Thanks for your post. You write “ Therefore, when foreigners use their dollars to buy more US stocks or bonds, it automatically reduces US net exports of goods and services“. Without a currency adjustment, what’s the “ automatic “ mechanism that reduces US net exports?
Great post, very interesting. I can’t help but wonder though about the late 1990s. During those years, the government budget was roughly balanced, the US was attracting large amounts of foreign investments, and the trade deficit was increasing. So indeed, consistent with your post, it seems clear that the attraction of FDI lead to the increase in the trade deficit.
However, at the same time, the economy was booming and debt / GDP was going down. Which begs the question: why is the trade deficit a problem? To me, it seems that foreigners were investing in US productivity growth, which led to US GDP growth in excess of the growth of debt to foreigners. The end result is that the US grew partly thanks to foreign money, but the debt/gdp still declined so this extra nominal foreign debt doesn’t matter. To me, it seems everybody is happy: foreigners get good returns, the US gets economic growth. Sure, exports relative to imports shrank, but why does that matter if your economy as a whole is growing?
This is a fantastic question and I'm happy to answer it because I wrestled with how much detail to include on this mechanism in the paper. I ultimately decided to simplify several technical concepts to maintain readability, but the underlying mechanics are crucial for understanding how trade and capital flows interact.
Let me explain the mechanism by starting from scratch. Consider a simple two-country world (U.S. and China) where initially no one owns foreign currency.
Chinese entities can acquire U.S. dollars in two ways:
1) Trade Chinese financial assets for U.S. dollars (a pure financial transaction that nets out in the balance of payments)
2) Trade Chinese goods and services for U.S. dollars
When Chinese entities receive dollars from selling goods and services to the U.S., these dollars must return to the U.S. in one of two ways: 1) Buy U.S. goods and services (which would balance trade flows) 2) Buy U.S. financial assets
If they use these trade-earned dollars to buy U.S. financial assets instead of U.S. goods and services, this creates an imbalance: China has exported goods without importing an equivalent amount, creating a trade surplus matched by a capital account deficit (accumulation of U.S. financial assets).
The "automatic" reduction in U.S. net exports occurs because dollars earned from trade but used to buy financial assets are, by definition, not being used to purchase U.S. goods and services.
Thanks for your post. You write “ Therefore, when foreigners use their dollars to buy more US stocks or bonds, it automatically reduces US net exports of goods and services“. Without a currency adjustment, what’s the “ automatic “ mechanism that reduces US net exports?
I was struggling with this as well and the whole argument is based off of this.
If I sell a good to the US for $100, I now have $100.
I can spend this $100 on goods/services or stocks/bonds.
I choose stocks/bonds.
Now $100 is back in the US.
But US net exports have been reduced by this action? Is it because of what the exports COULD have been?
Great post, very interesting. I can’t help but wonder though about the late 1990s. During those years, the government budget was roughly balanced, the US was attracting large amounts of foreign investments, and the trade deficit was increasing. So indeed, consistent with your post, it seems clear that the attraction of FDI lead to the increase in the trade deficit.
However, at the same time, the economy was booming and debt / GDP was going down. Which begs the question: why is the trade deficit a problem? To me, it seems that foreigners were investing in US productivity growth, which led to US GDP growth in excess of the growth of debt to foreigners. The end result is that the US grew partly thanks to foreign money, but the debt/gdp still declined so this extra nominal foreign debt doesn’t matter. To me, it seems everybody is happy: foreigners get good returns, the US gets economic growth. Sure, exports relative to imports shrank, but why does that matter if your economy as a whole is growing?
This is a fantastic question and I'm happy to answer it because I wrestled with how much detail to include on this mechanism in the paper. I ultimately decided to simplify several technical concepts to maintain readability, but the underlying mechanics are crucial for understanding how trade and capital flows interact.
Let me explain the mechanism by starting from scratch. Consider a simple two-country world (U.S. and China) where initially no one owns foreign currency.
Chinese entities can acquire U.S. dollars in two ways:
1) Trade Chinese financial assets for U.S. dollars (a pure financial transaction that nets out in the balance of payments)
2) Trade Chinese goods and services for U.S. dollars
When Chinese entities receive dollars from selling goods and services to the U.S., these dollars must return to the U.S. in one of two ways: 1) Buy U.S. goods and services (which would balance trade flows) 2) Buy U.S. financial assets
If they use these trade-earned dollars to buy U.S. financial assets instead of U.S. goods and services, this creates an imbalance: China has exported goods without importing an equivalent amount, creating a trade surplus matched by a capital account deficit (accumulation of U.S. financial assets).
The "automatic" reduction in U.S. net exports occurs because dollars earned from trade but used to buy financial assets are, by definition, not being used to purchase U.S. goods and services.