Is American Indebtedness Worse than Reported?
Today on the Financial Times, Daniel Gros argues that the US is in a deeper hole than reported:
The global financial system seems to have a black hole at its centre. Over the last two decades, US residents have sold a total of about $5,500bn worth of IOUs to foreigners, yet the officially recorded net investment position of the US has deteriorated only by a little more than half of this amount ($2,800bn). The US capital market seems to have acted like a black hole for investors from the rest of world in which $2,700bn vanished from sight – or at least from the official statistics.How can $2,700bn disappear?
Recently I began telling investors that the US dollar would have to depreciate farther from current levels than is generally accepted - to nearly 1.8 dollars per Euro. My reasoning was very similar to Dr. Gros' - namely that there were significant discrepencies between investment flows - which I have followed for years - and reported statistics.
This large foreign indebtedness is more than cause for concern, but it is not cause for alarm. Alarm is what one does when there is something one can do. The size of US foreign indebtedness implies that there are only one of two outcomes. One is a dramatic reduction in the autonomy of the United States over time, as debt produces a spiral - more of the national effort must be spent to pay debt service, making it harder to make investment in productive capacity, which means that there is less income to pay debt service.
What this means in the context of the recent stock market slide - which pushed key indicators into danger zone territory, even as technical indicators point to a rebound that is already in progress - is relatively simple.
The US is able to create dollar denominated debt on the credible expecation of other nations that dollars will one day be in short supply. The current fall of the dollar has allowed the US to reduce its foreign indebtedness without as much direct pain, because of foreign willingness not to dump dollars, and not to require the US to borrow in other currencies. If the US were a developing nation, it would have been IMFed by now.
This credible expectation that there will be another boom in the US economy requiring investment or being locked out of the ground floor of technology, or, though often and, another period of US fiscal restraint leading to a global dollar shortage, is what allows the US to print dollars, because countries that run a dollar surplus prudently expect that at some point the US will retrench, or dramatically substitute away from whatever it is we import. The long dynamism of the US economy, and the record of fiscal retrenchment, have given the US this credibility. However, credibility is like any other asset, it can be spent.
What the present almost synchronized dive in markets shows is that the US is still the source of expected profits and income. In essence, the US consumer is the mine from which other countries extract value. This makes sense, the US has a large fraction of the intellectual capital and industrial base, and that means that acquiring control over it, or access to it, is a good strategy for other nations, so long as that advantage lasts.
However, that advantage is based on the ability to research - both publicly and privately. As the US must cut costs - because of lowered revenues - two factors work against it. The first is direct offshoring of research. How long will India remain behind the US, when more and more research is done there? How long will China? The second is, of course, lowered funds for investment. That is, foreign debt service crowds out other forms of investment, until such time as the US is able to enact a "dollar scarcity" tax on other nations.
While the US is still the anchor of the world economy, and this will mean that other nations will not dump the dollar wantonly - after all, they need to unwind their dollar positions, even if they want out of the United States.
What Dr. Gros' argument means is that the present currency adjustment that is occuring, along with the US rate raising campaign, are likely to be longer and deeper than expected. Higher indebtedness implies higher interest rates to attract capital, and to manage an orderly transition to a permanently weaker dollar.
It also implies that current energy prices are due to continue to remain at high levels, because, in effect, they are a tax on the US for not having a credible threat of dollar shortage. Since these energy prices have been leaking out into general inflation - as they always have in the past - this in turn puts more pressure for much higher interest rates. This is a spiral similar to that seen in the early 1970's, when Nixon's failure to deal with currency misalignment lead to a decade of inflation.
That inflation statistics are also understating the real consumer rate of inflation merely adds fuel to the fire. If we used a CPI-W similar to that of the 1970's, we would have to adjust inflation up over the last 12 months. Specifically we would need to remove the difference between rent of equivalent shelter - currently listed as 3.3%, and thus contributing .66% to CPI-W and to core CPI-W - but instead 15%, which would contribute 3% to CPI-W all by itself. This would mean that the inflation rate would be, not 4.3%, but 6.64%
With an official Unemployment rate of 4.6%, standard models would call for a significant increase in interest rates. This would strengthen the dollar, push the US into recession, and worsen the debt service owed to foreigners.
