macroblog

Dark Matter By Any Other Name

From Austin Goolsbee, via Mark Thoma:

... The United States miracle of the 1990s was that our productivity began growing faster than that of other countries, even though we were the richest to start with...

To explain the experience in the United States, one would have to believe that Americans have some better way of translating the new technology into productivity than other countries. And that is precisely what [London School of Economics] Professor [John] Van Reenen’s research suggests.

His paper “Americans Do I.T. Better: U.S. Multinationals and the Productivity Miracle,” (with Nick Bloom of Stanford University and Raffaella Sadun of the London School of Economics) looked at the experience of companies in Britain that were taken over by multinational companies with headquarters in other countries. They wanted to know if there was any evidence that the American genius with information technology transfers to locations outside the United States. If American companies turn computers into productivity better than anyone else, can businesses in Britain do the same when they are taken over by Americans?

And in the huge service sectors — financial services, retail trade, wholesale trade — they found compelling evidence of exactly that. American takeovers caused a tremendous productivity advantage over a non-American alternative.

When Americans take over a business in Britain, the business becomes significantly better at translating technology spending into productivity than a comparable business taken over by someone else. It is as if the invisible hand of the American marketplace were somehow passing along a secret handshake to these firms.

Sound familiar?  If you can't quite put your finger on it, here's a refresher from Ricardo Hausmann and Federico Sturzenegger:

There is a large difference between our view of the US as a net creditor with assets of about 600 billion US dollars and BEA’s view of the US as a net debtor with total net debt of 2.5 trillion. We call the difference between these two equally arbitrary estimates dark matter, because it corresponds to assets that we know exist, since they generate revenue but cannot be seen (or, better said, cannot be properly measured)...

At least three factors account for the accumulation of dark matter. The first refers to foreign direct investment (FDI). Consider a simple example. Imagine the construction of EuroDisney at the cost of 100 million (the numbers are imaginary). Imagine also, for the sake of the argument that these resources were borrowed abroad at, say, a 5% rate of return. Once EuroDisney is in operation it yields 20 cents on the dollar. The investment generates a net income flow of 15 cents on the dollar but the BEA would say that the net foreign assets position would be equal to zero. We would say that EuroDisney in reality is not worth 100 million (what BEA would value it) but four times that (the capitalized value at our 5% rate of the 20 million per year that it earns). BEA is missing this and therefore grossly understates net assets. Why can EuroDisney earn such a return? Because the investment comes with a substantial amount of know-how, brand recognition, expertise, research and development and also with our good friends Mickey and Donald. This know-how is a source of dark matter. It explains why the US can earn more on its assets than it pays on its liabilities and why foreigners cannot do the same. We would say that the US exported 300 million in dark matter and is making a 5 percent return on it. The point is that in the accounting of FDI, the know-how than makes investments particularly productive is poorly accounted for.

That story might only go so far, as the Federal Reserve Bank of New York's Matthew Higgins, Thomas Klitgaard, and Cedric Tille claim...

... we review the argument that the United States holds large amounts of intangible assets not captured in the data—assets that would bring the true U.S. net investment position close to balance. We argue that intangible capital, while a relevant dimension of economic analysis, is unlikely to be substantial enough to alter the U.S. net liability position.

... but it's apparently more than a fairy tale.

Like Ben Said

Calculated Risk makes an interesting observation:

The trade deficit, ex-petroleum, appears to have peaked at about the same time as Mortgage Equity Withdrawal in the U.S.

"Interestingly, the change in U.S. home mortgage debt over the past half-century correlates significantly with our current account deficit. To be sure, correlation is not causation, and there have been many influences on both mortgage debt and the current account."
Alan Greenspan, Feb, 2005

... Declining MEW is one of the reasons I forecast the trade deficit to decline in '07. And a declining trade deficit also has possible implications for U.S. interest rates; as the trade deficit declines, rates may rise in the U.S. because foreign CBs will have less to invest in the U.S.. This is why I forecast rates to rise in '07.

I think that CR has the causation running from the housing market to the trade deficit, but as always there is another interpretation.  I take you back to one of my favorite Fed speeches of all time, from the current Fed chairman:

What then accounts for the rapid increase in the U.S. current account deficit? My own preferred explanation focuses on what I see as the emergence of a global saving glut in the past eight to ten years...

The current account positions of the industrial countries adjusted endogenously to these changes in financial market conditions. I will focus here on the case of the United States, which bore the bulk of the adjustment...

After the stock-market decline that began in March 2000, new capital investment and thus the demand for financing waned around the world. Yet desired global saving remained strong. The textbook analysis suggests that, with desired saving outstripping desired investment, the real rate of interest should fall to equilibrate the market for global saving. Indeed, real interest rates have been relatively low in recent years, not only in the United States but also abroad. From a narrow U.S. perspective, these low long-term rates are puzzling; from a global perspective, they may be less so.

The weakening of new capital investment after the drop in equity prices did not much change the net effect of the global saving glut on the U.S. current account. The transmission mechanism changed, however, as low real interest rates rather than high stock prices became a principal cause of lower U.S. saving. In particular, during the past few years, the key asset-price effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported record levels of home construction and strong gains in housing prices. Indeed, increases in home values, together with a stock-market recovery that began in 2003, have recently returned the wealth-to-income ratio of U.S. households to 5.4, not far from its peak value of 6.2 in 1999 and above its long-run (1960-2003) average of 4.8. The expansion of U.S. housing wealth, much of it easily accessible to households through cash-out refinancing and home equity lines of credit, has kept the U.S. national saving rate low--and indeed, together with the significant worsening of the federal budget outlook, helped to drive it lower...

