American Trade Deficits And The Unidirectionality Error

Kenneth Austin, "American Trade Deficits And The Unidirectionality Error,"Real World Economic Review, 2019, http://www.paecon.net/PAEReview/issue90/AustinK90.pdf

"... Safe Haven: Safe haven flows may originate in countries with surplus savings or where savings are scarce. Investors may be protecting money from their home government... Savings Glut: The “push” comes from economies with structural savings surpluses. In closed economies, these savings might cause recessions. In an open economy, the surplus savings can be lent abroad and finance net exports, avoiding a recession, high levels of debt-financed private and government consumption, or secular stagnation depending on the particular circumstances. This is the motive for many governments to try to achieve export surpluses: producing more than they consume. In some cases, the savings are mobilized by the state or central bank and used to directly finance the trade surpluses. In other cases, the private sector demands “safe” foreign assets in the absence of attractive returns or even in spite of poor returns abroad or concern about eventual depreciation. This can represent some form of market failure. Often, these private flows are aggravated by macroeconomic policies intended to increase savings in the country of origin, even though the savings may eventually become a drag on aggregate demand..... Reserve accumulation is the simplest push-factor mechanism…. A country with weak aggregate demand can expel surplus capital by setting a depreciated exchange rate. That rate fixes a low relative price of the country’s goods on world markets and creates a trade surplus and an inflow of foreign exchange (generally dollars) in the hands of exporters. If that inflow is simply sold locally, it depresses the local price of foreign currency and cause a corresponding appreciation of the local currency. That would reduce the trade surplus. To maintain the fixed exchange rate and the trade surplus, the surplus must be financed by the purchase of foreign assets. If the private sector cannot, or will not, purchase sufficient foreign assets, the central bank has to purchase the balance at the official rate. The central bank must buy this foreign exchange surplus and purchase reserves without regard to the needs of the reserve issuer or market conditions. Its demand for reserves is determined solely by the chosen exchange rate and the resulting private sector net sales of foreign exchange. The return on reserve assets is, at best, a secondary consideration. Prasad (2014, p. xiv) notes that emerging markets ultimately expect to experience capital losses on dollar reserves. The role of exchange rates in causing global imbalances is often misunderstood. Demanding that a country stop “manipulating” its currency is equivalent to asking that country to stop buying central-bank reserves. An exchange rate alone cannot cause and sustain a trade imbalance without a counterpart flow of savings to finance it. Such currency manipulation would be an obviously bad policy and a drag on growth for a capital-scarce economy. But for a country with a savings glut depressing aggregate demand, this would help maintain growth. Thus, maintaining a depreciated exchange rate and large surpluses is a strong indication of a savings glut... Precautionary Reserve Purchases: A common argument used to explain trade imbalances is that some countries need to acquire precautionary reserves as self-insurance against a sudden stop or reversal of capital flows. The precautionary motive may be real, but this is a weak explanation of trade imbalances. A central bank can sterilize the private inflows and purchase reserves to give it one-for-one insurance against sudden stops or reversals of capital flows without financing a trade surplus (but would probably pay a negative spread). The large reserve build ups after the East Asian financial crisis may have been an overreaction, or they could have just vented surplus savings (export-led growth). Even genuine precautionary reserve purchases, from the perspective of the reserve issuer, are pushed capital inflows.... Flows at the zero lower bound among advanced countries are puzzling. The large financial outflows from stable and conservative Germany do not have an obvious, return-maximizing mechanism driving them. One can easily understand how German funds flowed to the peripheral states of the EMU and Eastern Europe prior to the 2011 financial crisis. After that, it became harder. Even as the current accounts of the crisis countries swung to surpluses, German surpluses grew again; German investors acquired even more foreign assets elsewhere, including a significant amount of interbank lending. But the precise mechanism pushing German outflows is not clear, even if its effects are evident. But Germany is a clear case of an economy that benefits from capital outflows at the expense of its neighbors….”

His Five Factors:

“…This article labels assertions of one-sided causality “the Unidirectionality Error.” This error rules out by assumption the question, “Does the United States borrow because it needs to borrow or because other countries need to lend?” The flip side of efforts to increase trade surpluses is an effort to export or expel unwanted capital. This contradicts standard economic assumptions that capital is always scarce and economies benefit from more and cheaper capital. Capital outflows may be advantageous for one economy, but harmful to the receiving economy. When the drivers of capital flows are misunderstood, the resulting policy prescriptions can be globally deflationary….”

Kenneth Austin from Treasury has a list of Push factors driving money to US that might be useful at some point: