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February 27, 2006
Dark matter
I have been trying to understand a new economic theory that attempts to answer an intriguing puzzle in our international trade and finance statistics: why is it that the US has a positive income of around $30 billion when our net international investment position shows a debt of about $3 trillion. How can be earning income on debt?
This new theory claims that, in part, our current measures of investment miss a large chunk of intangible assets -- what they label "dark matter", akin to the concept in astrophysics where the known mass of the universe is not large enough to explain why gravity can hold the universe together, that there is more mass (some "dark matter") in the universe that we can see and measure. Just as astrophysicists can impute the amount of that dark matter from the laws of physics (how much is needed to explain how gravity is working), these economist have imputed the amount of economic "dark matter" missing from our international asset position. The conclusion is that we really aren't in debt at all. The policy implication is that the trade deficit and international debt don't matter and that the dreaded currency correction (where the dollar falls enough to bring our trade balance back in line) won't happen.
Are the trade statistics inadequate to understand intangibles? Yes!
Is there a mass of "dark matter' -- intangible assets -- missing from our asset position that show we are really not in debt? No!
I should be the first one to jump on the "dark matter" bandwagon, as it is all about the export of intangibles. But, the argument doesn't add up -- and unfortunately, I think, distorts the role of intangibles.
The lay version of the dark matter thesis is presented in a paper by Ricardo Hausmann and Federico Sturzenegger of the Kennedy School of Government at Harvard University: U.S. And Global Imbalances: Can Dark Matter Prevent A Big Bang?. The full paper contains a more technical discussion. Here is the summary of the thesis from their Financial Times op-ed 'Dark Matter' Makes the U.S. Deficit Disappear:
We know that the US net income on its financial portfolio is $30bn. This is a 5 per cent return on an asset of $600bn. So the US is a $600bn net creditor, not a $4,100bn net debtor. Since the assets have remained stable then on average the US has not had a current account deficit at all over the past 25 years. That is why it is still a net creditor.
We call the $4,700bn difference between our measure of US net assets and the standard numbers "dark matter", because it corresponds to assets that generate revenue but cannot be seen. 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 gravity emanating from visible matter.
There are several reasons why dark matter exists. The most obvious is superior returns on US foreign direct investment. Why do US assets earn such returns? Because that investment comes with a substantial amount of know-how that increases its earning potential. It explains why the US can earn more on its assets than it pays on its liabilities and why foreigners cannot do the same. In measuring FDI, the value of the know-how is poorly accounted for. There are other sources of dark matter, but FDI is where the big bucks are. Once dark matter is considered, the world is surprisingly balanced. The US and European Union essentially cover their apparent imbalance with the export of dark matter, emerging markets use their surplus to import dark matter and Japan finances the rest of the world. Net asset positions of all big regions are fairly small.
Is US dark matter a stable asset? We find that it is. It now stands at more than 40 per cent of gross domestic product and has fallen in only six of the last 25 years, never by more than 1.9 per cent of GDP.
In a nutshell our story is simple. Once assets are valued according to the income they generate, there has not been a big US external imbalance and there are no serious global imbalances.
Brad DeLong summarizes the argument this way:
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.
Michael Mandle of Business Week sees it all as intellectual property:
The international trade statistics are great at tracking flows of goods, and okay at tracking flows of services. The trade statistics are terrible at tracking cross-border flows of intellectual property. For example, when Intel sets up a chip fabrication plant in Ireland, that country reaps the benefit of Intel's designs, and all of Intel's accumulated wisdom about how to run a fab successfully. In effect, a massive amount of intellectual property has been exported to Ireland, without showing up in the trade statistics at all.
These massive and unobserved exports of intellectual property--"dark matter"--imply that the U.S. is actually running a much smaller current account deficit than the official data shows.
In addition, U.S. assets abroad are really worth a lot more than we thought, because the official calculation doesn't include the value of the intellectual property. That explains why it appears that U.S. investments abroad appear to earn a much higher rate of return than foreign investments in the U.S.
I first heard of the paper in the Economist "The United States' current-account deficit is a figment of bad accounting. If only" but the story really took off with the recent cover story of Business Week, Why The Economy Is A Lot Stronger Than You Think.
Since then, the comments have been flying fast and furious in the blog-sphere. I won't even try to summarize the arguments -- you can see for yourself at Brad Setser's and Michael Mandl's blogs.
The first problem I have with the dark-matter thesis is that it really doesn't explain why we continue to have a positive cash flow. The argument is that there are three factors for why US gains a greater return on our investment abroad: seignorage, the risk differential between US and elsewhere, and third, the greater return due to our intangibles. In one of their papers, the authors speculate that the risk differential is 3%: 5% paid on "safe" investments in the US versus 8% paid on "risky" investments abroad. Given the size of the investments (U.S.-owned assets abroad at market value of $9.97 trillion and foreign-owned assets in the United States at market value of $12.52 trillion), it is easy to do a back of the envelope calculation. At 5% foreigners earn $625 billion and at 8% the US would earn $797 billion. Our surplus in the current accounts for payments would be $172 billion.
