Michael Mandel thinks I am making a big mistake, albeit a very, very common one - worrying about rising US external debt rather than celebrating rising US household wealth.
Brad is making the very very common mistake of taking the value of U.S. assets--that is, our wealth--as a fixed number, so that everything that goes to foreigners is less for Americans. That is, he’s treated wealth as a zero-sum game.
In fact, U.S. wealth has historically grown at a pace which far exceeds the size of the current account deficit. As the economic pie gets bigger, there’s enough to feed our foreign friends while keeping an ever-growing piece for ourselves.
Since 1952 household net worth--that is, assets minus liabilities--has increased by an average of 7.4% annually, or 3.7% in real terms. That includes real estate booms and real estate busts, bull markets and bear markets. This annual percentage gain translates into a huge increase in net worth, in dollars. Household net worth today is just under $50 trillion, according to the Federal Reserve
I guess there is no need to worry about tomorrow’s trade data then, even if it shows a $60 b plus monthly deficit?
Steve Backus and Frederic Lambert agree with Dr. Mandel.
That leaves us with a natural explanation of the movement of capital around the world. Why are Americans consuming so much? Because they have experienced phenomenal returns on their assets. They’re rich. Why are other countries buying foreign assets? Because domestic investment prospects appear worse than those in the US.
I am not quite sure Backus and Lambert’s theory can explain why rapidly growing China, with strong domestic investment prospects, is financing the US. Or the fact that, at least in 2003 and 2004, private capital abroad sure did not seem to want to finance US external deficits of their current size.
But let’s set that aside, and focus on the core question.
If US household wealth is rising, should we worry if US external debt is also rising?
I don’t doubt for a second that rising household wealth - and particularly rising home values - has contributed to America’s low household savings rate, supported high levels of current consumption and led to US dependence on foreign savings. But I don’t think rising household wealth will mitigate the burden of rising US external debt, for two reasons.
1. US household wealth - and specifically home values -- depends on US interest rates and, since the US doesn’t save, US interest rates depend on the continued availability of savings from abroad that the US can borrow at low rates. So long as there is a savings surplus in abroad (or at least in the People’s Bank of China, the Bank of Russia, and the oil sheikdoms) that the US can tap at low rates, US external deficits can be financed at low rates and US household wealth will remain strong. But should the global savings glut - or investment drought -- disappear, and the US ever have to rely more on its own savings to finance the fiscal deficit and a decent level of investment, watch out. Indeed, the global savings glut/ investment drought would not even need to disappear to cause the US trouble. The US would be in trouble if global savings just stopped flowing into the US at current rates. Higher interest rates would simultaneously: increase the burden of servicing the existing stock of US debt, make it harder to raise the financing needed to sustain ongoing external deficits and reduce US household wealth.
2. External debt should be compared to external assets, not domestic assets. The US has two kinds of external assets - its existing stock of assets abroad (think Unocal’s Asian oil fields) and its future capacity to generate export revenue. US households generally don’t hold assets that will generate the export revenues required to pay the United States rising external debt, or, if not to pay the debt, at least to pay for US imports so the US does not have to borrow even more from abroad to pay for its imports. There is a reason why analysts of capital importing emerging economies look at external debt to export ratios, not external debt to domestic household wealth ratios.
First, what would happen if US interest rates - long-term rates that is - were to rise substantially? A) The value of many assets held by US households would fall. Too much of US household wealth depends on the interest rate for me to feel very comfortable. At some point, the United States foreign creditors are likely to want an interest rate high enough to compensate them for the risk of future dollar depreciation. A country that outsources savings will likely have to offer foreign investors a positive real return (over time) in terms of their local currency, not in dollar terms. US residents should be looking for assets whose value is uncorrelated with higher US rates. Read Michael Pettis.
B) Higher rates would - after a lag - increase the net interest bill on US external debt. Every year the US sells debt abroad to raise the funds needed to finance its current account deficit - unless equity flows turn around suddenly, it needs to raise at least $800 b this year - and to refinance a certain fraction of its existing external debt stock. This year the US needs to, for example, refinance ten year treasury notes sold in 1995, five year notes sold in 2000, three year notes sold in 2002, two year notes sold in 2003, and bills sold in 2004. All other things being equal, a higher interest rate on the United States external debt translates into a higher current account deficit.
C) Of course, all other things would not be equal. Higher interest rates would slow the US economy, reducing demand for imports. However, any the trade deficit would be partially offset by rising debt payments, so the improvement in the current account deficit would lag the improvement in the trade deficit.
The US likely will have a current account deficit of close to 7% of GDP by the end of 2005, and even if that deficit started to fall, the US would still need to finance a very large current account deficit for some time. That might not be much fun if interest rates were high.
Of course, there are scenarios where the US trade deficit falls and US interest rates stay low. For example, the US consumer could give out, pushing the US economy into a recession. Bill Gross has outlined one such scenario. But low interest rates, constant household wealth, no growth and stagnant (if not falling) household income is hardly a comforting prospect.
My second point: external debt should be compared to external assets.
US external debt - gross debt that is - is around $6.2 trillion (52% of 2004 GDP). It will rise to above $7 trillion, or 57% of US GDP, in 2005.
That is the measure that is most analogous to the debt numbers usually quoted for an emerging economy. Emerging economies don’t get to deduct their external assets from their external debt.
We usually look at the United States net debt, not its gross debt. But US external liabilities still exceed US external assets. The US net international investment position, which includes equities as well as debt -- was a negative 22% of US GDP at the end of 2004, but, as I have argued earlier, it is likely to be more like 30% of US GDP at the end of 2005. And it is poised to keep on rising so long as the US runs large trade deficits.
Exports as a share of US GDP, in contrast, are no higher now than they were in 1997, when the US had a lot less external debt.
I think that matters. Remember that external debt ultimately is a claim on the United States future export revenue.
New homes - and higher prices on existing homes - won’t help pay the interest on the US external debt. A new Boeing production line would.
Of course, the US could sell off some of the new homes now being built in the US to its foreign creditors to pay down its debt - but that only really works if the United States’ creditors ultimately want to come and live in the US.
If foreigner rent the US housing stock they buy out, they get dollars. And those dollars either have to be used to buy US goods or services (i.e. exports), used to buy goods and services from another country willing to accept dollars in exchange for its production, or lent back to the US. And if say China uses the dollars it gets from the US housing stock it owns to buy Saudi Arabian oil, Saudi Arabia then either has to lend the dollar back to the US (financing a US external deficit, and adding to future claims on the US) or trade the dollar for US made goods and services.
That is what worries me. It is not clear that the United States capacity to generate future export revenue to pay its external debt is set to rise as fast as its external debt looks likely to rise. Call me old fashioned. I think the external debt to exports ratio still matters.