Foreign Capital Inflows Don’t Lower U.S. Interest Rates

In a recent commentary on why persistent net capital inflows are a problem for the global economy, Martin Wolf, an economics editor at the Financial Times, suggested that one “obvious” way to resolve global imbalances would be to impose a tax on capital inflows.

While he is almost certainly right—a tax on capital inflows is the most effective way to limit the United States’ role as the main accommodator of global imbalances—many economists oppose such a tax on the grounds that it would raise the cost of capital for American business and raise interest rates for the federal government.

Their view is implicitly based on the premise that U.S. investment suffers from high costs of capital caused by the scarcity of domestic saving. If this premise were correct, it would be logical to argue that net capital inflows from abroad lower American interest rates by relaxing the domestic saving constraint, and that, by extension, any policy that reduces net foreign inflows could raise American interest rates.

But this premise is false. While capital may indeed be scarce in developing countries with high investment needs, it has long stopped being scarce in most advanced economies. In the United States, for example, businesses may refrain from expanding production for many reasons, but rarely is it because they lack access to capital.

This is a crucial difference for at least two reasons. First, if American business investment is not saving-constrained, the American economy will not adjust to net foreign inflows with higher domestic investment, and therefore it must adjust with lower domestic saving.¹ As explained below, the most likely adjustments that reduce domestic saving involve either higher unemployment or higher debt. Foreign inflows, in other words, can force the creation of additional U.S. debt so that the overall increased demand for American debt is matched by an overall increased supply—and in which case it will not drive down U.S. interest rates.

And second, if foreign capital inflows are not driven by the inability of American businesses to fund domestic investment, they must be driven by distortions abroad. That is why not only are these inflows unlikely to lower borrowing costs, they may also, paradoxically, force unwanted changes in the structure of the U.S. economy that create the conditions under which more borrowing becomes necessary just to sustain demand. It is not a coincidence, after all, that among advanced economies, those that receive the most amount of net foreign inflows—such as the United States, the United Kingdom, and Canada—are far more likely to be characterized among their peers by higher debt levels than by lower interest rates.

The Fallacy of Scarcity 

To understand the conventional misdiagnosis, we need to revisit the classical model from which it arises. In a world where domestic saving is insufficient to finance high-return investment opportunities, foreign capital is a welcome addition. In such a model—applicable, for example, to nineteenth-century America and many developing countries today—external inflows support growth by funding much-needed investment in infrastructure, industry, and productivity-enhancing projects that would otherwise go unfunded.

But this is not the reality of the twenty-first-century U.S. economy, or indeed most advanced economies. American corporations, for example, are not unable to invest because they are short of funds. Not only do they have access domestically to the most liquid and flexible debt and equity markets in the world, but even after using trillions of dollars mainly to buy back shares, pay dividends, or acquire competitors, they still sit on nearly $7 trillion in cash and cash equivalents, equal to nearly a quarter of U.S. GDP. They choose not to invest in new factories or technology.

This is not because they are myopic. It is because they find it difficult to sell their existing production capacity, and thus, increasing the amount of net funding available to them will not cause them to increase investment. Ironically, this weakness in domestic demand is amplified by the very capital inflows that are presumed to help because, by pushing up the value of the dollar, these inflows make foreign imports more competitive than products produced domestically. In other words, rather than drive American investment in domestic production facilities, net inflows can actually make this investment less desirable.

It helps to understand the effect of net capital inflows on domestic interest rates by considering the origins of these capital inflows. According to most mainstream economic understanding, foreign savings are “pulled” into the United States as Americans import capital to fund a domestic shortfall of saving. For those who subscribe to this view, the fact that net foreign inflows are by definition equal to the excess of American investment over American saving can only be explained in one way: net inflows must be pulled into the United States by the need of American businesses to fund investment.

But this denies the agency of foreigners. Countries such as China and Germany are not simply passive victims of American domestic imbalances. On the contrary, the fact that China fully controls its banking system while maintaining strict trade controls and even stricter capital controls—unlike the United States—should suggest that it is more likely to be the originator, rather than the absorber, of global saving imbalances. The reality is that countries such as China and Germany have purposely adopted economic models that suppress domestic consumption in favor of a more rapid expansion of manufacturing. As production grows faster than consumption, the saving rates in these countries automatically rise—leading to, in the case of China, the highest saving rate in history.

But supply needs demand. To avoid the rise in unemployment that would result from being forced to cut back on excess output, these countries must export their production surpluses, acquiring foreign assets in payment for exporting more than they import. Therefore, excess domestic saving in these countries is more likely to be “pushed” abroad by internal policies that boost production relative to consumption than be “pulled” abroad by conditions in deficit economies.

The United States is the main recipient of this exported capital. Foreign governments and investors purchase American Treasury bonds, corporate bonds, equities, factories, real estate, and other assets mainly because the United States has the deepest, most liquid, best-governed, and most open financial markets in the world. Surplus countries export their excess saving to the United States primarily for their own domestic reasons, whether or not U.S. businesses need the inflows to increase productive investment.

