Academic journal article The Cato Journal

Global Imbalances: A Source of Strength or Weakness?

Academic journal article The Cato Journal

Global Imbalances: A Source of Strength or Weakness?

Article excerpt

Gross capital flows into the United States totaled $1.8 trillion in 2006. When combined with the $1.0 trillion the United States sent abroad, these net capital inflows funded the U.S. current account deficit of about $800 billion. (1) The source of a large proportion of these capital inflows was developing economies--especially China and major oil exporters. Why are foreigners willing to invest such massive amounts of money in the U.S. economy? And perhaps even more surprising--why are countries with low levels of investment willing to send this relatively scarce resource to a capital-abundant economy instead of investing in their own countries? Understanding the motivation behind the millions of individual decisions that drive these capital inflows is critically important to understanding if this massive net transfer of capital into the United States reflects a strength or weakness of the global economy.

The debate on the risks and implications of global imbalances has been ongoing for years (see Cline 2005 and Frankel 2006). Using broad generalizations, the two major sides of this debate can be divided into the pessimists and optimists. Pessimists argue that the United States is accumulating debt at an unsustainable pace and that capital should flow from capital-abundant economies (such as developed countries) to capital-scarce countries (such as developing economies), instead of the opposite. Optimists argue that the United States is an attractive place to invest and that capital flows into the United States reflect an efficient functioning of capital markets, given the excess of savings (relative to investment) in the rest of the world. Pessimists argue that global imbalances will end soon and that the denouement will be difficult for the global economy--including a sharp decline in the U.S. dollar, an increase in global interest rates, and a contraction in global growth. Optimists argue that this system could last indefinitely, and if it did unwind, any adjustment would be smooth, gradual, and painless.

Although the two sides of this debate appear to have little in common, one key theme is a focus on the macroeconomic causes and implications of global imbalances. This article takes a different approach and instead focuses on the microeconomic determinants of the capital flows underlying these massive, macroeconomic imbalances. Understanding exactly why individuals from other countries choose to invest in the United States is critical if one is to evaluate whether the current global imbalances are a risk, as well as how the imbalances might unwind.

This article begins by discussing one factor that is not a major determinant of capital flows into the United States: high realized returns. I then discuss six possible reasons why private-sector investors around the world might chose to invest in the United States instead of in their own economies, despite earning lower returns than the United States earns on its foreign investments. Most of these reasons reflect an efficient functioning of global financial markets. Empirical analysis is needed to evaluate which, if any, of these factors are important determinants of capital flows into the United States. The answer will help resolve whether the system of global imbalances is a strength or weakness of today's global financial system.

Higher Realized Returns Do Not Motivate U.S. Capital Inflows

When U.S. policymakers discuss the sustainability of the capital inflows currently funding the U.S. current account deficit, they frequently describe the United States as an attractive investment opportunity for foreigners. For example, during his tenure as U.S. Treasury secretary, John W. Snow (2004) stated: "Today we are in a situation where sound, growth-enhancing policies in the United States have made it an extremely attractive place to invest." (2) Most people interpret "an attractive place to invest" as implying high expected returns on investment. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.