35 Trillion Reasons V
Part V - The Alternative Explanation
During the Strong Dollar Trend of the late 1990s, foreign investors, both private and public, invested heavily in the United States. Those investments put upward pressure on the dollar and on US asset prices, including stocks and bonds. The trend became self-reinforcing.
The more capital that entered the US, the more the dollar and dollar denominated assets rose in value. The more those assets appreciated, the more foreign investors wanted to own them.
Because of the large sums entering the country, the United States had no difficulty in financing its giant current account deficit, even though that deficit nearly tripled between 1997 and 2001.
By 2002, however, with the US current account deficit approaching 5% of US GDP, it became increasingly apparent that the Strong Dollar Trend was unsustainable.
The magnitude of the current account deficit made a downward adjustment in the value of the dollar unavoidable. At that point, the Strong Dollar Trend gave way and the Weak Dollar Trend began.
Foreign investors who had invested in US dollar denominated assets during the late 1990s naturally wanted to take their money back out of the United States once it became clear that a sharp correction of the dollar was underway.
Moreover, many US investors, and hedge funds in particular, also began selling dollar- denominated assets and buying non-US dollar-denominated assets to profit from the dollar's decline.
A change in the direction of capital flows can be seen very clearly in a breakdown of Japan's balance of payments. The balance on Japan's current account and financial account, are the two principle components of Japan's balance of payments.
By going back to 1985 and examining the data, one can see that traditionally, Japan runs a large current account surplus and a slightly less large financial account deficit, with the difference between the two resulting in changes (usually additions) to the country's foreign exchange reserves.
Beginning in 2003, however, there was a startling change in the direction of the financial account. Instead of large financial outflows from Japan to the rest of the world, there were very large financial inflows.
For instance, in May 2003, Japan's financial account reflected a net inflow of $23 billion into the country. The net inflow in September was $21 billion. These amounts increased considerably during the first quarter of 2004, averaging $37 billion a month.
The capital inflows into Japan at that time were massive, even relative to Japan's traditionally large annual current account surpluses. But, why did Japan, which normally exported capital, suddenly experience net capital inflows on a very large scale in the first place?
The most likely explanation is that very large amounts of private sector money began fleeing the dollar and seeking refuge in the relative safety of the yen.
When the Strong Dollar Trend broke, had the BOJ/MOF not bought the dollars that the private sector sold in such large quantities, the United States would have faced a balance of payments crisis,
In which case, in addition to having to fund a half a trillion dollar a year trade deficit, it would have had to find a way to fund a deficit of several hundred billion on its financial account as well. In Part VI we will discuss the roles of the other central banks.
During the Strong Dollar Trend of the late 1990s, foreign investors, both private and public, invested heavily in the United States. Those investments put upward pressure on the dollar and on US asset prices, including stocks and bonds. The trend became self-reinforcing.
The more capital that entered the US, the more the dollar and dollar denominated assets rose in value. The more those assets appreciated, the more foreign investors wanted to own them.
Because of the large sums entering the country, the United States had no difficulty in financing its giant current account deficit, even though that deficit nearly tripled between 1997 and 2001.
By 2002, however, with the US current account deficit approaching 5% of US GDP, it became increasingly apparent that the Strong Dollar Trend was unsustainable.
The magnitude of the current account deficit made a downward adjustment in the value of the dollar unavoidable. At that point, the Strong Dollar Trend gave way and the Weak Dollar Trend began.
Foreign investors who had invested in US dollar denominated assets during the late 1990s naturally wanted to take their money back out of the United States once it became clear that a sharp correction of the dollar was underway.
Moreover, many US investors, and hedge funds in particular, also began selling dollar- denominated assets and buying non-US dollar-denominated assets to profit from the dollar's decline.
A change in the direction of capital flows can be seen very clearly in a breakdown of Japan's balance of payments. The balance on Japan's current account and financial account, are the two principle components of Japan's balance of payments.
By going back to 1985 and examining the data, one can see that traditionally, Japan runs a large current account surplus and a slightly less large financial account deficit, with the difference between the two resulting in changes (usually additions) to the country's foreign exchange reserves.
Beginning in 2003, however, there was a startling change in the direction of the financial account. Instead of large financial outflows from Japan to the rest of the world, there were very large financial inflows.
For instance, in May 2003, Japan's financial account reflected a net inflow of $23 billion into the country. The net inflow in September was $21 billion. These amounts increased considerably during the first quarter of 2004, averaging $37 billion a month.
The capital inflows into Japan at that time were massive, even relative to Japan's traditionally large annual current account surpluses. But, why did Japan, which normally exported capital, suddenly experience net capital inflows on a very large scale in the first place?
The most likely explanation is that very large amounts of private sector money began fleeing the dollar and seeking refuge in the relative safety of the yen.
When the Strong Dollar Trend broke, had the BOJ/MOF not bought the dollars that the private sector sold in such large quantities, the United States would have faced a balance of payments crisis,
In which case, in addition to having to fund a half a trillion dollar a year trade deficit, it would have had to find a way to fund a deficit of several hundred billion on its financial account as well. In Part VI we will discuss the roles of the other central banks.
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