Dark Matter

In a recent blog post, George Mason University professor Bryan Caplan offers some interesting analysis of the U.S. trade deficit. His comments stem from an article published by Harvard scholars Ricardo Hausmann and Frederico Sturzenegger, in which they argue that conventional trade deficit accounting methods misrepresent the actual state of the current account deficit:

The Bureau of Economic Analysis (BEA) indicates that in 1980 the US had about 365 billion dollars of net foreign assets (that is the difference between the foreign assets owned abroad and the local assets owned by foreigners). These assets rendered a net return of about 30 billion dollars. Between 1980 and 2004, the US accumulated a current account deficit of 4.5 trillion dollars. You would expect the net foreign assets of the US to fall by that amount, to say, minus 4.1 trillion. If it paid 5 percent on that debt, the net return on its financial position should have moved from a surplus of 30 billion in 1982 to minus 210 billion dollars a year in 2004. Right? After all, debtors need to service their debt.

So let’s look at how much is the actual return on the US net financial position. The number for 2004 is, yes, you’ve guessed it, still a positive 30 billion, just like in 1982! The US has spent 4.5 trillion dollars more than it has earned (which is what the cumulative current account deficit implies) for free!

According to the article, while the U.S. has been spending more than it takes in for the last 24 years, our net income flow remains positive. This is due to so-called "dark matter" that isn’t taken into account when calculating net capital flows. The authors posit this dark matter consists largely of net capital gains on U.S. investment abroad, which total about $1.6 trillion. Additionally, the U.S. earns much higher rates of return on foreign assets than foreigners do on U.S. assets, which could account for the remainder of the dark matter.

To correct this, Hausmann and Sturzenegger propose an entirely new method of accounting in which assets are valued based on their rates of return:

We start by assuming that if an asset consistently pays more than another asset, then it is worth more, even if they both have the same historical cost or “book value”. We choose to value the assets on the basis of their returns. This is just like valuing a company by calculating its earnings and multiplying by some price-earnings ratio, or valuing a property based on its rental value.

If this new accounting method were implemented, U.S. debt holdings abroad would be valued much higher than foreign holdings on U.S. debt, meaning the current account deficit would shrink considerably. Perhaps the alarmists who constantly clamor about the trade deficit leading to a collapse of the dollar and subsequent capital flight should consider the presence of this dark matter before calling for more trade protectionism.