass up (Dooley, 2005)

Because observers disagree on what factors have produced the deficit,there is little agreement on what actions are needed to bring about anadjustment and when they will occur Those who give emphasis to USdomestic forces typically look for an adjustment in US public sector andprivate sector savings Those who focus on developments abroad as thecause invariably place the onus on foreign governments to boost domesticspending and purchase more US exports However, the problem may bethought to be too large for one or the other side to correct, prompting callsfor a coordinated international approach, in effect a new Plaza agreement(Cline, 2005b) Or, it might be considered better to leave the adjustment tothe market, which seemed to be the position of Alan Greenspan (2005a)who described the current account balance as ‘essentially a market phe-nomenon that is not readily subject to rebalance by targeting one or morepolicy variables’ (p 2)

These and other such related matters form the backdrop to this volume,which will seek to untangle the various issues and analyse them in a sys-tematic, rigorous manner Causation can run from domestic US factors tothe foreign (as under ‘international vendor finance’), or from foreign

influences to the domestic (under the ‘global savings glut’ argument), or beintertwined in quite complex ways (due to the pivotal position of the dollar

in the international order) A number of studies have drawn attention tothe unwritten rules of the current international system in terms of a

‘balance of financial terror’ (Summers, 2004, p 8) between the UnitedStates and creditor countries that is being relied on by both sides topostpone adjustment, and the special role of the US as world banker and

repository of short-term liquidity and other balances (‘collateral’) held bythose countries participating in the world trading system (Dooley et al.,2004; Gourinchas and Rey, 2005) Richard Cooper (2006) has drawn atten-tion to the importance of demographic changes in generating structuralcapital flows To these factors can be added the windfall gains of the oilexporting countries whether transitory or permanent Thus a distinctionneeds to be drawn between autonomous and induced changes, on the onehand, and those due to the monetary use of the dollar as a temporaryabode of purchasing power, between transitory and longer-term structural

influences, on the other

As these comments indicate, there are many explanations each offering

a different perspective on the causes of the US deficit However, Chairman of the Federal Reserve Board Roger Ferguson noted that therehave been relatively few attempts to assess and compare the full range ofexplanations that have been advanced for the emergence of the US deficit.Our aim in this volume is to address this absence and survey the factors thathave been put forward to explain the US external deficit, while not forget-ting that ‘it is possible and even likely that the deficit is the outcome ofseveral different developments’ (Ferguson, 2005, p 2)

Vice-In the final section of this chapter we outline the framework that weemploy to classify and analyse the explanations for the US current account

deficit, based around a 4
2 matrix that serves as our essential referencepoint Before doing so, however, we provide some summary statistics of the

US deficit, and its implications, to put the issues into some perspective

PERSPECTIVES ON THE US DEFICIT

An obvious starting point is the current account of the balance of ments statistics The balance of payments, or balance of internationaltransactions as it is otherwise known, simply provides an historical record

pay-of transactions between the residents pay-of one country, in this case the UnitedStates, and the rest of the world (Howard, 1989; Cumby and Levich, 1992;Higgins and Klitgaard, 1998) This accounting record is designed to reflectthe flow of international transactions over a period of time, usually onequarter or one year, and transactions are included if they are between resi-dents and non-residents, regardless of whether domestic currency orforeign currency is used for the transaction

Four major items make up the current account balance – merchandisetrade, services, net income and other current transfers The trade balancemeasures the domestic currency value of exports minus imports of goods,essentially manufacturing and agricultural products Net services comprise

the domestic currency value of exports minus imports of invisibles ing payments to holders of patents, royalties, tourism, air transport andshipping, and the overseas earnings of multinational firms Net income

includ-reflects interest, dividends, rents and profits on past overseas investments,net of debt servicing by US residents on foreign liabilities Finally, othercurrent transfers include foreign aid, development grants, social securitypaid to retirees who reside overseas, private donations and private remit-tances by guest workers

Of these four, the trade balance is the most widely cited measure ofthe US external imbalance, and with good reason Table 1.1 shows that inrecent years the trade balance and the current account balance have beenlargely synonymous, with service flows and net overseas income roughlyequal to net current transfers to non-residents This position may change inthe future if net income from overseas investments (previously a credit item)

Table 1.1 Components of the US balance of payments, 2003–2006

Capital account

becomes net debt servicing of overseas borrowings (a debit entry) Thefactors that have allowed the United States to preserve a net investmentincome surplus for so long in the teeth of rising net foreign indebtedness andthat may continue to help insulate the economy from the increasingly harshconsequences of mounting foreign indebtedness are examined in depth inChapter 6 Until this change around occurs we can jointly focus on the tradeand the current account balance and note the following trends:

● The US trade account has been persistently in deficit since the late1970s;

● The current account deficit in 2006 had risen to a record level,both in absolute terms ($811 billion) and as a per cent of GDP (6.12per cent);

● The deficit in 2006 greatly exceeded the twentieth-century peak of 3.3per cent of GDP in 1987;

● The trade deficit in 2006 averaged $64 billion per month or over $2billion per day;

● The US trade deficit was equivalent to $6690 per household in 2006;

