Dark Matter

The late Rudi Dornbusch said that one of the infallible warning signs that we are near the collapse of an overvalued currency associated with an unsustainable trade deficit is when highly intelligent and respected economists begin evolving plausible theories that--this time--the trade deficit is sustainable.

Now come Hausmann and Sturzenegger (2005), "U.S. and Global Imbalances: Can Dark Matter Prevent a Big Bang?" (Cambridge: Harvard CID Working Paper) with a theory that the U.S. trade deficit is not so big and not so unsustainable after all.

What is their theory? The best way I have found to explain it is to look at the spreadsheet immediately below, which presents what we think will happen on the U.S. capital account side in 2006 in two ways. In column 1 it presents what the Commerce Department's Bureau of Economic Analysis will record as the book value of assets created across countries in 2006. In column 2 it presents what Hausmann and Sturzenegger think should be recorded as the income-producing value of those assets.

In the BEA's book-value accounting, in 2006 U.S. companies will invest $600 billion in foreign direct investment elsewhere in the world--building factories, establishing links in value chains, taking over existing foreign-owned businesses, and so forth. In HS's accounting, that $600 billion in visible FDI will be accompanied by $300 billion worth of "dark matter" organizational and technological know-how that American firms carry to their operations abroad. The FDI flow will thereafter generate as much income as would a pure $900 billion bricks-and-mortar FDI flow.

In the BEA's book-value accounting, U.S. residents will also purchase $600 billion in foreign securities, and U.S. banks and other corporations will acquire $400 billion in loans payable and other credits. The gross overseas asset accumulation of Americans will thus amount to about $1,600 billion (in the BEA's book-value accounting) and to about $1,900 billion of income-producing assets (including the $300 billion of "dark matter" that boosts the income-producing potential of U.S. FDI).

Now let's look at the liabilities side. In the BEA's book-value accounting, in 2006 foreign governments will invest $800 billion acquiring U.S. securities--Treasuries, Fannie Maes, and others. Because the U.S. is at the center of the world monetary system it has the "exorbitant" privilege of being offer to sell its securities at lower interest rates. In HS's accounting, that $800 billion consists of the U.S. providing foreign governments and central banks seeking foreign exchange reserves with $600 billion of income-producing potential and an extra $200 billion of "dark matter" liquidity.

Similarly, foreign private investors will spend $700 billion acquiring U.S. securities, which HS assess as consisting of $600 billion of income-producing potential and $100 billion of extra security--insurance because whatever happens to foreigners' assets in their home countries, their U.S.-housed assets will still be there.

In addition, foreign companies will make $300 billion of FDI investments in America, and foreign banks and companies will acquire $600 billion in loans payable and other credits from U.S. residents. The gross accumulation by foreigners of assets in America will thus amount to about $2,400 billion (in the BEA's book-value accounting), and to about $2,100 billion of incomes-producing potential (plus an extra $200 billion of liquidity and an extra $100 billion of security provided by the superior qualities of ).

Look at this pattern of asset position changes through the BEA's eyes, and you see the U.S. becoming indebted to the rest of the world to the tune of an extra $800 billion every year: a staggering figure that we cannot imagine going on for even a decade. Look at this pattern of asset position changes through HS's eyes, on the other hand, and you see the U.S. becoming indebted to the rest of the world to the tune of an extra $200 billion of income-producing potential every year. That's not a big deal. That's sustainable: the flow of real profits and interest owed on an extra $200 billion is approximately $10 billion a year, and that is only 1/40 of the approximately $400 billion by which U.S. incomes grow every year.

The way that HS see it, U.S. trade is nearly balanced. We are importing some $2,000 billion and exporting some $1,200 billion of regular goods-and-services every year, but we are also exporting (a) $300 billion of technological and organizational knowledge via FDI, (b) $200 billion of liquidity services by serving as reserve banker to the world's central banks and governments, and (c) $100 billion of security services by giving foreign private investors a safer place to plant their wealth. Properly evaluated, HS argue, U.S. trade is nearly balanced.

