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Saturday, March 18, 2006

Investment Surplus

The United States trade deficit is one of those statistics that economic doomsayers like to latch onto. When people start talking about the trade deficit, I often point out that a trade deficit is the same thing as an investment surplus. Usually people ignore my little quip. However, someone recently requested that I explain the term investment surplus to them. I've been patiently waiting for a clear and simple explanation to materialize in the blogosphere, but it's been a while, and I haven't found what I'm looking for. To be sure, I've seen many postings using and even defining investment surplus, but I've found them a little more complicated than what I want, so I've decided to roll my own explanation.

The starting point I've chosen is a simple transaction proposed by Don Boudreaux in a recent article:
My next-door neighbor in Virginia agrees to mow my lawn for $25. He mows and I immediately give him $25 in greenbacks. Rather than spend his earnings on beer or a back massage, my neighbor uses the $25 to by a share of Microsoft.
This transaction is the epitome of a positive economic transaction. There was a need and a service was provided by the neighbor (let's call him Joe) to meet that need. Trade and investment ensued. Great!

The only possible downside is that Don is $25 poorer. Indeed, you might ask why lazy ol' Don didn't mow his own damn lawn. For now, assume that as Chairman of the Department of Economics at George Mason University, Don is able to consult at $250 per hour, and assume that he consulted for the hour that he would have otherwise spent mowing the lawn. In this case, he too is better off and the entire transaction is nothing but positive (assuming his clients got their money's worth).

Note that it doesn't matter much if Joe buys a share of stock or loans money to a business (probably via depositing the money in a bank). He's providing capital for others to use and for that he will get a return on his investment.

So far, the entire transaction was within the United States. But now, let's assume Don lives in San Diego and his neighbor, Jose, lives in Tijuana, Mexico. Now, all of the sudden, this very positive transaction adds $25 to the trade deficit and $25 to the investment surplus of the United States. Notice that a trade deficit can only happen in conjunction with an investment surplus. If Jose, or whoever ultimately ends up with the 25 US dollars, spends them on an American product or service, there's no net trade deficit and no net investment surplus. You can't have one without the other.

Is Don's purchase now a bad thing instead of a positive transaction just because the service provider's name is Jose instead of Joe? Is the United States somehow damaged by this trade? It's really not obvious that any damage is done. Certainly, the direct effects are only positive whether the transaction occurs across borders or completely within the borders of the United States. Everybody involved in this transaction is better off afterwards, and nobody else is worse off.

But there are some secondary effects that aren't necessarily positive and I think they can potentially be noticeable if the investment surplus is large enough. One potentially negative effect is lowered returns to investors in the United States. This can be seen in the very low real interest rates that businesses in the United States (and the government) pay when borrowing money. Since every Tomeo, Dedrick and Hari in the world are falling over each other to invest in and/or lend money to entities in the United States, this drives the cost of money way down for users of capital here. That's fantastic for those needing capital. They can buy and deploy more capital equipment, expand their businesses, hire more people, and sell more product at lower cost. It's also fantastic for keeping unemployment low and for minimizing consumers' expenses.

But investors and lenders (which is anyone with a bank account) within the United States can't get as high a real return on their investments and savings because there is so much foreign competition for those investments. For example, have you checked the interest rate on your checking account lately? Why bother with interest checking anymore?

All of the above effects help the poor and hurt the rich. Lenders are disadvantaged, but business can expand more easily and pay higher salaries to their employees, some of which are low wage earners. Egalitarians should love investment surpluses, no matter how large they are.

Many pundits also lament about the low savings rate in the United States. While I think savings/investment is actually okay, I think that one of the reasons that it isn't higher is because of the large investment surpluses were experiencing. Investment surpluses make dollars valuable. Valuable dollars make foreign products relatively inexpensive and that makes it more enticing to buy such products.

But there's a second reason investment surpluses increase domestic consumption. Let's consider an example. Let's say you have $5,000 in your pocket and you're on the way to the store to buy a large HDTV. On the way, you run into a friend and he wants to borrow that $5,000 for one month. Let's say you have complete confidence that he will pay it back. If he offers to pay you back the $5,000 principal plus $5,000 in interest for one month, I'd bet you'd take the deal. In other words, you would forego current consumption for savings (at least for a month). But instead of $5,000 in interest, let's say he only offered $50 in interest (which would still be a pretty good interest rate). Would you still loan him the money? It would certainly be less likely. I suspect you'd just stick with your original plan and go buy the HDTV.

The effects on returns of the investment surplus obviously aren't as extreme as in the above example, but the point is that the choice between consuming and saving is affected by the rate of return that's expected (adjusted for risk) if the choice is made to save, and the rate of return is affected by the size of the investment surplus. The bigger the investment surplus, the lower the rate of return and the more likely we are to consume instead of save.

This begs the question of why people in other countries are so much more keen to invest here than we are. Many pundits jump to the conclusion that it must be because everybody else is smarter, more disciplined, more future oriented, etc. than stupid, undisciplined, short term oriented, etc. Americans. I can't prove that explanation wrong, but I'd like to put forth a couple of alternate explanations for why it might objectively be a better deal for certain classes of foreigners to invest here than it is for us.

The most obvious explanation is that the dollar is a low risk haven for assets. The United States has a unique combination of stability, prosperity, and opportunity that can't be found anywhere else. For foreigners, this unique combination also represents a diversification. Their main economic potential exists in the country in which they reside because that's where they work. Investing assets in the United States provides a low risk diversification against downturns in their local economic fortunes. Unfortunately, it's asymmetric. If things go poorly in the United States, its citizenry will lose their jobs as they watch their domestic stock and real estate portfolios crash at the same time. But investing outside the United States entails even higher risk. Thus the consumption versus savings calculation is decidedly different for foreigners versus people living in the United States.