In short the US has used a spiral of borrowing to fund consumption, this has left the US in a bind. If it raises interest rates to strengthen its currency, then it will have a longer period of lower growth, because this will crowd out investment for debt service. If it does not, it will see a spiral of inflation, which despite being masked in the official statistics, will be visible to Americans. Dr. Gros' thesis puts the day of reckoning - when the US will have to make radical adjustments in the distribution of effort - closer, rather than farther away.
What Dr. Gros' argument means is that . . . .
Anybody have any idea what "Dr. Gros' argument" is?
June 15, 2006 6:20 AM | Reply | Permalink
I presume the $5.5 trillion includes the quantity discussed by Martin Mayer in NYT yesterday (Mark of the Bust"). He looks at the quantity of government and agency securities held "for foreign official and international accounts."
His point is that a rise in this number correlates with subsequent recession.
June 15, 2006 6:49 AM | Reply | Permalink
This whole idea of the "core" rate of inflation seems to be no more than another rhetorical flourish, designed to take the heat off of D.C.
High fuel prices means higher shipping costs - that's going to affect, well everything right?
So Bernanke is going to stick it to the US economy with interest hikes - and then that will lower oil prices? I suppose if US demand falls due to a recession oil prices might fall - but then I thought recessions were something we wanted to avoid.
June 15, 2006 7:51 AM | Reply | Permalink
Could the discrepancy be due to inaccurate statistics on the balance of payments? This is unlikely because the financial flows are just the mirror image of the current account which can be accurately measured given that it consists mostly of business-to-business transactions. With the improvement in current account statistics, the global current account balance discrepancy has now almost totally disappeared. If the current account figures constitute a more reliable source (except for “reinvested earnings”), it is likely that the true US net external debtor position is around $4,000bn (about 40 per cent of GDP) rather than the $2,500bn reported officially for end-2004. Taking into account the current account deficit of about $800bn for 2005 would bring the net current US debtor position to more than $4,500bn. (The official US net international investment position as of the end of 2005, to be published soon, is likely to again include a significant write-down of foreign assets in the US, so the official data are likely to show a net indebtedness below $3,000bn.)
Stirling Newberry http://www.bopnews.com
June 15, 2006 8:13 AM | Reply | Permalink
"Daniel Gros argues that the US is in a deeper hole than reported."
For more information you should read Gros' article.
June 15, 2006 8:53 AM | Reply | Permalink
I think the central bankers would rather we have a recession than inflation. There are some good arguments for their position, especially from the standpoint of the rich and super rich. After all a mild recession mostly hurts the "little guy." Central bankers don't eat lunch with "little guys." In fact most of them don't even know "little guys" except for their gardeners and housekeepers, and who gives a rats ass about them. Inflation, on the other hand, might mean the central bankers (the rich and super rich)would have to pay their gardeners and housekeepers more money, and that could really hurt them and their friends.
Sorry, I couldn't resist the snark.
Ron Byers
June 15, 2006 9:23 AM | Reply | Permalink
J. McCutchen "JmacSF"
San Francisco. CA
June 15, 2006 9:29 AM | Reply | Permalink
I've written on how core inflation is a useless indicator, and that the current spread between core and total inflation is an extremely bearish sign, not a sign for lack of concern.
June 15, 2006 9:51 AM | Reply | Permalink
i still think this is too sober. there are other factors we'll have to consider, conditions which will or already do exist that will coincide with "recession." perhaps you should find another word.
June 15, 2006 10:00 AM | Reply | Permalink
Greenspan had a simple philosophy, to protect the rentier class. This is the group that collects more or less fixed income from investments (real estate, bonds, etc.). Their concern is to preserve their wealth and thus inflation is the one thing they want to avoid.
It is not clear that Bernacke belongs to the same school of thought. He has been saying things to indicate that fighting inflation is his primary focus, but people seem not to believe him.
