418 section 8 The Open Economy: International Trade and Finance
Two-way Capital Flows
The loanable funds model helps us understand the direction of netcapital flows—the
excess of inflows into a country over outflows, or vice versa. As we saw in Table 41.2,
however, grossflows take place in both directions: for example, the United States both
sells assets to foreigners and buys assets from foreigners. Why does capital move in
both directions?
The answer to this question is that in the real world, as opposed to the simple
model we’ve just constructed, there are other motives for international capital flows
besides seeking a higher rate of interest. Individual investors often seek to diversify
against risk by buying stocks in a number of countries. Stocks in Europe may
do well when stocks in the United States do badly, or vice versa, so investors in
Europe try to reduce their risk by buying some U.S. stocks, even as investors
in the United States try to reduce their risk by buying some European
stocks. The result is capital flows in both directions. Meanwhile,
corporations often engage in international investment as part of
their business strategy—for example, auto companies may find that
they can compete better in a national market if they assemble some
of their cars locally. Such business investments can also lead to
two -way capital flows, as, say, European carmakers build plants in
the United States even as U.S. computer companies open facilities
in Europe.
Finally, some countries, including the United States, are international
banking centers: people from all over the world put money in U.S. finan-
cial institutions, which then invest many of those funds overseas.
The result of these two - way flows is that modern economies are typi-
cally both debtors (countries that owe money to the rest of the world)
and creditors (countries to which the rest of the world owes money). Due to years of
both capital inflows and outflows, at the end of 2008, the United States had accumu-
lated foreign assets worth $19.9 trillion and foreigners had accumulated assets in the
United States worth $23.3 trillion.A Global Savings Glut?
In the early years of the twenty-first century,
the United States entered into a massive current
account deficit, which meant that it became
the recipient of huge capital inflows from
the rest of the world, especially China, other
Asian countries, and the Middle East. Why did
that happen?
In an influential speech early in 2005, Ben
Bernanke—who was at that time a governor of
the Federal Reserve and who would soon be-
come the Fed’s chair—offered a hypothesis: the
United States wasn’t responsible. The “principal
causes of the U.S. current account deficit,” he
declared, lie “outside the country’s borders.”
Specifically, he argued that special factors hadcreated a “global savings glut” that had pushed
down interest rates worldwide and thereby led
to an excess of investment spending over sav-
ings in the United States.
What caused this global savings glut? Ac-
cording to Bernanke, the main cause was the
series of financial crises that began in Thailand
in 1997, ricocheted across much of Asia, and
then hit Russia in 1998, Brazil in 1999, and
Argentina in 2002. The ensuing fear and eco-
nomic devastation led to a fall in investment
spending and a rise in savings in many rela-
tively poor countries. As a result, a number of
these countries, which had previously been the
recipients of capital inflows from developedcountries like the United States, began experi-
encing large capital outflows. For the most part,
the capital flowed to the United States, perhaps
because “the depth and sophistication of the
country’s financial markets” made it an attrac-
tive destination.
When Bernanke gave his speech, it was
viewed as reassuring: basically, he argued that
the United States was responding in a sensible
way to the availability of cheap money in world
financial markets. Later, however, it would be-
come clear that the cheap money from abroad
helped fuel a housing bubble, which caused
widespread financial and economic damage
when it burst.fyi
Andrew Holbrooke/Time Life Pictures/Getty Images
Nike, like many other companies, has
opened plants in China to take advan-
tage of low labor costs and to gain better
access to the large Chinese market.
Here, two Chinese employees assemble
running shoes in a Nike factory in China.