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Tuesday, October 03, 2006

The Search for Dark Matter

You might guess from the title that this post is about physics and the universe. It turns out you'd be wrong. As you'll see, it's actually a post about trade.

If governments don't meddle, trade imbalances are usually nearly instantly eliminated by changes in exchange rates caused by market forces. In fact, if governments don't meddle, it's almost (but not quite) safe to say that there is no such thing as a trade imbalance. The exchange rate immediately finds the point that balances trade.

That's not to say that a country can't be a net importer of goods. But if it is, it has to, by definition, be a net exporter of investment, where foreign entities have created such a demand for that investment that the country has little choice but to be a net importer of goods. Another way of saying this is that a trade deficit equals an investment surplus. Generally, a small investment surplus is a good thing.

The United States currently has quite a large trade deficit/investment surplus. Around 7% of GDP, it's so large that it's hard to believe that there's not some sort of government meddling or trade imbalance. Any simple model would show that this level of investment surplus is not sustainable and is likely to have an unhappy ending.

But, as is often the case, the simple models may be, well, simply too simple. Ricardo Hausmann and Federic Sturzenegger from the Kennedy School of Government at Harvard University have come up with an explanation for the current situation which looks quite plausible to me. They believe it has to do "Dark Matter":
Let's look at some more facts. The Bureau of Economic Analysis (BEA) indicates that in 1980 the US had about 365 billion dollars of net foreign assets (that is the difference between the foreign assets owned abroad and the local assets owned by foreigners). These assets rendered a net return of about 30 billion dollars. Between 1980 and 2004, the US accumulated a current account deficit of 4.5 trillion dollars. You would expect the net foreign assets of the US to fall by that amount, to say, minus 4.1 trillion. If it paid 5 percent on that debt, the net return on its financial position should have moved from a surplus of 30 billion in 1982 to minus 210 billion dollars a year in 2004. Right? After all, debtors need to service their debt.

So let's look at how much is the actual return on the US net financial position. The number for 2004 is, yes, you've guessed it, still a positive 30 billion, just like in 1982! The US has spent 4.5 trillion dollars more than it has earned (which is what the cumulative current account deficit implies) for free! [...]

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). The name is taken from a term used in physics to account for the fact that the world is more stable than you would think if it were held together only by the gravity emanating from visible matter. In our measure the US owns about 3.1 trillion of unaccounted net foreign assets. This is big. Before analyzing where this comes from, we may point out that no methodological minutiae will reconcile the facts with the statistics. We can discuss the numbers but we cannot contest the existence of dark matter.
The bottom line is that the measuring the current account is an act of accounting. Accounting has rules that are designed to be logical and consistent. Unfortunately, the rules don't always give perfect insight into what's actually going on. That lack of insight is Dark Matter. Here is one example of dark matter given by the authors:
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 [Foreign Direct Investment], the know-how that makes investments particularly productive is poorly accounted for.
There are other examples as well given in the paper, but they all involve accounting arcana. It's not a bad read if you're so inclined, but I won't get into it here. The paper ends by trying to answer the question "Can dark matter be trusted?":
In a nut shell our story is very simple. The income generated by a country's financial position is a good measure of the true value of its assets. Once assets are valued accordingly, the US appears to be a net creditor, not a net debtor and its net foreign asset position appears to have been fairly stable over the last 20 years. The bulk of the difference with the official story comes from the unaccounted export of knowhow carried out by US corporations through their investments abroad, explaining why the US appears to be a consistently smarter investor, making more money on its assets than it pays on its liabilities and why the rest of the world cannot wise up. In addition, the value of this dark matter seems to be rather stable, indicating that they are likely to continue to compensate for the measured trade deficit.

Globalization has made the flows of dark matter a very significant part of the story and the traditional measures of current account balances paint a very distorted picture of reality. In particular, it points towards imbalances that are not really there, making analysts predict crises that, for good reason, remain elusive.
Currency traders seem to agree. I believe that's why, with fairly minimal government meddling, the exchange rates are remarkably constant in the face of supposedly huge trade deficits (investment surpluses). Those deficits are an illusion and the market knows it.


Howard said...

see this


the WSJ article he mentions is here


I'm not sure about everything in the article but there is some "scary" stuff - those Chinese bond buyers are supposed to be a problem so they don't tell you that the British have been buying more U.S. Debt than everyone else combined for the last few years...

Hey Skipper said...


When the headline trade surpluses are summed (where a deficit is taken as a negative surplus), what is the answer?

Bret said...

Hey Skipper,
I don't understand your question.