Brad Setser

Brad Setser: Follow the Money

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The Joint Economic Committee

by Brad Setser
October 25, 2005

Last Thursday, I had the opportunity to testify before the Joint Economic Committee on the US current account deficit, as part of the panel that followed Dr. Bernanke's testimony.

I strongly suspect that I will never testify in the same hearing as Bernanke again.  If you have not heard, he just got a big promotion.

I am sure you all will be shocked to discover that I do not think trade deficits of the current magnitude are sustainable, and that the United States' need for perhaps $900 billion net capital inflows is a risk to next year's economic outlook.   I am pretty sure that I did not say anything that would surprise regular readers of this blog – or, for that matter, anything that Mr. Geithner did not say better last Wednesday. 

Among other things, I did update my "what happens to the US net external debt" in a gradual adjustment scenario graphs for my testimony.  It turns out that if the US trade deficit starts to fall by about 0.4-0.5% of US GDP in 2006, the US external debt would stabilize at around 60% of US GDP.  Actually, it would be a bit lower, since that kind of fall in the trade deficit likely implies a fall in the dollar, and thus a rise in the value of US assets abroad.   My simple graphs did not take into account valuation gains. 

The scenario where the US trade deficit gradually falls to zero requires something like 9-10% export growth and 5% import growth over the next ten years.  It is in many ways an optimistic scenario, one where the deficit comes down gradually without any sharp interruptions in financial flows.  It now seems likely that the adjustment won't start in 2006, which implies either that the US net external debt stabilizes at a higher level or a sharper and more painful adjustment path.

One small point about these scenarios.   In the future, it is likely that net interest payments will make up a larger and larger share of the US current account deficit.  Debtors, after all, generally do have to pay interest on their debts.   The US net external debt is the difference between gross US external debts (and foreign investment in the US) and gross US assets (including US investment abroad).  Consequently, assumptions about the future rate of return (from interest and dividends) that foreigners will receive on their investments in the US and the rate of return that the US will receive on investments abroad can have a big impact on these forecasts. 

Back in 2004, Nouriel and I assumed that the overall interest rate that the US had to pay on its external liabilities would likely converge with the overall interest rate that the US earned on its external assets.  Bill Cline has argued that this assumption is too pessimistic (See Chapter 3 of his book).  That doesn't bother me much – I would worry If was not somewhat more pessimistic than Bill Cline.   The real news here is that even an optimist like Cline thinks the US is on an unsustainable path.

Cline argues that the US historically has earned more on its direct investment abroad than foreigners gave earned on their investment in the US.  That certainly is the case – read the IMF WEO, or Philip Lane and Gian Maria Milesi-Ferretti!  But if that continues to be true, doesn't it cut against the argument that the US should be able to finance large ongoing deficits with ease because it is such a great place to invest?

20 Comments

  • Posted by ReformerRay

    Interesting. I am coming late to this discussion. I would like to understand your variables “Gross External Debts” and “Gross U. S. Assets”. I am familiar with the FRB statistics on Net Worth for Households and non-profits organizations and with BEA data on Net International Investment Position. Is your data some combination of components of those two data sets? What do you do about governmental debt – or assets?

    I think I recall that you agreed, in some discussion, that Net International Investment Position is not a debt in the usual sense of requiring stated timely payments but is ownership of U. S. assets which requires return of all earnings of those assets to overseas owners. Perhaps this distinction makes no difference so long as these assets are earning money but it is a safeguard if the assets in the U. S. cease earning a return.

  • Posted by ReformerRay

    On the question of return on investments in the U. S. and abroad: The explanation I have heard is that Foreigners invest in bonds in the U. S. and that U. S. investors choose equities overseas. If that is so, the gross data on returns does not get to the question of the returns available to equities in both the U. S. and abroad or the return to bonds in both the U. S. and abroad.

    I view the returns available to stock markets as the relevant data. In 2003 and 2004, the U. S. won that race but in 2005 it is loosing (see The Economist, Oct. 15,2005, p.75)

    It is my conviction that relative stock market returns is the best predictor of change in the value of the dollar. That hypothesis will be tested in the comming years – expected lags of uncertain length – up to two years, make testing difficult. The U. S. stock market started down in 2000 but the decline in the dollar began in 2002. The stock market started back up again in 2003 but the dollar declined most of the period 2002 through 2004. The dollar stabilized in early 2005.

