from Follow the Money

DeLong is right. If the US wants to end up like Australia, US trade deficit needs to fall - unless foreigners continue to do terribly on their investments in the US.

June 30, 2006

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As Brad Delong notes, the big difference between the United States and Australia is that the United States has a  trade and transfers deficit of close to 7% of GDP.    That implies – assuming the stock of US dark matter doesn’t grow – that the US external debt to GDP ratio (really the US net international investment position to GDP ratio) will rise over time.   

Australia’s current account deficit is comparable to that of the United States.  But – see John Quiggin -- its trade deficit is far smaller.   That is at it must be: Australia has to pay interest on all its accumulated debt.   The basic rule of thumb is that if you have lots of debt and your economy is growing, you can borrow to pay interest on your external debt.  But you cannot borrow both to pay interest and run a trade deficit.

Indeed, if the US wants its net debt to stabilize at Australia’s levels, it probably needs to start the adjustment process now. 

In the written testimony I submitted for the record at the recent JEC hearing I provided a lot of the details behind my analysis of the US balance of payments data – including my latest estimates of 2005 global reserve growth and the role central banks have played in the financing of the US current account deficit.  One my charts showing the evolution of the US net international investment position in the “no adjustment” and “fast adjustment” scenarios i laid out in a post earlier this week.  

That chart – reproduced here – shows that the US net international investment position would stabilize at around 60% of US GDP if the US trade deficit started to shrink steadily in 2007 and basically disappeared by 2017 or so.  


The NIIP to GDP ration in this chart is a probably a bit high. I didn’t adjust for valuation gains from the dollar falls likely to accompany the adjustment path that brings the trade deficit down.    But it gives some sense of the likely dynamics.

But I also prepared my testimony – and this graph – before the latest data on the US Net international investment position was released yesterday.   

And that data does change the story a bit – at least for now.   If the US keeps getting massive capital gains on its foreign investments, there isn’t much too worry about.

I haven’t fully digested the data.   But it certainly didn't match my expectations. 

I was expecting a $800b deficit to push the end 2005 net international investment position up above $3 trillion.   The end 2004 position was around $2.5 trillion – and I didn’t think that the US was going to get net gains of over $300b on its equity investments abroad. 

My general sense was that, in dollar terms, US and European equities did about equally well in 2005.   European equities did better, but some of those gains were offset by the dollar’s rise.  And I didn’t think the US had enough  Japanese/ emerging market exposure to really get huge capital gains.

I was wrong.  The market value of US FDI abroad and US portfolio equity investments in foreign markets soared by $993b, offsetting $379b in currency losses on those investments.    

In the meantime, the market value of foreign investment in the US fell by around $70b. 

Foreign central banks lost $20b on their treasury portfolios.  Foreign holdings of US corporate bonds lost $70b or so in value.  The value of foreign holdings of US equities rose by around $60b.   But the market value of foreign FDI in the US fell by $23b.  

So much for the notion that the US is great place to invest.  Foreigners would have done a lot better investing in their home markets -- at least in 2005 -- rather than lending money to the US.

The strong rise in the market value of US investment abroad almost fully offset the US current account deficit.  Net claims on the US (claims on the US net of US investments abroad) rose by only about $100b.  the NIIP rose from a revised $2.45 trillion at the end of 2004 to $2.55 trillion at the end of 2005.    

 Mike Mandel take note: this supports your basic case.    Big deficits.   And the US Net International Investment Position doesn’t get worse. 

The huge net gain from the rising market value of US investments abroad (relative to the rise in the market value of foreign investments in the US) really was unprecedented.  Setting currency changes aside, the rise in the market value of US investments abroad – relative to the market value of foreign investment in the US -- generated something like a $1000b improvement in the US net international investment position.   That is more than three times the next largest gain the US has ever enjoyed from the rising market value of its investments abroad – a roughly $300b gain in 1999 (see this spreadsheet)

The US shouldn’t count on such gains in 2006.  US investment in Turkey isn’t worth what is was a few months ago.   Indeed the gains in 2005 seem just a bit too good to be true – but, at this stage, that is just a suspicion, not a suspicion backed with any evidence.  

I wonder what Philip Lane thinks.  He certainly has the best data on this.

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Budget, Debt, and Deficits