Perhaps the most important economic conundrum today is this one: the persistence of relatively low interest rates despite global growth, signs of inflation, and a gigantic and rising U.S. current-account deficit ($804.1 billion in 2005).
Economists have been trying hard to explain it. Federal Reserve Chairman Ben Bernanke posited a savings glut—excess savings around the globe have lowered interest rates universally, including in the United States. By voraciously borrowing and spending, America is doing the world a favor by providing a safe home for foreigners’ surplus capital. Business Week economics editor Michael Mandel has argued that the huge trade deficit is largely imaginary. Foreigners lend us money on favorable terms, he wrote in a much-discussed cover story, because the U.S. economy has such a great ability to generate returns from “dark matter”—intangible assets like brands, patents, knowledge, and business models. (The thesis receives a nice academic treatment in this paper by Ricardo Hausmann and Federico Sturzenegger of Harvard.)
Now Stephen King (a London-based economist at the bank HSBC, not the writer) has come up with an even more satisfying new argument. The much-lamented trade imbalances, he argues, are an entirely predictable and acceptable outcome of comparative advantage—specifically America’s skill at managing money.
In his April report, Global Imbalances: Economic Myth and Political Reality, King posits a simple model: two regions within a larger system that is mostly economically integrated. People in one region are good at investing money efficiently, and have been doing it for a long time. People in the other region, where labor is cheap, are good at putting things together efficiently. What’s more, one region “has a good system of law, well-established property rights and a price mechanism within capital markets that allows appropriate pricing of risk,” while the other has “only a rudimentary legal system, poor protection of property rights and a capital market structure that makes it near-enough impossible to price risk.”
Next, imagine that the barriers to the movement of capital between the two regions fall while barriers to the movement of people between the two regions remain intact. What would happen? The first region—China—would emerge as a manufacturing powerhouse while the second region—the United States—would shed its manufacturing capacity and emerge as a money-managing powerhouse. And that’s exactly what has happened. King notes that since the 1950s, manufacturing’s share of U.S. gross domestic product has fallen from about 30 percent to about 10 percent; in the same time period, the GDP share of financial services has risen from 10 percent to 20 percent.
And this dynamic isn’t just taking place with China. Just as the United States has exported manufacturing and certain low-end services (call centers) to the developing world, the developing world has effectively outsourced investment and money management to the United States. “What we’re seeing is a classic case of comparative advantage: Emerging markets specialize in global manufacturing and commodity extraction while the U.S. specializes in global capital allocation,” King writes.
And it works out well for both parties. Yes, people in China—and in India, or Brazil, or the Persian Gulf—are saving tons of money, in large part because they’re selling goods and services to wealthy Americans and Europeans. But they don’t trust their own poorly developed capital markets, banks, or corporations to take good care of their yuan, reais, and rials. (As Henry Blodget argued, in the case of China, this mistrust is well-founded.) But the U.S. stock and corporate-bond markets offer investors around the world the ability to gain exposure to the global economy. After all, the biggest American companies—McDonald’s, Coca-Cola, General Electric, etc.—derive the lion’s share of their revenues from overseas. And plenty of foreign-based firms list their shares on U.S. exchanges. Paradoxically, the best way for an investor in Beijing to place a bet on the growth of China’s growing civil aviation sector may be to buy the stock of Boeing, which is selling a lot of planes to China. “The best route through which Chinese savers can get the best returns on investments in their own country is through the U.S. capital markets,” King writes.
As for government bonds, many analysts assume that foreigners—and, in particular, foreign central banks—buy bonds for mercantilist purposes. By plowing cash into U.S. bonds, China’s central bank helps keep the yuan-dollar exchange rate relatively constant. Here, again, though, King argues that there are rational, purely economic reasons for foreigners to buy low-yielding U.S. government bonds. The U.S. government, regardless of its recent fiscal promiscuity, is still the world’s best credit risk.
In essence, King’s argument is a variant on Mandel’s dark-matter argument. America’s intangible assets—its brand image, legal and regulatory system, capital markets, management prowess, and history of stability—allow it to attract capital on favorable terms.
The presumption is that the trade imbalances get unwound in a messy fashion, largely through a decline in the dollar or a sharp cooling off of China’s economy. Martin Wolf, the learned Financial Times columnist, today declared (subscription required) that the dollar must fall. But economist Stephen King doesn’t foresee a bloody and violent resolution. “The world we’re describing seems to be one in which current account deficits and surpluses can be persistently bigger than they have been in previous episodes.”
The current-account deficits will begin to decline only as China develops its own capital markets, and as more Chinese decided to consume and invest at home. “But that’s years away. It takes a long time,” he notes. In the meantime, the United States will continue to enjoy its status as the world’s hedge-fund manager, allocating capital on behalf of hard-working laborers around the globe.