    Incidently, the changing value of the dollar in the period 2000 – 2004 did not prevent the U. S. trade deficit from increasing steadily from early 2002 up until the third quarter of 2005.

    The ability of Germany to maintain its trade surplus with the U. S. in spite of currency change in 2002 – 2004 shows that tariff increases of small amounts will not reduce our trade deficit with Germany until the tariffs become large enough to really bite.

    All seem to agree that reducing the U. S. trade deficit is a formidable task.

  • Posted by bsetser

    There is a footnote in my testimony where i explain my terms. both external assets and external liabilities come from the BEA’s net international investment position data. external assets = us holdings of the debt of other countries (US bank accounts in europe, us holdings of euro denominated bonds, us holdings of brazilian bonds — yep, mr. el-erian’s old portfolio countrs, etc), and us equity investments abroad. US liabilities are both foreign holdings of US debt (whether treasuries, agencies or corporate debt), foreign bank accounts in the us, foreign holdings of dollars cash (technically a claim on the us — it can be traded for us goods) and foreign investment in the us. it turns out that us equity investments abroad exceed foreign equity investments in the us, so the entire negative overall position is explained by the fact that foreign holdings of us debt far exceed us holdings of foreign debt … concretely, foreigners own lots of treasuries and us corporate debt and we in the states don’t own lots of bunds, JGBs, Brazilian bonds and the like.

  • Posted by bsetser

    Reformer Ray –

    I would divy it up a bit differently. The US does have a bit more FDI abroad than foreigners have here (and i think the same is true of portfolio equity, tho i would need to check), largely because of the fall in the euro/ dollar. but the gap is not big enough to explain why the us investment income account only just now turned in the red. the explanation is not that the us issues debt and buys equity, but rather that foreign equity has (particularly recently) brough american investors higher returns (both in a cash flow sense and an asset appreciation sense) than us equity has delivered for foreign investors. see the links in my post to the imf and lane.

    as for the impact of the falling dollar — a) it happens with a lag, so the 02 fall should have started having an impact in 03, the 03 fall in 04, and so on. b) the falling dollar typically has a bigger impact on exports than imports. i would argue that strong export growth in 04 and 05 is a function of the dollar’s big fall in 03 (and a smaller fall in 04) … the fact that the trade deficit kept rising just shows that other factors also matter. us domestic demand grew strongly, and us imports tend to rise quite strongly with domestic demand — that pushed the overall deficit up, along with oil, even as a falling dollar helped exports.

    put differently, without a falling dollar, the us trade deficit would be much bigger today –

    final point: a small export base does suggest to me that big moves in the dollar will be needed to close the trade deficit, along with significant changes in relative growth rates.

  • Posted by Movie Guy

    Brad,

    What prevents the following from continuing to occur in various global locations, even if China’s currency is revalued?

    A serious question…

    Here is what U.S. citizens are competing against, including U.S. corporate and government decisions related to WTO and U.S. trade policy:

    Economic Hydrology Theory

    The Future of U.S. Domestic Production versus Offshoring and Outsourcing to Foreign Locations

    Once the WTO and national governments improved the opportunities for corporations to invest in the least expensive global production locations, the stage was set. Coupled with continually improving transportation and communications efficiencies, the successes of offshoring and outsourcing corporations which led the way were met by competitive desires of other corporations to also seek new lowest cost production sources. At present, over 450 of 500 top U.S. corporations have operations in China, as an example.

    Unimpeded and with regard to available skill levels and technologies, corporations will seek out the lowest cost blue collar and white collar production sources on the planet and will create new production empires in those locations as fit their market needs. Currency manipulations and other foreign and domestic government incentives that improve foreign-based blue collar and white collar production opportunities increase the rate of flow or transference to such locations. The larger concentration of global production in lowest cost production environments results in a convergence of foreign direct investment (FDI) monies targeted toward achieving greater scales of production at these locations. This effort, in turn, minimizes the need for investment and development elsewhere by such corporations which further eliminates the logistical and technical support chains that previously existed for duplicate operations at facility locations in other nations. The results are reduced overall investment costs, reduced production costs, labor substitution, and reduction of related supporting logistical and technical support services and employment in other nations.

