With the US current account deficit close to a trillion dollars of course foreigners will soon own most of the US capital stock
The current political saga and debate about the purchase by a Dubai-based company of the management of six US ports misses the most crucial point: with a US current account deficit running towards $900b this year and probably above one trillion $ next year, in a matter of a few years foreigners may end up owning most of the U.S. capital stocks: ports, factories, corporations, land, real estate and even our national parks. This is basic accounting: if you run a current account deficit (import more than export, spend more than your income, save less than you invest) you need to borrow from the rest of the world to finance such excess of spending (on private and public consumption and investment) over your national income. And you need to borrow on net every year to the tune of the current account deficit. That is why countries that run current account deficits become net foreign debtors. There are only two ways in which this accumulation of foreign liabilities of a debtor country can occur: either debt (when you issue private or government bonds purchased by foreigners and when you borrow in the form of bank or other loans from foreigners) or equity that can take the forms of FDI (foreign direct investment when non-residents acquire a domestic firm or other domestic assets such as real estate or when they build a new factory in the US) or portfolio investment in the equity market. So, it is either debt or equity but in either case the foreign liabilities of the US go up and foreigners increase debt or equity claims against the US. It is as simple as that and, with a trillion $ current account deficit the US foreign liabilities will increase every year by a trillion dollars.
Now, until recently, foreigners have financed the US current account deficit more in the form of debt rather than equity. Since a good fraction of this current account deficit was driven in the 2004-2005 period by the growing US fiscal deficit, the foreigners have piled up more and more Treasury bills and bond. Indeed, by now over 53% of all Treasuries are held by non-residents, a good fraction of which by foreign central banks. But, increasingly, foreigners are starting to realize that exchanging their goods and services for lousy low-return IOUs of the US government is a most lousy deal for them. Why to hold Treasuries that give you a mediocre 4.5% return over 30 years when you can instead buy higher return capital such as US corporation, US factories, ports, real estate and any other asset currently owned by American in this great land of ours?
The nationalistic political backlash against this foreign acquisition of US capital it altogether hypocritical. Foreigners are selling us their high quality goods and services because we are on a national consumption binge and they are getting tired of getting in return useless low-return IOUs of the US government. There are plenty of great assets and gems in the US that are much more worth and provide in the long run much higher returns than T-bills. So, they rationally want to buy those assets, i.e. lend us in the form of equity rather than debt. An these foreigners are, increasingly, not just private investors but also central banks and other public authorities that have accumulated low-return dollar reserves to the tune of almost $400b last year alone with a total stock of such dollar reserves that is close to $3 trillion now. Also, altogether hypocritical is the behavior of US politicians who lobby hard all of the world to open up their markets to US foreign direct investment and now they are screaming, under the fig leaf of national security, about the foreign FDI into the U.S. And a big fig leaf it is as “national security” arguments have always been the first and last refuge of protectionist scoundrels. In France, the attempt by a US company to buy Danone, a yogurt producer, was repelled based on similar national security – or national pride – arguments; and such French resistance led to rightful mockery and scorn of such French yogurt nationalism. Now, both in the CNOOC-Unocal case and the Dubai-port case, national security scoundrels are hiding behind a flimsy national security argument to stop an altogether legitimate business transaction. Unfortunately, since the US is hollowing out the only goods and services that we are still producing at home are weapons, airplanes, high tech good, oil and other important commodities, financial services and other high tech services. And for each of these goods/services, one could make the argument that they are of some “national security” interest; any of these goods may have in principle military or security implications, even our ports as the current saga suggests. Unfortunately, for a country like the US whose core industrial base is hollowing out these are the goods and services that are up for sale and that foreigners want to buy. So, we may want to get used to it.
Also, the worry about unfriendly regimes is somehow misplaced as, unfortunately, the countries that are now financing the US current account deficit are not our friends and allies but, potentially, our geopolitical rivals or unfriendly states. In the 1980s, the biggest financer of US twin deficit deficits were the U.S. geo-strategic allies: Japan and Europe. Today instead, the biggest financers are of the U.S. twin deficits are China, Russia and Saudi Arabia. China is potentially the most significant strategic rival of the US or, at least, a strategic competitor; Russia is a relatively unstable country that is not a US ally and is becoming increasingly authoritarian; while Saudi Arabia is an authoritarian and unstable regime that has been using a small part of its accumulation of petrodollars to finance Islamic fundamentalism around the world. So, for its own financing the US is effectively captive to the political decisions of potentially unfriendly states, an indeed worrisome “balance of financial terror”. The war on terror and the war in Iraq are being financed by China, Russia, Saudi Arabia and a bunch of other unfriendly or unstable countries (Nigeria, Venezuela, Iraq, etc.). And all these countries and their private and public investors, whether friendly or unfriendly, now increasingly want to buy US equities rather than useless bonds. So, a Chinese company recently acquired the PC division of IBM and Chinese companies are already managing parts of US ports. So, whether we like it or not we will, increasingly, sell all of our assets and capital stock to foreigners, whether these foreigners are friendly or unfriendly to US. And since one can expect, at current trends, US current account deficits of at least one trillion dollars a year from next year on, one can forecast that, if an increasing fraction of the inflow of capital into the US will go into equities rather than debt, an increasing fraction of the entire US capital stock will, in a matter of a decade, be owned by non-residents. Not that there is anything wrong with that from the foreigners point of views: they will sell us their goods and services and they will require to be paid not in IOUs but rather real assets and the gems of the US capital stock. It is only a fair trade. And if we do not like that as a nation, maybe we should start taxing the rich, cut our budget deficit and have more public savings as we did in the 1990s; we should consume less, save more and build less homes that are increasingly bubbly. The alternative is clear: if we continue with our current patterns of spending above our incomes, by 2013 the US foreign liabilities could be as high as 75% of GDP and an increasing fraction of such liabilities will be in the form of equity, i.e. foreigners owning our capital, real estate, assets, ports, parks and whatever other national gems we own. It is simply a matter of basic national income accounting: if you spend more than your income, the willingness of your creditors to lend you money will eventually shrink and you will be instead forced to sell them your real assets rather than IOUs and debts on which you may eventually would want to default on.
