Wednesday, December 21, 2011

What is the capital account?

Writing in the Economist, Mark Thoma says something remarkable:

"A COUNTRY that runs a current account deficit is borrowing money from the rest of the world. As with any loan, that money will need to be paid back at some point in the future. The cost of these loans is the interest that must be paid, and any vulnerabilities to speculative attacks that come with them."

We know that a current account deficit means there will be a roughly equal sized capital account surplus. But there is nothing about the capital account that requires the net foreign investment be in bonds!

Foreign direct investment (FDI) is part of the capital account. If companies around the world build more factories in country A than country A companies do around the world, then country A (all else equal) will have a capital account surplus and a current account deficit. Net foreign purchases of equities are also part of the capital account. If more foreigners buy stocks in Country A that citizens of Country A buy in foreign countries, that contributes to Country A's capital account surplus (and current account deficit).

I don't consider net FDI or net foreign purchases of equities loans. Do you?

Suppose Toyota buys a factory from Ford. Does that mean the US is borrowing money from Japan? Suppose Lionel Messi buys shares in IBM. In what sense is that the US borrowing money from Argentina? There is no requirement that the government or domestic individuals buy these items back later. Suppose I buy a factory from Ford. Is the rest of the country borrowing money from me?

Maybe Mark is speaking broadly, metaphorically, and considers profits of foreign owned factories and dividends on foreign owned stocks as "interest on loans"?

Even if this is so, FDI is decidedly NOT "money that will need to be paid back", nor am I aware of any studies showing that FDI inflows (except perhaps by the indirect channel of creating currency appreciation).

In his blog, Mark says he consulted the Krugman & Obstfeld text before writing the Economist post. Does the book make a similar claim?

People, what am I missing here?


Doc Merlin said...

Maybe you are missing that capital investments are often very literally loans, bonds etc? In the case of the US this is especially true because of the US treasury market.

Angus said...

Yes obviously the capital account surplus is often foreign entities buying domestic debt. My point is that it is NOT exclusively so. Check the first paragraph after the quotation.

Mark Thoma said...

It's the Krugman and Obstfeld text, and yes, the entire discussion is in terms of the current account.

See pages 534-535 in the 6th ed.

For instance, the section "Problems with Excessive Current Accounts" begins with:

"...As noted, a current account deficit (which means the country is borrowing from abroad) ..."

So I was using the standard language for these discussions.

Mark Thoma said...

When I try to send you email, I get:

----- The following addresses had permanent fatal errors -----
(reason: 550 5.1.1 User unknown)

----- Transcript of session follows ----- ... while talking to
>>> DATA
<<< 550 5.1.1 User unknown
550 5.1.1 ... User unknown <<< 503 5.5.2 Need rcpt command

Angus said...

Mark: I got your email no problem. thanks. maybe Krugman will post a comment to clear things up for me.

Kindred Winecoff said...

I don't think the language "borrowing from abroad" is the best because it causes folks to have the reaction that Angus had. But I think Krugman would say that a current account deficit is a form of debt, because it requires repayment. Bonds are one mechanism for organizing the repayment, but are not the only one. You could also transfer portfolio assets (FPI), intermediate goods (FDI), or other types of goods (art, real estate, consumption goods). But until that happens, you "owe" the surplus country something.

Bonds are just a mechanism to pay back the deficit at a future date rather than today. If we pay off today's CA deficit by selling the Empire State Building (as we did, to the Japanese in the 1980s), then there is no need for future repayment.

Tim Worstall said...

"People, what am I missing here?"

The preparation of the masses to think that foreign investment is a bad idea.

You know, Buchananite nativism. That such as Mark Thoma are doing the preparing shows how weird the left has got (Buchananite nativism is already weird beyond belief).

Anonymous said...

Don Boudreaux has addressed this issue ("The current account deficit is not (necessarily) debt" multiple times on his Cafe Hayek blog.

Jo VB said...

"People, what am I missing here?"

I think you are taking the "loans" and "interest" terminology too literally. Let's just use the broadly speaking interpretation and I must say that I *do* believe these "loans" will need to paid back.

If Toyota eventually pays out its dividends *in yen* (for example by repatriating its US profits), it will imply an inverse capital account flow for the U.S., i.e. the money is paid back. If Messi or his heirs eventually have time to consume his earnings, most of it will be in terms of goods and especially services produced outside the US, unless he moves there. Again, when he sells off his investments the U.S. capital account flow is reversed and "the money is paid back."

The big insight I learned in macro is that the only thing in a representative consumer's utility function that makes sense is consumption. All the money flowing into the U.S. today has to some day flow out to finance foreign consumption, or at least the return on these investment has to flow out. These foreign consumers are no altruists, I don't understand why you would think they are. I myself invest some money in USD, but surely that is just an investment that I keep there as long as I like the returns and that I will some day (for sure) pull back out.

Joseph Clark said...

Equity is a long call option on a company's assets. Debt is a short put option on the company's assets. Pretty big difference.

Maybe Thoma should read less Krugman and Obstfeld and more Merton.

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