  • Posted by ReformerRay

    I feel like I have just sat in on a college seminar. I am going to do some reflection upon the two posts by Brad and Movie Guy. Thanks to both of you.

  • Posted by Charlie

    I work for a software company that has offshored many jobs to India. I manage a group in India. This is what we’ve discovered over many years…

    a) Offshoring works much better for some projects than others. Projects that require little supervision tend to work well. projects that require a lot of supervision don’t. Not suprising. We’ve had projects that required extensive business knowledge to complete and these projects have, in general, ending up costing more to do in India. This doesn’t take into account long term losses due to customer unsatisfaction. The projects took twice as long to complete and were a major headache. Some projects worked well and I suspsect we saved about 25% of the total overall cost by doing them overseas.

    b) There are cultural differences between India and the US that effect quality of work. The ‘good enough’ level in India is much lower than in the US. They would do work and state they were complete. We would review their work and our opinion was this needs a lot of improvement before we can give this to clients. They would state that they met their requirements. Anyone who has worked on software development knows that requirements are always incomplete. There’s always something that’s open to interpretation and they would use very poor judgement making these decisions.

    They also have a tendency to say that they can deliver anything on any date. This makes planning difficult. They give an impossible promise to deliver and 2 weeks before the deadline, they state they need an additional 2 months. They have a tendency to not admit that they’re in over their heads. They are overtly concerned about giving the appearance thay they are in control. Also, they never question their superiors. A manager takes great offense if they are questioned in any way and are extremely touchy about anything that might be perceived as an insult. I.e. someone sends an email about something and they aren’t included, even if it’s something they shouldn’t be concerned about. In their favor, they’re very polite, are willing to work long hours, and my guess is they have an equally long laundry list of complaints about how the US manages them.

    c) The software developers in India don’t have much, if any, experience. India hasn’t been in the software offshoring business long enough to get experienced programmers (or at least not in large quantities). What typically happens is we get new college graduates and pay them the equivalent of $12,000/yr. Their salaries quickly escalate to $20,000/yr due to competition and once they get 5 years experience, they can get up to $30,000/yr. Most decent programmers don’t get decent until at least 5 years of full time experience, so by the time they’re productive, the cost savings are much lower.

    After several years or moving things to India, our group has made a decision to actually cut back on offshoring and move some positions back to the US. Mainly because the cost savings aren’t as much as advertised, there are some things that can’t be done overseas, like troubleshooting issues with sensitive data, and we’ve found that 2 good people in the US can be as productive as 4 people in India (in many cases far more productive).

    My guess is that others who have offshored to China and India have similar issues and I wouldn’t be suprised to see an overshoot of offshoring followed by a pullback.

  • Posted by Gcs

    not to be too cryptic

    but inflation targeters tend to be
    over valuation friendly

    my guess mistah B
    WILL GO FOR
    A CONTINUING HIGH DOLLAR

    LOW NOMINAL INTEREST RATES

    AND WHAT HE’LL CALL
    “UNAVOIDABLE ”
    REAL WAGE DEFLATION

  • Posted by ReformerRay

    First, I want to thank Charlie for that really interesting information in his last post. Second, I want to send some heretical ideas. Please bear with me and give me some feedback. Here goes (gulp).

    The identity S = I + Current Account Balance has become central in the thinking of 99% of the writers dealing with the U. S. trade deficit, including Brad Sester.

    Too much is made of that identity. It applies only to the U. S. economy. It has no implication for the flow of funds between the U. S. and other countries. The “savings shortfall” – difference between savings and investment in the U. S. is unimportant.

    Why? Because the funds for investment in the U. S. by U. S. entities in any one year bears no relation to the level of savings in that year.

    Investment funds in any one year come from retained corporate earnings (savings in past years), banks and private investors drawing upon the 49 trillion dollars of Net Worth accumulated by Households and Non-Profit corporations over the years.