Any smart creditor know he/she needs collateral against its credit claims; and there is no better collateral than taking over directly the assets of the reckless debtor. Caveat Emptor!
So, let us stop whining about the dangers of unfriendly foreigners owning our firms and assets and get used to it. Unless we change our spending habits and stop our reckless fiscal and economic policies that are leading to the hollowing out of the US as a competitive producers of goods and services in the global market, the Chinese will indeed own most of America and its assets.
Yes, China should let its currency appreciate over time as an undervalued RMB is partly behind the loss of US competitiveness. But let us not kid ourselves: our fiscal and external deficits and accumulation of debts have much more to do with our reckless fiscal policies and a reckless consumption binge that is sustained by a housing asset bubble that will eventually pop than anything to do with what China does. And we should be thankful that China has been willing so far to finance us at low interest rates and thus allowed the reckless deficits of the US government and the US consumer.
But now China and our other creditors want us to sell them our best china rather than useless pieces of paper in exchange for the cheap and high quality goods that they are producing. If we balk and refuse and start using national security arguments to prevent that, they may just tire of financing us and may decide to dump our worthless IOUs; we may thus be better off shutting up and welcome their willingness to, at least buy, US real assets and capital on which they may still suffer severe capital losses once the dollar starts to depreciate against their currency. They are kind enough to still desire dollar assets when such capital losses are all but certain. But even a dumb creditor knows that it is better to suffer a capital loss on a productive assets that may give you a 10%-15% nominal return per year than on a piece of papers that gives you a crammy 4.5% per year for the next 30 years. So much for the U.S. dark matter and mysterious intangible assets; with our policies we are instead digging ourselves in a bigger and bigger black hole of liabilities that will eventually sink us all.
38 Responses to “With the US current account deficit close to a trillion dollars of course foreigners will soon own most of the US capital stock”
Charlie • February 22nd, 2006 at 2:49 pm
I don’t see any signs that China wouldn’t be willing to buy our debt. If China hasn’t slowed purchases at this point, why would they stop next year? or the year after? They must have concluded by now that their sterialization efforts are going to lose money. They would rather keep the US as a customer and work hard for small gains. The US doesn’t have to pay with assets. We can print money since the debt is denominated in USD. What can they do about it? If they stop loaning us money, the value of USD drops and their labor costs are no longer competitive. In time, US wages go up as demand for our cheaper products picks up and we longer need their financing.
bsetser • February 22nd, 2006 at 5:41 pm
Nouriel — so long as China is willing to lend at low rates, why would the US stop its (reckless) fiscal policy and consumption binge. i am not quite sure why you think these activities are independent of the willingness of China and the oil states to finance them. Without the financing, big fiscal deficit and a surge in consumption would have pushed interest rates up, and higher rates would generate more political pressure for fiscal adjustment and helped to limit the consumption binge. i.e. these policies would have been more costly. so i am not quite sure why you think the US should thank China for financing reckless policies, since without the financing, maybe the policies would be less reckless. In this case, it seems to me it takes two to tango, and i do think the overall outcome we have observed over the past few years has been jointly determined. easy financing has made reckless policies feel less reckless, and made it harder to mount a political case for adjustment. US fiscal policy was less reckless in 05 than in 04, and, in part because of continued easy financing from China and the oil producers, US rates stayed low and US consumers just spent more, pushing the current acocunt deficit up. all in all
Johan Panzer • February 22nd, 2006 at 6:20 pm
The US dollar needs to collapse against third world currencies; its time to end the paper dollar standard. There are only some 300 million Americans whilst the rest of the world population consists of some 5 billion citizens. If we collapse the dollar and instead revalue the currencies held by the remaining 5 billion citizens on this planet we create a much more balanced global consumer market that will easily make up for the loss of the American market whilst we wait for the Americans to sort out their miserable deficits and pay for all the debts they have accumulated and in the process clean up the tremendous corruption of the American political process (in the last presidential election the two candidates raised U$ 1 billion to try to purchase the presidency- the US therefore is no longer a representative democracy- its time to write off America to the history books-they have become more corrupt than the Romans in their most corrupt last days). The world pays too much attention to the Americans; never forget that there are only 300 million Americans and that the rest of us number some 5 billion. Forget about the Americans therefore and lets turn the rest of the planet into a vibrant market; that means wiping out the dollar standard and pegging all currencies against a basket of commodities or going back to the gold standard. That would raise the purchasing power of 95% of the planet and everybody would be better off.