The direct implication, of course, was that the reversal of U.S. current account deficits would likely be associated with higher real interest rates, a weakening of foreign-capital financed investment, and higher saving in the U.S. (of which a slowdown in mortgage equity withdrawals could be a part). It is worht noting that Chairman Bernanke was decidedly less than sanguine about the consequences of such adjustments:

... in the long run, productivity gains are more likely to be driven by nonresidential investment, such as business purchases of new machines. The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be.

Whether or not Mr. Bernanke believes that we find ourselves in the process of meeting those burdens I cannot say.  But those who buy the global saving glut story -- as I do -- have acknowledged all along that the day of adjustment would look pretty much like it does at the moment.

A Credit Crunch It's Not

It does appear that Wall Street is pretty happy with the way the world looks this week. U.S. macroeconomic data is only part of that picture, of course, but to the extent that it is I think Dean Baker makes good sense:

The Commerce Department's data did show better than expected durable good orders in March, but this was following very weak reports in January and February. Year over year, durable good orders are still down by more than 3 percent in nominal terms... Against a backdrop of serious weakness, a better than expected month is always good news, but it seems a bit excessive to make too much of this very erratic data.

The other cause for celebration was a 22,000 increase in the rate of new home sales in March, measured against a downwardly revised February level. The basis for the celebration here escapes me. The consensus forecast was for a considerably larger bounceback from the weak February level. Even with the uptick, March sales were the slowest since the recession, excluding February. And the small uptick was almost certainly driven by weather...

But I'm finding some comfort in a Wall Street Journal article (hat tip to Calculated Risk) titled "Home Equity Stalls" (page D1 of the print edition):

After years of piling debt on their homes, Americans are becoming more cautious about using them as a piggy bank.

A cooling housing market and higher interest rates have made homeowners more reluctant to tap the equity they may have built up in their residences...

Now, the slowdown in home-equity borrowing is leading to weaker sales in some markets for autos, building materials and electronics, says Mark Zandi, chief economist of Economy.com.

Barry Ritholtz sounds off on that last theme, and Calculated Risk is beginning to worry about a consumer-led recession.  So why would I feel encouraged?  The WSJ article continues:

Lenders are responding to slowing demand for home-equity borrowing by boosting their marketing, unveiling special offers and focusing on traditional uses of home equity, such as home improvement and debt consolidation. Wells Fargo this week rolled out a "Home Improvement Program" that gives home-equity customers discounts at retailers such as Best Buy, Brookstone and LampsPlus.com and access to a network of third-party local contractors.

J.P. Morgan Chase & Co. is running its first cable-television advertising campaign for home-equity borrowing, focusing on the product's flexibility. It's also rolling out a training program designed to help bankers in Chase branches do a better job of selling home-equity products. Bank of America, has launched a "green" home-equity card program, in which the bank will make a $100 donation to environmental group Conservation International on behalf of new home-equity customers who use their equity-line Visa card for purchases of $2,500 or more.

In my view, the biggest threat from housing-sector woes has all along been the possibility of spillovers into credit markets -- the kind that can restrain economic activity even after consumers and businesses shake off some of the caution that the stress of uncertainty inevitably brings.  Several posts back I offered the opinion that a lack of available credit does not seem to be the driving factor behind weak growth in business investment.  Today's story suggests that the same may be true of consumers.  And that may just be the difference between a soft patch and downright ugliness.   

Capital Spending Concerns On The Chart With A Bullet

Barry Ritholtz said it yesterday...

It is increasingly apparent from the many economic signals we have seen that business spending is fading, and is unlikely to replace consumer spending anytime soon. This is one of the reasons are recession expectations keep ticking higher, beyond 50%.

... and in an article dated tomorrow but posted online today, the Wall Street Journal reports that its own survey of economists reveals a similar concern, if not quite the same degree of pessimism:

Weakness in business capital spending is edging out housing as the dark cloud on the U.S. economic horizon.

A new WSJ.com survey found that 20 of 54 economic forecasters responding to a query cited soft capital spending as the chief risk to their forecast that the U.S. economy will grow slowly but avoid recession this year.

It is pretty clear from whence the worry comes:

The Commerce Department says overall business investment fell an inflation-adjusted 3.1% in the fourth quarter, the first drop since early 2003. And government measures of orders for and shipments of capital goods so far this year have been unexpectedly weak...

The Fed, in minutes of its March meeting released this week, said that "financing conditions and other fundamentals remained favorable for a pickup in capital spending."

But the current softness comes as a surprise to many analysts. Indeed, the Fed minutes noted, "Investment in goods and services other than transportation and high-tech equipment softened more than fundamentals had suggested."

The consensus, however, remains on the side of continued expansion:

Economists responding to the WSJ.com survey were slightly gloomier about the prospects for the U.S. economy than they were a month ago. On average, they now estimate the economy grew at a 2% annual rate in the first quarter, down from the 2.3% estimate they made in March. They predict the economy will grow at a 2.2% pace in the current quarter and pick up momentum in the second half...

On the whole, economists see limited risk of recession over the next 12 months, putting the probability at 26%, near the same level of risk they've forecast since last summer. When asked to identify the one economic indicator they would watch to determine if the economy will slip into recession, 23 of 58 named the Labor Department's monthly employment report...

Although I think Barry was correct in his warnings to not get carried away with the March employment report, the jobs picture is still the best reason to stay calm.

UPDATE:  Not surprisingly, The Big Picture notices this story too. Mr Ritholtz, however, seems to think tight monetary policy is the root cause:

When your growth is dependent upon cheap money and easy credit, guess what happens when credit tightens and money becomes less easy?

