The Hindu Business Line : Explaining away the US' imbalances

THE rising American current account deficit has spawned a number of attempts at explanation and mitigation. The latest such attempt at explanation is by Prof Ricardo Hausmann of Harvard University and his associate Federico Sturzenegger, in a paper entitled "US and Global Imbalances: Can dark matter prevent a big bang?"

The paper presents an interesting counter argument to the prevalent attitude of pessimism, and expectation that there will be a collapse of the American dollar because of the overhang of its current account deficit and rising external liabilities, resulting in loss of confidence of the rest of the world.

The Professors' thesis rests on what they call "Dark matter" — the invisible strength of America's prowess in knowledge and ability to procure higher returns for its investments abroad compared to its payments on its liabilities.

The authors explain that "Dark matter" is an expression borrowed from Physics, where the fact that the physical world is more stable than you would think if it were held together only by the gravity emanating from visible matter. The residual stabilising matter is dark matter. Borrowing from Physics, the Professors state that the global economy is more stable economically than is evident because of what they call "dark matter".

On their part, the Professors calculate the value of international assets of the US by a different method than the historical costs. They estimate the value by multiplying the returns from the assets by a factor equivalent to the pre-earnings ratio — the inverse of the US gilt rate of 5 per cent. That means a multiple of 20.

The authors state that the income on the US net investment portfolio is $30 billion. This means the US' net asset value is roughly $600 billion, almost 5 per cent of GDP. The authors point out that this was the same as the net asset position of the US about 20 years ago, when the income earned by the US from the financial assets was about $30 billion.

Against this, the estimate of US net assets on historical cost basis in 1982 was roughly $365 billion. Since then, till 2004, the current account deficit accumulated to $4.5 trillion (yes, trillion). This means the net assets of the US should have been reduced to minus $4.1 trillion. But, as against this, the Professors calculate the figure of net assets of the US in 2004 at roughly $600 billion. This is a conundrum.

The difference between the net asset position in 1982 and now should have been $4 trillion whereas it is more or less zero. This means, if the difference between change in net asset position during the period has to equal the total current account deficits, the current account deficit during the period should have been less than zero.

An ingenious argument indeed, which rests, however, on the calculation of asset value by multiplying income by price income ratio! The authors try to argue that their calculations show that there is a great deal of "dark matter", which accounts for the excess of income earned by the US on its assets abroad compared to what it pays on its liabilities.

The US has, of course, gained considerably on these differential earnings, what the authors call the "dark matter". First come the capital gains on the US investment abroad — estimated at around $2 trillion. Second, the knowledge premium, which is congealed into their FDI portfolios.

Again, the innovations that the US specialises in give a particular lift to the value of investments abroad and ensure a higher return. The net result is that the US gets a higher return on its investments abroad than it pays on its liabilities.

The secret of this excess revenue lies in the fact that the rest of the world lends moneys to the US at cheap rates, while the rates of interest on US investments, including gilts, lent to other countries are a good bit higher.

The net result is that the Americans not only borrow cheap from abroad, but invest in high-return assets in the very countries which lend them moneys cheap. Add to it the intellectual property, which garners income — ranging from Mickey Mouse in the Disney World abroad to the mouse that activates the windows in Microsoft. The authors seem to feel that the "dark matter" explanation — the premium on innovation, intellectual property and liquidity preference for US Securities — is enough to explain the US' current position. In their way of analysis, the doomsday scenario played out by the pessimists is overdone.

I feel both the explanation and the analysis by Prof Hausmann and Co. remain fragile. First, there is the technical problem that they are comparing apples and oranges when they calculate net asset value using a price-earning multiplier and setting it against the accumulated current account deficit total.

The current account deficit total is the actual amount that the US has to obtain from abroad to finance its splurge of expenditure over and above its receipts. It is no use saying that its "assets" are notionally worth much more, if they are calculated according to the pre-earning ratio. That calculation will not help pay the import bill

The position will be clear if we take, as an example, corporate earnings. If a corporate runs a loss in its accounts, it is no use saying that its assets are worth more than its liabilities because the assets are earning a handsome amount.

What counts is the actual difference between income and receipts. There is a flaw in the learned Professors' reasoning, which leads them to wrong conclusions.

There is, however, one aspect on which the authors' contributions have played a useful role. This is the point they make about the US' returns from its FDI being higher than what the foreigners make on their investments in the US. This does not necessarily mean that Americans are smarter than the rest of us.

It may be more a reflection of the fact that their financial markets are better organised and they have a lead in innovation and marketing.

This is also a pointer to the rest of the world to wake up and get its act together regarding the returns it gets on its investments in America. It is time the rest of the world gets a risk premium for investing in the scrip of a country which, notwithstanding what Hausmann et al say, is the world's greatest debtor.

While there has been much excitement in the financial press about the Hausmann's paper on "dark matter", I would like to draw attention to yet another discussion paper on the US current account imbalance written by Hilary Croke, Steven B. Kamin, and Sylvain Leduc of the US Federal Reserve on "Financial market developments and economic activity during current account adjustments" published in February 2005.

These authors have based their exercise on the econometric analysis of more than 20 episodes of current account adjustments in industrialised countries.

Their point is that although some of these episodes witnessed significant shortfalls in growth after the onset of adjustments, "these shortfalls were not associated with significant and sustained depreciation of exchange rates, increase in real interest rates or declines in real stock prices".

The authors caution that these findings do not preclude the possibility that future current account adjustments may be disruptive, but they weaken the historical case of those who predict such a disruptive outcome for the unravelling of US current account imbalances.

At the same time, the authors take care to point out that such current account adjustments can be quite disruptive for emerging or developing countries, as distinct from industrialised nations. Not for us poor countries the luxury of gaping current account deficits.

The conclusion that both sets of authors arrive at is that the doomsday scenario about the American current account deficit is overstated. But with all the econometric gloss of the two papers, we cannot help feeling that the Jeremiahs have a case.

A disruptive collapse of the American economy may well be more probable than the more beneficent outcome the authors of these papers anticipate. It is the path of wisdom to be prepared for the worst rather than hope for a miracle. The rest of the world has sufficient reason to believe that the American imbalance is most likely to be a candidate for disruptive settlement, with a collapse of the dollar, high interest rates and a falling stock market.

The world's economic leadership has to make arrangements for an orderly unravelling of the imbalance rather than await a disorderly, disruptive denouement.

The compassionate scribblings of professionals who "speculate" that all is well in this most unbalanced of all possible worlds deserve to be ignored.

Such sentiments only serve to delay the proper response of policy-makers to the real threat of a global crisis at hand. The danger of disruption is too serious to be ignored merely because of optimistic econometric gymnastics.