STARK • February 22nd, 2006 at 7:17 pm
None of this would be possible if it weren’t for Uncle Allen’s counterfeiting machine. Dollars for everyone and then some more. Deflation is worse than inflation, but balance is better than both. Unfortuneately, it’s a little late in the game. What we have here, me thinks, is inflation. The US counterfeiting operations are only matched by China, Japan, Korea, Germany, England,etc. As far as the mercantilists providing the US with cheap financing because of a “worldwide savings glut”, hogwash. The mercantilists are simply recycling dollars to keep the currency off the world market. The mercantilists thank God every night for GW and the profligate, conservative? US government. The low interest rates are simply a part of the mercantilist manipulation of the world’s currencies made possible by an over-abundance of dollars in the first place. The only solution is a Fed induced recession and excess dollar mop-up operation. It can be a painful correction now, or a cataclysmic correction, later. The Fed has been tippy-toeing with the 1/4 point increases when a few 50 BP’s are called for. Meanwhile, the “imbalances” continue to grow and inflation takes a foothold. Once the recession takes hold, we can resort to the Keynsian cure, excess government spending and rapid money supply growth. Oh, we’re already resorting to that. Does anyone remember the RTC ?
HK • February 22nd, 2006 at 10:14 pm
A very good article to remind US people and policymakers of the cost of having huge current account deficits year after year; you cannot continue issuing fiat money (IOUs) without paying increaingly high cost (interest rate) or selling your precious assets. Australia has maneged continuous current account deficits only by selling its natural resource reserves to foreigners. Of course, the US can reject selling of strategically important assets like aviation companies, essential infrastructures, or natural resources, but only through paying more and more interests or accepting eventual stoppage of borrowing (default). In either case, the US economy will suffer from a major recession. Then the global economy will also be seriuously affected. At this stage, neither the US nor major creditor countries (China, Korea, Taiwan, Singapore, Russia, Saudi, and other oil producers as well as Japan and Germany) are taking any policy measures to significantly reduce the global imbalances. I am afraid that the world economy may be destined on a crash course.
touche • February 22nd, 2006 at 11:01 pm
After you first realize that we’re nearing economic armageddon, it takes a few months for the shock to wear off. Then there’s denial, anger and acceptance. Be sure to bullet proof your portfolio along the way.
Dave Chiang • February 23rd, 2006 at 11:00 am
The primary driver behind the U.S. trade deficit is the addiction of so many American consumers to spending far more than they earn, courtesy of the housing bubble ATM machine. Excuse me, does everyone in the United States need to drive a gas guzzler SUV and live in a million dollar McMansion? Here in central New Jersey, every square acre of farmland is being developed into McMansion housing tracts and strip shopping malls. Inflating the housing bubble, Fannie Mae and Freddie Mac provide federal government guaranteed mortgages to anyone that can eat and breathe. And let’s stop pretending that the American middle-class family’s appetite for all sorts of cheap junk is the product of some Chinese-hatched communist conspiracy. Until the American public starts balancing their family budgets, and until Washington gets its own spending habits into better balance, a substantial trade deficit will be with us for the foreseeable future. Of course, if you listen to the Washington politicians and Economics media, the deficit problem would be resolved if only the Chinese yuan currency were revalued. A yuan revaluation, or a tax, would have to be massive to dent China’s hypercompetitive export ability, and neither would solve the root cause of U.S. woes — spendthrift habits and a seemingly arrogant inability to produce the kind of goods that the world wants at an affordable price.
PierGiorgio Gawronski • February 23rd, 2006 at 11:32 am
THE BALANCE OF FINANCIAL TERROR IS A WRONG IDEA I like your blog, Nouriel, but I just don’t buy the “balance of financial terror” story. And I don’t like it. By “balance of financial terror” one usually refers to the danger of (China?) dumping all its official reserves in one day (or in a few days/weeks) to cause collapse of the dollar and of the US economy. It’s a silly idea to implement: China would never harm itself this way. But ASSUMING they tried it: First, the DAILY TURNOVER in forex markets is about 1,5-1,6 trillions: roughly the double of China’s entire dollar reserves. The implications are straightforward: even if a foreign Central Bank decides to “attack the US” financially their “weapons” would be too small to cause anything but a brief blip (or collapse) in the value of the dollar: a minor nuisance for the payment system, and an excellent buying opportunity for all of us, including the US. China would be selling at “crash prices” its dollar (assets) dearly paid, who would recover their value soon afterwards. China would have nuked itself! Assume worse: that they are so powerful (in 2013) that – by “firing” all they have in one day – they manage to actually push the dollar value to zero, even find no more $ buyers on the market that day. Big deal? No. Their problem, then it’s over. Second, if you assume that they sell dollars slowly (let’s assume 1/100 of their reserves every day for 100 days), this may cause only a welcome gradual depreciation of the dollar. Maybe the dollar trend would turn into an “overshooting”, but again China cannot push things too far against the will of the market (eventually inspired by an appropriate reaction of the FED, who can raise interest rates if needed to stabilize the dollar exchange rate). Why would China’s sales (about 1/200 of the daily turnover) be more relevant than the buying and selling of other market participants (who would account for 99,5% of the total turnover), is unclear to me! Third, NO SERIOUS STUDY to my knowledge has ever demonstrated the feasibility and the dangerousness of such a (Chinese, or whatever evil ax) “nuclear finance” strategy. Thus it seems to me that the idea of “balance of financial terror” is only a journalistic catch-word. It should not be used lightly by economists, else it becomes an accepted platitude that provides ammunitions to non-economist students of international relations (and diplomats and policy makers) for distorted analysis, maniacs, and reactions. We live in a world of uncertainty, suspicion, and growing protectionism; foreigners are too easily depicted as “evil” just because they are different from us: let us not add ridiculous fears to actual ones. Regards.
vorpal • February 23rd, 2006 at 3:35 pm
Nouriel: I was in a coffee shop and a Republican (I know him) came up to me and exclaimed, “They’re going to sell our ports to the Arabs!” I replied, “What do you expect, we have a huge trade deficit, of course they’re going to buy our assets.” He was clueless. As for the fear of terrorists and the like. This President has made virtually all of his hay by selling fear of terrorists to the American people. Now he doesn’t want Americans to have an “unreasonable” fear of terrorists from the UAE. He wants it both ways. “Be paranoid only when I want you to be paranoid.” I don’t think this wish is consistent with human nature. Once people are scared, they stay scared. (a la nuclear power) unless they have a darn good reason to change. Finally, I would like to know what assets foreigners with US dollars will attempt to purchase. Could we see a Chinese company (out of Shanghai?) buy General Motors much akin to Lenovo purchasing IBM PC? Will they wait for a large drop in the stock market to maximize their purchasing power? Will they go after agricultural assets? Would they buy Citigroup? Your post affirmed my thoughts, but it did little to answer the questions I have! 
