Yesterday I nodded approvingly to the following remarks on the consequences of trade and current account deficits from Nouriel Roubini, as recounted by the Wall Street Journal:
"Your standard of living is going to be reduced unless you work much harder," says Nouriel Roubini, chairman of Roubini Global Economics. "The longer we wait to adjust our consumption and reduce our debt, the bigger will be the impact on our consumption in the future."
Reader Jim K responded...
"Your standard of living is going to be reduced unless you work much harder...."
Doesn't that depend on what we do with the proceeds of all this borrowing? If it is invested productively, then we won't have to reduce our consumption.
... and reader Gerald MacDonnell seconded the objection:
I agree with Jim. If anything he understates the point. The question boils down to what returns we earn on capital investment here. The tendency for capital deepening to raise labor returns is independent of who owns the capital. And even the net financial return seems likely to rise, despite the rising net tribute paid to foreigners.
Well, those are mighty fine points, and I was mighty remiss in not making them. So then, is it likely true that the sharp increase in the U.S. current account deficit that commenced in about 1997 has deepened the capital stock beyond what it otherwise would have been? knzn responds to Jim and Gerald's comments:
Although the other commentators make theoretically correct points, I think they are wrong empirically. Over the past few years, the US capital surplus (i.e., “borrowing”) has mostly been invested in residential real estate, which is not nearly as productive a use as one might hope for. Residential investment won’t do a whole lot to raise labor returns in the future.
Ben Bernanke raised the same issue a few years back in what, by pure virtue of the number of times I have cited it, is one of my all-time favorite Fed speeches:
Because investment by businesses in equipment and structures has been relatively low in recent years (for cyclical and other reasons) and because the tax and financial systems in the United States and many other countries are designed to promote homeownership, much of the recent capital inflow into the developed world has shown up in higher rates of home construction and in higher home prices. Higher home prices in turn have encouraged households to increase their consumption. Of course, increased rates of homeownership and household consumption are both good things. However, in the long run, productivity gains are more likely to be driven by nonresidential investment, such as business purchases of new machines. The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be.
This is a really intriguing question: Should we care if investment takes the form of physical capital that will ultimately be devoted to producing goods and services sold in markets, as opposed to physical capital that will ultimately be devoted to "home production" (that is, the manufacture of all those things that make us happy that households create for themselves)?
I'm not so sure. It would be true that increased quantity and quality in residential housing would do little to raise productivity in market activities, but surely it must raise productivity in home production. It would also be true that devoting more resources to home production means fewer resources for market production. In other words, if we decide to enjoy the "output" a larger yard, a more inviting family room, a gourmet kitchen,or whatever, we may have to cut down on our consumption of other things. But so what? That's a choice that individuals make all the time, and the truth is that economists don't have much to say about whether it is a good thing or a bad thing: De gustibus non est disputandum.
I can think of at least a couple of reasons to not be indifferent about the market/home investment distinction. For one thing, as mentioned by Mr. Bernanke, the deck is already stacked in favor of housing via tax incentives, institutions like Fannie Mae, and so on. A boom in a distorted market may not be such a great thing.
Perhaps more important from the financial stability point of view, home production is, by definition, non-tradable, so investment in housing has a limited capacity to directly generate the means to pay back foreigners who lend to us. That's the sense in which I was agreeing with Roubini and knzn -- the payback would have to come in the form of reducing our own consumption of market goods (again, below what it would otherwise be). Again, that is not a bad thing per se, but there is some possibility that this makes the whole set of transactions riskier from the point of view of the lenders, raising borrowing costs and inducing market volatility. There is yet scant evidence that this is the case, but I suppose it is a possibility.
Others may have additional reasons for worrying about a shift from market to home production. I'd like to hear them. But for now, I take the point that conclusions about the "problem" of the current account deficit are not clear cut. Consider me duly chastened.
UPDATE: Be sure to read the very thoughtful contributions to the comment section.
MORE WORTHY THOUGHTS: From Claus Vistesen, who you should be checking out regularly if you aren't already. Claus ruminates on this post, and Brad Setser's more extensive version of his comments below.