I don't know about that take -- "money" doesn't seem to me to be the problem.  I'd worry about something more fundamental being afoot.

Where The Risk Is

And so it appears that the moment of truth is near, when we will finally see beyond the immediate fate of the housing market and determine the magnitude of the collateral damage (no pun intended).  I think that there is a consensus that, if the worst is to come, some sort of substantial disruption to financial markets will be in the middle of it all.  Nouriel Roubini covers about every inch of territory you can on this theme, even managing to juxtapose Alan Greenspan and Ben Bernanke with foreign-policy neo-conservatives.  In somewhat more measured tones, Kash Mansori and Calculated Risk have begun to fret about the potential for spillover into the commercial banking sector.  Says Kash:

In my previous post I explained why I think that the quantity of bad mortgages in the US economy may actually be enough to significantly affect the non-performance and write-off rates for the US banking system as a whole. Yesterday, Calculated Risk followed this up with a discussion of why he thinks that the health of commercial real estate loan portfolios may soon suffer the same fate that residential loan portfolios are currently experiencing.

Some of that is not speculation, as this story from own neck of the woods so clearly shows:

The quaking U.S. market for subprime mortgage loans is rattling National City Corp. too.

The parent of National City Bank of Pennsylvania has decided it won't try to sell $1.6 billion in subprime loans after all, due to "adverse market conditions," National City said in a securities filing Thursday. The loans "are currently not saleable at what management considers an acceptable price," the bank said.

Instead, Cleveland-based National City took a write-down of $11 million in February, and sometime this month will return to its portfolio the loans it had intended to sell. "A further write-down is likely," the filing said. Spokeswoman Kristen Adams would not elaborate...

Additionally, National City expects to add "on the order of $50 million" to its reserves for possible loan losses, the filing said.

But here's how the story ends:

National City shares closed yesterday at $35.99, up 30 cents.

Hmm.  Frankly, I just don't think the traditional banking sector is where be the dragons.  Instead, I worry about the answers to three questions: 1. Will a growing perception of risk begin to choke off lending to investment projects that are otherwise economically viable?  2. Will a growing perception of risk cause businesses to forgo or defer an increasingly large quantity of investment projects?  3.  Have hedge funds, private equity funds, and specialty financial corporations become such important parts of the credit channel that there is scant relief to be found from a relatively unscathed traditional banking sector?

To question 1, we have this, from Bloomberg:

Risk premiums on investment-grade corporate bonds are at their highest level in more than three months on concern rising delinquencies by subprime borrowers will slow the U.S. economy...

"This period of volatility is likely to continue as long as there is divided opinion about the magnitude and resulting financial impact of the subprime problem,'' said Edward Marrinan, head of North American credit strategy at JPMorgan Chase & Co. in New York. "Subprime risks and accompanying fears of a spillover into the broader consumer sector are the catalysts for the heightened volatility currently exhibited by all risky asset classes,'' he said in an interview...

The 7-basis-point increase in investment-grade spreads is the index's worst three-week performance since the period ending May 20, 2005, Merrill data show. The increase means a company would pay $70,000 more in annual interest for every $100 million borrowed.

We might hold on to the belief that firms are partially insulated from rising borrowing costs (or restrictions on loan availability) due to the fact the corporate cash-flow to investment ratio remains relatively high...

   

   

... but there are two problems with seeking shelter in that picture.  First, we have data only through the third quarter of 2006, which is pretty stale information at this point.  Second, and more importantly, a high cash-flow to investment ratio may itself be a symptom of business's unwillingness to commit to fixed investment spending.

To question number 3, I have no idea what the answer is.  And I wish I did.

Are We Panicking Just A Bit Too Soon?

If there was any doubt about it before, that groaning sound from the residential housing market definitely has our attention now.  A woefully incomplete list of blogger commentary from the past several days would include items at Alpha.Sources blog (here, with some international perspective here), at Angry Bear, at Beat the Press, at The Big Picture, at Bizzy Blog, at Brad DeLong's, at Daniel Gross, at Economic Dreams - Economic Nightmares (here and here), at Economics Unbound, at Economist's View (here and here), at Euro Intelligence, at Felix Salmon, at The Housing Bubble Blog (here and here), at Mish's Global Economic Trends Analysis, at the Skeptical Speculator, and at The Street Light.  I won't even bother to list individual items from Calculated Risk or Nouriel Roubini.  Just head on over and start reading.

In the midst of this, let me make one brief plea for a little perspective:  It might be good to remember that this was not entirely unexpected.  Since at least summer I have been giving "economic outlook" speeches with the same basic message:  Weakness in the residential housing market will continue for some time -- the bottom in prices seems unlikely until at least mid-year.  Adjustments of this sort are never easy, there will be some pain, and probably a disruption in the pace of economic expansion as things sort themselves out.  The punch line is always something like, "but things do sort themselves out, and there is no reason to expect that the economy will fail to return to a normal pace of growth after a sluggish quarter or two."

Anything yet make that projection look wrong?  Not within my confidence intervals.  Forecasters, economic pundits, and other human beings are congenital slaves to the latest surprises in the data, so confidence has ebbed and flowed and ebbed again as the news has surprised to the downside, to the upside, and back again.  But would anyone really want to argue that we aren't in the neighborhood of where most informed observers thought we would be about now? 

Trouble, of course, often looks worse when it arrives than it did when we were merely contemplating its arrival.  It is understandable that we feel a little wobbly now that the shake-out among certain mortgage lenders is here at last.  And there are parts of the "soft-landing" scenario that look a bit tenuous at the moment -- I would put the worrisome signs of weakening business investment expenditures, emphasized by pgl at Angry Bear and Jim Hamilton at Econbrowser, at the top of my list.  But for the time being, I'm going to go easy on the panic button. 

