Continuing on Dark Matter

When you first begin on this one it is difficult to lay down the pen. Consequently Dave Altig continues the discussion on the subject responding and reflecting on the comments made from readers to his previous post on the US current accounts. The discussion converges on the difference between investment in home or market production and whether we should be normative in preferring one or the other.

Dave quotes from an old speech by Bernanke ...

'The greater the extent to which capital inflows act to augment residential construction and especially current consumption spending, the greater the future economic burden of repaying the foreign debt is likely to be.'

This seems to be the classical trade off between spending now or later and the question is whether the US has seen a mismatch between the two; the current account deficit certainly suggests so but what about all that Dark Matter then? Dave Altig muses on intial question ...

'I'm not so sure. It would be true that increased quantity and quality in residential housing would do little to raise productivity in market activities, but surely it must raise productivity in home production. It would also be true that devoting more resources to home production means fewer resources for market production.'

The key point however seems to be ... (also Dave)

'(...) home production is, by definition, non-tradable, so investment in housing has a limited capacity to directly generate the means to pay back foreigners who lend to us. That's the sense in which I was agreeing with Roubini and knzn -- the payback would have to come in the form of reducing our own consumption of market goods (again, below what it would otherwise be).'

This is indeed an interesting question which is raised here I believe.

Meanwhile Brad Setser has a tour de force post in which he presents calculations on the US income balance (current account). Be sure to do a quick stop in the kitchen to fill up on those depotes before embarking on reading Brad's post, but it is worthwhile; excellent work indeed. The bottomline is as follows ...

'In this post, I’ll argue that that US lending abroad has a shorter-term structure than US external borrowing. Most US lending and US borrowing is denominated in dollars. Consequently, an increase in US short-term (policy) interest rates tends to increase the return on US lending abroad faster than it increases the interest rate the US pays on its borrowing.

In the first half of 2006, this effect turned out to be quite significant – slowing the pace of deterioration in the US income balance. US lending abroad is around $3.9 trillion (end 2005 data), so a gap on US borrowing and lending rates can have a significant impact on the overall income balance.

But as US policy rates stabilize and the interest rate on US borrowing catches up with the interest rate on US lending, this effect will disappear. The result: higher net income payments, even if the gap between the returns on US equity investment abroad (decent) and the returns on foreign equity investment in the US (embarassingly low) continues …'

(...)

Let us move on to the question of Dark Matter shall we ... (BTW; Hausmann and Sturzenegger have revised their original paper ... see the new one here.)

'Hausmann and Sturzenegger postulated that the US borrowed cheaply from the rest of the world to lend money out at higher rates. Think of it as borrowing cheaply from the People’s Bank of China to buy high yielding Brazilian debt. The argued that the United States ability to provide a safe store of value allowed the US to earn an “insurance” premium. The US offered the world’s investors safety, and then put the funds that came in to work.

It was an interesting idea, but it didn’t turn out to be true. The amount of US lending to high-yielding emerging economies is very small relative to total US lending to the world.'

Needless to say that Brad's post contains much more for you to discover so my suggestion is to go read it.