The debate over HS's "dark matter" claims is rolling around the internet, with Willem Buiter and Ricardo Hausmann exchanging views at Martin Wolf's distressingly ovary-free Martin Wolf's Financial Times Economic Forum, Brad Setser harassing Hausmann and Business Week's Michael Mandel from his perch at Roubini Global Economics, and Michael Mandel parrying at his Economics Unbound.

Do I believe in Hausmann and Sturzenegger's "Dark Matter"? No. This post is in the interest of explicating an interesting line of argument only.

I believe what Rudi Dornbusch said: that when highly intelligent and respected economists begin evolving plausible theories that--this time--the trade deficit is sustainable, that is the time to start running for the hills, because the crash is near.

Comments

[theCoach]

Brad,
Can you explain under what scenario, given multiple actors, there will not be a rush to realize the most value for a rapidly depreciating asset?

[kharris]

Does the HS analysis, when it breaks up $700 bln in securities into $600 bln in income-production and $100 bln in extra security, recognize that the $100 bln must be paid back or refinanced? If the need for extra security diminishes over time (can we assume that is one implication of India and China and many other countries growing fast and modernizing fast and adopting new economic norms), how does the HS analysis handle the transition? Ignore it?

I recognize that breaking gross economic and financial numbers into their logical parts is a useful explanatory tool, but are these parts really logical - will they hold up when conditions change or when assets mature?

[pgl]

Brad S. got me interested in this topic when he cited a couple of Angrybear posts (Kash and mine) as he teased up an alternative explanation for the Net Income from Abroad Puzzle - that being transfer pricing manipulation. H&S start with this puzzle and conclude it must be explained by market to book differences in balance sheet accounting - whereas the Angrybear-Brad S. explainaton for the Puzzle is fuzzy income accounting.

[Nicholas Mycroft]

I would state slightly differently. People talk about declining U.S. manufacturing capacity/competitiveness and the growth in Chinese capacity, but they rarely mention that a lot of this capacity is being added by American companies whose profits are accounted for in the U.S.--a trade deficit, but a profit surplus. Another way of looking at it is that the ROIC of the U.S. is higher than almost all other countries, thus attracting investment flows from the third world, but a lot of the capital that derives from these flows is actually being turned around and reinvested in third world industrial and distribution capacity--and furthermore that the profits derived therefrom are distributed to employees, many of them who lead alternate lives as U.S. consumers. Or, still another way of looking at it is to compare the typical, USD-bearish view of the world:

U.S. consumer $ => WMT $ => Chinese-produced goods $ => U.S. bonds $ => U.S. consumer

to

U.S. consumer $ => WMT $ => Chinese-produced goods
$ => U.S. bonds $ => U.S. consumer
$ => U.S. corporate profits $ => U.S. consumer
$ => U.S. corporate profits $ => capex in Chinese capacity

I don't see this as all that far-fetched....

[anne]

http://economistsview.typepad.com/economistsview/2006/02/debating_dark_m.html

Martin Wolf's Economist's Forum, by Willem Buiter

"Paraphrasing something Ed McKelvey of Goldman Sachs wrote quite recently: blind faith in the existence of Dark Matter as an excuse for taking a relaxed attitude about the financial deficits of the combined US private and public sectors, would be evidence of a lack of Grey Matter."

[JK]

As any physicist will tell you, too much dark matter will bring about a "big crunch".

( http://en.wikipedia.org/wiki/Big_Crunch )

[Anonymous]

If HS are going to account for the exported know-how by American companies, shouldn't they also count the imported know-how in the form of foreign students? They should probably be accounted for at the cost of a 12-year or 16-year education each, no? Probably add to that the NPV of their future contribution times the student retention rate.