U.S. Saving: Not Quite As Bad As Sometimes Advertised

Last week's report that the US personal saving rate dipped further into negative territory last year prompted similar responses from Steven Kyle at Angry Bear and Barry Ritholtz at The Big Picture.  Said Steven:

This can’t go on indefinitely but the longer it does the more unpleasant it will be to unwind it. Time to batten down the financial hatches folks.

Said Barry:

Yesterday, DF asked about the negative savings rate. I noted the RM column I wrote last June (Ignore Statistical Oddities at Your Peril) in response. Like all unsustainable things, they will continue until they no longer can. This is often for far longer than expected, but not forever (an admittedly large range of time).

They may be both be correct, but on this one Steven's sources are a bit better than Barry's.  Steven has pgl around to point out that the most recent data is about personal saving by households -- not private saving (which includes business saving) or national saving (which adds government surpluses to private saving).  Barry is less fortunate:

As Abelson points out this morning, "the only time ever before that our worthy population had two years in a row of negative savings, as we did in '05 and '06, was in those heartbreak years, 1932 and 1933"...

A fresh take on the subject comes courtesy of MacroMaven's Stephanie Pomboy (via Alan Abelson). Stephanie notes not just the negative national savings rate, but two other relevant data points: The ratio of cash to debt, and how that cash and debt is distributed in the country...

So, for the record:

   

   

These statistics only cover the period through the third quarter of last year, but based on what we know about the federal deficit, corporate profits, and investment spending in the fourth quarter, it is a safe bet that the storyline will not change: Though personal saving rates failed to rise out of negative territory, overall saving in the US -- though still low by historical standards -- actually improved in 2006.

The claim that households may be especially illiquid at the moment is an interesting one, and something to think about. And you are certainly entitled to fret that national saving is still too low for our own good.  But we might as well acknowledge progress when it appears (slight as it is).

UPDATE: Tom Blumer at Bizzy Blog links to the folks at OpinionJournal.com reminding us that saving calculated from the National Income and Product Accounts does not really measure changes in the value of assets -- a more appropriate measure of saving.  I would, however, note knzn's call for caution in thinking about wealth from housing.

UPDATE, THE SECOND: Mark J. Perry takes the net worth angle too.

UPDATE, THE THIRD: pgl pokes some holes in the claim that the saving behavior of US households will look much better if only we focus on changes in net worth.

UPDATE, THE FOURTh: Steven Kyle has some follow-up thoughts (about which I have no quarrel).

'Tis The Season

The global saving glut in song (with a big giant tip of Santa's stocking cap to Axiom Management's Stan Jonas).

And in case I forget, blessings to each and every one of you.

UPDATE: Well, I see Greg Mankiw beat me to the punch.  So, in case you are in the mood for something a little less lighthearted, here's a rundown of various musings about global interest rates and such, from the bloggy wonderland:

Barry Riholtz points to Paul Kasriel's musings on many things, including the ongoing role of global demand in "explaining" the low long-term interest rates in the US. (See page 5 of the December 15 article "Festivus Flow-of-Funds Stocking Stuffers."  I'm still not too sure I buy into implicit "market segmentation" theory of the term structure, but the whole thing is interesting reading in any event.)

Jim Hamilton discusses a paper by the San Francisco Fed's Glenn Rudebusch, Eric Swanson, and Tao Wu, on the disappearing term premium in long-term bonds (and offers the hopeful possibility that "perhaps there is another little chunk of that inverted yield curve that's maybe not so scary"). At Angry Bear, pgl has some thoughts on the topic too.  Jon Rotger is apparently unmoved by claims that yield curve inversions  ain't what they used to be.  Neither is Nouriel Roubini.

Looking to the great world beyond, Brad Setser has lots of interesting things to say (as usual) about the role of Asian central banks in the year behind and the year ahead.  At Bonobo Land, Edward Hugh has the premium on emerging market interest rates (and much more) on his mind. While you're on that topic, check out Felix Salmon at Economonitor as well. At Alpha.Sources-CV, Claus Vistesen considers Japan's widening trade surplus, and suggests the country's current dependence of export production willimit the Bank of Japan's options on policy rates.  At Eurozone Watch, Sebastian Dullien is bullish on Germany and colleagues, unless "the hawks in the ECB get their way and rise their interest rates overly quickly."  The Skeptical Speculator adds the UK to the higher-rates-in-07 clan.

Calculated Risk takes a calculated risk and predicts "the Fed to start lowering rates later next year", but conjectures "long rates will start to rise."

Do These Numbers Add Up?

Today's Wall Street Journal has a long, and interesting, article (page A1 of the print edition) on where the Democrat-controlled Congress might take economic policy if they have their druthers. On the let's-pay-for-things side of the ledger:

The Senate Finance Committee, with the blessing of both parties' leaders, is circulating a list of ways to shrink the "tax gap" between taxes owed and taxes actually paid. Most are aimed at upper-income taxpayers, such as requiring stock brokers to report not only the price a client got for shares, but also the original purchase price paid.

Boosting taxes on upper-income Americans would reduce disparities and provide revenues for other attacks on inequality. Raising the top two tax rates, now 33% and 35%, by a single percentage point would yield $90 billion over five years, the Congressional Budget Office estimates.

Another favorite Democratic target is the lower tax rate -- a maximum of 15% -- on capital gains and dividends.

But then there is this list, which includes expanded tax breaks for low-income workers...

Enlarging the earned-income tax credit, viewed by many economists as a smart alternative to a higher minimum wage, is an option likely to figure in Democratic tax deliberations. The credit offers up to $4,536 to a family with two or more children to offset payroll taxes that the working poor pay. And it offers a cash bonus if the credit exceeds taxes paid, rewarding low-wage workers without raising employers' costs...