● For every $1 of goods that the US exported in 2006, it bought $1.80

of imported goods;

● The US current account deficit in 2006 absorbed nearly 80 per cent

of the cumulative current account surpluses of the world’s surpluscountries

A particular concern amongst many in the United States is the tradeimbalance with China Some measures of this position are as follows:

● The trade deficit with China amounted to $233 billion in 2006;1

● The US–China bilateral deficit increased in 2005 relative to 2004 by

25 per cent and widened by a further 15 per cent over the course of2006;

● Chinese exports to the United States in 2006 were over five timeslarger than US exports to China;

● In February 2006, China displaced Japan as the largest single holder

of US dollar reserve assets with reserves of $854 billion comparedwith Japan’s $850 billion;

● China’s total foreign exchange reserves at the end of March 2007were $1.2 trillion

As these last points indicate, there is necessarily a close relationship betweentrade transactions and capital flows (indeed, they are mirror images), since

by accounting necessity the current and capital accounts of the balance

of payments sum to zero (allowing for statistical discrepancies) and acurrent account deficit will be matched by a capital account surplus of anequal amount A current account deficit implies that a country’s receiptsfall short of its expenditures on current account items In order to supportthis pattern of spending, the country must finance its deficit by borrowingfrom abroad or by running down its previously acquired holdings offoreign assets Apart from the capital gains or losses, the current account,therefore, measures the rate of change in the country’s stock of net foreignassets.

Accordingly, the capital account balance measures the excess of exportsover imports of financial obligations including equity shares, bonds andbank liabilities Capital account transactions can be subdivided intoseveral categories One distinction is between portfolio investments involv-ing securities and bank liabilities and direct investments that imply controlover productive resources Portfolio investments, in turn, can be splitbetween short-term and long-term, between private and official, andbetween equities and bonds From the bottom part of Table 1.1, it is appar-ent that the capital inflows are dominated by portfolio investments in USbonds, which have covered a large part of the financing requirement for thecurrent account deficit Although differing data sources tell differentstories, it is clear that a substantial portion of these inflows came primar-ily from foreign governments, foreign central banks or foreign governmentinstrumentalities (Feldstein, 2006) Some features of the capital transac-tions are:

● From being the world’s largest creditor (capital exporter) in the1950s, the United States is now the world’s largest debtor (capitalimporter);

● Foreigners have acquired an extra $2.4 trillion of US assets from

1990 to 2005, based on the changes to the net international ment position;

invest-● In 2005, Asian central banks bought $500 billion of US assets;

● By mid-2006, 43 per cent of the stock of US Treasury bonds were

in foreign hands compared with less than 5 per cent as recently as1970;

● At September 2006, China and Japan combined held in excess of

$900 billion of US Treasury bonds

So far we have focused on the current and capital accounts of the balance

of payments statistics However, from another perspective, imports of goods(and services) allow domestic spending to exceed domestic productionand incomes In effect, all other things being equal, an increase in domestic

spending, whether government spending or private expenditure, absorbsproduction that could otherwise be exported or used to replace imports,increasing the trade deficit Contrariwise, a reduction in spending releases(‘disabsorbs’) resources that can now be devoted to import replacement orused for expanding exports, and tends to reduce the trade deficit From thisway of looking at things, some developments are:

● The federal government budget has been in deficit since 1970 (exceptfor the years 1998–2001);

● The fiscal position changed from a surplus of $236 billion in 2000(2.4 per cent of GDP) to a deficit of $412 billion in 2004 (3.4 per cent

of GDP) before narrowing again to a $248 billion shortfall in 2006(1.8 per cent of GDP);

● Personal consumption spending has grown from 67 per cent of GDP

a current account deficit must equal the difference between US domesticinvestment, or capital formation, and total US savings emanating from theprivate sector and government sectors Table 1.2 shows the current account

deficit from the perspective of the national income and product accounts

Of course, the totals sum to the same amounts irrespective of whether thecurrent account is looked at through trade flows or capital flows, or throughsaving and investment flows, or in terms of gross national expenditures(national turnover) and production

Considering the savings and investment flows, in broad terms for 2006the government deficit (investment greater than savings for federal, stateand local government) was about 2.4 per cent of GDP, the household

deficit was around 4.5 per cent of GDP, the combined corporate sector(financial and non-financial) had a surplus of 0.8 per cent of GDP, with the

difference being the current account deficit (or capital account surplus) ofabout 6.1 per cent of GDP It needs to be emphasized what an unusual con-junction these circumstances represent Not only is there an unusual flow

of capital at the world level (from poor to rich), there is also an atypicalsituation in the United States where the corporate sector (usually a netborrower) is now supplying funds to the household sector (usually a large

net lender) Some other distinctive features from a savings–investment spective are as follows:

per-● In the third quarter of 2005, US net national savings temporarilybecame negative, meaning that for the first time the United States wasnot saving enough even to maintain its existing capital stock;

● During 2005, US households actually dissaved out of current come That is, their savings relative to their after-tax income was 0.3per cent compared with an average savings ratio of 8 per cent from1950–2000

in-● Residential investment relative to GDP peaked at 6.3 per cent in thesecond half of 2005, its highest level since the 1950s, before starting