All the best.
pd98004 • February 23rd, 2006 at 10:00 pm
Nouriel, your comments are of course correct (maybe not the tone). Brad Setser makes a valuable addition, I very much agree. However, how come nobody mentions that this is a STATE-OWNED company, like CNOOC, that does change the issue a bit. Purchases can be made for not entirely business reasons. It is one thing for Lenovo to purchase the PC division of IBM and something different for a state-controlled vehicle. Should the People’s Army, with their vast business assets, be allowed to purchase assets in the U.S. – of course not! I believe DP World outbid Temasek, or was it Hutchison? . . by a considerable amount. Not that I am arguing that DP has alterior motifs, I am not. But what about the specific issue of state controlled companies purchasing important assets in the U.S.? What are your thoughts? Otherwise, yes the world is just beginning a dollar asset buying binge of the scale described above and should be allowed to do so. Thought: flush with cash will the Chinese, Saudis, etc. overpay for assets to an even greater degree than the Japanese did for Pebble Beach, Rock Center, Sony . . .? Don’t know how we will buy it all back though?
pd98004 • February 23rd, 2006 at 10:00 pm
Nouriel, your comments are of course correct (maybe not the tone). Brad Setser makes a valuable addition, I very much agree. However, how come nobody mentions that this is a STATE-OWNED company, like CNOOC, that does change the issue a bit. Purchases can be made for not entirely business reasons. It is one thing for Lenovo to purchase the PC division of IBM and something different for a state-controlled vehicle. Should the People’s Army, with their vast business assets, be allowed to purchase assets in the U.S. – of course not! I believe DP World outbid Temasek, or was it Hutchison? . . by a considerable amount. Not that I am arguing that DP has alterior motifs, I am not. But what about the specific issue of state controlled companies purchasing important assets in the U.S.? What are your thoughts? Otherwise, yes the world is just beginning a dollar asset buying binge of the scale described above and should be allowed to do so. Thought: flush with cash will the Chinese, Saudis, etc. overpay for assets to an even greater degree than the Japanese did for Pebble Beach, Rock Center, Sony . . .? Don’t know how we will buy it all back though?
Bert Hofman • February 24th, 2006 at 1:19 am
The premise of your article seems to be that the US capital stock is fixed. This seems far away from the truth. Existing housing, enterprises, land becoming more valuable–so if you want, the US is using some of its increased equity in the stock of capital–the capital stock is also growing–through investment in physical and human capital and innovation. Surely, this increase in the (value of) the capital stock is much more than 6 percent of GDP.
Guest • February 25th, 2006 at 2:38 am
Imagine how stupid anyone would think me if all I did was speak about one’s debts, ignoring their assets. Every corporation or person, save a rare exception, has debt. What gives the full financial picture is the inclusion of their assets. Why so many able, knowledgeable, and expert people neglect this crucial component is beyond my understanding. The US is the wealthiest country on this earth. No one comes even a close second. Regards, Gary Marshall
Dave Chiang • February 25th, 2006 at 8:33 am
To Nouriel, For the past two decades, the United States has been relying on geo-political externalities, rather than developing domestic industrial production for “real” economic wealth. US Dollar hegemony has allowed the United States to live beyond its means for far too long. Even Brad Setser has commented that the Federal government has been able to finance massive budget deficits without an economic dislocation that would have provided some market discipline. The previous Clinton administration under Robert Rubin in effect resisted political pressure from US export manufacturers to devalue the dollar, arguing that devaluation, while helpful to US exports, is not good for the overall US national interest, which lies in the Wall Street global dominance of finance. And US global financial dominance depends on a strong dollar made possible by dollar hegemony. In reality, Clinton was more helpful to Wall Street financial hegemony by undercutting organized labor than any Republican dared venture. To defuse political backlash of falling wages in the US economy caused by outsourcing to low-waged economies, an asset bubble in housing, was allowed to give the American masses capital-gains income to compensate for reduced income from work. The formula was to take jobs from high-paid US workers and give them to low-wage overseas workers, and to compensate US workers with rising prices on their homes, low-price imports and larger return for their pension-fund investments overseas. This formula worked for a while, but it requires an escalating expansion of the money supply to support a debt bubble. The US housing bubble will sooner or later burst from insufficient and stagnant income even if mortgage rates should remain low. Regards,
Steven • February 25th, 2006 at 8:49 am
Actually, US deficit does not have too much with China. 1. China is not compteting against US in most of the economical area. Both economies are bascially complementary. For example, US will give up the textile industry to other developing countries. 2. Chinese low-price goods help US market and keep the US high-tech industry more competitive. Why? since the living cost decreased for a long time. in turn, the cost of US high tech companies decrease too. 3. US companies gain a lot from Chinese market. 4. US companies get back some biz after they lost. For example, today we can see GE microwaves, TVs…. GE lost these biz to Japan long time ago. Today, so many Chinese companies know how to make these products and make them in quality at lost cost. GE gets back the biz again. Same thing happens in other US companies too. 5. US should not count on low-end products. Innovation is the king. Hi-tech is US’s rice bowl. But apparantly, US is losing hi-tech to India now. The jobs outsourced to India are the jobs Americans should keep. Indians are using US’s money, technology, and market to make money. India’s maket is very small today. For example, only 5 million PC were sold in India in 2005, while 20 million in China. India’s IT market is less than 1/4 of China’s. US companies are making big money in China but losing jobs to India. If US loses in the hi-tech, then pretty much everything. 6. US should get out of the hostile sensation towards China. US today only want to sell airplanes, PCs, and such to China. But China needs much more from outside. For example, the nuclear power generator is what China needs urgently for the energy issue. But US gov does not allow US companies to sell the generators to CHina. Did anything good to US? NO. The first, China has the military nuclear tech already. and sell the power generator will not do too much to boost CHina’s military. The second, other countries are selling the same or similar generators to China. France, Canada, and Russia are making money. Their gain is US’s lost. The third, It pushes China to invest and improve the ability to built CHina’s own nuclear power generators. For example, China is building nuclear power plant by domestic 1000MW generators. China is also building the World’s first commercial VHTR generators which is more safe, more efficient than todays generators. Basically, the US deficit is caused by Americans.
