Deficit, Interest Rates, Exchange Rates, and Inflation: A Tutorial

I think I’ve finally found a simple explanation of the relationships between the trade deficit, interest rates, foreign exchange rates, and inflation.

Current account deficit means we (as a nation) import (consume) more than we export (produce). How can we afford to do this?

One way is by selling domestic assets–trading them for money to buy imports. Domestic assets include real estate (land and buildings) as well as equity (shares of domestic corporations). This is fine as long as the value of US assets rises faster than the value of other countries’ assets. The money we make from selling some assets isn’t necessarily used to improve the assets we continue to own. Sometimes it’s transferred to foreign countries providing outsourced services, and sometimes it is just used to fund our desire for consumer goods. If growth of value of US assets slows, then buyers will shop for the assets of other countries instead.

Another way is by borrowing money. This is accomplished by selling bonds. The US Treasury sells the bond and pays periodic interest for the duration of the bond. (In turn, the Treasury loans money to US banks, which loan money to domestic home buyers and businesses.) This is fine as long as the interest rates and security against default of US bonds is higher than the rates and security of other countries’ bonds. If other countries raise their rates or lower their risk of default, then buyers will buy their bonds instead of US bonds. (Admittedly, it will be difficult in the near future for any other country to provide greater security against default than the world’s last remaining superpower.) If the borrowed money does nothing but pay for imports, then there is a net outflow of money: payment for imports as well as interest.

As stated in The Passing of the Buck?, The Economist, December 4, 2004, p. 71-73,

Asia's purchases of bonds hold down interest rates in America, and so support consumer spending and imports. This cycle, it has been argued, could last another decade.

If we send money to foreign countries in exchange for their goods and services, pay interest to foreign countries in exchange for loans, and also invest money in foreign countries, then we should eventually run out of money, right?

Not necessarily. There are two things we can do: First, we can print more money. Of course, that means that the value of every dollar in the world is reduced, and things start to cost more. That’s one reason for inflation.

We can also lower interest rates on short-term bonds. This provides economic stimulus to the nation by allowing companies and consumers to borrow funds from banks (which borrow funds from the federal reserve) more cheaply. The expectation of “economic stimulus” is that companies and consumers will use these funds to improve their assets and productivity. However, if consumers and companies don’t use the funds to improve domestic assets, then the economic stimulus fails.

As Robert Kiyosaki said,

In simple terms, we send cash overseas to buy goods, and overseas investors take our cash and use it to buy our assets. That's why the Wal-Mart shopper finds bargains in the store but can't afford to buy a house, gas, gold, or stocks. Those same "consumers" also worry about their jobs going overseas.

One critical advantage to the US, pointed out in the Economist article, is that the US borrows in its own currency.

A normal debtor country, such as Argentina, has to borrow in foreign currency, so while a devaluation will help to reduce its trade deficit [by increasing the cost of imported goods], it will also increase the local currency value of its debt. In contrast, foreign creditors carry the currency risk on America's $11 trillion-worth of gross liabilities. Its net foreign investment position actually improves as the dollar declines, because this boosts the dollar value of overseas assets. This makes devaluation an attractive option for America.

Marketplace had a brief article on this subject.

Tags: Business, Economics, Finance

Updated at: 15 February 2006 12:02 AM