    The lack of savings in any one year, as reported by the BEA, does not require that foreigners send money to the U. S. in that year to make up for a shortage of savings. The reported savings in one year are what they are – an outcome of the U. S. economy. When we have a large trade deficit, we are likely to have a low level of savings. The reported lack of savings in any year cannot be a problem for an economy that has seen corporate profits and retained earnings soar in the last 30 months and have added 9 trillion dollars to the Net Worth of Households and Non-Profit organizations in the years 2003 and 2004.

    The decision of BEA to limit their definition of savings to the economic gains produced by the output of the economy in a limited time period makes sense to me, because it is consistent with the meaning of GDP. Therefore, it must exclude changes in the value of existing assets.

    But the gains in Net Worth in 2003 and 2004 are mostly change in the value of existing assets.

    “The current account deficit measures essentially the amount we have to borrow from the rest of the world to support the amount we consume in excess of the amount we produce in any one year.”

    Wrong! We can and we do support consumption in excess of production by drawing down on the net worth of the private sector. The private sector (including the corporate sector) pays for our excess imports.

    This slightly different view of the relationship between the U. S. economy and the rest of the world does not eliminate or reduce the need for the U.S. to reduce our trade deficit. It just makes the statement of the problem more complex.

    Savings as reported by the BEA behaves more like a dependent variable than an independent one, in my view. Give it little thought.

  • Posted by Guest

    here’s a look back on NAFTA from the PBS newshour last nite :D cheers!

  • Posted by bsetser

    Movie Guy. No guarantees. But i certainly think china might be a less formidable export machine (And magnet for investment) if the rMB appreciated to something close to its fair value, even if other policies remain unchanged.

    I am not with you on trade, but i do think the current system of taxing MNCs v. taxing local companies makes no sense. Why does china give tax breaks to foreign investment (still?), encouraging round tripping? why are us mnc profits untaxed so long as they are kept offshore, but not the moment they are moved onshore (setting aside 05)?

    all that said tho, if at fair exchange rates, the US cannot maintain a gap between us productivity and chinese productivity, us wages will tend to converge toward chinese wages — indeed, some covergence is inevitable, because the current gap is bigger than the gap in productivity. And as everyone here knows, i would rather that convegence happen with chinese wages rising in $ terms (in part via a RMB appreciation), not with US wages falling in $ terms toward Chinese levels. Helicopter Ben agrees with me, i think. Loyal commentator and clever foil on chinese quesitons, DOR not so much ;)

  • Posted by Gcs

    i sense at least one of u
    may be
    grappling with an open system problem
    using closed system tools

    yes US household
    and even
    corporate savings are no barrier
    to
    borrowing

    the rest of the planet
    will lend to us
    in dollars
    based
    on the good credit
    our 50 trillion
    net worth

    that
    allows us to buy
    lots of stuff for sale out there
    today
    without today
    producing an equivalent

    so what so wrong
    with doing this ???

    external
    consumption borrowing
    produces long term
    nasty effects
    if the global system
    has
    no significant production slack

    if and when that’s so
    our new flat screen bought on the card
    is crowding out global investment
    investment
    in additional
    state of tech
    productive capacity

    nicely
    todays global plant
    seems to be running
    well under its top rate
    but
    the crunch would come
    if we saw this output gap close
    over the next few years
    and we gringos
    still wanted to borrow overseas
    for consumption
    on our present scale
    then
    the crowding would begin:

    global ” real interest rates”
    would spike
    and we would end up somewhere
    between
    a total overseas
    borrowing back off
    and a serious gringo drag
    on global capacity growth

  • Posted by camille roy

    Charlie, re: offshoring software.

    I am very experienced in this industry and your experience tallies with what I’ve heard. I think we have a problem however, in that we’ve already depleted the software talent in this country, both current and future.

    You probably are aware that computer science enrollment has declined by over a third. An anecdote about the job market for college grads: a young man engaged to a relative couldn’t find a programming job for over a year, after graduating from U.C. Santa Barbara. He only found a job through family connections.

    I think the race to offshore has convinced some existing engineers and many prospectives that the profession doesn’t have a future. The salary declines have already been substantial. If our salaries are to be competitive with Indian salaries, how to finance a middle class life in this country? It can’t be done. Also, the profession simply won’t attract the same caliber of talent – probably is not doing so now. The smart ones can read the handwriting on the wall.