The real per capita GDP growth in the United States is quite good for a developed country. Since wages and income correlate with GDP over the long haul, wage growth will also likely be good. What that means is that, on average, we'll all have substantially higher income in the coming decades. If we compare that with countries with low economic growth, we'll have relatively more money to invest in the future than those from other countries. This also objectively tips the balance for us away from savings and investment and towards consumption relative to those in low growth countries.

In summary, a trade deficit is the same thing as an investment surplus, the direct effects from an investment surplus are all positive, some indirect effects are potentially negative, and there are objectively rational explanations for why foreigners are more interested in investing in the United States than we are. Investment surplus sounds oh so much better than trade deficit, and since it's net positive, I prefer using the term investment surplus.


Duck said...

I have a few questions about your thesis. Jose is not obligated to invest the $25 in the United States. He's not obligated to invest the $25 at all, he could just spend it in Mexico. Wouldn't that cause a net drain of wealth from the US?

Also, there is an issue as to whether the investments in the US are true investments or are just loans to fuel consumption. If the money is loaned to a company that will build a plant in the US that will employ Americans, then it obviously benefits the US economy. But if it is borrowed by consumers to buy foreign goods, then it is not creating wealth building capacity in the US, but elsewhere.

Bret said...


Regarding "Jose not obligated to invest the $25 at all, he could just spend it in Mexico. Wouldn't that cause a net drain of wealth from the US? "

No! It would only cause a temporary drain of liquidity. There are three cases:

1. Jose (or somebody) spends the $25 on products or services in the United States. In this case, the trade deficit is lessened so it's good.

2. Jose (or somebody) invests the $25 in the United States. In this case, additional capital is invested in the United States so it's good.

3. The $25 stays outside the United States either in Jose's mattress or it becomes part of the secondary currency of Mexico. In this case the Fed injects another $25 (or some fraction thereof) into the economy via open market operations (buying treasury instruments with what I like to call "magic money"), and the liquidity is restored. Note that as the economy grows, the Fed constantly injects liquidity in order to preserve (more or less) price stability. If lots of Joses take liquidity to foreign destinations, the Fed increases the rate at which it injects liquidity. If those Jose's start to repatriate those dollars via (1) or (2) in the future, the Fed reduces the rate at which it injects liquidity.

It is true that if all the Joses suddenly decided to repatriate those dollars all at the same time, it could potentially overwhelm the Fed's ability to control the domestic money supply. Even this wouldn't necessarily be all that catastrophic though. There would be a spike in demand for American products and services, which would give our economy quite a boost while driving down the dollar. There would be some inflation until things came to an equilibrium again. This would mean that the service Jose provided for $25 would end up buying less than $25 worth of product when it's finally repatriated. Once again, not a bad deal for the United States.

Regarding "...there is an issue as to whether the investments in the US are true investments or are just loans to fuel consumption.".

While everything is somewhat interlinked, and indeed that's what I was writing about when I was talking about how it shifts the balance towards consumption, the two topics should be considered to be independent. In other words, once an entity (such as the government) makes a choice to borrow, it doesn't really matter how that borrowing is financed. It doesn't really matter whether Joe or Jose lends you the money. If we think we borrow too much, spend too much, and save too little, that may or may not be true, but it's a question that's mostly independent from the investment surplus issue. Again, the main point is that the trade deficit is caused by the demand for investments in the United States.

Hey Skipper said...


Your expertise in this area never ceases to amaze me -- thanks for taking the time to clue-in the ignoranti.

Sometime ago I read an article in the Economist that looked at trade balances from a global, rather than country perspective. Since the Earth is, UFO abductees notwithstanding, a closed system with respect to trade, the sum of trade balances should be precisely zero.

Turns out that wasn't the case, by a long shot. The delta was opposite in sign and, no doubt coincidentally, very nearly the magnitude of the prevailing US trade d..., uh, investment balance.

You'd think someone would have noticed that beforehand.

Also, my limited knowledge of the issue suggests that the investment balance adequately encompasses goods, but fails miserably when it comes to services.

Oroborous said...

America's trade deficit with China, for instance, is huge because they subsidize their goods, and then essentially offer to finance their purchase.

If, as many people think, the Chinese will soon tire of slaving away so that the American middle class can live more comfortably, then that trade deficit will dramatically decrease.

That particular deficit isn't a manifestation of the lack of American ability to manufacture, it's simply us taking advantage of their desire to build market share by offering deep discounts - kinda like what the U.S. auto manufacturers have been doing, and with the same results: GM shareholders and Chinese citizens alike have been bribing us to buy their products.

When they stop, we'll simply make alternate arrangements. No big deal.

Bret said...

hey skipper,

You're right, and I should've mentioned that some economists think the investment surplus is greatly overstated. I think one should take nearly all economic statistics that involve huge amounts of many different types of data and/or some subjective formulas with some skepticism. That includes trade figures, the CPI, median incomes, poverty numbers, etc. The statistics are somewhat better at noticing change than giving any absolute information.

Bret said...

Yes, China's trade deficit with the United States is pretty big. Just to keep things in perspective, though, the total accumulated holdings of United States treasuries as of 9/2005 by China was $252.2 billion. While that's a fair chunk of change, and the Chinese been investing in other U.S. assets, their treasury holdings only represents about 2% of GDP. A drop in the bucket. So I completely agree with your "no big deal" sentiments.