In actuality, the income payments on foreign-owned assets in the United States in 2004 were $340 billion, while the income receipts on U.S.-owned assets abroad were $376 billion -- for a surplus of investment income of $36 billion. That translates into a (simply) rate of return of 2.7% for foreign investment in the US and 3.7% for US investment abroad. That seems to me to be well within the risk premium.
(Others take exception to even this point -- Willem Buiter argues that seignorage on foreign holdings of US currency is the only "dark matter" and accounts for at most a sixth of what H-S calculate.)
What is more remarkable about our current accounts is what the authors start with: why have income payments stayed constant while debt has increased. A shift of $4.5 trillion in debt has left our income payments at positive $30 billion.
In other words, why are we earning as much now as we did then?
This seems to be the underpinning of the argument: there is something offsetting our increasing debt -- something we are not counting. Thus our net foreign assets must be greater than we measure.
To start with, we need to understand that the differential in the rates of return has not been steady -- but has been consistantly positive in our favor.
The answer to the question of why we still have positive cash flow with increased debt lies in the absolute size of the investment assets, not the relative size (the net investment position). A thought exercise and simply calculations may help illustrate my point. Assume that the US asset position abroad had remained fixed since 1981 with no net increase in the value of US assets owned abroad. But assume that the foreign asset position in the US continued to grow at a rate that given us exactly the same net debt. In other words, we continue to accumulate net debt at the same rate and level but without an increase in ownership of foreign assets. (See charts below for the existing and hypothesized asset positions).
Some simple calculations show that under this scenario, the US income stream does shift from positive to negative. Assuming the historical simply rates of return on both US and foreign assets, US investment income goes into deficit in 1994 and in 2003 is a negative $42 billion (see chart below).
So, the reason we continue to have a surplus in our income payments is because 1) the risk differential and 2) our investments abroad (which have a higher rate of return that investments here because of that risk differential) continue to grow. As the old saying goes, what we are lacking in profit margin, we are making up in volume.
The real question is why the US continues to enjoy a differential in the rates of returns.
"Dark matter" proponents argue that it is intangibles. But this argument falls flat in one simple way: it does not explain why the differential in the rate of return is roughly the same today as it was in 1976. If the difference is due to superior American know-how, why has that know-how in the trade statistics been relatively constant over 30 years while it has exploded in the real world? Do the authors believe that our stock of intangible assets is the same today as in 1976?
Another problem with the dark matter argument (and especially those who extend it to intangibles) is that it misunderstands the role of intangible. Intangibles are factors of production. They are inputs into the process. But unlike tangible assets, they are not necessarily used up in the production process. Knowledge is non-rival, meaning that more than one person can use the economic good at the same time (e.g. a software program). As a result, the spillovers from knowledge make the accumulation of knowledge self-perpetuating. Not only is the growth of knowledge self-perpetuating, there are increasing rather than diminishing returns. In the neoclassical model, the growth effect of simply adding more capital and labor diminishes over time; it takes more and more input to maintain the same growth. Knowledge is different; it continues to grow.
Mandle quotes Hausmann in Why The Economy Is A Lot Stronger Than You Think"
Using these arguments, Hausmann finds that the U.S. current account deficit actually disappears, averaged over time. "With globalization, you develop a blueprint and sell it in all countries," he says. "Countries that are good at creating blueprints get more exports of dark matter."
But this is not an "export" of an asset. When someone in Russia buys a Big Mac, they are not purchasing the McDonald's brand and know-how. They are buying the results of that know-how; there is no transfer of an asset. In essence, they are renting that know-how. And that rent (the licensing fees, etc) already show up in our trade statistics as royalties. This make up a part of the intangibles trade balance which I report on each month. The surplus in our intangibles trade amounted to $82.4 billion in 2005 -- compared with the overall deficit of $725.8 billion. This surplus has been relatively steady at a monthly level of $6 to 7 billion for the last 5 years -- precisely when H-S argue that the amount of US "dark matter" exports have exploded.
As Mandle points out, there is a problem with these trade statistics concerning internal corporate transfer pricing. When the know-how is shared internally (such as the Intel plant example), the rents are not caluclated as part of the royalities that flow back to the US. Presumably, they do show up as part of that higher return on our foreign investments. But that rent by foreigners of our know-how is offset in part by our rent of foreigners know-how (Toyota auto plants?).
So, for now, I think I agree with the comment of Geert Noels (Chief Economist, Petercam, Brussels-Belgium) on Mandle's blog:
"Unmasking the Economy" seems to me the economic equivalent of Glassman's "Dow 36,000". If we change the accounting, wrong seems right, and imbalances disappear...
More on intangibles and "dark matter" later.
Posted by Ken Jarboe at February 27, 2006 1:06 PM
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