Guest • February 26th, 2006 at 12:22 pm
I agree with most of your premises, but I don’t think the Dubai port issue is a good example. Dubai isn’t buying control from an American company, they are acquiring it from a British one. It is like a swap between foreigners of something foreigners already own, not the purchase of something new by foreigners from Americans.
df • February 26th, 2006 at 5:56 pm
Gary, you miss the main point, if there is a bubble in debt, it will boost asset and consumption goods prices. That’s basic monetarism. So people may feel richer, look richer, they ARE NOT richer. All they have is illusory wealth, based on irrealistic asset prices. THe US is the most debt addicted country on earth, more than 50 % of it’s wealth is illusory and due to collapse in the oncoming deflation.
Guest • February 27th, 2006 at 2:54 am
Greetings DF, I did read your post. And I am still trying to understand it. You suggest that housing prices will collapse at some time. Will they? Is this in fact a bubble? The market or supply and demand determines asset prices, with interest rates as the chief arbiter. With interest rates low (assisted by the Japanese and Chinese Governments striving to keep their exchange rate low, depriving Chinese and Japanese citizens of their hard earned wealth), demand for housing is high. When interest rates rise, then demand shall moderate. But will housing prices collapse? Maybe there will be just a meager change in price? But you and a few others declare a collapse, just one assertion amoung so many. The US does carry a lot of debt. But the value of the assets of companies and individuals, homes and not, far exceed that debt, always have and probably always will. Boom and bust is a fact of market life. And you, to foretell such doom, like so many before you, will find the resilient and vibrant state of the US economy a clear refutation of such nonsense, a refutation in existence for 200 years and more. Sure, a little hardship and struggle here and there mingling with undeniable progress, but a complete annihilation of most wealth?? You have to be kidding. By the way, even if the economy tanked, so would the amount of outstanding debt, as bankruptcies would flourish. So with an asset deflation would come a debt deflation. Regards, Gary Marshall
DF • February 27th, 2006 at 10:23 am
Gary, sorry if I’ve been summarizing different stuff. this sentence : “The market or supply and demand determines asset prices, with interest rates as the chief arbiter.” Is false. Asset prices vary with money creation. When there’s a lot of money around, asset prices boom. So you have to realise that interest rate does two things : A it helps to influence endogeneous money creation B it helps to influence the profitability of investments and of savings Both factors influence demand for assets. The factor A however creates unsustainable demand for assets, it is just inflation, not a real rise in asset prices. You have to reread Keynes. You can phrase it another way, the Debt/GDP ratio has been rising continuously in all economies post 1965. This has boosted asset prices. However the debt/GDP ratio can not rise to the sky. Besides it has never of all history, remained at a constant plateau. It usually rises and fall. When it falls deflation follows and hits asset prices first. You mention 200 years. I have to remind you that in 1933 close to 50% of the US industrial production had been wiped out. Since then, the economy has become more interconnected, debt levels are now higher than in 1929, there are less selfsufficient households, self sufficient countries … ALl this point to one clear conclusion, when the grand cycle of increasing debt/GDP will be complete, the crisis that will follow will probably, unless political leaders act very very wisely, be bigger than the one in the 30′s. The more flexible the economy the more it rises and falls with the winds of fluctuating expectations. ”With an asset deflation would come a debt deflation.” exactly and vice versa. For more info on the housing bubble read here : http://www.cepr.net Remember : M*V = P*Y Y is production of production goods (assets) and consuming goods. A rise in M, can result in boosting Production good prices (assets) or Consuming goods prices (CPI)
Anonymous • February 27th, 2006 at 10:28 am
Well said. You’ve once again reminded me that National Income Analysis was the most useful class I took in college.
Anonymous • February 27th, 2006 at 10:28 am
Well said. You’ve once again reminded me that National Income Analysis was the most useful class I took in college.
