Dark Matter
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Introduction

In November a paper was published at the Kennedy School of Government and Center for International Development at Harvard University by Riccardo Hausmann of Harvard and Federico Sturzenegger of Universidad Torcuato Di Tella. The title was "U.S. and Global Imbalances: Can Dark Matter Prevent a Big Bang?" They claim the current US account deficit is not a problem because "dark matter" does not show up in government statistics. They propose that this dark matter explains away the deficit and no real imbalance exists. You can read the original paper at http://www.cid.harvard.edu/cidpublications/darkmatter_051130.pdf

This week we will take a look at what two different economists have to say about their theory. The first comments come from Tim Drayson of ABN AMRO in the UK and the second comments are from Martin Barnes of Bank Credit Analyst in Canada. It is always exciting to watch some of the brightest economic minds debate a subject and that is why it was picked for this week's Outside the Box.

- John Mauldin

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Dark Matter

I can handle getting the dollar call wrong. The dollar must eventually fall, it's just a question of timing. But a number of people have sent me an article by Harvard University economists, R. Hausmann and F. Sturzenegger that argues the global imbalances aren't really there. Each time I receive the report I have to lie in a dark room to calm down.

The authors argue that if the current-account deficit is a problem, why have the markets not yet reacted? They note that between 1980 and 2004, the US ran an accumulated current-account deficit of $4.5 trillion. Given the US began the period with only a small positive stock of net foreign assets (the difference between the foreign assets owned abroad and the local assets owned by foreigners), one might have expected net external debt to have deteriorated by around $4.5 trillion over the period. So the US should be paying out much more on its liabilities than it receives in income on its foreign-owned assets. But the US net income position remained in surplus in 2004 at $30bn, the same as its surplus in 1980. They give two reasons for this. First, US net external debt has only deteriorated to $2.5 trillion as the US has enjoyed net capital gains (partly through devaluing the dollar). Second, the US earns a higher return on its holdings of foreign assets than it pays to foreigners on its liabilities. The authors then argue assets should be valued by their rates of return. This means US overseas assets are so undervalued that the US is actually a net creditor. The difference between official external debt and their measure of external debt is termed 'dark matter', because it corresponds to assets that generate revenue, but can't be seen.

But this view is backward looking and fails to recognize today's starting point for the current-account deficit. Yes, the income balance has held up, but it is starting to deteriorate and likely to become increasingly negative. Three factors have helped to support the US's net income position. First, the US has generated a higher rate of return on its assets than it pays on its debt. This reflects the fact that US assets are predominantly in equities and FDI, while its liabilities are principally in bonds. Second, the bull market in bonds has held down interest rates, cutting US debt servicing costs. Third, the dollar's fall between 2002 and 2004 boosted the net income balance through positive translation effects on repatriated overseas earnings.

Even if the US maintains high returns on its foreign assets, with a current-account deficit approaching an annual rate of $800bn this will add to the external debt stock and lead to higher interest payments. This will be compounded by higher domestic interest rates. A large part of external debt is in short-dated fixed-income securities. As this debt matures, the US will have to issue higher-yielding securities. Even if the trade deficit stabilizes (which is unlikely while US domestic demand remains strong - see 'Black Hole - Economics Focus, 14 December 2005), the current-account deficit and external debt are on an explosive path (see page 2). Ultimately, US domestic demand has to slow and the dollar needs to fall.

It might be too late for a benign outcome for global imbalances. If the dollar were to fall sharply now, there is little spare capacity left in the US economy to absorb a weaker exchange rate. Inflation could rise, forcing up interest rates. This could trigger a sharp adjustment for the household sector. So what happens if the dollar doesn't fall?

First, if the dollar's nominal exchange rate is flat, the US's higher relative inflation rate implies a continuing appreciation of its real exchange rate. The dollar's real appreciation in the late 1990s had a dramatic impact on US competitiveness. US industry experienced a significant weakening of its export performance, while the appetite for foreign goods increased. The dollar's decline since 2002 had begun to stem this loss of competitiveness, but the rally during 2005 threatens this improvement. The current level of the dollar implies a further widening of the trade deficit.

