Savings Glut or Domestic Demand?
A lively debate has arisen over the contribution that foreign savings may have made to our current economic problems. Some economists argue that an influx of foreign savings helped to inflate the U.S. housing bubble, whose bursting caused the financial turmoil that led to our current recession. Others insist that the problems were by and large home grown. Most of the arguments have focused on the behavior of interest rates, yield spreads, and asset prices for proof, but foreign saving flows affect exchange rates and balance-of-payments patterns, so these data might help tell the tale.
When the influx of foreign savings rises, it increases the current-account deficit. An increase in domestic demand has the same effect. But each cause leaves a distinct footprint. An expansion of the current-account deficit that stems from an exogenous inflow of foreign savings will be accompanied by an appreciation of the dollar. An expansion of the current-account deficit that stems from an increase in domestic demand will cause a dollar depreciation.
Both types of patterns have appeared in U.S. data over the last few decades. Foreign savings, for example, shot in from mid-1997 through 2000, during the dot-com boom. To buy assets in the United States, foreigners first needed to acquire dollars in the foreign-exchange market.
As they did, the dollar appreciated 17.4 percent in real (inflation-adjusted) terms against a broad array of our major trading partners’ currencies. The dollar’s real appreciation raised the foreign-currency price of U.S. exports and lowered the dollar-price of foreign-made goods and services. As a result, worldwide demand shifted away from the United States, and our current-account deficit widened from 2 percent of GDP to over 4 percent of GDP. A similar savings-led pattern also appeared in the early 1980s.
The configuration of dollar and current-account trends that developed after the 2001 recession and before the real estate bust points to expanding domestic demand—not foreign savings—as the key causal development. The 2001 recession was very mild, but labor markets recovered slowly and output seemed to remain below potential. The Federal Reserve maintained an accommodative monetary policy with a real federal funds rate in negative territory through 2004. Domestic demand was strong enough to fuel import growth, but foreign economic activity and U.S. export growth lagged behind. The U.S. current account deficit grew from over 4 percent of GDP in early 2002 to 6½ percent of GDP in late 2005.
To buy imports, Americans must sell dollars and buy foreign currencies, which promotes a dollar depreciation. From early 2002 through 2005, the dollar depreciated 12.9 percent on a real basis. The dollar’s depreciation, however, made U.S. dollar-denominated financial assets more attractive to foreigners, who then channeled additional savings into these instruments.
To be sure, more foreign savings flowed into the United States between 2002 and 2005 than between 1997 and 2000, but between 2002 and 2005 developments in this country essentially enticed the foreign savings in. Between 1997 and 2000, foreign savings seemed to have barged in, as if they had no place else to settle.