Table 1.2 The US current account position and national income and

product accounts, 2003–2006 (US$ billion)

Domestic absorption

Savings and investment

2 Net foreign investment is conceptually equivalent to the current account balance shown

in Table 1.1 with some measurement di fferences from the flow of funds data

● In total, the United States in 2005 was absorbing perhaps 80 per cent

of the international savings that crossed borders

OUR APPROACH IN THIS VOLUME

The different ways of looking at the current account deficit given in the vious section are derived from basic accounting identities involving thecurrent and capital account items in the balance of payments, and fromlinking these with the national income and production accounts As withany identity, no causation can be deduced from the various approaches Anation with a current account deficit will have a capital account surplus.Whether this situation is caused by developments in goods markets or infinancial markets, either at home or abroad, cannot be ascertained withoutadditional information The different perspectives do, nonetheless, high-light some linkages between spending, consumption, savings and invest-ment behaviour in one country and its payments position with the rest ofthe world While the expenditure data and the balance-of-payments datacannot offer any prescriptive advice to either private or public decision-makers, knowledge of the magnitudes and the alternative viewpoints may

pre-be useful for private decision-makers (for example, indicating a change

in competitiveness in goods or services, or a change in savings and ment behaviour), or they may suggest the need for some microeconomic ormacroeconomic policy adjustments

invest-For these reasons, our analysis is based around the four alternative ways

of thinking about a country’s current account balance and how it adjusts

to policy and other changes (Artis and Lewis, 1991; Lewis and Mizen, 2000;Truman, 2005) These viewpoints are:

Trade balance approach

A country’s current account position measures the balance between exportsand imports of goods and services plus the income from or the cost of ser-vicing existing net international assets and liabilities and net transfer pay-ments This approach focuses mainly on the determinants of exports andimports (economic activity, relative prices and exchange rates) with anemphasis on real exchange rates and the competitiveness of exportablesand import replacement industries

Absorption approach

A country’s current account position reflects an imbalance between totaldomestic use of resources (‘absorption’) and total domestic production oravailability of goods and services This perspective emphasizes policies that

affect total domestic demand and supply – consumption and governmentspending and fiscal and monetary policies with respect to demand, andstructural or supply-side policies with respect to output.

Savings and investment approach

A country’s current account position indicates an imbalance betweendomestic saving and domestic investment This viewpoint concentrates onthe determinants of domestic private sector and government saving, andthe relative attractiveness of domestic investment opportunities

Portfolio balance approach

Since a country’s current account position is mirrored by the capitalaccount position and a change in net foreign assets, it reflects the balancebetween the net external demand for and supply of a country’s financialassets This capital account perspective focuses on relative rates of return,liquidity, risk and wealth allocation decisions

Each of these four analytical perspectives, equally valid because of their

definitional equivalence, can be thought of as having a ‘domestic’ version

and a ‘global’ or ‘international’ version (or ‘Nth country’ version) Consider,

first, the trade balance view From a domestic point of view, US producersmay have lost competitiveness vis-à-vis Chinese firms In the internationalinterpretation, China might be thought of as maintaining the yuan at anundervalued level in order to boost exports to the United States Amongstmany US congressmen especially, China’s cheap currency policy, lack ofrespect for intellectual property rights, and other trade barriers, are thecause, with the rapidly growing US–China bilateral trade deficit seen as

‘proof’ that China is an unfair trader (The Economist, 18 February 2006,

pp 32–3) However, China is not the only country seemingly resistingincreases in its exchange rate to stimulate export-led growth In the extreme

case, since global trade positions must sum to zero, if N1 countries have

running trade surpluses, the Nth country (say, the United States) will

necessarily have a trade deficit

In terms of the absorption approach, the US current account deficitmight be attributed to a fiscal deficit and a residential housing investmentboom fuelled by historically low real interest rates resulting from FederalReserve monetary policy under Chairman Greenspan On an internationalinterpretation, much of the rest of the world is producing more than itwants to consume In particular, ‘disabsorption’ due to slow economicgrowth in Japan and the Euro area may have contributed to trade surpluses

in those regions and a trade deficit in the United States, which has been left

to take on the role of international spender of last resort

Under the savings and investment viewpoint, the domestic version wouldfocus on the dramatic reduction in household saving, the equally rapidincrease in residential housing investment, and abundant other investmentopportunities in the United States By contrast, the international dimen-sion would emphasize an excess of savings over investment in many othercountries, especially in East Asia, creating a ‘global savings glut’ Thisview was popularized in 2005 by Ben Bernanke, then a Federal ReserveGovernor, now Chairman of the Board of Governors (Bernanke, 2005) In

the Economic Report of the President, 2006 (Chapter 6) that largely reflectsthis view, even the terminology changes and the current account deficitbecomes the US capital account surplus