The key issue here is the direction of causality. The inflows are not responding to a shortage of saving in the United States. Rather, they are the result of saving surpluses generated abroad by policies that repress household consumption.

But this absorption by the United States comes at a cost. A country’s domestic imbalances must always be perfectly consistent with its external imbalances. By changing its external imbalances, capital inflows force adjustments in the U.S. economy—most obviously by raising the value of the dollar, although there are many other forms of adjustment—and these adjustments make U.S. exports less competitive and imports cheaper. As this dynamic erodes America’s tradable goods sector, manufacturing declines and wages stagnate.

If Washington doesn’t want the resulting contraction in American manufacturing to lead to unemployment, consumption must be sustained. With incomes under pressure and competitiveness falling, households and governments are encouraged to borrow and spend so that the decline in the American tradable goods sector is matched by an expansion elsewhere—job creation, in other words, shifts from manufacturing to low-productivity service sectors.² In this way, not only do foreign capital inflows not serve the existing borrowing needs of the economy, they force a shift in the composition of American production—away from manufacturing and towards services—and create conditions under which additional borrowing becomes necessary to prevent trade deficits from forcing up domestic unemployment.

Two Scenarios for Capital Inflows

The important point that many analysts fail to recognize is that in advanced economies like that of the United States, rather than fund investment, foreign capital inflows indirectly fund the consumer or fiscal borrowing that is required to absorb the excess production of surplus countries. This is how the United States acts as the world’s “consumer of last resort,” which is just another way of saying that it is the absorber of last resort of global excess saving. But it does so at the cost of rising debt and weakening economic fundamentals.

To make sense of the macroeconomic implications, it is helpful to consider two stylized scenarios that reflect the potential outcomes of foreign capital inflows:

1. The conventional scenario: In this world, capital is genuinely scarce, especially in countries such as the United States, the United Kingdom, and Canada—all major deficit economies. Domestic investment opportunities in these countries abound, but domestic saving falls short. As foreign capital fills the gap, interest rates fall, productive investment increases, and growth accelerates. This is the nineteenth-century American story, or the story of some rapidly industrializing economies today.
2. The advanced economy scenario: In this more realistic scenario, American firms and households are not starved of capital. Instead, they lack the demand that justifies an expansion of production capacity, in part because capital inflows overvalue the dollar, suppress net exports, and lead to declining industrial output. As U.S. factories move production offshore or find themselves unable to compete against cheaper imports, offering them foreign saving has no effect on their domestic investment plans.

In the first scenario, it is clear that foreign capital inflows, by relieving domestic saving scarcities, can lower interest rates and boost domestic investment. However, this is much less certain in the second scenario. Interest rates may indeed fall in the second scenario—but not due to capital abundance. They may fall because these inflows are the flip side of the weak domestic demand surplus countries must export to deficit countries like the U.S. As Americans pay for that weak demand by closing factories and firing workers, the resulting recession may lead to monetary easing. In this world, lower interest rates are a symptom of malaise, not a sign of healthier investment.

There is another—and more likely—way the second scenario may play out. American policymakers may decide to implement countercyclical policies to reverse the potential contraction in the economy and the accompanying rise in unemployment. They can either encourage more consumer borrowing or expand the fiscal deficit. In these cases, foreign capital inflows are matched by more domestic borrowing designed to sustain domestic demand. So, while the foreign inflows increase demand for U.S. debt, which may push yields down, they also create the need for more debt issuance, which pushes yields up. The overall effect on rates is ambiguous—it depends on whether the United States chooses to respond to the inflows with higher unemployment or with higher debt. If Washington chooses the former, interest rates will decline. If it chooses the latter, they won’t.

Which of these two stylized scenarios applies to the American economy matters greatly, because of the four ways the U.S. economy can adjust to net capital inflows, with each representing a different way in the gap between American investment and American saving can rise. These are:

• Investment rises. In this scenario, American businesses are eager to invest in a wide range of domestic investment opportunities, but lack the capital to do so. By making this capital available, foreigner investors lower American interest rates and encourage more American investment.
• Saving declines. As net foreign inflows push up the value of the dollar, American manufacturers in this scenario become less competitive and are forced to close down and fire workers. With unemployment rising, the American saving rate automatically declines (unemployed workers have negative saving rates). This is the form of adjustment that Joan Robinson warned was the most likely consequence of “beggar-my-neighbour” trade surpluses.
• Saving declines. To prevent unemployment from rising, the financial authorities in this scenario encourage consumer lending in order to increase domestic demand by an amount equal to the domestic demand that has bled abroad through the trade deficit. Rising household debt, of course, is the equivalent of declining household saving, and the resulting higher demand is divided between foreign manufacturers and domestic service providers. In this scenario, foreign inflows finance increased consumer borrowing.
• Saving declines. To prevent unemployment from rising, the government expands its fiscal deficit, in order—again—to increase domestic demand by an amount equal to the domestic demand that has bled abroad through the trade deficit; the resulting higher demand is divided between foreign manufacturers and domestic service providers. In this scenario, foreign inflows finance increased fiscal borrowing.

