Economists have long had an obsession with physics, evidenced by the metaphors of utility indifference curves and production iso-quants that derive from 19th century force field physics. Recently (Financial Times, Friday 8 December – not The Onion, April 1), Harvard University economists Ricardo Hausmann and Federico Sturzenegger claim to have discovered financial “dark matter“ that shows that neither the U.S. nor the global economy suffer from international financial imbalances. Consequently, the U.S. trade deficit is no longer an issue of concern.
The dark matter story runs as follows. Over the past twenty-five years the U.S. has spent approximately 4.5 trillion dollars more than it has earned via its cumulative current account deficit. Given this accumulation of debt and the fact that foreign lenders must be paid, the U.S. should have experienced a massive decrease in its net foreign income. Yet, surprisingly, U.S. net foreign income in 2004 was $30 billion, roughly what it was in 1980. Hausman and Sturzenegger claim that this is because U.S. foreign investments have been ultra-productive, generating enough income to cover the debts incurred through cumulative trade deficits. They call these investments “dark matter†because they supposedly offset the black hole of foreign debt, thereby preventing financial crisis.
Unfortunately, there are problems with the “dark matter†thesis. First, throughout the 1990s U.S. net foreign receipts actually trended down. Though net foreign receipts rose in the last four years, they were approximately zero in the first six months of 2005. Second, net foreign payments to the U.S. include repatriated profits of multinational corporations that are partly owned by foreigners who have increasingly purchased shares in them. If these undistributed company profits were attributed to foreign shareholders, the U.S. net position would look worse. Third, U.S. foreign investments tend to be illiquid and hard to cash out, whereas much foreign investment in the U.S. is liquid and easy to cash out. That is partly why foreigners earn a lower return, but it also makes for U.S. financial vulnerability. Fourth, and most importantly, there remains a fundamental problem with the trade deficit regardless of the U.S. net foreign investment position. The deficit is draining spending out of the economy and costing jobs and real investment; it is remaking the economy by eroding manufacturing, which in turn entrenches America’s reliance on imports and erodes capacity to export; lastly, it is being financed by an unsustainable household borrowing bubble, which promises to tank the global economy when it bursts.
Hausmann and Sturzenegger claim that financial dark matter has prevented a financial crisis, and that none looms because the U.S. is far wealthier than the records show. But there is another less exotic explanation for the absence of crisis — supply and demand for credit. On the supply side, countries like China have been willing to provide unlimited foreign finance to purchase their products. They do so because their economies depend on exports and would tumble into recession if they raised the price of their exports. On the demand side, U.S. consumers have been on a spending binge financed by successive stock market and housing price bubbles. These bubbles have backed borrowing that has funded both domestic consumption and imports, and China and others have willingly accepted the borrowed dollars as payment.
There are two ways the spending merry-go-round can stop. One is if foreign countries stop accepting dollars as payment. This is unlikely because these countries need the U.S. market. The second is if either American consumers stop borrowing or local American banks stop lending because of fears that households are over-extended and housing prices are inflated so that the collateral is unsound. This seems the more likely channel.
If the merry-go round does stop, the U.S. economy will surely be hit and the dollar will likely fall owing to diminished U.S. economic prospects. However, other economies that depend on the U.S. market will also be hit, so that the dollar may fall less than many predict. Recognition of the source of unsustainability and the implications of interdependence are the missing elements in discussions of both global policy and the dollar’s future course. Financial dark matter is an unhelpful distraction, a case of more heat than light.
Are your figures for National Debt expressed in real terms? Presumably the net foreign income is for the figures to be comparable. Also – do any of your figures include state assets abroad? The sale and lease of these assets could account for the net foreign income to remain realitively favourable.
Thanks for your time!
Why the U.S. has been able to sustain a large trade deficit for so long is not explained by the hypothesis of “dark matter”, as this post explains.
We need more discussion on this subject.
Dark matter is an unnecessary postulation. When we compare line 14 with line 31 on Table 1 U.S. International Transations, we see that the US direct investment abroad is more productive of income than is direct investment in the U.S. It was more productive in 1990 (net of 63 billion). U.S. owned assets were even more productive in 2005 (net of 134 billion). One set of investments produces more income than another. That is what the data say. No need to postulate dark matter. Why the difference in productivity of investments? Apparently, profits are increasing faster overseas than in the U.S – and the U.S. concentrates investments in direct investment.
It is true that foreign owners of dollars tend to invest more in bonds. Other private payments (lines 15 and 32) are mostly a wash – U.S. advantage of 24 billion in a1998 and foreign advantage of 11 billion in 2002. Government exchanges provide a significant and growing advantage to foreigners, but those numbers are not sufficient to overcome the U.S. advantage from direct investment.
OK. Explain the other mystery. How does the U.S. sustain such a large and growing trade deficit? By creating financial assets in the private sector much faster than finanical assets are sent overseas to pay for the trade deficit.