For the portfolio balance story, a domestic explanation might begin withhigh productivity and a strong ‘home bias’ in the United States for dollarassets, particularly real estate An international interpretation would look

to the strong world demand for dollar assets, especially due to reserve ings by foreign central banks In total, net foreign purchases of US securi-ties amounted to a massive $890 billion in 2004

hold-This 4
2 classification provides our basic frame of reference However,the competing explanations surveyed by us are not confined to this number.For example, there are at least seven different hypotheses that come underthe portfolio balance ‘international version’ alone: a changed world prefer-ence for dollar assets (Obstfeld, 2004); revisions to risk premia (Ferguson,2005); precautionary reserves holdings (Feldstein, 1999, 2006); the ‘collat-eral’ view (Dooley et al., 2004); the ‘exorbitant privilege’ idea (Gourinchasand Rey, 2005); the world financial intermediary argument (Poole, 2004)and the ‘empire of debt’ narrative (Bonner and Wiggin, 2006) Also, anumber of the explanations, while giving prominence to one strand ofanalysis, overlap some other categories, which is only to be expected sincethey are ultimately all different parts of the same story

AN OUTLINE OF THE BOOK

The plan of the book is as follows Chapters 2 and 3 focus on the causes ofthe US current account deficit The analysis is built around the four majoranalytical strands: the trade balance view (related to exports, imports anddebt servicing); the absorption view (revolving around domestic demandand supply); the savings and investment view (concerning the imbalancebetween investment and savings); and the portfolio balance view (involvingthe demand for dollar financial assets) Chapter 2 considers the trade per-spective, while Chapter 3 looks at the other three approaches Each of theseanalytical frameworks, as we have said, needs to be examined and assessed

from a US domestic perspective and from a global viewpoint The currentaccount deficit is an endogenous variable, affected by both policies andfinancial decisions in the United States and the rest of the world.

The international dimension is the subject of Chapter 4 In addition tothe ‘global savings glut’ view espoused by Federal Reserve Bank ChairmanBen Bernanke (and strongly endorsed by his then counterpart in Australia,Reserve Bank Governor Ian MacFarlane), a number of economists havechristened the current configuration of international capital flows as

‘Bretton Woods II’ Various hypotheses built around this theme are veyed in this chapter

sur-Chapter 5 focuses on the nature of the adjustment mechanisms to ments imbalances in the context of a world system of independent curren-cies and ‘international financial laissez-faire’, the term used by Max Corden

pay-(1983) to describe the new policy environment post-Bretton Woods.Thanks to the arguments of Alan Greenspan and others to the effect thatthere has been a ‘sea change’ recently in the degree of globalization andreduction in home bias of investment portfolios, there is now emerging agreater appreciation of the implications of this environment for globalimbalances The upshot of these views is a marked change in the rules ofthe game for debtor countries (and the sustainability of imbalances) due tocapital’s much greater ability to flow across borders

This leads us to the question of sustainability and Chapter 6 considersalternative scenarios of the extent and sustainability of the US currentaccount position The orthodox analysis of the dynamics of the currentaccount balance serves as the starting point, but the conclusions of thisanalysis are found to be compromised by the ‘unorthodox’ behaviour of theUnited States’ external balance sheet There then follows a detailed exam-ination of the ‘investment income riddle’, the ‘net international investmentposition enigma’, the ‘dark matter’ debate and the ‘black hole’ in the globalfinancial system Sustainability turns out to be a much more complexmatter than is commonly appreciated

What becomes apparent is that the sustainability of the US deficit is ditioned by the nature and composition of international holdings of USdollar assets For this reason, Chapter 7 concentrates on the demand for USassets, starting with the implications of a reduction in home bias for thefinancing of the US deficit The chapter then goes on to examine the mainsources of capital flows to the United States over the last decade Four mainsources are identified Two of them are well discussed in the literature, thesebeing the vast increase in invested funds emanating from non-Japan Asiaand the surpluses of the oil-exporting countries The two less well knownsources are the ‘old’ economies of Japan and Europe, and the private and

con-official capital responding to financial innovations in US financial markets

Funds are attracted to the United States because of the sophistication andinnovation of US capital markets, but the monetary role of the US dollarunderpins the demand The final section of the chapter considers whetherthe euro might eventually displace the dollar in its international monetaryrole.

Chapter 8 is concerned with the China–United States relationship Formany Americans the US trade deficit is synonymous with China and thereare many who see the balance of economic power shifting across the Pacific

to Asia, with China at its head as the next ‘superpower’2 Already, the tribution of Asia (China, India, Hong Kong, Indonesia, Japan, Malaysia,Singapore, South Korea, Thailand, the Philippines, Taiwan) to the growth

con-in world GDP from 2001–2005 at 21 per cent exceeds America’s 19 per cent

(The Economist, 21 October 2006, p 72) The chapter tries to put these

issues in perspective, and examines the economic issues that confront Chinaand the question of whether its own agenda matches this vision Finally, thechapter takes up what is for the United States, the vexing issue of China’sexchange rate regime