Guest • February 27th, 2006 at 5:37 pm
Hello DF, I read your response. Interest rates will determine how much money will be lying around. If rates are high, then loans or money creation will be at a minimum. If rates are low, then loans or money creation will be at a maximum. Whether one proceeds with an investment will be determined by the expected return and the expected cost. And the interest rate will figure prominently in the calculation. Inflation is always figured into the interest rate, so one still only need look to the interest rate as chief arbiter. I think we are agreed here, so no need to review the always incomprehensible and long dead Mr. Keynes. Yes, financial disasters occur as one did in the 30′s, at a time when governments were small and when most little understood economics, money, banking, etc. Will it repeat today? Who really knows. Maybe you do, but given the disaster scenario at every turn by so many, I really doubt it. If you wish to loan someone money, do you discount all his assets and focus exclusively on his debts and income? Let us say that you denied a man a loan of $10 million because his income is only $10,000 and his debts are $10 million. He says in response, ” but I have $40 million in assets.” You reply, yes, but all your assets are worth relatively nothing because of the impending disaster just around the corner that will strike all assets and leave all debts untouched. How long do you think that you would be in the banking business were that your reasoning? Again, it does not matter what the debt to GDP ratio is. It does not matter what the debt level is. This is only one half of the story. What matters is the value of your assets. If debts equal or exceed assets, then do not lend. Otherwise lend. Regards, Gary Marshall
DF • February 28th, 2006 at 3:40 am
Gary, you wrote : Inflation is always figured into the interest rate, so one still only need look to the interest rate as chief arbiter. this shows that you do not understand that inflation can go into asset price (production goods) just as in consuming goods (CPI). You will find nowhere an estimation of the asset price inflation rate. M. Keynes is easy to read and there are accessible short versions. The question you ask then is really interesting and indeed follows exactly a famous reasonning of Keynes (he said asset markets where like beauty contests where voters would choose who’s the most beautiful, with the most beautiful being the one chosen by the majority) You ask Let us say that you denied a man a loan of $10 million because his income is only $10,000 and his debts are $10 million. He says in response, ” but I have $40 million in assets.” You reply, yes, but all your assets are worth relatively nothing because of the impending disaster just around the corner that will strike all assets and leave all debts untouched. How long do you think that you would be in the banking business were that your reasoning ? OF course not long. That’s exactly the idea. Such a rational reasoning is wiped out from markets. And this is how bubbles form. I suppose you still not get it at this stage, so let’s make a short case for you. SUppose that there are 100 individuals with each 10000 dollars in revenue. 59 own their homes, each worth 10 millions, and one 41 homes each worth 10 millions, and that one rents them, for 1000 dollars a year (yeah I know renting is not profitable). The individual owning homes propose his houses for sale and offer really attractive financing (1%) and housing prices never fall. So 5 individual show up and buy a house worth 10 milions, take a debt of 10 millions, and then, just by doing this the value of all houses raises to 11 millions … Gee, the total worth of the economy increase by 10 millions, 10%. ANd it’s not finished. Individuals go on buying till the housing ownership rates moves to 69%, despite stagnating real wages and rising rates … Prices soar. The economy is richer. Of course there’s much more debt, but hey who cares, asset valuations are high. Now, if you are wise, you may ask : how come there’s not been a tremendous rise in interest rate ? Well the central bank is keeping rates still low and there are close to no regulation on banking activities. Subprime rates etc. This is asset price inflation, a rise in the price not reflecting a rise in the underlying value of the assets. I tell you what, homes around the world have risen 50% in price (around the WORLD), and I tell you what, they have not risen 50% in value. But you ask : it can’t be inflation, inflation is the CPI. And no, CPI is consumption goods inflation, it does not measure production goods inflation. In fact there’s no tracking of production goods inflation, because it’s hard to tell what is inflation and what is a rise in value, and probably also because entrenched interests oppose such an indicator … If you followed carefully, you know are convinced. Of course everyone will lend to someone looking at the face value of his assets, everyone will think, in case of problem I will sell those assets, everyone will think it is less risky to lend to a house buyer than to rent, I can’t force a renter to pay, I can always sell the house of the buyer and get my money back… Of course this drives prices up. And then someday, all lenders find that they want to seize and sell houses at the same time. Prices plundge and they go bankrupt. We’ve seen that 1000s of times accross history.
DF • February 28th, 2006 at 3:40 am
Gary, you wrote : Inflation is always figured into the interest rate, so one still only need look to the interest rate as chief arbiter. this shows that you do not understand that inflation can go into asset price (production goods) just as in consuming goods (CPI). You will find nowhere an estimation of the asset price inflation rate. M. Keynes is easy to read and there are accessible short versions. The question you ask then is really interesting and indeed follows exactly a famous reasonning of Keynes (he said asset markets where like beauty contests where voters would choose who’s the most beautiful, with the most beautiful being the one chosen by the majority) You ask Let us say that you denied a man a loan of $10 million because his income is only $10,000 and his debts are $10 million. He says in response, ” but I have $40 million in assets.” You reply, yes, but all your assets are worth relatively nothing because of the impending disaster just around the corner that will strike all assets and leave all debts untouched. How long do you think that you would be in the banking business were that your reasoning ? OF course not long. That’s exactly the idea. Such a rational reasoning is wiped out from markets. And this is how bubbles form. I suppose you still not get it at this stage, so let’s make a short case for you. SUppose that there are 100 individuals with each 10000 dollars in revenue. 59 own their homes, each worth 10 millions, and one 41 homes each worth 10 millions, and that one rents them, for 1000 dollars a year (yeah I know renting is not profitable). The individual owning homes propose his houses for sale and offer really attractive financing (1%) and housing prices never fall. So 5 individual show up and buy a house worth 10 milions, take a debt of 10 millions, and then, just by doing this the value of all houses raises to 11 millions … Gee, the total worth of the economy increase by 10 millions, 10%. ANd it’s not finished. Individuals go on buying till the housing ownership rates moves to 69%, despite stagnating real wages and rising rates … Prices soar. The economy is richer. Of course there’s much more debt, but hey who cares, asset valuations are high. Now, if you are wise, you may ask : how come there’s not been a tremendous rise in interest rate ? Well the central bank is keeping rates still low and there are close to no regulation on banking activities. Subprime rates etc. This is asset price inflation, a rise in the price not reflecting a rise in the underlying value of the assets. I tell you what, homes around the world have risen 50% in price (around the WORLD), and I tell you what, they have not risen 50% in value. But you ask : it can’t be inflation, inflation is the CPI. And no, CPI is consumption goods inflation, it does not measure production goods inflation. In fact there’s no tracking of production goods inflation, because it’s hard to tell what is inflation and what is a rise in value, and probably also because entrenched interests oppose such an indicator … If you followed carefully, you know are convinced. Of course everyone will lend to someone looking at the face value of his assets, everyone will think, in case of problem I will sell those assets, everyone will think it is less risky to lend to a house buyer than to rent, I can’t force a renter to pay, I can always sell the house of the buyer and get my money back… Of course this drives prices up. And then someday, all lenders find that they want to seize and sell houses at the same time. Prices plundge and they go bankrupt. We’ve seen that 1000s of times accross history.