Because Net Worth in the private sector in the U.S. increase from 20 Trillion in 1990 to 52 trillion at the end of 2005, the value of the dollar has remained high, despite the trade deficit. This allows the U.S. to pay for the trade deficit simply by shipping dollars overseas. Paying for the trade deficit with cash reduces the Net Worth and the Net International Investment Position in the U.S. But those reductions are tolerable because of the wealth creating ability of the U.S. economy.
Of course, it is possible for the wealth creating ability of the U.S. economy to falter. If and when that happens, we will have a new reality to confront. The above is a recital of what has happened in the past.
The trade deficit is harmful to the U.S. economy because imports cripple domestic production of tradable goods. An economy that cannot produce goods for sale in the international market is one that ultimately will be unable to receive imports (after the financial assets existing in the U.S. have been transferred to foriegners).
“Dark matter is an unnecessary postulation. When we compare line 14 with line 31 on Table 1 U.S. International Transations, we see that the US direct investment abroad is more productive of income than is direct investment in the U.S. It was more productive in 1990 (net of 63 billion). U.S. owned assets were even more productive in 2005 (net of 134 billion). One set of investments produces more income than another. That is what the data say. No need to postulate dark matter.”
From what I understood, this higher productivity of US owned assets is what Hausmann and Sturzenegger are calling the “dark matter.” In other words, you are repeating what they are saying. 🙂
They call it “dark matter” simply because, like real dark matter that was ignored by physicists, the net investment income surplus is often ignored when discussing economic issues such as the trade deficit.
“Of course, it is possible for the wealth creating ability of the U.S. economy to falter. If and when that happens, we will have a new reality to confront. The above is a recital of what has happened in the past.”
If the wealth creating ability of the US somehow ceases, then, you are correct, there may come serious problems. However, I wish to point out that the wealth creating ability of a service/investment oriented nation is no more likely to falter than the wealth creating ability of a more goods oriented nation. In fact, one might be able to argue that the economy of goods manufacturing nations is significantly less stable than that of service based nations. The reason is that technological progress and labor-saving devices are more easily used to replace labor that works to create goods than labor that works to supply services.
For example, in times past, agriculture was where the largest portion of the population worked. Because of this. land was considered to be the most valuable resource, and the nation that had the most land was considered quite well off. In that time, “wealth” meant “land”. The manufacturers/craftsmen that existed were considered lower on the economic hierarchy than the land/farm-owners because manufacturers were dependent on land-owners.
Technological progress changed that. The manufacturers began producing labor-saving devices for the agricultural sector. This eventually led to the results we have today, where a small number of farmers created much inexpensive food for the rest of us. But perhaps the most interesting result is that the “economic hierarchy” (so to speak) was rearranged, this time with the manufacturers on top.
The reason for this is simple: in times past, many, many people worked in agriculture; with the advent of the manufacturers, few people worked *in* argriculture, but many still worked *for* agriculture (creating new labor-saving devices, developing various new technologies). This shifted the “power” away from the land-owners and to the factory-owners. Agriculture was now dependent on the factory owners, not the other way around.
Some people did not realize why the factory-owners suddenly seemed to climb to economic hierarchy. They did not understand the effect of technological change; so they feared it.
Some of the England’s agriculture even began to be shipped overseas (to America as well as elsewhere). Some people saw this as something that would eventually send England back to the dark ages. But progress does not pay heed to the cries of the doom-mongers.
And so through the years, peoples attitudes changed. A solid manufacturing base began to be viewed as what made a country strong. Ah, how things change.
But even as I write, technology is advancing. The economic hierarchy is being reshuffled again.
“An economy that cannot produce goods for sale in the international market is one that ultimately will be unable to receive imports (after the financial assets existing in the U.S. have been transferred to foriegners). ”
My house has a gigantic trade deficit. I constantly import things to it, and (aside from the occasional eBay auction) never export anything.
Actually, it is possible for a nation (or a household) to export nothing from within its geographical borders and still maintain a trade deficit indefinitely (even without selling its assets). This can happen if the nation/household’s inhabitants produce profit outside the geography of the nation/house. Assigning balances of trade to geographical areas instead of individuals is silly. Adam Smith, the great promoter of economic individualism, once wrote, “Nothing can be more absurd than this whole doctrine of the balance of trade.”
The dollar, as predicted is being crushed. We are now at Par with the Canadian Dollar, the Loonie as it is called. This was all so predictable. You cannot run an 800 bilion dollar trade deficit and have your currency in demand. We have a lot farther to fall. Within 5 years from 2008 we should see the Canadian Dollar worth 25 % more than the U.S. dollar. The Euro at 1.40 now, should move to near 2.50, as China buys more and more of the Euro.
The pound at 2.04 as I write this will be near 3.00. Be ready for CHINA. When they finally let their currency float it will appreciate 70% over a 36 month period. The US trade deficit will be cut in half and then some by 2020.