Inflation fears rise as trade deficit jumps, foreign investors flee
By Dean Calbreath
UNION-TRIBUNE STAFF WRITER
uniontrib.com
July 1, 2002
Shaken by Wall Street's growing scandals and sickly profits, foreign investors are pulling the plug on their U.S. investments, adding to an outflow of cash that tops $1.25 billion a day.
Some economists worry that if the exodus goes too far, it could threaten the underpinnings of the wobbly economy.
"This is an enormous problem that will become unsustainable within a very short period of time," said Mark Weisbrot, co-director of the Center for Economic and Policy Research in Washington, D.C.
If the trend continues, some economists warn, inflation could roar back to life. That would force the Federal Reserve to raise interest rates, which in turn would slow the economic recovery.
"Foreigners don't have to sell their U.S. securities to have a tremendous impact on our economy," said James Welsh, who heads Welsh Money Management in Carlsbad. "They just have to stop buying."
Japan, which has long been one of the chief U.S. bond buyers, has already been sharply cutting its purchases.
"A lot of Japanese invested in Enron's corporate bonds, which were supposed to be very low risk," said Takeo Hoshi, a Japanese economist who teaches at the University of California San Diego. "After Enron collapsed, Japanese investors began reassessing the risk of U.S. investments. And each scandal makes things look more risky."
Hoshi added that the Japanese are a bit amused by the current state of affairs. "Japanese businesses have been bad for a decade, and they've been pressured to upgrade their accounting to global standards, which means U.S. standards. But now they see that U.S. standards aren't perfect either."
Concerns are widespread. Net foreign purchases of stock decreased nearly 60 percent in the past year, dropping from $41.7 billion in the first quarter of 2001 to $17.6 billion in the first quarter of 2002.
That outflow has contributed to the burgeoning current account deficit, which measures the flow of trade, stock and bond purchases, direct investment and foreign aid between the United States and foreign countries.
During the first three months of the year, the deficit – which has been in the red for years – soared to a record $112.5 billion. In just three months, the deficit jumped 18 percent, rising from $95.1 billion in the fourth quarter of 2001.
For the past two years, the current account deficit has hovered around 4 percent of the nation's gross domestic product – a gap that most economists view as dangerous. If the deficit continues at its current rate, it will total an estimated $10.6 trillion by 2010 and $32.5 trillion by 2035.
In the boom times of the 1990s, it was easy to ignore the deficit. Skyrocketing stock prices drew a deluge of foreign investors, eager to pump money into an Enron-style energy conglomerate or a rising dot-com upstart.
Times were so good that the government printed lots of cash – helping boost the money supply at a clip of 7 percent per year. In normal times, the Federal Reserve might have worried that such an influx of cash would have sparked inflation. But the Fed apparently did not worry much about inflation, since there was so much demand for U.S. dollars overseas.
However, now that Wall Street's bubble has burst, the supply of dollars – which are no longer in hot demand – could fuel inflation. During the past few months, the euro has become more popular than the dollar, rising from 85.88 cents in January to 99.90 cents on Friday.
The decline in the value of the dollar should help companies export more goods abroad. But if the dollar drops too fast, it could scare investors and spark the Fed to take strong remedies, including a sharp spike to interest rates.
"The less attractive the U.S. appears, the more rapid the dollar will go down," said UCSD economics professor Miles Kahler, who specializes in capital flows. "We could have some precipitous dives."
The dollar's decline and the pullback in foreign investments come at a bad time for the federal government, which needs foreign cash to help make up for the growing budget deficit.
During the first eight months of this year, the government is projected to incur a budget deficit of $140 billion. That compares with a budget surplus of $140 billion during the first eight months of 2001.
"Until recently, U.S. fiscal policy was very orderly. But with the government heading into deficit, a major concern is whether foreigners are willing to hold dollars," said Tom Lieser, chief economist at UCLA's Anderson School of Business. "The strength of the euro has got to be more attractive than dollars to institutional investors."
To finance the trade deficit, the United States has been borrowing $450 billion a year from abroad, largely through the sale of Treasury securities. To raise more money to cover the budget deficit, the Treasury will need to issue new bonds. But U.S. bonds have not been doing well lately, since the Fed has pushed interest rates so low to stimulate the U.S. economy. And the declining value of the dollar is also making bonds less attractive to foreigners.
"The dollar's decline complicates the Fed's management," Lieser said. "Typically, the Fed wouldn't consider raising interest rates at a time when the economy is still shaky. With the dollar declining, though, it might be pushed closer to that."
A rise in interest rates would probably attract more foreign investors to U.S. bonds, offering the promise of higher returns. But if interest rates go too high, it would add to the federal debt, so that interest payments alone could soon start choking the economy.
"The big policy debates for politicians recently have been over the national budget deficit or the Social Security gap, but those pale in comparison to the current account deficit," Weisbrot said.
"With Social Security, you're talking about a problem that amounts to 1 percent of our GDP, which could turn into a major problem 40 years from now. The current account deficit is much larger and could create major problems this decade." |
