Saturday, December 18, 2004

Contrarian macro numbers

Here are some numbers suggesting the US current account deficit is sustainable. They come from a 10/31 FT article by Richard Cooper, Harvard economics prof and former undersecretary of state for economic affairs.

Cooper assumes a continuing US account deficit of $500B, which is 5% of current GDP. (This year it is a bit bigger - at 6%, but going forward $500B is not implausible.) If US nominal GDP growth is 5% (3% real + 2% inflation), the fraction of US assets owned by foreigners as a consequence of the account deficit will rise over the years (due to payments), but not unsustainably.

From the rest of the world's point of view, the numbers are also not necessarily alarming. The ex-USA world produces $6 trillion per year in savings, so the account deficit means the US absorbs 10% of savings from other countries. Let's think about this a bit - if US GDP is $10 trillion, then ex-USA GDP is $30 trillion, so $6 trillion represents a world ex-USA savings rate of 20%. This seems a bit high to me (although the savings rate in China is reported as 40%!), but is confirmed by this Morgan Stanley report (How Depleted is the Global Savings Base?): ... the deterioration in the US C/A has been matched by an even larger accumulation of overseas savings.   As a result, the US now absorbs a smaller share of the rest of the world’s savings compared to the historical trend.  A related figure, which is often reported, is that the US account deficit absorbs almost 80% of foreign trade surpluses (usually the reports confuse foreign savings and foreign trade surpluses). Now, the US is 25% of the world economy, has 50% of marketable financial assets, and higher economic growth rates than either Europe or Japan, making it a desirable destination for investment. So perhaps absorbing 10% of foreign savings is sustainable. A portfolio manager might advise foreign investors to place at least that amount in US assets each year.

From this macro perspective, a meltdown is not inevitable. However, investor sentiment is a tricky thing. If foreigners become convinced that the dollar must decline in the coming years, they are unlikely to allocate 10% of their savings to US investments, even if we are a large and relatively dynamic component of the world economy.


Anonymous said...

Richard Cooper bases his argument on two points:

1: a current account deficit is consistent with a stable external debt to GDP stock (true), and with cooper's assumptions,a current account deficit of 2.8% of GDP is consistent with a stable debt to GDP ratio (that is something cooper suggests the US will hit in 2018, when the US debt to GDP ratio peaks at 46 % of US GDP)

2: it is reasonable to think the world will continue to lend the US $500 billion of its $6 trillion in annual savings -- 10% of world savings is not so much in globalized economy, particularly if the United States need to import external savings will fall over time in relation to a growing supply of savings from a growing global economy.


An interesting response from Brad Setser. My sense is that Richard Cooper's analysis does not hold, though we could wish it might.

Steve Hsu said...

I also feel Cooper is too sanguine, although I thought I should present some arguments from the other side :-)

One problem is that there is no evidence that recent inflows are really foreign investors diversifying their portfolios into dollar assets. I discussed this in a post entitled "Raw Data" back in November:

FT: ...Within the US political debate, the administration often paints the current account deficit as a success story. The refrain is that the US has an excess of investment opportunities which foreigners want to use. That was true until 2000, when investment as a share of US GDP was growing. But since then the share has fallen and it does not explain the growing current account deficit. Rather, as the US government began to borrow heavily, national savings fell even faster, causing the current account to deteriorate further.

...Net capital inflows in the year to September, at $657bn, exceeded the $445bn trade deficit over the same period. But Ashraf Laidi, currency analyst at MG Financial Group in New York, points out that foreign demand for US assets has been falling. A year ago, the US was importing twice as much capital a month as it needed to cover the trade deficit. The gap has narrowed: the $63.4bn of capital imported in September compared with the $51.6bn trade deficit in that month.
Even though the macro numbers can support this shift of savings from foreigners to the US, it may be a very bumpy ride!

Anonymous said...

Nicely done.

Anonymous said...

Vanguard Returns
12/31/03 to 12/17/04

S&P is up 9.1%
Growth Index is 5.5
Value Index is 13.5

Mid Cap Index is 18.4%

Small Cap Index is 17.9%
Small Cap Value is 21.6

Europe Index is 16.9
Pacific Index is 13.2

Energy is 34.3
Health Care is 7.7
REIT Index is 29.0

High Yield Corporate Bond Fund is 8.2
Long Term Corporate Bond Fund is 8.5

Anonymous said...