What I don't understand is why inflation is attributed to everything except the obvious - scarce resouces (whether oil or land) cause prices to rise. Labor is not strong enough in this country to force wage increases, as a matter of fact it is organized labor that has been seeing the biggest losses in wages, just look at the airlines and auto industry.
If wages are rising (questionable) then this is because of shortages of labor in various sectors and the subsequent bidding for worker's services.
Government (and just plain folks) have a different view of inflation, it is a way to eliminate much of the burden of debt. This is why it has been an irresistible option throughout history. With the average family having very little wealth what would inflation do to them? Very little as long as wages mostly kept pace. This is what happened in the 1970's.
Recent studies have shown that just a handful of super rich families have determined the course of the estate tax policies over the past decade, how do we know that a similar clandestine effort is not being undertaken to preserve the capital of the wealthy?
--- Policies not Politics
Daily Landscape
June 15, 2006 11:04 AM | Reply | Permalink
Stirling:
Does the "$2,700bn" Dr. Gros mentions =
(US)$2,700,000,000.00
or (US)$2,700,000,000,000.00?
-Dave Adams-
June 15, 2006 12:28 PM | Reply | Permalink
Never will; ft requires site registration, and I won't encourage authors who link to non-free or retricted sites -- especially, authors too lazy to put the gist of the linked article in their own postings.
June 15, 2006 12:40 PM | Reply | Permalink
Has to be the latter, i.e. US$2.7 trillion. The former isn't even small change.
June 15, 2006 1:45 PM | Reply | Permalink
I'm hoping that typing this in helps me understand it better. The paragraphs posted by SN in comments above appear to be the crux of it.
Discrepancies in America's accounts hide a black hole
by Daniel Gros, Finaincial Times comment, 15 June, 2006
The global financial system seems to have a black hole at its centre. Over the past two decades, US residents have sold a total of about $5,500bn worth of IOU's to foreigners, yet the officially recorded net investment position of the US has deteriorated only by a little more than half this amount ($2,800). The US capital market seems to have acted like a black hole for investors from the rest of [the] world in which $2,70bn vanished from sight - or at least from the official statistics.
How can $2,700bn disapear?
It is often argued that the US can simply make large capital gains on its gross positions because its assets are denominated in foreign currency and its liabilities in dollars. However, the available data indicate that over the past two decades this factor has netted the US at most $300bn-$400bn. This still leaves a loss of well over $2,000bn to be explained.
The explanation comes in two tranches of about $1,000bn each.
The first source of accounting revenues for the US derives from an anomaly in the item "reinvested earnings" on foreign direct investment in the US balance of payments. This item improves the current account by about $100bn a year because foreign companies systematically report abnormally low profits for their US operations to avoid US corporate income taxes. If one assumes that foreign companies earn the same rate of return on their direct investment in the US as on their portfolio investment in equity, the US current account would deteriorate by about $100bn. Properly measured, the country's current accoune deficit would thus be about 1 per cent of gross domestic product larger than officially reported.
The underreporting of the current account deficit implies that US indebtednessis also underestimated. Over the past two decades the cumulative correction for the anomaly in "reinvested earnings" would lead to a higher US net debtor position of about $1,000bn.
A second source of gains comes from very large residuals - labelled "other changes" by the Bureau of Economic Analysis in its statistics on the evolution of the net US international investment position - the total of which also reaches about $1,000bn over the past two decades.
The US international investment position today should in principle be equal to the sum of past current acount balances (mostly deficits). However, this is not the case by far, even taking into account the balancing item "errors and omissions". The quite detailed data available for the period 1989-2004 show that th exchange rate and valuation adjustments mentioned above have netted the US $300m-$400m, still leaving the discrepancy of about $1,000bn.
The discrepancy arises for a simple reason: current account data are based on the actual flows of payments recorded in the balance of payments. By contrast, the data on the US international investment position are based on surveys of depository institutions, which year after year tend to lose sight of US assets held by foreigners, especially portfolio investment and real estate.