Finally, Chapter 9 presents our conclusions and recommendations forpolicy

2 The trade perspective

TWO APPROACHES

This chapter and the next examine the causes of the US current account

deficit (or, if preferred, the US capital account surplus) There is no age of hypotheses put forward to account for this phenomenon which, fromthe perspective of the United States at $811 billion in 2006, is at an histori-cally unprecedented high and, from the viewpoint of the internationaleconomy, absorbs perhaps as much as four-fifths of cross-border worldsavings flows Our analysis seeks to untangle the various explanations thathave been offered and analyse them in a systematic manner

short-As noted in the previous chapter, there are two broad ways to approach

a country’s current account position One is in terms of the imports andexports of goods and services (along with other current transfers andincome flows) and the associated financing implications in terms of capitalflows The other starts with the national income and production accounts

to show how an imbalance between total domestic demand for goods andservices and domestic production or, equivalently, between domestic invest-ment and domestic savings, gives rise to net imports or net exports of goodsand services to fill the gap The first tends to look more narrowly, althoughnot exclusively, upon trade flows and the financial aspects of capital inflowsand outflows, whereas the second introduces a wider range of factors bothwithin and across countries The trade flow perspective is the topic of thischapter Chapter 3 considers the national income accounting approaches.Putting the two aspects together, four equivalent definitions can be pro-vided for a current account deficit (CAD):

(2.1)(2.2)(2.3)(2.4)

The first is obtained from the balance of payments identity and defines thecurrent account deficit in terms of imports (Z) relative to exports (X), which

is matched, on the second definition, by the non-official net capital inflow

 (I  S)  (G  T)

 (C  I  G)  Y

 K  R CAD  Z  X

16

and borrowings from overseas (K) net of the authorities’ addition to

inter-national reserves (R) The third definition relates the deficit to the excess

of absorption, A CIG, over domestic income (Y) In the fourth

equality, the current account deficit is presented as equal to the excess of

private sector investment (I) over private sector savings (S) and the

govern-ment budget deficit (G – T) These four definitions provide the springboard

for what we have described as the trade balance approach, portfolio ance approach, absorption approach and savings–investment approach Anumber of different hypotheses fall within these four categories

bal-These hypotheses are necessarily not confined to any one nation For anycountry open to trade and with a reasonable degree of capital mobility, thecurrent account balance can be understood fully only within the framework

of a general equilibrium involving the spending and saving decisions ofnationals of many countries The deficits which the United States incurs onthe current account of the balance of payments must be twinned by sur-pluses on the part of countries with which it has trading and financial rela-tionships These individual national relationships should be seen as part of

an overall pattern of global saving and investment and not viewed purely

in domestic terms This is the basic insight of the ‘Bernanke thesis’ or of-savings’ view His argument is that the US current account deficit isnot all made in the United States Rather, it is also, and from his view-point, mainly, due to a glut of savings elsewhere, particularly amongstAsian countries As the major recipient of these surplus savings, the UnitedStates has experienced a current account deficit, which ought to be seen

‘glut-as the balance-of-payments counterpart of the net inflows of funds.Bernanke’s thesis makes relevant the policy conclusion succinctly put muchearlier by another Princeton economist, Richard Cooper:

In the context of overall savings – investment analysis, countries should not take any particular view of their current account positions at all Some will draw savings from the rest of the world, others will invest in the rest of the world Nothing is wrong with this It is as it should be (1981, p 269)

This benign attitude to the sustainability of the US deficit relies on the viewthat, if there are substantial national differences in inter-temporal time pref-erences and the marginal efficiency of capital, those areas with low savingspropensities and/or high investment propensities will export financial assetsand attract an inflow of capital carried, in effect, by an inflow of goods andservices that constitutes the current account deficit Such interaction ofinvestors in search of the highest rate of return with the behaviour of saversseeking to maximize inter-temporal utility determines the efficient world-wide distribution of savings and investment with its counterpart on the

goods side being national current account imbalances It then follows that

if the comparative advantages in present and future goods differ widelyacross countries (as it has been suggested that they do between China, Japanand the euro area vis-à-vis the United States), then even large current pay-ments imbalances among countries can persist, contrary to the conventionalview that focuses only on the current transactions section of the balance ofpayments accounts

Such a conclusion rests on acceptance of one particular view of thecauses of the US deficit, and to this extent we have run well ahead of our-selves We need to backtrack and look at some of the alternative hypoth-eses under the framework we employ, encompassing four approaches(trade, absorption, savings–investment, portfolio balance) and two inter-pretations for each (domestic and global) We begin with the trade view andmove on to the others in the next chapter

THE TRADE VIEW

Discussion of external imbalances has traditionally focused on trade flows,based on the elasticities approach that dates back to the early post-SecondWorld War period (Robinson, 1947; Metzler, 1948; Meade, 1951) Fromthis perspective, the emphasis is on the underlying economic conditionsthat determine whether a country runs a deficit in trade in terms of thefactors governing the export and import of goods and services The capitalaccount of the balance of payments is commensurately downplayed andsimply records the accommodating financial transactions that take place inresponse to trade flows, with investors passively providing vendor financefor what is happening in the trade account.1

Application of the trade view lends itself to the use of the basic tools ofdemand and supply analysis, involving relative prices and incomes as deter-minants of the demand for imports and the supply of exports In the case

of imports, the quantity of goods and services that a country obtains fromoverseas depends on income and the relative price of imported products,which is determined importantly by the exchange rate Exports depend onthe responses of a country’s trading partners to changes in their income andexchange rate movements

