Originally published in THE BOSTON GLOBE

Tuesday, July 18, 2000

Closing our $1b-a-day gap

"More saving needed to cut dependence on foreign funds"


Martin and Kathleen Feldstein

In sharp contrast to the growing surplus in the federal budget, the US trade deficit continues to surge, raising risks for the US economy. By importing more than we are exporting and by selling American assets, Americans are able to consume more than we can really afford.

Borrowing from abroad has helped Americans increase their standard of living, but it also has made our economy vulnerable if foreigners decide to reduce the flow of loans and investments to the United States. An important goal for the next president should be to develop effective policies to reduce this danger by increasing national saving in order to cut our dependence on funds from abroad.

While United States has been a net borrower from abroad for the last two decades, the numbers have become really big in the last eight years. In 1992, the United States imported $28 billion more than we exported. By the first quarter of 2000, net imports - or the excess of imports over exports - were running at a rate of more than $330 billion annually. And the trade deficit is likely to go on rising this year. That $300 billion increase in net imports over the past eight years is equivalent to 4.5 percent of total US consumer spending.

The net imports figure actually understates our international deficit because it doesnt take into account the growing interest, dividends, and rents that we have to pay to the rest of the world. The current account deficit - a more comprehensive measure of our international deficit that includes these financial payments - rose from $51 billion in 1992 to an annual rate of $400 billion at the end of 1999 and is likely to be even larger this year. That means the United States has to attract more than $1 billion a day to finance its gap with the rest of the world.

The cumulative effect of these growing annual deficits has been a shift in our net investment position compared with the rest of the world by more than $1.5 trillion between the end of 1991 and the end of 1999. The value of foreign investments and loans in the United States exceeds our investments and loans abroad by more than $1.8 trillion - up from $260 billion at the end of 1991.

Why have foreigners been willing to extend so much credit to the United States? Dollar bonds have been attractive to foreigners because interest rates have been higher here than in Europe and Japan (where they have been close to zero). And companies such as Daimler, Vivendi, and AXA have bought businesses here because the United States is a better place to grow their business than their home countries or other places in Europe. It is only in the area of portfolio equity investments that US purchases abroad have matched foreign purchases in this country.

An important consequence of this net flow of investment to the United States has been the increase in the value of the dollar. Since 1992, the dollar has risen by nearly 14 percent, relative to a broad index of other currencies and adjusted for national differences in inflation. The strong dollar has made foreign products relatively cheap for American buyers and has made US exports more expensive abroad. So it is no wonder that foreigners have slowed their purchases of US goods, while Americans have been eager to buy foreign goods of all types, from cars to childrens toys. The lower prices of imports also have helped to keep inflation down in the United States. All of this seems quite benign. But how long will foreigners be willing to lend and invest more than $400 billion a year in the United States? And what are the consequences if and when they pull back?

The gap between US interest rates and those in Europe and Asia is likely to narrow as the European and Japanese economies strengthen. That will make US bonds less attractive than they are now and will cause the inflow of funds from abroad to decline. That will have several effects that may hurt the US economy.

The decrease in foreign investment may put pressure on the stock market. And the decreased demand for US bonds will in turn decrease the demand for dollars. When the dollar falls, inflation rises as the cost of imports rises. That also means less discipline on American firms when it comes to raising prices. Finally, Alan Greenspan and his colleagues at the Fed may find it necessary to raise short-term interest rates to stop the increased inflation caused by the dollars fall.

In short, the rapid increase in borrowing from abroad over the last decade has left the US economy in a precarious situation. If - or when - foreigners decide that they dont want to lend so much to the United States, the dollar will decline, interest rates will rise, and inflation will increase.

Those are not circumstances under which Americans are likely to save more to replace the lost foreign investment inflows. To become less vulnerable, it is important for Americans to increase their savings now. That will mean reversing a long-term decline in US household saving. Developing policies to encourage higher household saving should be a key priority for the next administration and Congress.

Martin Feldstein,, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.