  • Posted by ReformerRay

    i sense at least one of u
    may be
    grappling with an open system problem
    using closed system tools (by Gcs).

    A perceptive comment. S=I in a closed system. For an open system, we write S=I+CAB. That allows us to acknowledge imports and exports.

    In my view, it is a mistake to assume that CAB is exactly the same as S in the closed system case. In an open system, there are multiple sources to fund investment, not just S and CAB. In addition, savings in the closed system requires two time periods. The harvest at the end of the year cannot be planted at the beginning of the same year. In the BEA system, S=I+CAB occur in the same time period. There is no lag between CAB and I. Therefore, CAB cannot be the cause of I.

    Further discussion is possible. The main point is because the level of savings in a closed system controls the level of investment is not a proposition that can legitimately be applied to an open system protrayed by BEA.

  • Posted by Movie Guy

    Brad,

    As you may have noted, there wasn’t any mention of tariffs in my above post.

    The issue, as I see it, is what will be offered in the U.S. to counter the further outshoring / offshoring of production to any foreign location. To that end, I expect that Richard Fisher, Fed Dallas, touched on some of the future effort.

    We may see a government shift toward investment incentives, whatever they may be. I assume that somewhere in the mix will be a move to reduce taxation on corporations and production of whatever in the USA.

    Otherwise, I see nothing to stop further offshoring/outsourcing. Production will continue to find the cheapest sources around the globe. Only major currency shifts and other, perhaps, less desirable moves will slow or stop those shifts. And I don’t believe we see enough movement in currency valuations to pull any major chunk of production back to the U.S. shores unless corporate taxes are trimmed substantially.

    I expect that the investment glut will continue until such time as global demand picks up. And then, growth in investments other than the lowest sources of production will be limited in scope.

    Interesting times.

  • Posted by ReformerRay

    Movie Guy -
    You didn’t see any mention of tariffs in the above posts because tariffs have been ruled out as discriminatory to those domestic industries not favored by the tariff system.

    No one seems to realize that tariffs do not need to be applied to selected industries. Tariffs can be applied to ALL imports from selected countries. Pick out the 5 countries that account for 60% of our trade deficit and apply tariffs to all imports from those countries.

    This will preserve competition among industries in both the countries. It will also allow greater access to the U. S. market by those countries who have been unable to compete, up to now, with the countries who have large trade surpluses with the U. S.

  • Posted by alex

    Movie Guy,

    I sympathize with your comments abount MNC’s. One of the usually overlooked aspects of offshoring sophisticated manufacturing, engineering, R&D, etc. is that it winds up exporting know-how in the affected industries. I realize that know-how (or expertise, technology transfer, or whatever you want to call it) is a fuzzy concept that can’t be directly quantified. That doesn’t make it any less real though. As someone who’s been involved in several startups I know it’s crucial to find people that have it. Basically it’s the result of actual experience in a specific industry. Formal education and published information can’t replace it anymore than a new grad is as useful as an experienced person. It can’t be covered by IP (even if that can be enforced) because it always includes a mass of non-patentable detail and experience based judgement.

    Yes, know-how can be homegrown in other countries. That’s fine, since I have no desire to impoverish the rest of the world. Doing it that way takes time though, which allows wages to catch up with productivity and for displaced workers to adjust. Exporting it wholesale is a bad idea. I would argue it’s an externality because it has been developed over many years by having a good educational system, government funded research and procurement, private domestic investments, a robust domestic market, etc. It’s a valuable commodity that can’t be attributed to any one company, but any one company is free to export it by giving on-the-job training to the next generation of people in another country.

    Lastly, for all it’s fuzziness, it’s obviously valued by countries like China. This is why they insist on technology transfers that involve far more than just patent rights.

  • Posted by Movie Guy

    There are some good posts on this thread.

    camille roy – Dead on. (exactly)

    alex – Dead on.

    Gcs – Right, there is no crowding right now. Not close.

    Glory (guest) – I’ll watch it.

    Charlie – Good points. It’s true that not all offshoring and outsourcing works well. But we’ll see foreign source improvements in the areas where failures or less than pure sucess is achieved.