The analysis can be applied to a relatively fixed exchange rate world, withdevaluation as a policy option, or to a system of floating exchange rates.Certainly, when Milton Friedman (1953) and Harry Johnson (1969) pre-sented the case for flexible exchange rates they envisaged that the exchangerate for any country would adjust to the point where the demand for foreign

exchange to buy imports (Z) and make other current payments would equal

the supply resulting from exports (X) and other current receipts Suppose

that exports and imports both depend on relative prices and real income.Equilibrium requires:

(2.5)

and for a given y y0, this is defined by:

(2.6)

If 1 we have absolute purchasing power parity (PPP) and when 1

we have relative PPP when (2.2) is expressed in terms of rates of change.Strictly speaking, PPP is applicable if national output is internationallytradable with no restrictions upon trade such as tariffs and quotas In thiscase, perfect international commodity arbitrage (the ‘law of one price’)requires that:

cur-are the growth rates However, if goods arbitrage enforces parity across a

sufficiently wide range of individual goods, so that the price of each good,expressed in terms of US dollars or a basket of international currencies, isequalized across countries, PPP may extend to aggregate price levels In thatcase, PPP is ‘the disarmingly simple empirical proposition that, onceconverted to a common currency, national price levels should be equal’(Rogoff, 1996, p 647)

THE DOMESTIC PERSPECTIVE

In general terms, the trade view and the estimated demand relationshipsthey imply can explain much about the fluctuations in trade and associatedcapital flows that are observed across countries However, when applied tothe United States, two puzzles emerge One is in terms of ‘elasticity pes-simism’ and the role of the exchange rate in bringing about adjustment to

p  e  p*

P  EP*

EP* P   X(y, EP* P)  Z(y, EP*P)

the trade deficit The other puzzle is that US import demand appears torespond more strongly to changes in income growth than correspondingincome responses in other countries This finding suggests that, in the longrun, with exchange rates equal, the US is predicted to run a persistentlywidening current account deficit (Poole, 2004).

is completely unresponsive to the real exchange rate, the dollar value of USexports would remain unchanged The same result may arise in the shortrun for US agricultural products (e.g wheat) sold in fixed quantities for USdollars on world markets However, in general, some expansion of USexports would seem likely to result over time By contrast, US dollar depre-ciation may increase, decrease or leave unchanged the US dollar value ofimports Depreciation reduces the demand for imports in terms of foreigncurrency (or increases the supply in terms of US dollars) Whether the USdollar value of imports will rise, fall, or remain unchanged depends uponthe elasticity of demand for imports If this elasticity is unity, the value ofimports will remain unchanged If it is less than one, it will increase If it isgreater than one, it will fall

These relationships are summarized by the Marshall–Lerner condition(developed by Marshall, 1924, and Lerner, 1944) to the effect that depreci-ation will improve the balance of trade of a country so long as the sum ofthe elasticities of demand for a country’s exports and of its demand forimports is greater than one At one extreme, suppose that the elasticity ofdemand for exports is zero Exports in US dollar terms are no smaller thanbefore If the sum of the elasticities is greater than unity, this must bebecause the elasticity of demand for imports is greater than one, so that thevalue of imports falls With no reduction in the US dollar value of exportsand a decline in the value of imports, the balance of trade must improve.Vice versa, should the demand for imports have zero elasticity, the value ofimports will rise in US dollars by the full percentage of the depreciation.But if the demand for exports is greater than unity, as it has to be if the sum

of the elasticities of demand is greater than one, the value of exports willexpand by more than the percentage of depreciation and the balance oftrade will again improve If each elasticity of demand is less than one, butthe sum is greater than one, this will lead to an improvement in the balance

of trade expressed in US dollars because the expansion in US exports indollars exceeds the expansion in the value of imports.

The Marshall–Lerner condition serves as a useful litmus test, althoughfor substantial improvements in the trade balance with an exchange ratedepreciation, the sum should desirably be higher, perhaps four or five Thesmaller the sum of the elasticities, the larger the price changes needed to

effect a given balance-of-payments change A fuller account would alsotake account of supply elasticities and the extent of the trade imbalance.The value of unity for the sum of the demand elasticities is broadly correct

if supply elasticities are relatively large and if the balance of trade is in librium to begin with If imports are larger than exports (as seems likely inthe case of a depreciation), more weight falls on the size of the elasticity ofthe demand for imports.2

equi-This last condition assumes significance in the light of present conditions

in the US balance of payments, where imports are roughly double the value

of exports, and also in view of the estimated elasticities The standard

‘workhorse’ model for estimating trade elasticities relates the volume ofexports and imports to movements in real foreign and US domestic incomeand relative prices (usually in log-linear form) Various measures of the realexchange rate have been employed, using various trade-weighted indices ofthe dollar and different measures of prices, covering producer prices, con-sumer prices and unit labour costs Typical of the most recent estimates arethose of Chinn (2005) who finds that the price elasticities for US exportsrange from 0.68 to 0.84 while for US imports the price elasticity is low(between 0.11 and 0.27) and not statistically significant In fact, a statisti-cally significant price elasticity for imports can be found only by disaggre-gating the totals and excluding oil and computers (which together accountfor over 15 per cent of total imports) Even then the Marshall–Lerner con-dition barely holds, with the sum of the elasticities ranging from belowunity to a high of 1.33 The implication is that in the absence of incomechanges, a relatively large exchange rate adjustment is needed to alter thetrade position

