Over the fold, my column in today’s Fin, which deals with the latest “don’t worry, be happy” theory on the US (but not Australian) current account deficit.

A dark matter of deficits

AFR 22/12

Given the unwillingness of the Bush Administration to offer any policy response to the massive growth in US budget and current account deficits, it is not surprising to observe a steady stream of theories explaining that such deficits can be sustained indefinitely.

The latest put forward by Ricardo Hausmann and Fredrico Sturzenegger of the Kennedy School of Government at Harvard, uses the catchy idea of ‘dark matter’, a reference to the unseen matter cosmologists believe is necessary to explain the observed properties of the universe.

Such hypothetical forms of matter have a patchy history. Successes include the prediction, by the Big Bang theory, of the cosmic microwave background radiation, discovered in 1963. In the eighteenth century, on the other hand, physicists posited the existence of a substance called phlogiston, with negative mass, suppose to be emitted in the process of combustion. In reality, substances gained mass during combustion because they combined with oxygen.

Another hypothetical substance was the luminiferous ether of the 19th century supposed to carry light waves. Einstein’s theory of relativity eliminated any need for the ether and the idea has been discarded.

Hausmann and Sturzenegger use the idea of dark matter in a couple of ways. The first (fairly uncontroversial) is to argue that while the official accounts show that the US is a large net debtor, the fact that the income account has shown a small surplus for most of the past two decades suggests that the value of US assets overseas is understated. The unmeasured excess is referred to as dark matter.

The second idea is to argue that, since the income balance has been roughly stable over the past five years, the massive trade deficits of that period must have been offset by steadily increasing exports of dark matter, totalling around $3 trillion. Hausmann and Sturzenegger suggest that this dark matter consists of such things as seignorage on US currency, the expertise embodied in operations like EuroDisney and the capacity of the US to provide implicit insurance services.

Something like this must be true if it is assumed that the willingness of foreign lenders to support the trade deficit is the rational outcome of efficient markets. In this sense, the ‘dark matter’ hypothesis is very like phlogiston. No-one would believe in its existence if it were not necessary to make the theory work.

In 1999, after all, the US economy was riding high. The dotcom mania was in full swing and a stream of books promised a golden future, with an unending boom and the Dow rising to 36 000. The US government had balanced its books and was projecting a surplus of $US5 trillion over the period to 2010.

Is it really plausible that the last five years, with the collapse of the dotcom boom, the emergence of chronic government budget deficits and weak employment growth have increased international faith in the US to the tune of $3 trillion, as claimed by Hausmann and Sturzenegger?

There have been some important positive developments in the US economy in this period, such as strong growth in output per hour. But this ought to have led to an inflow of equity capital. In fact, foreign investors have generally withdrawn equity capital from the US in this period.

There are some technical difficulties with the ‘dark matter’ analysis. A crucial analytical assumption is that assets should be valued according to the average value of the returns they generate. In fact, however, the riskiness of returns is equally important. The visible transactions in the national accounts show that the US has built up a large stock of short-term debt, which offers relatively low risk in the absence of an exchange rate collapse. By contrast, the putative dark matter is illiquid and almost certainly highly risky.

The real problem though is that Hausmann and Sturzenegger overlook the obvious explanation for the recent strength of the US income balance. For most of the period since 2000, US interest rates have been exceptionally low. Given the importance of short-term debt, this obviously improved the balance temporarily. As interest rates have risen, however, the income balance has turned negative, and this trend will accelerate as debt is rolled over.

One final point. If the sustainability of the US current account deficit is explained by ‘dark matter’ what does this say for Australia? It’s hard to believe that we share the supposedly unique capacity of the US for seignorage, insurance and so on. The ‘dark matter’ hypothesis actually makes Australia’s chronic deficits look less sustainable.

John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland.