Source: Forbes
People like me, who studied economics in the old days, learned that foreign trade imbalances were financed by passive capital flows, but that market forces would tend to correct significant trade imbalances, either through changes in the exchange rate or equivalent changes in internal income, output, prices, etc.
However, sometime between then and now, capital flows or international investment flows became less passive and took on more of a life of their own. They would still offset trade imbalances to keep the balance in the balance of payments, but the equilibrium balance no longer reflected separate balances in trade and hence capital flows. This was especially true for the United States since the dollar was a reserve currency that made it desirable to hold on its own for reasons beyond financing trade in goods and services.
The United States has a chronic trade deficit and capital inflows of equal size which show no signs of reaching a separate trade balance. Indeed, the trade and current account deficits have recently grown larger, but, since they are both independently motivated, the trade deficit has not put downward pressure on the exchange rate for the dollar. Or, more precisely, the downward pressure on the dollar from the trade deficit is offset by the upward pressure from the capital inflow.
What’s wrong with that is hard to say. Maybe nothing. Certainly, keeping the balance does not require government policies, and, if the government takes too keen an interest in the foreign trade imbalance, it is likely to adopt undesirable protectionist policies. But there is something perverse about the United States in 2014 being a net long-term capital importer. It would be more “normal” for one of the richest major economies in the world to be exporting capital to poorer countries rather than the other way around.
Alan Greenspan used to talk a lot about imbalances in the economy, and he pointed out that these imbalances were the basis of many forecasts. Thus, if we consider the large U.S. trade deficit an imbalance, it would lead one to forecast a decline in the dollar. If we consider overall payments to be in balance, we wouldn’t forecast a decline the dollar. The relative stability of the dollar in recent years suggests that the latter view is probably the correct one. Thus, benign neglect of the balance of payments is not necessarily a reckless policy, and doesn’t threaten the dollar.