from Follow the Money

RGE pays my salary, not the IIE — and I am not exactly a true believer in dark matter

April 24, 2006

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

Patrick Smith seems to be based in Hong Kong, so I guess I can forgive him for thinking I work for the IIE (the Institute for International Economics).  The IIE is a great place, but they , alas, don't pay my salary and they hardly need any additional publicity.    Roubini Global Economics, by contrast, does pay me and it needs the publicity.  I did write a book that the IIE published, but that doesn't mean I am a fellow there.    

Smith's article focuses on the debate between those who believe in a new paradigm for international economics, where globalization and dark matter render old measures like the current account deficit obsolete, and stubborn traditionalists who cling to discredited measures that the market currently chooses to ignore. 

Currently may be the wrong word; the dollar tumbled today.  But certainly the market didn't focus on the US current account deficit last year.   Smith tries to explain why:

"The markets are powering ahead, and we need to understand why," said Louis-Vincent Gave, a partner at GaveKal Research, a Hong Kong economic and market research firm. "We need to understand why the scenario of the permabears, as we call them, hasn't come to pass."
 
 [Those think the current situation is sustainable make] two core arguments: Either the globalized economy has made traditional economic measures inaccurate, or if they are still valid, they are no longer relevant.
 
Either way, those favoring a new look at accepted economic thinking arrive at the same conclusion: There is no cause for concern over those quaint things called structural problems, they say.
 
For a time those of a bearish bent could dismiss such notions as little more than the flying of kites - a more sophisticated story in the markets but a story nonetheless. With the emergence of new theoretical backing, however, those who justify the high valuations now found in many share markets are gaining adherents.
 
... Two economists, Ricardo Hausmann of Harvard University and Federico Sturzenegger of Harvard and the Universidad Torcuato di Tella in Buenos Aires, say that current account statistics mismeasure a country's financial position because they are based on the geographic origin of goods - an outmoded concept.
 
...  "When we apply our methodology," the authors wrote in a much-circulated paper, "we find that the U.S. has run no current account deficits over the last two decades and that global imbalances are relatively small and very stable."
 
....   If there is one theory that draws these strands neatly together into a compelling whole, it belongs to GaveKal, a small, independent research firm whose startling ideas draw large clients.
 
The shift from industry to services in the advanced economies, the outsourcing of manufacturing to developing nations, the real estate "revolution," as Gave calls it - all of this has yet to be fully reckoned into the data and has brought us into "Our Brave New World," which is the title of a book GaveKal published last year.
 
"The bears argue that the structure of the world economy today is unsustainable," Gave said during an interview.
 
"We argue that it's not only sustainable but that it's stronger than it was."  ...
 
GaveKal's clients include the huge U.S. hedge fund Tudor Investments and J.P. Morgan Chase.

Meanwhile, Brad Setser, a fellow at the Institute for International Economics in Washington and a former official at the U.S. Treasury Department, tries to incorporate the sum of "dark matter" into his analysis of the current account.  

The last sentence caught my attention, for obvious reasons.    I do try to calculate "dark matter" or more precisely changes in dark matter.    It isn't hard: dark matter is just another way of measuring the US income balance.

As importantly, I need to calculate the amount of "dark matter" the US created in 2005 - using Hausmann and Sturzenegger's methodology - to test their most important prediction.   Hausmann and Sturzenegger make two key claims: first, the US is really a net creditor, not a debt debtor, if you calculate assets based on income flows; and second, the US can expect to create between $300 and $400b of new dark matter every year, helping to offset the $950b plus current account deficit the US now looks set to run.

$300-$400b of dark matter implies $15-20 b in new investment income from mysterious sources will appear in the US data, helping to offset the $50b or so in interest payments the US will have to pay on the debt it is taking out to cover its $950-1000b current account deficit.

So I do watch the data for signs of this dark matter.  Hausmann and Sturzenegger's argument is too influential to ignore.  And it is not inconceivable that the US could earn more on its roughly $10 trillion in external assets than it pays on its $13 trillion plus in external liabilities -- unlikely, but not inconceivable. 

