Follow the Money

In a fake news classic, Rob Corddry and Jon Stewart of the Daily Show once pondered how to report "the facts" when "the facts themselves were biased."  Michael Mandel seems to think the facts are biased against the US economy.Not really the facts.  National income accounting.According to Mandel, national income accounting is biased against the US. It was designed for countries that invest heavily in factories that make things.   The US in the 1920s and 1930s and above all the 1940s.   Or China today.National income accounting doesn't work for the current knowledge-driven American economy, driven by platform companies that have outsourced all the dirty work of manufacturing.   Rather than obsess about all the weaknesses that US shows in the conventional national income accounts - low savings, not-so-wonderful investment, big current account deficits - we should embrace a set of new metrics designed for the Ipod  (designed in California, assembled in Asia) economy. Time and other worry warts have it all wrong, in part because it looked at the wrong measures.   National income accounting understates both US investment in "knowledge" and brand equity and US "knowledge" exports. To be fair to Michael Mandel, I am exaggerating his argument a bit for effect, and ignoring the caveats in his Business Week cover story.   But he clearly thinks the "doom and gloom caucus, trade deficit division" doesn't get the new knowledge economy.  Is he right? Mandel's core argment is that the national accounts understate US investment in the knowledge economy and other intangible assets, understate savings by counting investment as consumption and fails to capture US knowledge exports.  I do not have an informed opinion on the question of whether the national accounts definition of investment is dated, and too narrow.   Should some of McDonald's advertising budget be considered a long-term investment in McDonald's brand - an investment with a longer half-life than a new PC - rather than just an attempt to sell more burgers today.    That would drive up US investment rates.  And US savings rates, as both business investment and business savings would rise. Maybe the US invests (and saves) more than the national income accounts show.   I don't think, though, that mismeasured advertising investment changes the bottom line: the US now saves a lot less than it used to.  The US savings rate may not be negative, but it still fall short of what the US needs to finance all the investment the US does.But that's old thinking according to Mandel.   The Gloom and Doom caucus - trade deficit division (I suspect most would consider me a member) misses all the fantastic profits that US firms are making exporting their know-how.  It mismeasures the Ipod economy.   A country that is the home of the company that owns Eurodisney, Tokyo Disney and Hong Kong Disney  and profits from all the Brits lining up to get into Orlando's Disney World must be doing well ... One caveat.   Eurodisney is not my example.  It belongs to the Harvard economists who conjured up dark matter. I suspect it isn't the best of all examples of US prowess abroad ... According to Mandel, the doom and gloom caucus, trade deficit division, doesn't get the Ipod economy.  It also ignores all the gains the US gets from importing human capital.  Immigrants educated abroad generate large big windfall gains when they come to the US.  India pays for the world class education at Indian Institutes of Technology (IITs), US firms (and therefore US economy) reap the benefits. Mandel: Perhaps the trickiest and most controversial aspect of the shadow economy is how it alters our assessment of international trade. The same intangible investments not counted in GDP, such as business know-how and brand equity, are for the most part left out of foreign trade stats, too. Also largely ignored is the mass influx of trained workers into the U.S. They represent an immense contribution of human capital to the economy that the U.S. gets free of charge, which can substantially balance out the trade deficit of goods and services. "I don't know that the trade deficit really tells you where you are in the global economy," says Gary L. Ellis, chief financial officer of Medtronic Inc., a world leader in medical devices such as implantable defibrillators. "We're exporting a lot of knowledge."I want to touch (hopefully briefly) on both parts of Mandel's arguments.Should a country that is importing human capital also be importing savings from abroad, as Mandel argues?  Perhaps.   Consider Australia in the 1800s.  It imported people and capital from the British Isles.  But those resources were invested in the export sector, producing wool, wheat and iron to sell back to Britain.Taking on external debt to build up an export sector (staffed with immigrant labor) is one thing.  But that is not what the US seems to be doing.  The debt seems to be financing the housing sector.  And lots of immigrants seem to be employed in the US service sector.  Visit a restaurant kitchen in New York.   Or look for domestic help ... Still, I can see why the US might be importing capital from other advanced economies whose labor forces are forecast to fall.   Though it isn't immediately obvious why Japan is financing the US rater than say emerging Asia.  Or why the emerging world and its rapidly expanding urban labor force is financing the US.  