... expanded social insurance for displaced workers...

One direct response to workers' anxiety is expanded government programs to cushion the fall of those who lose jobs in today's rapidly changing economy...

Lori Kletzer of the University of California at Santa Cruz and Howard Rosen of the Peterson Institute for International Economics in Washington, for instance, would offer eligible dislocated workers up to half the difference between weekly earnings at their old and new jobs, up to $10,000 a year. This isn't cheap: They put the price tag at between $2.6 billion and $4.3 billion a year, financed through general tax revenues or an expanded payroll tax.

... larger expenditures on education...

Democrats are focused on doing more to help Americans pay for college, especially important since the typical college grad earns 45% more than the typical high-school grad. Ms. Pelosi's platform calls for making up to $12,000 a year in college tuition tax-deductible -- or the equivalent in a $3,000 tax credit -- as well as cutting interest rates on student loans and increasing the maximum Pell Grant for low-income students to $5,100 from $4,050.

A coalition that spans the political spectrum is pushing more government support of Pre-K education. The case: Low-income children are behind when they arrive at kindergarten and never catch up; spending more on them sooner would have a big payoff.

... and incentives to induce more private saving

... such as replacing current tax breaks for retirement savings with universal 401(k) accounts into which the government would match family savings -- a 2-to-1 match for low-income families, 1-to-1 for middle income families and perhaps 0.5-to-1 for high-income families.

... an idea suggested by Clinton economic adviser Gene Sperling, described in an online companion article.

These are all responses to very legitimate concerns -- how do we encourage more saving, how do we ensure opportunities to develop the skills that so clearly separate the haves from the have-nots, how should we view society's responsibilities to people who are harmed by economic change through no fault of their own?  And though the ideas above may or may not be the best approaches to dealing with these questions, they are certainly worthy of discussion.

But how should that discussion proceed? An awful lot of people seem to feel that just reversing past tax cuts will somehow lead us to the promised land, but the arithmetic looks pretty shaky to me.  That's why I think this is a good place to start:

New House Speaker Nancy Pelosi has vowed to restore a 1990s rule requiring new spending to be offset by spending cuts or tax increases...

First, a means to institutionalize priority setting.  Then, on the specifics of those priorities, we can talk.

Of Course Trade Deficits Aren't Necessarily Bad (Wherein In My Readers Set Me Straight)

Yesterday I nodded approvingly to the following remarks on the consequences of trade and current account deficits from Nouriel Roubini, as recounted by the Wall Street Journal:

"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."

Reader Jim K responded...

"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.

... and reader Gerald MacDonnell seconded the objection:

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.

Well, those are mighty fine points, and I was mighty remiss in not making them.  So then, is it likely true that the sharp increase in the U.S. current account deficit that commenced in about 1997 has deepened the capital stock beyond what it otherwise would have been?  knzn responds to Jim and Gerald's comments: 

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.

Ben Bernanke raised the same issue a few years back in what, by pure virtue of the number of times I have cited it, is one of my all-time favorite Fed speeches:

Because investment by businesses in equipment and structures has been relatively low in recent years (for cyclical and other reasons) and because the tax and financial systems in the United States and many other countries are designed to promote homeownership, much of the recent capital inflow into the developed world has shown up in higher rates of home construction and in higher home prices. Higher home prices in turn have encouraged households to increase their consumption. Of course, increased rates of homeownership and household consumption are both good things. However, in the long run, productivity gains are more likely to be driven by nonresidential investment, such as business purchases of new machines. The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be.

This is a really intriguing question:  Should we care if investment takes the form of physical capital that will ultimately be devoted to producing goods and services sold in markets, as opposed to physical capital that will ultimately be devoted to "home production" (that is, the manufacture of all those things that make us happy that households create for themselves)?

I'm not so sure.  It would be true that increased quantity and quality in residential housing would do little to raise productivity in market activities, but surely it must raise productivity in home production.  It would also be true that devoting more resources to home production means fewer resources for market production.  In other words, if we decide to enjoy the "output" a larger yard, a more inviting family room, a gourmet kitchen,or whatever, we may have to cut down on our consumption of other things.  But so what?  That's a choice that individuals make all the time, and the truth is that economists don't have much to say about whether it is a good thing or a bad thing: De gustibus non est disputandum.

I can think of at least a couple of reasons to not be indifferent about the market/home investment distinction.  For one thing, as mentioned by Mr. Bernanke, the deck is already stacked in favor of housing via tax incentives, institutions like Fannie Mae, and so on.  A boom in a distorted market may not be such a great thing.   

Perhaps more important from the financial stability point of view, home production is, by definition, non-tradable, so investment in housing has a limited capacity to directly generate the means to pay back foreigners who lend to us.  That's the sense in which I was agreeing with Roubini and knzn -- the payback would have to come in the form of reducing our own consumption of market goods (again, below what it would otherwise be).  Again, that is not a bad thing per se, but there is some possibility that this makes the whole set of transactions riskier from the point of view of the lenders, raising borrowing costs and inducing market volatility.  There is yet scant evidence that this is the case, but I suppose it is a possibility.

Others may have additional reasons for worrying about a shift from market to home production.  I'd like to hear them.  But for now, I take the point that conclusions about the "problem" of the current account deficit are not clear cut.  Consider me duly chastened.

UPDATE:  Be sure to read the very thoughtful contributions to the comment section.

MORE WORTHY THOUGHTS:  From Claus Vistesen, who you should be checking out regularly if you aren't already.   Claus ruminates on this post, and Brad Setser's more extensive version of his comments below.

