How Excessive Capital Inflows Harm the U.S. Economy
They fuel asset bubbles, increase the trade deficit, unemployment, and debt
It is a widely accepted opinion that capital inflows benefit the economy. While in most cases the conventional wisdom holds true, there are some nuances of the balance of payments dynamics that need to be considered when analyzing the impact of excessive foreign investment.
The capital account, by definition of the balance of payments, must always equal to the current account. This happens for the following reason ( I will use the US and the dollar in my example):
Demand for the US dollar comes from
- Exports (foreigners buy US goods and services, American companies then exchange earned foreign currency for dollars, driving up demand for the dollar)
- Capital inflows (foreigners invest in the US economy, increasing demands for US assets and consequently dollars)
Supply of the US dollar comes from
- Imports (Americans, when purchasing foreign goods and services, gave their dollars to foreigners, increasing supply of dollars)
- Capital outflows (Americans investing abroad sell their dollars to purchase foreign assets, increasing supply of dollars)
Demand = Supply, therefore
Exports+Capital inflows=Imports+Capital outflows
(Exports-Imports)+(Capital inflows-Capital outflows)=0
Current account + Capital account=0.
So, if capital account equals the current account and their sum is zero, then an increase in one of the variables means a decrease in another.
Consequently, high capital inflows (capital account surplus) are accompanied by large trade deficits (or current account deficits).
What are the consequences of trade deficits for the economy? (This is the same thing as saying “How excessive capital inflows impact the economy?”).
- Unemployment. Foreign producers replace domestic manufacturers, and domestic employers go bankrupt. This leads to an increase in unemployment.
- Debt. In order to avoid unemployment, the government encourages large fiscal transfers, such as benefits to unemployed, food stamps, social security, etc. This results in the rise of government debt.
- Low savings rate. By definition, all income has to be either consumed or saved. High inflow of foreign capital loosens credit standards, decreases interest rates, and, due to increased demand for US assets, creates “wealth effect”, which makes consumers feel wealthier than they are in reality. All in all, excessive capital inflows conduce to increased consumption, which, in turn, pushes down the savings rate. Reduced savings exacerbate trade deficit.
- Asset bubbles. Ben Bernanke once argued that excessive capital inflows contributed to the 2008 housing bubble. Foreign investors, mostly from Asia, increased demand for safe assets before the Global financial crisis, inflating their prices and contributing to the housing bubble. Today, Asian savings glut is again becoming a problem, thereby endangering the global economy — savings rate is even higher than before the crisis
Some might say that foreign investment is beneficial in that it helps finance new infrastructure and R&D. This is true in case of developing economies; but the US is a developed country, and as we see from above-provided facts, excessive foreign capital harms its economy.
With historically low-interest rates and American corporations sitting on piles of cash (Apple alone, with its $250 bln in reserves, has twice the amount of money Washington used for the Marshall plan, which revitalized Europe’s economy after the WWII), the US does not need so much foreign capital.
High capital inflows are accompanied by trade deficits, which lead to either more unemployment or debt and asset bubbles. If the US wants to get rid of these problems, it should restrict capital inflows into its economy, for example, by taxing them — this will result in the reduced trade deficit, mitigate the vulnerabilities in the financial system and help stop the inexorable rise of its debt.