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September 25, 2006

The End Of Dark Matter?

From this morning's Wall Street Journal (page A1 in the print edition), a return to one of last year's hot debates:

Exactly how the U.S. has managed to load on so much debt without seeing its net payments rise remains something of a mystery. Even in the second quarter, the U.S., in effect, was paying only a 0.4% annualized interest rate on its net debt. "It's still quite a good deal," says Pierre-Olivier Gourinchas, an economics professor at the University of California, Berkeley.

In a recent paper, Harvard economists Ricardo Hausmann and Federico Sturzenegger went so far as to suggest that the U.S. might not be a net debtor at all. Instead, they surmised, the U.S. might actually have income-producing assets abroad, such as know-how transferred to foreign subsidiaries, that have evaded measurement -- assets they call "dark matter," after a similarly elusive quarry in physics. Mr. Sturzenegger says the latest data haven't changed his view.

Most economists, however, see a more prosaic explanation: Foreigners have been willing to accept a much lower return on relatively safe U.S. investments than U.S. investors have earned on their assets abroad. Take, for example, China, which since 2001 has invested some $250 billion in U.S. Treasury bonds yielding around 5% or less -- part of a strategy to boost its exports by keeping its currency cheap in relation to the dollar.

Well, to be fair to Hausmann and Sturzenegger, that interest rate differential was part of their story.  Much of the debate was actually about the meaning of that differential: Is it some inherently superior aspect of the US economy that drives foreigners to pay a premium for our financial assets?  Or is it the agenda of, for example, the People's Bank of China, pursuing policies that are more about internal political objectives than market fundamentals? 

In any event, the Journal article suggests that, just maybe, we are seeing the beginning of the end:

As interest rates rise, America's debt payments are starting to climb -- so much so that for the first time in at least 90 years, the U.S. is paying noticeably more to its foreign creditors than it receives from its investments abroad. The gap reached $2.5 billion in the second quarter of 2006. In effect, the U.S. made a quarterly debt payment of about $22 for each American household, a turnaround from the $31 in net investment income per household it received a year earlier...

The gap is still small within the context of the $13 trillion American economy. And the trend could reverse if U.S. interest rates decline. But economists say America's emergence as a net payer illustrates an important point: In years to come, a growing share of whatever prosperity the nation achieves probably will be sent abroad in the form of debt-service payments. That means Americans will have to work harder to maintain the same living standards -- or cut back sharply to pay down the debt.

The article contains a lot of comments hinting at a deep instability that seem, to me, a bit over the top:

If the trend persists, it could also raise concerns about the nation's creditworthiness, putting pressure on the U.S. currency. "It's an additional challenge for the dollar," says Jim O'Neill, chief economist at Goldman Sachs in London...

Among economists' biggest concerns, though, is the fast pace at which the U.S. is accumulating new debt. As that leads to larger interest payments, it will make the current-account deficit harder to control -- a vicious cycle that could accelerate if worried foreign investors demand higher interest rates to compensate for the added risk...

"You end up having to pay more and borrow more," says the University of California's Prof. Gourinchas. "Things could get out of hand very quickly."

And this statement just seems wrong:

The size of the nation's debt payments matters because it represents a share of income that American consumers, companies and government won't be able to spend or save. The higher the debt payments, the harder it will be for the U.S. to prosper.

Any rapid change in capital flows could, of course, be disruptive in the short run, but a lot of borrowing by the country means the same thing as it does for you:  Accumulated debt doesn't stop you from earning income, it just limits your ability to spend it.  Nouriel Roubini puts his finger on what it all really means:

"Your standard of living is going to be reduced unless you work much harder," says Nouriel Roubini, chairman of Roubini Global Economics. "The longer we wait to adjust our consumption and reduce our debt, the bigger will be the impact on our consumption in the future."

No argument here.

UPDATE: You can find quite a few links to comments on dark matter at Alpha.Sources blog.

September 25, 2006 in Exchange Rates and the Dollar, Saving, Capital, and Investment, Trade Deficit | Permalink


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"Your standard of living is going to be reduced unless you work much harder...."

Doesn't that depend on what we do with the proceeds of all this borrowing? If it is invested productively, then we won't have to reduce our consumption. If it's consumed or invested unproductively we will. That's the same as with any other kind of borrowing. The presumption of all these dark warnings is that we are doing the latter, but I don't see what that's based on.

Posted by: Jim K. | September 25, 2006 at 02:49 PM

I agree with Jim. If anything he understates the point. The question boils down to what returns we earn on capital investment here. The tendency for capital deepening to raise labor returns is independent of who owns the capital. And even the net financial return seems likely to rise, despite the rising net tribute paid to foreigners.

Posted by: Gerard MacDonelll | September 25, 2006 at 03:38 PM

Although the other commentators make theoretically correct points, I think they are wrong empirically. Over the past few years, the US capital surplus (i.e., “borrowing”) has mostly been invested in residential real estate, which is not nearly as productive a use as one might hope for. Residential investment won’t do a whole lot to raise labor returns in the future. Moreover, if you compare investment and savings levels (as derived from the national accounts) to historical averages, you would have to say that much of the surplus has been consumed.

On the other hand, we don’t really know the answer to the counterfactual, how much would have been consumed and invested if we hadn’t been borrowing so much. And one could even argue that borrowing for consumption was a reasonable thing to do given expected productivity growth.

But…with Medicare already actuarially bankrupt, it seems to me we should be saving more, despite expected productivity growth.

Posted by: knzn | September 25, 2006 at 04:35 PM

Dr. Dave,

The symbiotic US debt & Chinese savings relationship is going to get severely tested in the next 4 years.

And yes the standard of living is going to come down and quite a bit.

Hit the URL for more...

Posted by: The Nattering Naybob | October 02, 2006 at 08:13 PM

"Your standard of living is going to be reduced unless you work much harder," says Nouriel Roubini,....etc.
"No argument here." ???

I beg to differ, change the word "harder" to "more efficiently" and I might concur, add "Enthusiastically" to that maxim, and I will concur with enthusiasm. Engineers tend to see accountants as puppy dogs, trying to catch their tails, running round in ever decreasing circles till they fall over, panting with a big innocent smile on their face! A 'for instance' as far back as I can remember (pre-1960's) Engineers have scratched their heads in total perplexity at why we put sticky oil in pipes and pump that sticky oil hundreds if not thousands of miles at huge labour. Madness! Engineers would bag the oil into sausages, place each sausage ballel of oil into a magnetic levitation "PIG" and then fly the oil at break neck speed down a much smaller evacuated tube. Deaserts need water, seawater evaporates in the deasert...slightly obvious the "PIGS" brake at each end of their jourlney, the momentum is converted into electricity...which in turn propells the out-going "PIGS". Oil arrives at a Sea-Port, and Sea-Water arrives at the Oil Well. Sea Water turns to Fresh Clean Potable water and Sea-Salt. which is a highly desireable and marketable commodity on it's own.

Common Sense. All we need to do, is do it!

Posted by: Alastair Carnegie | May 18, 2007 at 12:11 PM

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