Second, a flat dollar also implies a further deterioration in the US's net income balance. Through 2003, the dollar's weakness and the sharp fall in US interest rates helped to boost the US's net-income position. US investors received higher returns on their overseas investments and paid out less to foreign investors. The rally in the dollar and higher US interest rates have started to unravel this improvement. In 2005, the net income position was close to zero and in 2006 is likely to turn negative (Chart 1).




Third, the dollar's decline between 2002 and 2004 helped to arrest the deterioration in the US's net international investment position. It increased the dollar value of investments held overseas. This valuation effect helped to offset the underlying deterioration in the US's net investment position. Last year's dollar strength will unwind those positive effects. With the dollar materially stronger compared with its end-04 level, this will affect the valuation of US assets adversely, increasing the US's net overseas debt.

Put these three together and what do you get? See Chart 3. Depending on your optimism about underlying trade flows, I think you could see a current account deficit of at least 8-9% of GDP by the end of the decade. What stops this explosion of the deficit and net debt? A sharp drop in the dollar.




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Dark Matter
By Martin Barnes
Bank Credit Analyst
December 21, 2005

Hi John (et al)

I did read the op-ed piece about this in the FT, and have to say it is one of the more bizarre pieces of research that I have read in some time. It is always good to see new work that challenges conventional thinking, and this piece certainly fits the bill on that score. However, it does not pass muster for me on a number of grounds.

The authors start with the puzzle of why the U.S. is a net recipient of investment income flows if it is supposed to be a large net debtor. This is indeed rather strange, but can be explained by looking at the data. The large gap between the rate of return the U.S. earns on its overseas assets versus what foreigners earn in the U.S., partly reflects the fact that foreigners have largely invested in U.S. interest-bearing securities, while the U.S. has focused on direct investment. We have a detailed breakdown on the various types of assets and liabilities that make up the net international debt position, so why make an arbitrary assumption of a 5% return across all assets?

If we just stick to FDI, the U.S. does earn a higher rate of return than foreigners. Why is that? Perhaps because the Japanese bought assets such as Pebble Beach Golf Club, and the U.S. buys/builds factories.

Clearly, there are all kinds of statistical challenges in measuring overseas assets and liabilities and it is quite probable that the U.S. net debt position is overstated. The current account deficit may also be overstated because of the under-recording of low-value merchandise exports and services exports in general. However, to argue that the U.S. has not been running deficits at all because it is a net recipient of investment income is ludicrous.

Other than issues about under-recording of exports noted above, the trade data are reasonably reliable. Are the authors suggesting that the value of imports has not exceeded exports by a substantial margin in recent years? Surely there can be no doubt that the U.S. runs a large trade deficit.

The article is really about the valuation of overseas assets and liabilities. This means that the authors are mixing up issues to do with stocks and flows. Of course, if assets are worth more than the data suggest, then there is more potential to sell those assets in order to finance the trade deficit. It is a bit like the consumer saving rate and the house price boom. If consumer wealth is higher because of rising house prices, then consumers do not need to save, and can tap into housing wealth to support spending. Is this desirable? That is another question.

If the argument is that the current account deficit can be sustained for a long time, then I have no problem with that. Whether one believes in the Bretton Woods II thesis or just the more simple view that Asian central banks have an incentive to remain the dollar buyers of last resort, then the deficit could be sustainable for a while. Also, the fact that the U.S. does have net receipts of investment income means that there is no worry about hitting a "debt wall" any time soon. However, we should not mix up the question of current account deficit sustainability with desirability.

There is no need to make Armageddon predictions because of the U.S. current account deficit. However, it is not unreasonable to assume that the dollar will drop further over the next few years and the gap between demand growth in the U.S. and overseas will close. The dollar may well drop in benign fashion as in 2002-04, but we all know how fickle currency markets can be.

This is a complex subject and there is much more to say. But I thought I would just give a quick response.

Happy holidays and best wishes for 2006.

Your skeptical friend

Martin Barnes
Managing Editor
The Bank Credit Analyst

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Conclusion

I hope you enjoyed this look at "Dark Matter."

Your sometimes in the dark analyst,


John F. Mauldin
johnmauldin@investorsinsight.com

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Posted 01-16-2006 10:01 PM by John Mauldin