Demographics cannot explain why Saudi Arabia - with a ballooning labor force from high population growth - is financing the US.    Or even China -- a particularly interesting case.   Its demographics are unusual.   The one child policy and all.  Its overall population isn't growing.  But if you think of China not as one economy but as two, a rural interior economy and a coastal manufacturing economy, the picture changes a bit.   The coastal economy - not the interior - is the source of financing for the US.  And migration from the interior to the coast implies that the coastal labor force is growing far faster than the US labor force.   Employing rural migrants in the Chinese industrial sector certainly takes lots of capital, and uses lots of savings  ... China just happens to be the world champion right now at both savings and investing.But maybe my concern is misplaced - the US isn't importing savings to build houses and a domestic services sector, but successful, global platform companies that stride the world, sucking up profits from their activities abroad that "old" metrics like the current account don't capture.  That too is part of Mandel's argument.US knowledge exports that make Intel's plants in Israel, Costa Rica, Ireland, Singapore and no doubt many other places hum.  Pepsi exports knowledge to Ireland, where it now produces Pepsi concentrate for sale back to the US.  OK, not that one.  It is too obviously tax arbitrage.  Coke does it too.I don't buy the broader argument, at least not in full.Mandel didn't mention the Japanese knowledge Toyota exports to its US plants.  Or the German knowledge that Mercedes and BMW export to their US (and Eastern European) plants.  Or the French knowledge exported in the perfume, fashion and wine businesses ... The flow of intangibles in the global economy is not one way.  Nor do US firms capture all of the benefits of their "intangible" knowledge exports.  A US firm sets up a plant in China, and teaches its employees the secrets of building cars or computer chips.  And then a Chinese firm poaches its US firms' employees.   This is no doubt good for economic development, as it helps increase the productivity of Chinese firms.   But it makes it harder for the US to continue to reap monopoly profits on its knowledge.  Or its brands.I also don't think the current account is quite as outdated a concept as Mandel suggests.The current account deficit is not just the trade deficit.   It also includes US overseas "income" - as well as the payments the US makes on its external debt.There are obviously enormous issues about the correct measurement of the overseas profits of US firms.  But the overseas income of US firms is a big part of the US current account.   Indeed, it is the income that the US gets from its firms abroad that has keep the US from making (net) interest and dividend payments on the world.  Dark matter and all.Let's go back to the accounting for the Ipod economy.Suppose Apple makes Ipods in China with a set of components that are generally made either in China or Asia.   But the design and software are American.  And since the components are commodities, most of the profits go to Apple (whether Apple USA, Apple Hong Kong, or Apple Ireland - taxes and all).   And since Apple is mostly owned by American residents, those profits generally benefit the US.Suppose that an Ipod that sells for $100 consists of $50 in Asian components and assembly (with associated small profits), and $50 in design, software and engineering, with associated large profits)  How would this all show up in the current account?Let's first consider the case where Apple USA imports Ipods (without any software) from Asia for $50, installs the software in the US and then sells them in the US for $100.   That is a net $50 outflow from the US - the US is importing Asian components and assembly.  And if the software costs $5 to install (including the amortized cost of the initial investment in writing the code), Apple gets a juicy $45 profit ... Suppose that Apple Ireland imports Ipods (without software) from Asia for $50, installs the software, and then sells the Ipods to Apple USA for $100. The US is importing $50 in Asian components and assembly, and $50 in "Irish" know-how ...   So US imports go up.  But that's not all.  If the $5 in software was written in the US, it should show up as a service export.  And if Apple Ireland is 100% owned by Apple US, the $45 profit shows up as $45 credit (the equivalent of an export) in to the United States investment income.  Think of it as a dividend payment from Apple Ireland to Apple USA.Add it all up, and the net impact on the US current account is the same.  The US imports $100, exports $5 and gets $45 in investment income.  Total impact on the balance of payments: $50.I won't go through all the complexities when Ipods made in Asia are sold not in the US but in say Europe.  Suffice to say that the US gets $50 in external income from exporting its software and design.  If the Ipods were shipped to the US for $50, then exported to Europe with software for $100, the full $50 would show up as export income.  If the Ipod software is installed in Ireland, the US exports $5 in software to Ireland and gets $45 in investment income abroad.  It still is a $50 credit to the United States external balance.  The credit just shows up primarily in the investment income line, not the export line.This is the point Philip Lane made in the Economist.  