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Dark Matter And Inequality

If we use proper accounting, is America really a net-credit nation?

I appear to be really late to the Dark Matter party, (h/t Kevin Drum), but I’m going to try to catch up.

The term comes from this paper from 2005, which argues, in so many words, that America’s apparent massive net-debtor status is an accounting illusion caused by not marking our assets to market.

Here’s the argument, somewhat simplified.

The United States has been running trade deficits since, basically, forever. What that means is that America purchases more stuff abroad than we sell. A trade deficit implies a capital surplus – the “extra” money we send abroad must be “recycled” by investment back in the United States. What that looks like, on the surface, is that Americans are buying stuff abroad, and financing their purchases by mortgaging our country. And, in the traditional green-eyeshade mode of looking at this, one day it’ll all come crashing down when our foreign creditors call in their debts and we have to sell Alaska or Apple Computer or whatever to the Chinese to pay back the loans we took out to buy all that cool stuff.

The “Dark Matter” theory says that this is incorrect because it assumes that the net capital surplus (equal to the net trade deficit) is the only number that matters. What should matter, rather, is the relative value of national assets and liabilities. And that requires looking at foreign investment in the U.S., and U.S. investment abroad, separately, and to look not only at the annual investment numbers but the change in value of those portfolios over time.

We don’t have mark-to-market numbers for these investment portfolios, but we do have values on the earnings from those portfolios. We know how much we pay to service our debt (public and private) owned by foreign entities, and we know how much we receive on the assets we’ve accumulated abroad. And it turns out that the net income number is positive, relatively stable, and has been rising over a long period of time. What the paper concludes from this information is that the real value of America’s investments abroad has risen faster than our liabilities have accumulated, and that the apparently massive accumulated trade deficit is just an accounting fiction. It’s not that we mortgaged Alaska to buy a Lexus or a Mercedes. It’s that we mortgaged Alaska to buy Eurodisney, with a little money left over to buy a Lexus or a Mercedes; and Eurodisney has proved so profitable that if we sold it we could easily pay off the Alaskan mortgage.

That’s a really interesting argument! The obvious question to ask is how such a thing could be – why should America earn so much more on its investments abroad than foreigners earn on their investments in America. Hausmann and Sturzenegger (the authors of the paper) make the argument that the primary driver of America’s higher returns on its investments abroad relative to foreign investments in America is America’s greater knowledge advantage. We’re applying intellectual property and expertise (brands, technology, management skill) to foreign assets, causing them to yield more than could be achieved by another investor; by contrast, foreign investors in the U.S. overwhelmingly are buying government bonds, and so are not leveraging any intellectual property or expertise of their own to increase the value of their investment. But they acknowledge other possibilities – for example, that the immaturity of the Chinese financial markets creates a large preference for safe American securities, so that (in effect) the Chinese are using the American financial system as an intermediary, investing in American bonds to indirectly finance American companies’ investments in (among other places) China, and in effect we’re earning profits (as a nation) simply by virtue of being middlemen. I’d also argue that the dollar’s status as the premier global reserve currency plays a big role here – it’s a lot easier to make profits on your international investments when you pay a lower interest rate on the money you borrow than your competitors because of the currency you’re borrowing in.

If the theory is true, it goes a long way to discounting fears that we’re “turning into Greece” because we’re living beyond our national means. With proper accounting, we see that we’re not a net-debtor at all; we’re a net creditor. And the only thing that would change that picture materially would be a sharp drop in returns on our investments abroad, something that has never been observed in recent years (possibly because, in recent years, we haven’t seen any major global economies go Communist – the easiest way to imagine a sudden and precipitous drop in the value of our foreign investments is to assume that they are simply seized by foreign governments). But the Greek scenario has never been particularly applicable to America; countries that borrow exclusively in their own currency can have lots of financial problems, but literally replicating the Greek experience isn’t one of them.

On the other hand, I’m not sure how much it should reassure anyone concerned about the effects of global imbalances like these on America’s social structure. After all, if I understand the argument correctly, America is borrowing more money abroad than we’re investing abroad, and earning sufficient return on the investment that we can easily pay the interest on what we borrow. But a great deal is hidden in that “we.” The entity doing the net borrowing is overwhelmingly the Federal government. The entities doing the investing abroad are overwhelmingly American corporations. And the distributional consequences of rising Federal debt and rising corporate returns are not identical. America may be behaving like a successful giant hedge fund but we’re not all investors in the hedge fund – some of us are just creditors to it. And the political consequences that flow from such an arrangement would tend to cement it in place.

Instead, it should reassure folks who are concerned about those distributional consequences that there’s plenty of return sloshing around to redress them. After all, if there’s so much return from Eurodisney that we can afford to borrow more than we need to pay for that investment, and spend the excess on a Lexus or a Mercedes, maybe we could think about better ways to deploy that “excess” borrowing for something other than current consumption. Something that would upgrade America’s physical and human capital, say.