RECORD DEFICITS, PART TROIS

THE CAPITAL ACCOUNT. BECAUSE THAT’S WHERE THE MONEY IS.


Both companies and countries have assets. A company’s assets are its machines, its materials to be used in production, its office equipment, unsold product, its accounts receivables (money owed to it by other businesses) all kinds of things it uses in conducting its operation. A country can be thought of in the same way. Its assets are the businesses within its borders, its government buildings, the cash, gold and other deposits it holds in its central bank, and the debts it is owed by other counties or organizations.

In economics, finance, and investment analysis, we often refer to capital. Capital is used in many different contexts and has many shades of meaning. Below are a couple of good definitions that will work in the context of analyzing a nation’s Capital Account:

1. Monetary Capital: Money used (or to be used) for investment purposes
2.Real or Invested Capital: Capital goods (machines and production- & distribution infrastructure) needed for the production of goods and services. [i]

When the US (usually through its citizens) sells assets to foreigners, it has a capital inflow and a credit in the Capital Account. When the US (usually through its citizens) buys a foreign asset, it has a capital outflow and a debit in the Capital Account. And a surplus (credit) in the Capital Account will offset a deficit (debit) in the Current Account. So a trade deficit can be offset by Capital Surplus. And that is what is occurring with the US Balance of Payments situation.

There are three general categories of capital assets in the Capital Account:

A. Direct Foreign Investment. If Honda or BMW builds an auto plant in the United States, this is a direct foreign investment in the US. Similarly, if Ford builds a plant in Argentina, it is a direct US foreign investment in Argentina. One thing to note is that these direct foreign investments result in control of the investment remaining in the hands of the investing company.
B. Portfolio Investment. These are assets such as stocks, bonds, options, and the like. Foreigners can buy and hold them in a manner similar to that in which an American investor would hold such an investment. Conversely, Americans can buy foreign bonds, foreign stocks, and American Depository Receipts (ADRs), an investment generally comparable to owning stock of a foreign company.[ii]
C. Other Investments. These are shorter tem instruments like currency, cash deposits, and trade credits. Banks, corporations, and other large organizations buy and sell such investments in the international market.

The Capital Account is what keeps American Balance of Payments in equilibrium. Foreign governments and investors are huge purchasers of American stocks and corporate bonds. And they are gorging on US government debt, buying huge percentages of US Treasury Securities issued or available.

BACK TO THE BALANCE SHEET.

The last post looked at the Current Account for a hypothetical “Year”. In that Year, the US had a trade deficit of .25 Billion Dollars. The Current Account is reprinted from yesterday’s post and set out below. The Capital Account will follow.

CURRENT ACCOUNT.

Credit/Debit

Imports. 200 billion dollars

1. Merchandise 100 billion dollars
2. Services 50 billion dollars
3. Factor income 50 billion dollars

B. Exports 175 billion dollars

1. Merchandise 50 billion dollars
2. Services 75 billion dollars
3. Factor Income 25 billion dollars

Current Account Surplus/Deficit: Imports 200 billion dollars
Exports 175 billion dollars

-25 billion dollars, or a 25 billion
dollar debit (deficit).


CAPITAL ACCOUNT.
Credit Debit

C. Direct Investment 8 Billion - 1 Billion
D. Portfolio Investment 30 Billion - 16 Billion
E. Other Investment 15 Billion - 11 Billion

Balance On Capital Account 25 Billion (53 Billion credit- 28 Billion Debit)

So the Balance of Payments books equal out.[iii] In effect, the US Trade Deficit, as we have often discussed in this forum, is offset by foreign investment in the US.

HOW LONG CAN THE CAPITAL ACCOUNT CARRY THE MASSIVE TRADE DEFICITS, OR ATTENTION WALMART SHOPPERS-CASH ONLY. NO CREDIT CARDS.

This is the question that has occupied economists and analysts for a number of years. Attention to this question increases as each month seems to reveal an increasing trade deficit and more Treasury Securities being purchased by foreign investors and foreign central banks. The risk, as readers should know, is that international bondholders will become insecure in their Treasury holdings and start selling them off to diversify their holdings. Such a bond sell off will raise US interest rates and, if large enough, trigger a cascade failure in the American economy as consumption drops, the cost of debt service rises, and businesses and consumers default on their obligations.

The foregoing scenario would not be a bad result in the long-term as the US imports would shrink, a cheaper Dollar would spur exports, asset prices would fall, and interest rates would plunge as the good old mean reversion mechanisms of capitalism work out the situation. But it would be a kick in the teeth for many an American.

In any event, your always intrepid and engaging Author is set to read a couple of books over the next few weeks on the possibility that the US Capital Account surplus will continue to grow and offset the increasing trade deficits. And of course the Author is always reading and researching economic, financial, science, and political material for this weblog. That is the price one pays to toil in misdirected obscurity.

THERE CAN BE NO CASCADE FAILURES IN THE DESERT OF THE REAL!

[i] http://faculty.washington.edu/krumme/gloss/c.html
[ii] ADRS are held by an American Bank and represent shares of a foreign corporation. The shares of the foreign company are actually held by the American Bank. The ADR gives the ADR holder a right to the shares held by the bank.
[iii] For simplicity’s sake, we have ignored statistical discrepancies in the calculation and the Official Reserve Account. Statistical discrepancies arise because these balance of payment figures are estimates, not actual totals. The Official Reserve Account is an account held by the central bank, the Federal Reserve System here in the US. These accounts hold gold, foreign exchange credits and can borrow from foreign banks. These accounts are used if there must be payments made on actual balance-of-payment deficits.