No Warm Glow from the Nobel Prize Here

Or more precisely, one of this year’s Nobel Prize winners in Economics seems to disagree with parts of the analysis Nouriel and I have been putting forward. It seems like Nouriel and I don’t understand balance sheets ...

"The U.S. (current) account deficit, no problem. People that say there is (a problem) are ignorant, they do not understand something called balance sheet, present value, something that a good undergraduate (economics student) learns," [Nobel Laureate Edward] Prescott said.

That is news to me.

I personally thought our analysis of US external sustainability was very focused on balance sheets, both the US external balance sheet and the balance sheets of foreign central banks.

Our assessment of the US external balance sheet looked at assets as well as liabilities. Shock, shock -- we have more liabilities than assets, and our liabilities are rising fast, both relative to US GDP and US exports. So our net external debt is rising -- though in a some years (2003) the US gets lucky and the value of our existing assets rises, offsetting the rising liabilities from our current account deficit.

The rise in US external liabilities v. our exports number is by far scarier than the rise against GDP, as Martin Wolf highlighted today. When you borrow 5% of GDP every year and export only 10% of GDP, you mortgage your future export revenues pretty rapidly. The "asset" that offsets rising US external liabilities on the US balance sheet is our future trade surplus -- technically, our future surplus in trade and transfers. External debt is a claim on future exports revenues, just as Treasury debt is a claim on future tax revenues. Since the interest rate on US external debt is very low now and will remain low absolutely (though a bit more than it is presently) as long as the US dollar remains a reserve currency, the US can probably get by if its trade deficit moves close to zero. That would keep our external debt to GDP ratio constant.

The problem with the US external balance sheet is that our net external liabilities are going up fast, and the implicit offsetting asset -- our future capacity to balance imports and exports, if not to run future trade surpluses (appropriately discounted of course) -- only can be created by painful economic adjustments (a falling dollar, less US consumption, higher interest rates leading to lower asset values), both here in the US and in the rest of the world.

Nouriel and I also pay careful attention to another aspect of the US external balance sheet: the currency composition of US liabilities (mostly in dollars), and US assets (roughly half in dollars and half in other currencies). It turns out that the majority of US assets denominated in foreign currency are in Europe, not Asia. The US enjoyed the big valuation gains in 2003 on back of the dollar’s fall against the euro -- a rising euro meant the dollar value of US investments in Europe went up [corrected,I initialy got my dollars and euros reversed, Brad]. The adjustment in the dollar’s value against East Asian currencies -- necessary for reducing the trade deficit -- won’t generate comparable valuation gains. We did the math: we won’t be saved by windfall capital gains on our overseas assets as the dollar falls.

And remember, the rest of the world’s aggregate capital losses in the event of balanced dollar depreciation against all the world’s currencies would far exceed the United States’ capital gain. Almost all the world’s claims on the US are in dollars, while only a fraction of US claims on the rest of the world are denominated in foreign currency. [Revised and edited for clarity -- Brad]

Our argument against the sustainability of the current system of central bank financing of the US trade deficit is fundamentally a balance sheet argument: US external debt is another country’s external asset, and since the US currency account deficit is absorbing most of the world’s current account surplus (its external savings), the share of US assets on other countries balance sheets is rising. Remember the "concentration risk" Alan Greenspan discussed in November? These claims on the US -- often held by foreign central banks -- are often in low yielding dollar debt. Our argument against the stability of the Bretton Woods II system of central bank financing of US deficits is that other countries are not being sufficiently compensated for the risks that are accumulating on their balance sheets. Even central banks eventually will worry about the risk of future losses on their dollar reserve assets.

Prescott recognizes this:

"I don’t know why the Chinese are subsidizing the Americans so much, holding all this American debt that pays very, very low interest rates," he said, adding: "It’s ridiculous for them to hold too much. It’s not in the interest of the Chinese people. ... They are not just going to keep accumulating American dollars ad infinitum (forever), there’s going to be adjustments within a couple of years, it’s not a matter of whether, it’s a matter of when."

I would love to hear someone tease out why Prescott thinks the end of the Chinese interest rate subsidy won’t be problem for the US -- particularly given that sheet amount of debt (both domestic and external) on America’s balance sheet -- as well as why he thinks the US external balance sheet is so sound. The US debt to export ratio now is much worse than Brazil’s ... to take one example. Brazil external debt is heading down and its exports boomed recently. US external debt is heading up and our exports -- while growing strongly this year after several bad years -- are not keeping pace with import growth.

I recognize that this is a rather wonky economist geek speak post. I also am discussing central bank financing of the US trade deficit in a Q&A format for the Neiman foundation. Hopefully, I am using accessible language there!