One possible explanation for these findings is provided by Goldberg andTille (2006) on the basis of currency of invoicing in international trade.They find that more than 99 per cent of US exports and 92 per cent of USimports are invoiced in US dollars This finding assumes importance interms of ‘exchange rate pass-through’ Strictly speaking, the two need not

be connected For example, a European firm selling into the United Statescould invoice in dollars, but adjust this price to make up for any fluctuations

in the dollar–euro exchange rate In practice, however, prices are frequentlynot reset The European exporter, say, sets a price in dollars and leaves thisprice unchanged even if the dollar–euro rate changes When import prices

are not affected significantly by exchange rate movements, a US dollardepreciation does not lead to much of a decline in import quantities In thisway the trade adjustment may be asymmetric US importers may not adjustdemand for imported goods when the US dollar depreciates By contrast,the dollar depreciation renders US-produced goods (invoiced in dollars)cheaper to euro-zone consumers, enhancing the price competitiveness of

US enterprises Depending on the size of the exchange rate changes, theadjustment in real trade volumes may be largely restricted to exports of USgoods and services, and the foreign products that these exports displace.3

The Houthakker–Magee Asymmetry

When the response of exports and imports to real income movements is sidered, the second puzzle emerges This is the Houthakker–Magee incomeelasticity asymmetry Those authors (Houthakker and Magee, 1969) esti-mated the US income elasticity for total imports of 1.7 and the foreignincome elasticity for US exports of around 1 Subsequent studies have tried

con-different measures, different estimation techniques and different datasamples, but the Houthakker–Magee asymmetry persists For example, inone of the more recent studies, Hooper et al (2000) report long-run incomeelasticities for US exports and imports of 0.8 and 1.8 respectively Whilesome other research finds much higher export and import income elastici-ties than these, the ratio of the import to export income elasticity varies littlefrom the 1.7 found by Houthakker and Magee in 1969 (Mann and Pluck,2005) The implication seems clear: if the United States and the rest of theworld grow at the same pace, and there is no trend change in relative prices,the US trade deficit would continue to increase (Krugman and Baldwin,1987)

In combination, the ‘elasticity pessimism’ and the Houthakker–Mageeasymmetry would suggest that the United States is ‘doomed to deficits’(Chinn, 2005) In the absence of a realignment of income trends in theUnited States vis-à-vis those abroad, a mild depreciation of the US dollarwould be unlikely in itself to bring about a major correction to the tradeimbalance At the same time, boosting foreign income may do little toexpand US exports Far more effective, it would seem, would be a lowering

of US income and a dampening of the US demand for imported goods.This somewhat pessimistic assessment of the prospects for turningaround the US trade deficit is underscored by recent trends in the US tradeaccount The rising price of oil has been a key factor in the widening trade

deficit in recent years, accounting for about two-thirds of the increased

deficit in 2005 Figure 2.1 divides the trade deficit into that for petroleumand non-petroleum products Data for 2006 show that both the petroleum

deficit and the non-petroleum deficit changed little The latter was in the face

of a strong expansion in exports US exports grew strongly over the course

of 2005 and 2006 despite signs of major structural problems in the USexport sector These problems are evidenced by the US share of worldexports dropping from 14 per cent in 1997–2000 to under 11 per cent in

2004 The lion’s share of this drop was produced by a disproportionate fall

in real capital goods (except autos) exports (see Figure 2.2) It would seemthat foreign competitors have been able to undercut US exporters in theirtraditional area of strength – capital goods Notably, the growth of ‘tech’exports (the computers, peripherals and parts subcategory) has been par-ticularly low Beginning in the mid-1990s, the United States’ terms of trade

in capital goods (the ratio of export to import prices) began to rise sharply,implying a steady loss of competitiveness in this key area of exports Indeed,

as shown in Figure 2.3, by the end of 2005 the United States’ terms of trade

in capital goods had strengthened by 27.5 per cent since 1995

To put this rise in context, the terms of trade for US consumer goodsexcluding autos rose by only 8 per cent over the same period Importantly,the higher increase in the terms of capital goods trade was not a product ofaggressive price rises by US exporters, seeking to boost profitability at theexpense of market share Export prices for capital goods declined by some

6 per cent over this decade Rather, this terms of trade ‘shock’ has been the

1990 1992 1994 1996 1998 2000 2002 2004 2006 –50

US petroleum and related products trade balance ($ billion)

US non-petroleum goods trade balance ($ billion)

Figure 2.1 US goods trade de ficit decomposed, 1990–2006 (monthly data)

result of a deflation in the price of imported capital goods in the wake ofthe ‘Asian crisis’ of 1997, as indicated in Figure 2.4.