The bottom line is that contrary to what most American economists assume, the accounting identity that requires net inflows to equal the excess of investment over saving does not necessarily mean that inflows must cause investment to rise. The accounting identity can also be maintained by a decline in saving. Rather than simply assume only one form of adjustment is consistent, economists must analyze the structure of each economy in a more nuanced way and determine which type of adjustment is most likely. 

It is worth noting that in an important recent paper, Atif Mian, Ludwig Straub, and Amir Sufi make a similar argument from a different angle. They show a comparable effect caused not by a net inflow of foreign saving but rather by a rise in the saving of the rich as income inequality deepens. In an economy without strong investment needs, they note that the higher saving of the rich is balanced by “substantial dissaving by the non-rich and dissaving by the government” (in other words, household and fiscal debt). The key point is that if the rise in saving in one sector—whether it is foreign saving or the saving of the rich—isn’t balanced by a rise in investment, it must be balanced by a decline in saving elsewhere in the economy, and this usually happens in the form of higher unemployment, higher household debt, higher fiscal deficits, or some combination of the three.

The Myth of Interest Rate Suppression

An extension of the mainstream model is the claim that polices that push up U.S. saving—via some form of austerity, such as lower fiscal deficits, tighter household credit, or greater income inequality—would reduce the investment-saving gap and shrink the current account deficit. But this again assumes that the United States is the sole causal agent in global imbalances.

What if, instead, global imbalances originate abroad? If surplus countries such as China and Germany are exporting capital to sustain domestic employment and suppress consumption, then cutting U.S. fiscal deficits won’t reduce those capital exports except by forcing a contraction in the U.S. economy, which, by causing American imports to decline, forces a contraction in foreign production and thus foreign saving. In fact, if lower U.S. deficits improve perceptions of creditworthiness, they may actually increase the relative attractiveness of American assets. The result, in that case, would be that surplus countries direct an even greater share of their excess saving to the United States, leading to a stronger dollar and an even larger American trade deficit. This would be the opposite of what most American economists claim. 

Ultimately, there are two starkly different narratives for understanding why foreign capital flows into the United States: 

1. The domestic imbalance view: The United States runs external deficits because Americans save too little. The rest of the world must restructure their economies and force up domestic saving passively to supply capital to meet American demand, and this must be true even when they control their domestic banking systems, their trade accounts, and their capital accounts. In this view, only the United States has agency and raising U.S. saving should automatically reduce excess foreign saving, reduce the U.S. trade deficit, and lower American interest rates.
2. The foreign imbalance view: Some major economies suppress domestic demand to generate trade surpluses and stronger manufacturing sectors while controlling their trade and capital accounts in ways that allow them to externalize the domestic costs. The United States absorbs this surplus by running capital account surpluses and trade deficits. In this view, foreigners have agency, and capital inflows into the United States are a cause, not the consequence, of domestic American imbalances. Raising U.S. saving under this model—for example, by imposing austerity and reducing the fiscal deficit—either reduces demand (and raises unemployment through a corresponding reduction in investment) or forces more debt elsewhere in the U.S. economy.

Mainstream economists generally believe that only the first narrative can be the case, whereas in fact both can be. But these two narratives are not just competing interpretations on interest only to economists—they have radically different policy implications. The first suggests Americans must tighten belts and save more—austerity becomes the preferred solution to yet another economic problem caused by financialization. The second suggests that the trade deficit cannot be resolved by austerity at home. Instead, the United States should reverse its role in accommodating distortions from abroad, perhaps by implementing a kind of Tobin tax that discriminates against foreign inflows that are not directed toward long-term investment. This is the kind of tax Martin Wolf refers to above.

Capital Inflows Do Not Benefit the U.S. Economy

It’s time to retire the muddled notion that foreign capital inflows reduce American interest rates and boost American investment. That was true a century ago or more, when the U.S. economy—like other developing economies today—was capital constrained. But in today’s environment of excess global saving and insufficient demand, capital inflows do not relieve pressure on domestic borrowers—they only lower American interest rates to the extent that they cause American unemployment to rise. Ultimately, they are more likely to create additional debt to counter the unemployment impact of net American demand being diverted to foreign suppliers.

The more general point is that while capital inflows are not inherently bad—especially for rapidly growing developing countries with high investment needs—they are not inherently good. Their impact on the American economy depends on whether they are pulled into the United States by domestic needs or pushed into the United States by foreign needs. When they reflect distortions abroad, rather than productive opportunities at home, they become part of a process by which more-open economies are forced to adjust to the imbalances of less-open economies. They set up a dysfunctional global system that shifts the burden of adjustment onto deficit countries—the beggar-my-neighbor process that Robinson described many decades ago. In the United States’ case, that means more debt, less investment, and slower wage growth. That is why rather than encourage unlimited capital inflows, Washington should consider ways of limiting them. 

Michael Pettis is a senior associate at the Carnegie Endowment for International Peace.