Auros (auros) wrote,

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Economic "Dark Matter" explained...

Conservative economists have devoted a lot of effort, lately, to the task of explaining why we should not worry about the twin deficits -- the fiscal deficit (government spending more than it takes in as taxes) and the trade deficit (the country as a whole buying more goods and services from abroad than foreigners buy from us).

The first attempt was the "global savings glut", which says that the US is not spending too much, foreigners are saving too much. This is generally accompanied by recasting the current account deficit as a capital account surplus. In order for us to get foreign currency to spend on imports, we sell dollars to foreigners. They don't stuff those dollars under a mattress -- they either buy goods with them (in which case they reduce our current account deficit), or they buy assets (stocks, bonds, real estate) in which case they add to our capital account. (The downside of this is that in all future years, the cash-flows produced by those assets -- dividends, interest, etc -- flow to foreigners, thus reducing our national income.) There's an element of truth to this, but it's question begging. Even if there's a problem on both sides of the Pacific, it's still a problem. At some point, we start looking like Argentina -- bond traders demand higher interest rates, we're unable to service our debt, the money stops coming in very suddenly, and we don't have time to rearrange our economy to produce more at home, so we go through five years (minimum) of crushing recession and massive dislocations of labor (i.e. poverty).

The new, more sophisticated excuse is the theory of "dark matter", which says that the current account deficit is an illusion. The US is making up for its trade deficit by exporting "intangibles" which don't get captured by the accountants -- we export investment savvy, basically. Again, there may be an element of truth to this; American companies have been very innovative over the years, creating new products and entirely new markets. The evidence offered for this theory is that US firms report much higher earnings on their investments abroad, than foreigners report on their investments in the US. The numbers on this actually turn out to be large enough that, if you take them seriously, the implied dollar inflows (which don't show up in the current account or capital account) balance out something like half of the trade deficit, at minimum. On this theory, foreigners are willing to advance us lots of their currency in exchange for the benefits of our productivity genius -- we juice their economies so much that they can hand us all that cash, and still end up richer themselves.

Aside from the fact that this sounds like an awfully convenient fairy-tale -- flattering to the prejudices of right-wing economics -- it turns out there's a good reason not to take these numbers seriously. Daniel Gros, of the Centre for European Policy Studies, did some number crunching, and found that in fact, it's not that US firms are reporting such amazing profits abroad; we earn pretty similar risk-adjusted returns abroad, to our returns at home. The distortion is almost entirely on the other side -- foreign firms report terrible returns on their investments in the US -- something like 2.5%. Since bonds have a fixed return, whether you're a foreign or domestic buyer (leaving aside large changes in exchange rates, which haven't been a factor between the dollar and the euro recently), this would seem to imply that we've been selling dud stocks to folks in Europe, Japan, Saudi Arabia, etc.

But why would they keep buying, or even holding, dud assets? Why not at least move towards bonds, until the return on the bonds was driven down to a similarly dismal level? Gros thinks the reason is very simple: they're lying. The first clue is that for companies in which the foreign investors hold a less than 10% stake -- the level at which the investment starts being counted as "Foreign Direct Investment" for tax purposes -- their reported returns are normal. Why would owning 9% of a company yield good returns, while owning 11% yields lousy returns?

Gros points out that there's a difference in the way the US and most foreign countries treat reinvestment of foreign profits of domestic firms, and the way they treat reinvestment of domestic profits of foreign firms. US firms are perfectly happy to report money they earned abroad, because they pay low taxes in the places they invest (e.g. Ireland, which has a very low corporate tax rate), and pay no US taxes on those profits unless they repatriate them to the US. Also, accounting tricks may allow them to understate the costs of some of the assets they buy abroad, raising their apparent return on investment. Foreign investors in the US, on the other hand, try to avoid reporting reinvested earnings at all, because they would have to pay profit taxes on that money; they do want to reinvest (because repatriating their profits would also trigger high tax rates, especially in Europe), they just don't want to tell the IRS about it. As a result, some of their profits just disappear into the cauldron of corporate-accountant book-cooking.

The scale of this distortion is sufficient to explain the entire difference in reported returns: From 1999-2004, US firms reported an average of $103-104B in reinvested earnings, while the foreigners reported only $7B a year. To believe the investment income balance is in surplus (as the dark-matter theory says), you have to believe that a) foreign investors have a burning desire to buy assets on which they earn a return even lower than government bonds, and b) despite this burning desire, they hate investing in those assets with money they earned in the US. Is anyone thinking this sounds a little crazy?

The worst part about this is the implication that we're chronically undercounting assets in the US that are controlled by foreigners. Not that there's anything wrong with foreign ownership of assets, per se; it's just that our net foreign indebtedness is even worse than it looks. This means that a rising fraction of our domestic production will leave the country, and even if we do earn more on our holdings abroad, we would have to constantly increase our foreign returns to offset the increased outflows. That can't go on forever, and, as Stein's law says, "Things that can't go on forever, don't." The official numbers already put our net external debt position at something like 15% of GDP. Maybe those foreigners aren't such un-savvy investors after all.

Unless we start, soon, to cut our twin deficits; unless we start trying to spin up some export and domestic-manufacture industries, and letting the dollar fall to make those industries competitive at home and abroad; we will be in for a very rough time, whenever the next downturn hits -- probably whenever the housing market turns around.

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