Foreign Investment and the Coming Cash Crunch - TheStreet

Foreign Investment and the Coming Cash Crunch

The U.S. spends far more than it invests, leaving it vulnerable to capital flight.
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Hot for Teacher

JACKSON HOLE, Wyo. -- The total income of a country's residents can be expressed as

(a) GDP + NIFA

Where GDP represents

gross domestic product

(the value of the economy's domestically produced goods and services) and NIFA represents net income from abroad (the money earned by domestic residents from the net ownership of capital held in foreign countries).

The total expenditure on goods and services of a country's residents can be expressed as

(b) C + I + G

Where C and G represent personal and government consumption (respectively) and I represents investment.

And the

current account balance

is defined simply as the difference between the income and the expenditure of a country's residents.

(c) CAB = GDP + NIFA - (C + I + G)

Good so far?

Cool.

In the discussion to follow it will also help to note that the current account balance can be written as

(d) CAB = TB + NIFA

Where TB represents the trade balance (exports less imports), the balance on goods and services that Census

reports every month.

To arrive at identity (d) yourself, note that

(e) GDP = C + I + G + TB.

Then plug (e) into (c) and reduce.

Still good?

Cool.

Snap

Identity (c), which simply says that the current account balance equals net foreign investment, is the key to understanding what's going on with all the recent talk about the current account.

Specifically, the U.S. runs a huge current-account deficit: We spend much more than we earn; we are net borrowers.

Who's doing the lending?

Other countries.

Total world income must (of course) equal total world expenditure, so the countries running current-account deficits -- the ones wanting to spend beyond their means -- must necessarily turn to the ones running surpluses in order to finance such desires.

We must count on other countries to keep pouring money into ours.

And that's precisely what we've been doing.

To the tune of $818 million per day during the first half of this year.

Crackle

So what's the problem here?

The economists at

Salomon Smith Barney

put it more succinctly than your narrator could (italics mine).

The current-account deficit appears headed for $321 billion this year (a record 3.6% of GDP). In Jan. 20 testimony, Mr. Greenspan portrayed the deficit as a sign of U.S. strength, arguing that foreigners want to invest in the American economy because of its improved productivity and ability to allocate capital in a highly efficient manner. That may be, but investors mostly are acquiring financial, not tangible, assets. The global financial crisis has demonstrated that such capital is highly mobile and subject to violent swings in investor sentiment.

Peek back at identities (c) and (d) for this next part.

The U.S. trade deficit is rising both because of trade fundamentals (relative growth and the dollar) and because of the perception that the U.S. offers relatively high and safe returns. The net capital inflow that finances the deficit is bolstering U.S. asset prices, and the corresponding household wealth effects and low cost of capital are feeding domestic demand. The potential danger down the road is that this mutually-enforcing process will work in reverse if global investors sour on the U.S., either because they believe that domestic asset prices are unsustainably high or because of a relative improvement in overseas growth prospects, or because of forced repatriation.

Cool?

Cool. Cause that's really all there is to it.

The U.S. demand for funds is approaching a billion dollars a day and, as better opportunities for hungry, fast-moving money present themselves, the risk is that global investors will consider this country an increasingly less qualified candidate for that cash.

That risk will rise accordingly for as long as the rest-of-the-world concern that the Feds are falling behind the curve continues to heighten -- as it is doing now.

Pop

For a long long time the rest of the world sucked so much that the U.S. was the best game in town -- because it was the only one around.

That just ain't the case anymore.

Long euro-dollar, anyone?

Side Dish

One of the best bond guys I know says he smells serious trouble.

That is all.