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.

Odds And Ends -- July 22 Edition

A rainy morning in Cleveland, and an opportunity to do some quality blog-surfing.

The confluence of Chairman Bernanke's Congressional testimony and the release of the June FOMC meeting minutes got lots of people thinking about what is next for U.S. monetary policy. Brad Delong is "surprised that there hasn't been a pause yet" and thinks that we haven't seen one because "the Fed is scared of the 'soft on inflation' headlines that a pause would generate."  The Capital Spectator offers a terrific round-up of the week's economic news, and claims that "In theory, a slowing economy makes it easier for the Federal Reserve to cease and desist with its current round of interest rate hikes. In practice, life's more difficult, thanks to the worrisome rise in core CPI in June..."  Tim Duy also thinks that "although the Bernanke sounded soothing relative to expectations, the incoming data argue for another rate hike in August."  Toni Straka believes the "rate trend will stay the same and probably accelerate." At Hypothetical Bias, the opinion is "Once more and done (for a bit, at least)". William Polley is leaning that way too.  Barry Ritholtz reiterates: The Bernanke bounce in the stock market is a "sucker bet".

Speaking of the Chairman -- more specifically his ideas about the global savings and investment and their relationship with interest rates -- Mark Thoma has a legitimate beef with the use of the word "glut."

Other summaries of, and commentary on, the week's economic news: From Dr. John John Rutledge (here and here). Calculated Risk provides a nice graphical look at where housing inventories are building, replicated from the Wall Street Journal. The Nattering Naybob Chronicles has its usual rundown of the week in bond and equity markets. MacroMouse contemplates the end of quantitative easing in Japan, and sees lessons for U.S. policymakers.  Tim Iacono has plenty of this and that, as does The Skeptical Speculator.

On my exchange with Nouriel Roubini on Chinese currency reform, Kash agrees "it does not feel like we're getting closer to some sort of crisis" but wonders "what should we expect it to feel like?"  Paul at Truck and Barter gets right to the substance of our exchange, while Brad Setser adds his own, ever insightful, thoughts at RGE Monitor. The Skeptical Speculator notes that "China has taken additional steps to cool its economy." Though not about the Chinese case specifically, Daniel Gross addresses a related and really important question: Is the end of American dominance in capital markets done?

Russell Roberts echoes an argument made this week by Ben Bernanke: In dealing with low-wage workers, an earned-income credit is preferable to a minimum wage.  He also takes on Paul Krugman's position on both the minimum wage and the inequality statistics that Krugman argues support a minimum wage policy.

Brad DeLong highlights an interesting column by Hal Varian on luck and taxation.  (Bottom line: If luck -- as opposed to hard work and risk-taking -- is a big part of being rich  progressive taxation makes good economic sense.  The intuition would be that luck is not sensitive to prices, and so won't be diminished by relatively high taxes.) 

Mark Thoma noticed the Varian piece too, and has several links to others opining on the inequality debate more generally. I'd also check out Greg Mankiw's ruminations, Tom McGuire's recent "Stalking Points", and, if you have the time, everything in the Cafe Hayek archive on inequality.

Taking a more global perspective on poverty and inequality, J.S. at Environmental Economics shares some thoughts on "Rethinking Development Aid For The 21st Century" (thoughts which sound pretty darn sensible to me).  Also, NEI Nuclear Notes asks "Should Developing Nations Embrace Nuclear Energy?"  In the category of excellent advice, The New Economist quite rightly commends your attention to the Private Sector Development Blog. (So do I.)

A colorful picture of who gets what from oil revenues across the G7 is available at Contango.

John Irons documents the continuing, and puzzling, mix of profits versus labor compensation in overall income.  As I've noted before, however, there may be more to this story than meets the eye.

Hat tip to Captain Capitalism for the link to this article about a county in Oregon that is running its own monetary system.  Mark Thoma comments intelligently on a proposal to implement a commodity-based monetary system backed by "local renewable energy" (whatever that might mean).

Daniel Drezner links to an interesting article in the Economist on the value (or lack thereof?) of large quantitative trade models.

The Chairman Speaks: The Savings Glut Persists

More from Chairman Bernanke's exchange with Senator Bennett during yesterday's testimony:

BENNETT: Do you still believe there's a global savings glut and that we can expect people to continue to want to put their money here?

BERNANKE: I think there still is a global savings glut. It may have moderated somewhat because of increased growth in some of our trading partners. But on the other hand, there's also been, of course, these large revenues that the oil producers are accumulating because of the high price of oil. They are not able to absorb - - use those revenues at home very quickly. So they are taking that money and putting it back into the global financial system. And so that's contributing to this overall global savings glut...

So I think there has been some change, but the broad idea that the global savings glut is out there I think is still valid.

Of what Mr. Bernanke speaks, in pictures:

   

   

Still looking pretty gluttish.  The data, if you are interested:

Download savings_glut.ppt

UPDATE: Shame on me.  I should have added this part of the discussion:

BENNETT: So you're suggesting that foreign investment in the United States is not about to dry up at any point soon?

BERNANKE: I don't think it's going to dry up. I do think that over a period of time we should become more reliant on our own saving and reduce the current account deficit.

Emphasis added.

Odds And Ends

Another quarter begins at the University of Chicago Graduate School of Business, and I have once again cleverly fallen behind on my reading, giving me the excuse to introduce some of my favorite weblogs to new students, via this review of things I should have talked about last week.

First things first, the week ended with economic news that was mixed, at best. Kash at Angry Bear reads the durable goods reports and concludes (fairly, I think) that business investment spending is still short of spectacular.  On the other hand, at The Nattering Naybob Chronicles, Mr. Naybob is able to look on the bright side: "Both [the durable goods and house sales] reports eased inflation fears and bond yield dropped."