DF • February 28th, 2006 at 3:42 am
OF course you realise that the impending disaster just around the corner that will strike all assets and force all borrowers and lenders to bankrupcy. (It will destroy debt, not leave it untouched). This is why wise people are now moving out of debt and getting into cash. And this is why deflation is so hard to fight, because suddenly there’s close to an infinite demand for cash, monetaty authorities have little power to fight deflation.
Guest • February 28th, 2006 at 12:33 pm
Hello DF, I did read your last post. Inflation is a monetary phenomenon. There is no inflation to be found in the normal ebb and flow of prices for some item. This is just adjustments in supply and demand working themselves out and coming to some intersection bearing some price. The price of oil goes up and down not because of inflation, but because the markets demand it does. A general rise in prices is certainly inflationary. When all prices rise across the board, it is because too much money has been created and the market is incapable of absorbing it all. In your analysis, you appear to be confusing inflation, or a general rise in prices, with adjustments in the price of some item caused by changing supply and demand. Housing prices have risen, not because of inflation, but rather because of changes in demand and supply in the market. Oil was $12 a barrel some 4 years ago, and now it is $60, not because of inflation, but because of changes in supply and demand. Where will it be tomorrow? You have about as much idea as anyone else wading through the incalculable number of variables that influence the supply and demand for oil. The interest rate really dictates what happens in the housing market. At some point in the future, interest rates may rise and probably will. But will this cause a rapid depreciation in the value of the stock of housing, or a minor correction? You have about as much idea as anyone else. Some say disaster, others say a negligible effect. God knows pal. If you, having made a couple of calculations from the immense number of variables influencing the housing market, believe that it will collapse and leave the US economy a small fraction of its present state, so be it. I have heard such nonsense before regarding Global Warming, the Sun exploding, the end of the world in many forms, etc., etc. And we are still here and still moving along just fine. If your theory works, then we shall soon know. If not, well no surprise. Regards, Gary Marshall
DF • February 28th, 2006 at 2:07 pm
Gary gary gary … Again, and again and again, I’m not talking about a specific price, oil, microsoft or a given house. I’m not talking about commodities at all (which include oil) I’m talking about asset prices. I did not say housing has risen because of inflation. I said higher housing and stock prices ARE inflation in asset prices. It takes more money to buy any house or any company. A single dollar is worth less in terms of how much houses and companies you can buy with it. That is asset price inflation. And yest it is a monetary phenomenon. Over the last 20 years, good prices inflation has been relatively tame globally, your dollar has lost less that 5% buying power each year. Over the last 5 years a dollar has lost less than 3% buying power each year in CONSUMPTION GOODS. IF you want to buy a doll, a computer, a massage, on average it takes only a bit more dollars. Now over the same last 5 years, a dollar has lost 33% of its buying power in terms of houses. If you look at stocks you find that a company is about as expansive than it was 5 years ago. However if you look 20 years ago, you find that the dollar has lost tremendous buying power in companies. Do you get it now ? Now the interest rate is only helping to drive the demand for housing. That is not the cause of the oncoming collapse of prices. This inevitable collapse is due to the fact that asset prices have risen because of a rise in the money supply. This rise in the money supply has been mostly endogeneous credit based money supply. Said otherwise, prices have risen because people have taken on more debt. However the ratio of debt to revenue can not rise to the infinite, asset prices can not rise infinitely relative to consumtion prices. What we are about to see, just like in Japan and germany 1989, is falling housing prices AND falling interest rate. The basic of speculation is this : a good price (or a class of goods price) rises because it has risen and is expected to rise. THis not supply and demand of people wanting to use the good (say housing, say enjoy dividends) it is speculation on the part of people wanting to profit from the future rise in the relative price level. Just a simple question for you : how do you define a general rise in price ? If that is CPI or CPE then you are talking about the rise of the price of consuming goods. THis is not for this reason a “general” rise in price, you exclude the price of companies, housing, land : all assets. Why do you call “general” what is not “general” ? Check on RGEMonitor you will see tons of texts explaining that asset prices should be monitored …
Guest • February 28th, 2006 at 4:40 pm
Okay DF, you win. Gary Marshall
DF • March 1st, 2006 at 3:21 am
lol… It’s hard for me to believe that you changed you mind. But it’s even harder for me to grasp what made you think so in the first place… Therefore I can’t see which point convinced you.
ewulf • March 1st, 2006 at 10:34 am
The global financial world ,is looking for the best alternatives to sustain higher portfolio returns.Wherever they are,money goes in.The problem is that the most you depend on others,the less you may decide on your own.Autonomy to make decisions, is not a free good ,but rather it is becoming an economic good .Its price is getting higher!.Interdependence is creating a global network economies.What are the implications?. Maybe it is too soon to make conclusions,but anyhow It is better to start some corrections,than to wait the lasting effects.