He is right.You can add the income US firms earn abroad to US exports, and the income foreign firms earn in the US to US imports.   The result is the "ownership-based" current account.    The BEA publishes the US current account data in this format regularly.Adding FDI income in this way reduces the trade deficit  - as I discussed a couple of weeks ago, foreign firms (for some reason .... ) report very small earnings on their US operations.  I guess Toyota isn't as good at running an auto plant as Intel is at running a semiconductor plant.  So US firms earns more abroad than foreign firms earn in the US.  In 2004, the balance on goods, service and net receipts by US firms is $490 - while the standard goods and services deficit was $618 billion.But it doesn't change the bottom line.  The US still imports far more than it exports.   And that gap between US imports and exports is growing.  Look at the BEA table.Nor does it change the US current account deficit.  Adding profits on FDI to profits reduces the trade balance, but it makes the income balance work.   Right now the profits from US firms foreign operations are offsetting payments on US treasuries held abroad rather than offsetting US imports.   Where the overseas profits of US firms are counted in the external balance matters less than whether they are counted accurately.That is where I suspect Mandel (and others) are on to something.   There are problems with the measurement of US firms operations abroad.  I would bet the real data doesn't perfectly capture the foreign activities of Apple.  Or Pepsi.  But the errors go both ways.   I suspect foreign firms' US operations are a bit more profitable than the US data suggests as well.   So I don't think the measurement of firm's overseas income is systematically biased against the US.   Actually, I suspect it works the other way.If you don't like the trade data, look at the capital flow data.  There is a lot more money flowing into the US from abroad than flowing from the US to the world.   But maybe the Treasury's survey data is biased against the US too ...

According to the Financial Times, the Pentagon sees China as the United States greatest potential rival."China has the "greatest potential to compete militarily" with America in the future, but the US is also increasingly worried about Russian arms sales, the Pentagon said in major review of military priorities. Underscoring mounting concerns about the rise of China, the highly anticipated quadrennial defence review [QDR] focuses on the potential future threat from a Chinese military build-up that "already puts regional military balances at risk."The Pentagon plots how to contain China using money that the US Treasury raises by selling bonds to China.  Tis a strange world we live in.No one played a bigger role financing the 2005 US current account deficit than China's central bank.   Rather than advocating new weapons systems, maybe the US top brass should be advocating for new taxes, so the US government isn't so financially dependent on China, Saudi Arabia and Russia.  National power has many components.John Gray's commentary on the financial achilles heel that underlines America's hegemony seems relevant:The Case for Goliath is an eloquent statement of the vital role of America in twenty-first-century global security. Yet the picture it presents of America's unchallenged hegemony passes over some awkward facts. Unlike Britain in the nineteenth century, which was the world's largest exporter of capital, the United States is the world's largest debtor. In effect America's military adventures are paid for with borrowed money—notably that lent by China, whose purchases of American government debt have become crucial in underpinning the US economy. This dependency on China cannot easily be squared with the idea that the US is acting as the world's unpaid global enforcer. It is America's foreign creditors who fund this role, and if they come to perceive US foreign policy as dangerously threatening or irrational they are in a position to raise its costs to the point where they become prohibitive. As Emmanuel Todd, the French analyst who, in 1975, forecast the impending Soviet collapse, has noted: The United States is unable to live on its own economic activity and must be subsidized to maintain its current level of consumption—at present cruising speed that subsidy amounts to 1.4 billion dollars a day (as of April 2003). If its behavior continues to be disruptive, it is America that ought to fear an embargo. Given that it would also harm America's creditors the likelihood of such an embargo may be remote, but it is no longer unthinkable.I have long been puzzled why those who believe America must go it alone and not allow any country a veto over US foreign policy have been relatively unconcerned by the United States growing financial dependence on the rest of the world, and a few countries in particular.   I think part of the answer is that most folks in the US don't see if as dependence.   As my friends at the US Treasury like to say, we aren't asking anyone to build up their reserves and buy Treasuries.But that doesn't mean that the end of this existing financial subsidy would be painless.  Paying for your imports with exports is rather different than paying for them with credit.    And there might be some impacts on the housing market (and housing jobs) too.