Ultimately, two factors determine export performance – export marketgrowth and competitiveness The export ‘boomlet’ of 2005 and much of 2006

reflects a buoyant export market backdrop and, most probably as well, the

1990 1992 1994 1996 1998 2000 2002 2004 2006 1

US capital goods exports excluding autos

Figure 2.2 US goods export shares, 1990–2006 (as a % of potential GDP,

monthly data)

1990 1992 1994 1996 1998 2000 2002 2004 2006 95

130 (Ratio of export to import prices, 1995 = 100)

US terms of trade in capital goods

US terms of trade in ex-auto consumer goods

Figure 2.3 US terms of trade, 1989–2006 (Ratio of export to import

prices, 1995 = 100, monthly data)

lagged impact of the dollar’s trade-weighted depreciation over 2002–2004when the Federal Reserve Board real effective dollar index dropped by 16 percent Figure 2.5 graphs both the broad and major trading partner real

effective indices for the dollar While the dollar in 2006 was broadly in linewith its 30-year average level, its value against a broad range of currencieshas not been as low for nearly ten years Some researchers, for examplePettersson (2006), suggest that competitiveness may be less important than

it used to be for foreign trade, or that it takes longer to impact upon exportperformance However, the failure of this changed competitiveness, andassociated export expansion to make more of an impact on the trade imbal-ance (see Figure 2.4) can be seen as a corollary, at least in a proximate sense,

of what can be termed the ‘dismal arithmetic’ of the trade deficit Withimports of goods around 80 per cent larger than exports, as shown in Figure2.6, exports need to grow that much faster than imports just to stabilize thetrade deficit at its present (historically high) level Given the strength of USfinal demand until the second half of 2006, the strong export expansion wasnot adequate to do the job In order to stabilize the trade deficit, imports cangrow no faster than around 6 per cent at an annual rate Using an elasticitywith respect of gross final expenditure (domestic demand plus exports) ofaround 2, this implies that final expenditure needs to grow at a sub-trendpace of around 3 per cent if the trade deficit is to stop growing

Productivity has a major bearing on competitiveness, and popularbeliefs in the United States to the effect that the US industrial base is being

US capital goods export prices US capital goods import prices

1990 1992 1994 1996 1998 2000 2002 2004 2006 70

Figure 2.4 US capital goods trade prices, 1989–2006 (1995 = 100,

monthly data)

‘hollowed out’ by foreign competition seem an overstatement The reality

is that the productivity in US manufacturing grew by 4 per cent per annumbetween 1995–2000, and from 2000 to Q1 2006 accelerated to 5.1 per cent

per annum (The Economist, 1 July 2006, p 62) There may be important

Real ‘broad’ US $ index

‘Broad’ average 1975–2005

Real ‘major currencies’ US $ index

1974 1978 1982 1986 1990 1994 1998 2002 2006 70

Figure 2.5 Real trade-weighted US dollar, 1973–2006 (monthly data)

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 25

US total imports as a % of total exports

US goods imports as a % of goods exports

Figure 2.6 The ‘dismal arithmetic’ of US trade, 1948–2006

(quarterly data)

structural factors at work in the American economy underpinning thesedevelopments Whereas US productivity in 1995 to 2000 was largely driven

by the information technology sector, higher productivity growth sincethen would appear to have been more broadly based (Jorgenson et al.,2006)

In fact, it was predicted back in 1999 that the greatest impact of ‘neweconomy’ technologies may well be in a wide range of ‘old economy’ appli-cations Technical progress most often comes from a myriad of improve-ments, and general purpose or enabling technologies such as the computeroften require further developments, or ‘micro inventions’ in Mokyr’s ter-minology, to make them broadly applicable (Mokyr, 1999) This was thecase with the steam engine,first, and then the electric dynamo, or genera-tor, later Decades elapsed between their introduction and widespread use

in industry Much the same lag may have occurred with the computer(which was first built before the Second World War) Perhaps only now are

we beginning to see the impact on a broad front of the technological throughs, in the form of widespread commercial applications, due to inno-vations that allow firms in many sectors to produce new goods and services

break-or reduce the cost of existing goods and services

It may be true that developing nations can now manufacture and exportproducts that high-income countries once dominated, but equally thedigital revolution enables services once thought to be non-tradable to

be traded, while manufacturing processes can be unbundled in ever more

efficient ways (Lewis, 2003) Firms such as Caterpillar, General Electric andBoeing may have remained powerhouses in US and world markets because

of the knowledge embedded in their products and processes, but there areundoubtedly many other US firms that have raised productivity throughthe sophistication of their equipment and the skills of workers As we shallsee, such embedded knowledge in US enterprises is one possible source ofthe ‘dark materials’ discussed in Chapter 6

THE OVERSEAS PERSPECTIVE

So far we have looked at the US trade deficit from a largely US orientation

In the global system, the US trade position is necessarily influenced by what

is happening abroad Since the 1970s when the US trade balance movedconsistently into deficit there have been large changes in the composition of

US exports and imports, both in terms of country and type of goods andservices involved There have also been large swings in competitivenessdue to relative productivity movements and exchange rate swings A recenttheme that has emerged is unfair trade competition Most usually China is