Could the discrepancy be due to incccurate statistics on the blance of payments? This is unlikely because the financial flows are just the mirror image of the current account which can be acurately measured given that it consists mostly of business-to-business transactions. With the improvement in current account statistics, the global current account balance discrepancy has now almost totally disappeared. If the current account figures constitute a more reliable source (except for "reinvested earnings"), it is likely that the true US net external debtor position is about $4,000bn (about 40 per cent of GCP) rather than the $2,500bn reported officially for end-2004. Taking into account the current account deficit of about $800bn for 2005 would fing the net current US debtor position to more than $4,500bn. (The official US net international investment position as of the end of 2005, to be published soon, is likely to again include a significant write-down of foreign assets in the US, so the official data are likely to show a net indebtedness below $3,000bn.)
A closer look at the data thus suggests that both the current account deficit and the net debtor position of the US are even worse than officially reported. This can only mean than the need for a substantial depreciation of the dollar and/or a period of sub-par growth is even bigger than generally accepted.
<i>The writer is director of the Centre for European Policy Studies in Brussels and chairman of the board of San Paolo IMI Asset Manafement. For more details, see CEPS working documents nos <a xhref='http://shop.ceps.be'>242 and 243</a>.</i>
June 15, 2006 2:12 PM | Reply | Permalink
With the average family having very little wealth what would inflation do to them? Very little as long as wages mostly kept pace. This is what happened in the 1970's.
I don't know if you remember the 1970s or not, but I sure do. It was hell. High inflation ultimately means high interest rates, because that's what investors demand for dollar-denominated investments. High interest rates means that a lot of people get squeezed out of the housing market, because they cannot afford mortages at high rates. That means the housing market collapses, and people start walking away from their mortgages.
In addition, high inflation makes people disinclined to save, since saved money loses value over time. And we already have a problem with a too-low national savings rate.
I think you're also overlooking that the "fixed income" group includes most retirees. Most retirees I know would qualify as "just plain folks."
Inflation is not cost-free for anyone. Ask the people of Argentina.
June 15, 2006 3:31 PM | Reply | Permalink
authors too lazy to put the gist of the linked article in their own postings.
He did post the gist of it; are you demanding that authors ignore the copyright law?
(Besides which, the site didn't demand that I register when I clicked on the link to the article. Why don't you try it before deciding it won't work?)
June 15, 2006 3:41 PM | Reply | Permalink
lol
June 15, 2006 4:31 PM | Reply | Permalink
Re: How long will India remain behind the US, when more and more research is done there? How long will China?
Given the enormous poverty and illteracy problem India has, probably 50 years minimum before India can hope to catch up to the US and Europe economically (as they are now). As for China, as long as it is hobbled with its current form of government it will not catch up. Both countries are something of a Potemkin village, a glowing front superimposed on massive squalor-- rather like Russia itself back when the real Potemkin villages were created. A tiny fraction of engineers and physicists in a population of dirt poor peasants no more makes one an economic powerhouse than Catherine's the Great's French-speaking, enlightened Court made Russia the most advanced country in Europe.
June 15, 2006 4:32 PM | Reply | Permalink
Re: I think you're also overlooking that the "fixed income" group includes most retirees.
Last I checked Social Security is still indexed to inflation. That's not a "fixed income".
June 15, 2006 4:34 PM | Reply | Permalink
I guess my "just plain folks" was a bit unclear. Those who have debt (which until recently was mostly 30 year fixed rate mortgages) do all right during inflation - their monthly payments are fixed and the "value" of their home goes up. Those who have no real assets don't see much change. Thus who have a fixed income, which includes retirees are in trouble. Retirees, from this point of view, are members of the rentier class I discussed above.
All of the above remarks are predicated on the assumption that wages will keep pace with inflation. During the 1970's they almost did for many, especially those in unionized industries. Things this time may be quite different. More people have adjustable rate loans, more people are invested in stocks (which generally do poorly during inflation) and unions won't be able to force wages to keep up. The net result will be that some will do well and some poorly. Perhaps even many more will do poorly than will benefit. This doesn't change the fact that governments find inflation a quick way to fix their deficits.
--- Policies not Politics
Daily Landscape
June 15, 2006 4:37 PM | Reply | Permalink