National Index Returns
12/31/03 - 12/17/04

Australia 25.2
Canada 17.5
Denmark 25.2
France 13.9
Germany 11.9
Hong Kong 22.4
Ireland 38.8
Japan 10.1
Norway 48.1
Sweden 32.2
Switzerland 11.4
UK 17.5


brad said...

I see that the enterprising Anne has referred you to my arguments against cooper. I think they can be summarized in four points:

1) Getting to a $500 billion current account deficit over time requires a very significant adjustment in our trade deficit -- probably the kind that takes our deficit down to zero. Over time, a growing share of the current account deficit will be interest payments on our existing debt. A little known point in the theory of external debt sustainability (taking a stable debt to GDP ratio as a proxy for external sustainability) is as follows: a stable debt to GDP ratio is consistent with a permanent current account deficit, but not with a permanent trade deficit. right now our trade and transfers deficit is close to 6% of GDP.

2) Our current account (and trade) deficts are still rising, not falling, both absolutely and as a share of GDP -- i.e. we are moving away from the $500 billion a year current account deficit envisioned by cooper, not toward it.

3) As you note, given that there is a substantial dollar adjustment in store in most scenarios that bring the trade deficit down to levels consistent with a stable debt to GDP ratio, it is not clear why foreigners would want to finance the US at current rates (foreigners right now are buying agencies and treasuries, which don't carry high yields). Right now, private investors from abroad are not dumping tons of money into US assets -- most of financing is coming from central banks (the actual level of central bank financing is understated in the official data -- see a NY Fed paper by Higgins and Klitgaard).

4) Greenspan's concentration of risk point applies -- if foreigners are putting most of the savings that they abroad rather than at home in the US (as is the case now), they all have portfolio's concentrated in two sets of assets -- their "home" country's assets, and US assets. So China has lots of money in China and the uS, India lots of money in India and the US, Europe lots of money in Europe and the US -- but everyone has most of the external savings invested in the US rather than in a diversified basket of countries. In fact, current deficits imply a rising share of US assets in their "foreign" asset portfolios. AT some point, they will want a more diversified portfolio -- (i am leaving a few things out -- i.e. asset swaps without net flows that finance current accoutn deficits that could provide some diversification -- but this is getting long ... ).

None of this says that the US external debt cannot rise from a bit under 30% of GDP (end 04) to a bit under 40% of GDP (end 06, on the current trajectory) -- i.e. foreign central banks could keep financing the US, and foreign external portfolios could keep getting more concentrated. But the longer the US goes before it start to adjust and reduce it external borrowing needs, the greater the risk the US will lose the ability to keep adding to our external debt at our current pace quite suddently, and face unpleasant consequences ...

so I do think cooper is rather too sanguine

p.s. I have enjoyed your commentary on volatility.

Anonymous said...

Who's Afraid of China?

Austin, Tex.

SHAYNE MYHAND, the day-shift manager of Dell's flagship factory here, does a lot of chaperoning. As many as four or five times a day, he finds himself playing host to corporate chieftains and midlevel scouts who come to marvel at the dazzlingly efficient assembly plant that may be the best hope for keeping blue-collar jobs in the United States.


Steve Hsu said...

Brad and Anne,

Thanks for the interesting posts. An honor to have you on my blog :-)

Anonymous said...

A comment you made about international stock markets, reminded me of a puzzle. There appears to be a persistent skew of international stock returns in favor of value stocks as defined by Morgan Stanley. The same skew appears in American small cap stocks. I think I am reading the data properly for starting point of 10 year periods seems to matter little. Why the persistent skew? I do not know.

Thank you, Steve :)

Steve Hsu said...

I seem to have seen some studies which conclude that US value (low P/E) stocks have outperformed historically - I don't know about foreign stocks, though. It may have been in Jeremey Siegel's book Stocks for the Long Run, which I highly recommend as a source of historical equities data. Your university or public library almost certainly has a copy of it.

There is some nice data here on historical risk and return of various asset classes (although not organized by P/E):

Anonymous said...

Value and growth criteria are set not p/e or dividend, but price to book ratio. Jeremy Siegel is excellent. The difference between growth and value stock returns in America is questionable for the S&P, but striking for small cap stocks. I will look to Duke.

Anne :)

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