Guest • March 6th, 2006 at 2:53 pm
DF, To be fair to Gary it is possible that a certain percentage of the rise in real estate asset prices is due to supply and demand factors. The question is how much? If we take 1995 as a baseline and then examine the same houses price in 2005 what % of the change is driven by asset inflation and what % of the change is driven by demand and supply factors? My suspicion, like yours is that it is 10%S&D and 90% inflation. But quantifying it would be interesting.
Guest • March 6th, 2006 at 9:24 pm
Greetings Guest, Well, getting warmer. If inflation is factored into the lending rate. And the lending rate has been at a minimum for some 5 years now. Then inflation must have been at a minimum for 5 years. Therefore, the rise in housing prices has little to do with inflation and mostly to do with supply and demand. Therefore, I would say that your numbers should be reversed: 10% inflation and 90% supply and demand. Gary Marshall
Meryn • March 16th, 2006 at 11:29 am
Readers of this blog all know how big total american debt is, but what’s the actual size of the US capital stock? And on what is such an estimate based? What kind of capital is included?
Beal • March 18th, 2006 at 5:50 pm
Nouriel, What? The US has had a significant number of firms bought by companies domiciled outside of the US. I will ask if you are familiar with a company that use to be know as Chrysler or Amoco? Your position that the US is against foreign ownership is just not fact-based. Please refrain from making nonsensical statements.
ReformerRay • March 29th, 2006 at 9:20 am
U. S. citizens who object to foreigners obtaining control of wealth prooducing assets in the United States should turn off the spigot. The trade deficit sent 725 billion dollars overseas last year. The only way to stop asset accumulation by foreigners is to stop sending them dollars for excess imports. That message from Nouriel is valid, has not been discredited by any of the above comments, and should be shouted from the roof-tops until it is understood and assimilated. Debt versus assets is a side issue. Depreciation of debt and depreciation of currency is a side issue. I agree that the longer the U.S. continues to accumulate Net Worth in housholds faster than dollars are shipped overseas, the trade deficit will not disappear due to natural economic forces. But no one knows how long the stock market and growth in housing assets will continue to create Net Worth rapidly. Two important points: 1. The longer the current reality continues, the fewer productive assets in the U. S. will be available to create financial returns to U. S. citizens. 2. When the current folly ends, as it inevitaably will, the future of the U. S. will depend, not on currency or debt, but on the ability of U. S. business firms to produce profits for domestic owners and to sell products on the international market. CURRENT CONDITIONS ARE SETTING THE UNITED STATES UP FOR DISASTER WHEN WE WILL BE FORCED TO DEPEND UPON THE PRODUCTIVE RESOURCES IN THE U.S. OWNED BY U.S. CITIZENS.
Guest • March 29th, 2006 at 11:22 pm
Hello ReformerRay, You say, “The longer the current reality continues, the fewer productive assets in the U. S. will be available to create financial returns to U. S. citizens. “ Well, the US is far greater than its borders. What about all those assets that US citizens possess that lie beyond the nation’s limits? What about those productive assets enriching their US owners and the nation? Your argument ignores this extensive component of the equation. You also state, “the future of the U. S. will depend, not on currency or debt, but on the ability of U. S. business firms to produce profits for domestic owners and to sell products on the international market.” If US owned firms overseas produce such goods for domestic and foreigh consumption, are not US citizens equally enriched? You also say that debt vs. assets is a side issue. Tell that to any banker or any borrower or any person with a rude understanding of business principles. People must look at the full financial story rather than just the perceived negatives. Regards, Gary Marshall
Dr Jay Veeoh • May 20th, 2006 at 12:47 am
Question : how are you guys going to pay back these trillions (a lot of dough,even after devaluation) if you keep fighting the wrong wars ,loose your industrial base as well as your competitive spirit ? When one outsources ,being a manufacturer ,one becomes a trader. Think about the consequenses of that : a trader competes on a different plan than a manufacturer.If the product does not sell he quickly drops it.And another thing : his produtivity is high (far less staff )So much for the recent beautifull productivity figures. jvo/05/19/06
Guest • May 22nd, 2006 at 2:45 am
Hello Mr. Veeoh, Just because a company decides to transfer the actual manufacture of a product offshore, does not mean that the bulk of the product’s value added has been transferred offshore. The actual manufacture of a product is usually a very small component in its overall cost. Innovation, design, marketing, etc. constitute the majority of the value in any product. Lowly paid Chinese labourers can snap the thing together, but the highly paid engineers, marketers, company shareholders, and so on, remain in the US. The US gets rid of low paying jobs and retains or creates high paying jobs. And with the US creating products not only for itself but also for the now thriving Chinese labourers, the US really scores big. I think this answers the question of discharging the national debt. Not that the national debt is ever discharged, it mounts yearly. However, the assets of the US and its citizens augment ever faster. Is the US fighting the wrong wars? Many would argue that there are in exactly the right place, the Middle East, where there always seems an abundance of mayhem, slaughter, and turmoil. Better the US in the Middle East than the opposite. Regards, Gary Marshall
