A range of factors have contributed to the deindustrialization of the US economy – that is, the relative decline of the tradable sector relative to the non-tradable sector. Much of this shift can be explained by the changes in the structure of production catalysed by capital inflows. In addition to this effect, economists such as Baumol have hypothesised that economies tend toward deindustrialization due to the inherent characteristics of tradable and non-tradable sector. This decline in manufacturing leads to a deterioration of the current account and makes it increasingly difficult to recover.
As noted by Bernake in 2005[i], an increase in global savings led to an increase in capital inflows to the USA. One of the key push factors that led to the “global savings glut” was the fact that from the mid 90s onwards, developing countries went from being net capital importers to being net capital exporters. This was a strategic choice adopted by developing countries that had been negatively affected by the instability of capital flows and the exchange rate, and therefore began to build up large quantities of foreign-exchange reserves to protect themselves. Furthermore, the sharp rise in oil prices led oil-exporting countries to greatly increase their savings, leading many developing countries to become net lenders rather than net borrowers.
But why did the capital flows end up in the USA? A pivotal pull factor was the technology boom of the 1990s that made the country an attractive investment destination. Furthermore, the importance of the dollar as a currency to which others are pegged and as a leading international reserve currency ensured that savings from the developing world were translated into dollar-denominated assets. In addition to this, stock market wealth led to an increase in consumption, and therefore demand for capital.
This accumulation of capital inflows has pernicious effects on an economy. Firstly, it can lead to what is called immiseration, which is incentivizing the wrong sectors of an economy thus leading growth to make the country worse off. There is also the issue of Macroeconomic Overheating in which the excess inflow overstimulates the economy, creating bubbles. Another typical issue is the vulnerability of the country to a sudden stop in the capital inflows which would enforce a steep adjustment to the economy. Due to the pivotal role of the U.S. in the world economy, however, it can be held that it is not subjected to sudden stops. Nonetheless, empirical evidence shows that capital inflows have led to the relative decline of the non-tradable sector, ultimately leading to a deterioration of the current account.
The increase in house prices in the early 2000s is symptomatic of this. According to data from the US census, house prices rose 11% from 2003 to 2004 (with inflation at 3.3%). On the other hand, the manufacturing sector’s contribution to GDP declined 2.46% from 1999 to 2009[ii]. While part of this change can be explained by capital inflows, Baumol’s unbalanced growth theory[iii] also provides some rationale. The theory departs from the fact that the tradable sector experiences growth in productivity whilst the non-tradable sector doesn’t. This leads the non-tradable sector to absorb more labour, ultimately decreasing the relative weight of the tradable sector. This effect is compounded by the fact that increased demand due to capital inflows leads to a rise in the relative prices of non-tradable goods (because domestic demand changes the price of non-tradables while tradables obey the law of one price).
This change in the economic structure of the country leads to an uncompetitive tradable sector and an overblown non-tradable market. Since the capital inflows, and the current account, are paid with the tradable sector, it gets increasingly hard for a country to pay its debts (you can’t pay Japanese investors with houses in Arizona). If this growth of the non-competitive sector does not stop, the country will eventually have difficulties in paying its obligations and it may run into a current account crisis. Additionally, the more the change is postponed, the harder it is to implement it. The U.S. may still be far from having to face a current account crisis but the readjustment it needs is still large and it is getting larger as time passes.
Manuel Costa Reis
[i] Bernake, B. (2005). The Global Saving Glut and the U.S. Current Account Deficit. Sandridge Lecture. Richmond, Virginia.
[ii] Hunt, B. (2009). The Declining Importance of Tradable Goods Manufacturing in Australia and New Zealand: How Much Can Growth Theory Explain? IMF Working Paper .
[iii] Baumol, W. (1967). Macroeconomics of Unbalanced Growth: The Anatomy of Urban Crisis. American Economic Review , 415-426.