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 exporting some $2,000 billion and importing 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.