    ReformerRay – Interesting posts. Just a matter of background, know that some of us have gone through the same drill to open up discussions of U.S. and WTO trade policy. With very few exceptions, trade policy is pretty much a closed if not banned subject on most econ blogs. Mark Thoma (Economist View) recently opened up a valued opportunity to kick it around after Paul Krugman wrote his ‘Big Squeeze’ column last week. Typically, currency valuations and budget deficits are discussed.

    Somewhere back in the archives of Brad’s web log are extensive posts by some which discuss trade policy as best we could.

    The bottom line in my judgment is relatively simple. A nation shouldn’t jump into big trade relations with nations that don’t allow their currencies to float. And WTO shouldn’t extend membership to large developing and capable nations that do not allow their currencies to float. Conditional membership at best should be the consideration… Instead, we have dug ourselves a hole.

    After due consideration of the variables and nonvariables (don’t touch open border trade policy), I drafted the Economic Hydrology Theory shown above. Thus far no one has knocked it down, and I don’t think anyone can because it is very much in play. Moreover, it offers an explanation as to why investments are flowing as they are. So, this is where we are. Much more to come, too.

    Meanwhile, the U.S. GDP growth rate is declining. (Again, not much discussion on this subject.)

    Keep up the good posts. And keep the faith.

    Perhaps we will discuss trade policy when we have given most of other competitive production away. Another slug of auto parts and components are headed offshore, with similar high tech and low tech production to follow.

  • Posted by ReformerRay

    Movie Guy,

    Thanks for your helpful and encouraging comments. I am not suprised that no one attacked my out-in-left-field views. In contrasts to your position, mine is very much open to criticism because it goes beyond what can be documented. You probably are not suprised to know that I have been peddling various versions in as many places as possible for 2 years. Silence inevitably is the response. I attribute the silence to unwillingness to take the time to deal with something that is so contrary to received opinion. Still, it is a puzzle to me. I like to deal with these kind of issues and I can’t understand why others are not intrigued.

  • Posted by Movie Guy

    “I attribute the silence to unwillingness to take the time to deal with something that is so contrary to received opinion. Still, it is a puzzle to me. I like to deal with these kind of issues and I can’t understand why others are not intrigued.”

    Right.

    It’s not so dissimilar from religious discussions. If an economist is married to his/her group of econ models and can’t make them work with the ongoing WTO global trade model, the resistance to consider a new alternative is considerable. Some are actually lost in discussions if they can’t plug numbers into a model or fall back upon theory framework. We’re not talking about real leaders in such cases. They’re wearing shackles in their brains, so they don’t respond well to crisis events or major global changes. It’s sometimes a case of “My model doesn’t work, and I don’t know what to do…”, so the silence kicks in. But the religious faith stays the course. Besides, these people need peer support to have their journal articles approved for publication. So, the econ framework for considering new ideas beyond the basic premises of religious thought can be quite limited. But it is very clear that many do not really understand the full implications of the WTO trade model. In my judgment, that’s because they’re not businessmen and businesswomen who are putting their money in places that count.

    Beyond the basic econ blogs, we have a number of Fed governors who have openly acknowledged that they do not understand some of the ongoing global imbalances. Fed NY governor and Fed Dallas governor most recently discussed these points. See posts at Mark Thoma’s blog for the speech presentations.

    You might be interesting in the views of Peter Morici who is an economist at the University of Maryland; previously served in the Clinton Administration over at the International Trade Commission. His commentaries are published in Finfact (Ireland publication). I talked to him two weeks ago. He gets it.

    It’s very obvious that many economists, including Brad, are betting the farm on correction of currency valuations. The problem, though, is the time lag. It’s easy to point to currency valuations as the problem (of which some are PART OF the problem), but the longer we wait for corrections, the greater the damage will be. And, the thinking that much of the production will just pull up and return to the U.S. is misplaced. As Greenspan noted a few months ago, the majority of the production in China that leaves due to currency valuation changes will shift to other foreign destinations. He is correct, of course. Very little of the production will flow back to the USA because the investment incentives/production cost package is not competitive. Corrections will have to made, and many will be unpleasant.

    We moved the wrong chess pieces, and we’re still playing the same game.