A wild guess about the cost of a first-year grad student would be around $1 million, taking into account (a) direct tuition costs, (b) health care and other sustainance costs and (c) the fact that not every college grad chooses to stay in school. Assume a 50% retention rate, a $3M NPV of their lifetime contribution, multiply by the annual student influx and you have a large wad of 'Dark Matter' that HS completely ignored.

With Boston being the foreign student capital of the US, one wonders if these guys have ever actually set foot to Cambridge...

[robert waldmann]

I have no idea why H and S assume FDI into the USA is not accompanied by "dark matter" investment. If they assume it is not, they have to explain to me why foreigners bother. As a first guess, I would cut the FDI dark matter flow in half. Now if it is true that foreign subsidiaries of US firms are more profitable that subsidiaries of foreign firms in the US, my guess is wrong. On the other hand if FDI into the US earns higher returns than T-bills (as it sure ought to) they are wrong.

The other entries are even more problematic. H and S argue (assume) that foreign central banks are building dollar denominated reserves for some reason which will cause them to continue indefinitely, "Because the U.S. is at the center of the world monetary system [and thus] it has the "exorbitant" privilege of being offer to sell its securities at lower interest rates."" Or maybe they are trying to keep workers employed and non revolutionary by keeping the won undervalued. No one would have guessed that there would be huge official flows into the center of the world monetary system, so no one should assume that this is natural and ineviatable. In such a case the US has indeed gotten a $ 10 billion gift from the ChiComs, but there is no guarantee that they will keep on giving as they must for the US trade deficit to be sustainable.

Finally the last argument makes no sense at all. People afraid of instability in their home countries have a wide choice of safe havens. The US is not a lonely stronghold in a wilderness of revolution and expropriation. Can H and S manage to invent some kind of risk against which the only insurance is investment in the USA ? A balanced portfollio of investment in revolution prone countries should be roughly safe. It is true that the stated return on assets in such countries is higher than the stated return on assets in the US, the difference being the expected loss due to expropriation. However, the expected loss due to expropriation would, on net, be a loss for US based investors.
To ignore this dark negimatter aspect of US investments abroad is to assume that the assets of US based investors are protected by gunboat diplomacy. Hence the flow would be the expected flow from forcible extraction of wealth from foreign countries.

Now I pose the question, I realise that the USA could probably finance its trade deficit if it became a bandit nation demanding "protection" money.

Somehow this doesn't strike me as likely so I'm gonna bite the bullet take the loss and sell all my remaining dollar denominated assets (which I only just now admitted exist).

[anon]

I remember reading Gary Becker at the Becker-Posner blog. If I am not mistaken, Becker said something to the effect that the Japanese overpaid for assets in the U.S. back around the 1980s or so. The Japanese bought high profile buildings and properties (gold course, etc) at what turned out to be too high of price.

Maybe this explains why the Japanese today buy U.S. Treasuries. The Japanese have not had tons of success investing in assets in the U.S.?

This Japan situation has to translate to "market value" balance sheets.

One problem with "market value" (vs. historical cost or other) balance sheets is market value may change and can be subjective. Expropriation.

Liquidation value is probably below book value. We also might need to throw in a discussion of CFD - cost of financial distress.

Anecdotally, you tend to run into many people with common sense in the U.S. They may not come from prestigious universities or big cities, but you run into quite a few of them. They can read, do basic math, and zero-in on critical assumptions and risks. I am not sure this is as-common in other parts of the world.

[Tom Cecere]

Yeah, and I was gonna buy puts on Google last month, too. It was when some dope at First Albany suggested that perhaps $600 a share was too low a target. I had the same feeling my old prof Dornbush described...time to go the other way.

Bummer. Maybe this time I'll move my bank accounts to Canada in time.

[Unstable Isotope]

That is so cool. I actually had the same hypothesis -- that whenever you start reading economists saying "this time it's different" that means the end is nigh. (This could also be the reason I usually believe the opposite is true.) I could be a respected economist!

[anon]

Tom

How about selling puts on Google at as low of a strike price as available on the market (eg, March 2006 puts at around $200 per share)? It might help if you have cash in the bank to cover the put.