With respect to the real estate news, Calculated Risk, a consistently fine go-to source on the housing market, has the latest on home mortgage applications (down slightly), existing home sales (up, but perhaps not the best indicator),  and new home sales (a better indicator, and coming in "very weak".) CR also has a handy chart, mapping the pattern of home sales in recessions.  At the Big Picture, Barry Ritholtz opines: "The [Real Estate] market has dropped from white hot to red hot to mid-plateau."  Calculated Risk says   "The sky may not be falling, but... housing sales are clearly trending down."  Captain Capitalism, however, is not cheered by that prognosis, and Michael Shedlock pores over the Calculated Risk pictures, to find that his disposition is soured as well.  ElectEcon finds a prediction that things are going to get ugly fast. 

For those who simply must have more housing indicators to watch, Daniel Gross bears good news, from Standard & Poor's.  For those who just can't get enough detail on economic data period, Mark Thoma has more at Economist's View.

Speaking of data, a nice summary of U.S. wealth as reported in the Federal Reserve's Flow of Funds can be found at Angry Bear. (Although I don't necessarily endorse the conclusions, you might also enjoy the pictures provided at Economic Dreams - Economic Nightmares.)

Last week I (sort of) came to the rescue of the Consumer Price Index.  Barry Ritholtz (again) counter punches, with a Wall Street Journal survey of readers indicating the vast majority don't think very highly of the Consumer Price Index, but Russell Roberts effectively (in my view) defends the beleaguered index, at Cafe Hayek.

Also in the inflation vein, Mark Thoma follows up my post on the relationship between the CPI and the PPI with some work of his own -- broadly illustrating the point of the research I was citing.

Mark also relays the crux of Federal Reserve Chairman Ben Bernanke's speech on the yield curve.  Meanwhile, the inverted yield curve watch continues, at The Capital Spectator.

Shifting to the fiscal side of the government house, Kash breaks down the sources of federal spending growth in the United States over the past five years.  The guys at Angry Bear have had several useful, even if a bit partisan, posts on the subject in the recent past -- here, here, here, here, and here.  Gary Becker and Richard Posner provide some much needed perspective on how to think about the build-up in defense spending. 

In other legislative news, Andrew Chamberlain at Tax Policy Blog indicates that tax reform may not be dead just yet (good), and at Vox Baby, Andrew Samwick reports on the progress of pension reform (decidedly not good).

David Weman at A Few Euros More gives us the heads up on an item (from the Guardian Unlimited (U.K.) blog) bemoaning the rising tide of protectionism (among countries, including the U.S., that really ought to know better).  The Skeptical Speculator concurs that "protectionism looms." Asia Pundit reminds us that, in the United States, the impulse is bipartisan (and Sun Bin channels Stephen Roach's comments on the subject). William Polley deems it "Nothing if not predictable." Mark Thoma provides an extended commentary from the Financial Times on the dangers of "Dobbism" (as in Lou).  Daniel Drezner, however, has better news. Brad DeLong takes notice of a Alan Blinder's sometimes less charitable view of trade and globalization, to which Arnold Kling replies -- here and here.

Steve Antler (of EconoPundit) makes the connection from trade protectionism to immigration reform.   Russell Roberts is even less tolerant of the anti-immigration argument.  So is Arnold Kling (at EconLog).  EurActiv reports on how the EU is attempting to deal with its own immigration questions. The New Economist provides a glimpse of research suggesting that outsourcing explains about 28 percent of the growth in the wage gap between high- and low-skilled labor between 1980 and 1999.

Continuing with the international theme, Brad Setser thinks both sides are at fault in the ongoing tensions over Chinese exchange rate policies.  He also has terrific coverage of Larry Summers' must-read views on the current state of global financial markets and capital flows.  Mark Thoma notes an article on the relationship between exchange rate policies and trade gaps and a summary of research on foreign direct investment. Steve Antler suggests an explanation for "why the dollar still reigns".  Barry Ritholtz is pretty sure the answer is not Dark Matter.  Menzie Chinn, writing at Econbrowser, is even less convinced.  (He follows up that post with a very nice discussion of "purchasing power parity."  Don't worry if you don't know what that means -- Menzie will fill you in.)

Speaking of China, Daniel Gross carries a story from the New York Times on the development race between China and India, the latter a country that I think gets far less attention than it deserves.  (Lest there is any confusion, I mean positive attention.)  Interestingly, Toni Straka at The Prudent Investor -- who  unfailingly does not ignore India -- reports that India is about to float its currency and remove foreign exchange controls.

About Economics has a macro-relevant post on the, increasingly quaint, problem of the so-called zero nominal interest rate bound.  Digging even further into the history of monetary theory, Jane Galt ruminates on "free money." In the some-think-it-matters-I-don't category, The Capital Spectator comments on the retirement of M3.  So does Tim Iacono. That makes the graphs at Economist's View on M3 velocity -- explained here -- somewhat obsolete, but don't worry -- there is still M1 and M2 to absorb your attention.

UPDATE: Oh yeah -- Tyler Cowen has a new gig at the New York Times.

SPECIAL BRAIN-LOCK UPDATE:  Above I hat-tipped A Fistful of Euro's David Weman for a Guardian article  "bemoaning  the rising tide of protectionism" (my words).  Unfortunately, the Guardian article that does the bemoaning is not the one David cites.  I had in mind an earlier article by James Surowiecki.  David was pointing to another article, by Daniel Davies, arguing that capital controls do not count as protectionism.  Double hat-tip to David for keeping me on the straight and narrow.  (Oh, and by the way -- I'm with Surowiecki.)