I also pay attention to valuation gains and other evidence that the US may benefit from what Helene Rey and Pierre-Olivier Gourinchas call "exorbitant privilege."   There is no doubt that the currency composition of US external assets and liabilities favor the United States: the value of many US external assets rises as the dollar falls, while US liabilities are all denominated in dollars and don't change.  

But just because I watch the data does not mean I believe in the underlying Hausmann and Sturzenegger thesis.   The evidence for "exorbitant privilege" seems quite good (the US just doesn't have enough exorbintant privilege to offset deficits of the current magnitude); the evidence for dark matter seems much thinner.

Specifically, I think the "dark matter" argument is likely to be off in three ways.

First, I think some of the dark matter that Hausmann and Sturzenegger argue the US created from 2002 through 2004 actually came from falling US interest rates, not from any export of US know-how or US insurance services.   The income balance improved - or did not deteriorate as fast as one would expect - because of  large falls in US short-term "policy rates" and smaller falls in long-term market rates.  Not because the US provided more "insurance services" to the world.  This is a relatively easy thesis to test.   As interest rates rise, I expect the income balance to deteriorate by more than would be expected if you just multiplied the net increase in US external debt from the current account deficit by the going interest rate.   The 2006 income should deteriorate by more than say $40b ($800b * 5%).

Second, I found Daniel Gros' explanation for the extremely low returns on foreign direct investment in the US every bit as persuasive as Paul Krugman did.    Gros thinks it is odd that US firms reinvest a lot of their overseas earnings (and those earnings are counted as income in the US balance of payments data) while foreign firms operating in the US - at least judging from the official US data - don't reinvest any of their earnings from the US operations.   He thinks that foreign firms operating in the US are earning a bit more than they report, since they aren't reporting their reinvested earnings to the US taxman.  I agree.   If you assume that foreign firms operating in the US do reinvest their earnings but just don't report their reinvested earnings to the US authorities, the US data starts to make a lot more sense.    For one, the returns on foreign direct investment in the US are not absurdly low.   And the US income balance turns negative.    If Gros is right, the US income balance (and the US current account balance) is about $100b worse than the official data suggests.   That cuts into the amount of "dark matter" that Hausmann and Sturzenegger would calculate.

Third, I do think there is solid evidence suggesting that US firms operating in Ireland are unusually profitable - presumably because they are using "transfer" pricing to shift profits into Ireland, which has a low corporate tax rate.    I suspect European firms also tend to want to show profits in low-tax jurisdictions.   To shift profits to Ireland, US firms charge their Irish operations less than they should for various imported inputs (including US intellectual capital).  That lowers US exports, but increases the income US firms earn abroad.   Foreign firms similarly overcharge their US operations for imports, so they show less profit in the US.  The overall effect on the current account deficit is a wash.    But such tax arbitrage increases (reported) US investment income, and reduces (reported) foreign investment income in the US - so shows up as dark matter.

And don't even get me started with GaveKal and platform firms.  Suffice to say that the business model of platform firms wouldn't work without the export subsidy that China's central bank currently provides to US MNCs, and to US consumers.  Just because shifting production to China can increase the profit margins of US firms doesn't mean the balance of payments magically adds up.   What works for a company doesn't work for an economy.  Outsourcing all manufacturing to China and paying for it by selling bonds is not a viable long-term economic strategy for a country.  At least not if China ever demands payments on the bonds it buys.   The flows only work right now because China's central banks buy up all the surplus dollars US (and other) firms are sending to China to pay for Chinese assembly, and then lends the surplus dollars back to the US.   

The system is only sustainable so long as China is willing to play ball.   The permabears' scenario hasn't come to pass because China has continued to add to its reserves at an unheard of rate.    Case closed.

Note: edited after my initial posting.  I typed Patrick Stewart.  I meant Patrick Smith.  And DOR caught me making a White House style gaff.

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