[nate]

http://www.suttontrust.com/reports/endowments_report.pdf

Look how much the U.S. has set aside for education. Compare this to other parts of the world. How does this figure into the balance sheet? (either directly or indirectly)

[Bruce Webb]

Maybe I could rename myself (in tribute, really UI is a treasure,and has been for years) Elliptical Isotope.

Is the Dark Matter simply lurking in the bright Global Structure that is Social Security Solvency?

Could it just be that simple? Some people are projecting $69 billion dollar Social Security Trust Fund by 2080 (Low Cost) and others predicting zero by 2041 (Intermediate Cost). And as it turns out those are the same few people. It just depends on subtle assumptions in economic performance over the the next five years. Swings like that have to have an impact on whether bets on the 10, 15, and 30 year bonds make sense. The bend points come at 2011, 2017, and 2023. But I am seeing zero evidence that the US bond market is fundamentally pricing these bend point in. And if commentators don't understand the implications of 2011, 2017, and 2023 then I suspect you could be doing a little more research. Because a lot of bond traders are making a bet against 2017 and not even understanding what they are doing.

Or so saith the Third Bruce. I am not Bartlett, I am not Wilder, but I can read a chart. And it suggests that buying 30 years makes big, big sense right now. But the only people listening are sitting at the Chinese Central BAnk.

[still working it out]

The creation of the Dark Matter hypothesis is not a sign of impending disaster. There are still a lot steps to go.

1) People inside the beltway pretend they understand Dark Matter.

2) James K Glassman's launches his new book "36,000 Billion Dollars of Dark Matter - Why too much debt is good for you".

3) Republicans pass another round of huge tax cuts. Deficit increases. Interest rates do not skyrocket.
Front page of Wall Street Journal reads "Dark Matter Vindicated".

4) China buys Google, GE, Exxon, Microsoft, Fannie Mae and Freddie Mac. Republicans launch the "A true patriot is Chinese" talking point.

5) Democrats win office. Pass even bigger unfundeded tax cuts.
NY Times - "Democrats Save the Economy".

6) United States Federal Reserve issues bonds in Renmimbi. China demands and gets the Washington Monument, Library of Congress, Los Alamos and the Statue of Liberty as collateral.
National Review - "America's national treasures are safer in Chinese hands"

7) Berkely Economics professor and blogger, puzzled by the lack of an economic meltdown says "I have to admit, it appears I was wrong about Dark Matter".

8) I read the above Berkely Economics professor and promptly go short the USD against everything.

9) Reality. Crash. I'm rich.

[wkwillis]

1. I still go with all the third world black money seeking safe haven in the US for their children and assets.
2. I would like to point out that the words "This time it's different" are only wrong about the booms. They have been correct about the busts. 1900, 1929, 1966, and 2000 (so far) all have taken radically different inflation/deflation, import/export paths during the collapse.

[ChrisJ]

The mere fact that this debate is taking place should tell us something: conventional macroeconomics has failed. The external imbalances defy conventional explanation and the vacuum is being filled - initially with theories that are easily shot down but, eventually, with something that works a whole lot better than we have right now. The conventional macro response to the accusation that their theories cannot account for current events is 'not yet'. This is intellectually indefensible.

[steve kyle]

It is silly to think that foreign FDI here doesnt have just as much technology and knowhow as ours does over there. I have called this "dark antimatter" in previous posts, but just think about one single example and see if you dont agree.

Toyota and Honda have large investments in the US. Dont you think that their management and technology are markedly better than what passes for the equivalent in Detroit? While H and S may be right that "dark matter" is important, there is absolutely no reason to think that it is larger than "dark antimatter".

But, dont worry, be happy!! Why? Our leaders told us everything is O K !!

[Scott Nance]

Hi, Brad. Did you mean $2 trillion in imports, and $1.2 trillion in exports? I want to make sure I'm not confused (or at least no more than usual).