Household Debt Increases -- What's New?

The latest statistics from the Federal Reserve on household finances seems to have everyone touching a different part of the elephant.   One Reuters report bore this news...

U.S. consumer credit unexpectedly slid by a record $7.20 billion in October, on a big drop in loans taken for cars and boats, a Federal Reserve report showed on Wednesday.

... which was picked up by Daniel Gross and by The Skeptical Speculator.  Echoing Calculated Risk, MarketWatch chose to stress this news:

Americans increased their household debt at an annual rate of 11.6% in the third quarter, the fastest growth in 18 years, the Federal Reserve said Thursday in its quarterly flow of funds report.

But Fox News, channeling yet another Reuters piece, emphasized the broader story about household balance sheets:

The net wealth of American households rose in the third quarter of 2005 as real estate and financial assets gained value, but household debt grew at the fastest rate since 1987, the Federal Reserve said on Thursday.

That last piece seems, to me, the important part of the data.  Although there is always a lot of hand-wringing about the precarious degree of household debt accumulation, it is a good idea to keep a couple of things in mind.  First, a rising ratio of household debt to disposable income has been the story for a long time now:

Second, there is no evidence of a dramatic acceleration in the burden of servicing that debt:

 

Finally, as the Federal Reserve Bank of San Francisco's Kevin Lansing has emphasized, if you are the representative consumer, you have been doing just what theory predicts you will do:

Rapidly rising stock and house prices, fueled by an accommodative environment of low interest rates and a proliferation of "exotic" mortgage products (loans with little or no down payment, minimal documentation of income, and payments for interest-only or less) have sustained a boom in household spending and provided collateral for record-setting levels of household debt relative to income.

In fact, according to Kevin's estimates households have, if anything, been consuming less than might be suggested by changes in net worth, interest rates, and the secular trend he associates with financial market innovation:

We can argue -- and will, I suppose -- about what part of the increase in household net worth is "real."  But I can't say that anything in the data revealing consumer behavior seems all that surprising.

The "Real" Story On Investment

In my previous post, I highlighted the fact that success in describing the drivers of recent global investment behavior is proving somewhat illusive.  The International Monetary Fund takes a stab at it in chapter 2 of the September World Economic Outlook:

This low investment is largely a result of the still-ongoing efforts by corporates in many countries to strengthen their balance sheets by paying down debt. Consequently, despite strong corporate profit growth, investment has generally remained weak. The evolution of investment is therefore likely to be a critical factor determining long-term interest rates going forward. A return of investment to a more normal cyclical relationship with growth would likely put upward pressure on interest rates.

That's my story too, although as far as I can tell, this is an explanation that is more conjecture than demonstrated fact. And as I contemplate the issue, I am a bit uncomfortable that we still don't have our facts quite straight.  One thing that caught my eye in the IMF investment discussion was this:

Investment rates in the United States are broadly unchanged from their levels in 1997, although they remain below the peak in 2000. Of course, the decline in the nominal investment ratios over time partly reflects the fact that capital goods have become relatively less expensive—mainly owing to the extensive process of information technology (IT) capital deepening and productivity growth in the capital good–producing sectors.

What this means is that even though the share of investment may have remained relatively flat in dollar terms, technological progress has made a dollar's expenditure more valuable because each dollar buys more in the way of effective capital.  A picture:

The blue line in the graph above is the nominal investment ratio for the United States -- it is the current-dollar value of investment divided by the current-value of GDP.  The red line adjusts the ratio for the differences in the price of investment goods relative to the prices of all goods and services.  If the relative price of investment goods falls -- which we often interpret as a rise in the inherent productivity of new capital -- the red line increases more than the blue line.

The distinction matters.  The nominal investment ratio is, at best, about in line with its post-WWII average.  When we adjust for relative prices, however, we see that the ratio has risen substantially since 1991.  Although the recession of 2001 is clearly associated with a dive in investment spending  -- relative to GDP, investment began to fall dramatically in third quarter of 2000 -- it has since recovered, and is now near its postwar peak.

Can this sort of measurement issue explain the global investment bust?  No, probably not.  And it is certainly less clear that the measurement problem contaminates cross-country comparisons. On the other hand, the picture above is based on price adjustments from the National Income and Product Accounts that almost certainly understate the magnitude of productivity gains embodied in new investment goods.   As we rightly scratch our heads over the pattern of global investment, it is a good idea to bear in mind that what we see is not always what we got.

Global Savings Glut Or Worldwide Investment Bust? Yes.

Angry Bear's pgl did us all a favor this weekend by reminding us that Brad Setser previously reminded us about the International Monetary Fund's recent analysis of global saving and investment.  pgl has been out front in making the case --in his latest installment, with well-constructed supply-of-saving and demand-for-investment graphs -- that whatever the ultimate sources of low worldwide interest rates, they are working through both investment and saving choices.

There is a hardly a clearer demonstration that pgl is right than this picture from the IMF report:

For the East Asia economies, the recent story is clearly an investment bust.  For oil producing countries, it's an investment bust accompanied by a saving boom.  And for China, it's a boom in both saving and investment -- with saving being the larger of the two.

Among the several interesting items in the IMF chapter is the finding that you can "explain" saving pretty well with a simple statistical model, but get nowhere close to capturing investment outcomes:

What that picture means is that a few well-chosen "fundamentals" --  changes in income and wealth, capital market development, demographics, and fiscal policy -- are sufficient to remove most of the mystery from global saving patterns over the past eight years.  That goes for both industrialized countries and emerging-market economies.

No such luck with investment. Some thoughts on that to follow.