Tuesday, March 14, 2006

Dark matter not so dark anymore?

The Q4 current account deficit set a record at just under $225B, or nearly $1T (that's trillion) annualized. More ominous, at least to me, the net investment income went negative in Q4. I wonder if the dark matter faithful are scratching their heads today.

Faith in the virtues of "dark matter" is strong among economists who don't worry about the the eventual effects of the US current account deficit. Dark matter being the term used to describe the curious phenomenon where US receipts on US owned foreign assets exceeds US payments on foreign owned US assets despite US owned foreign assets being valued at far less (roughly $2.5T less) than foreign owned US assets.

According to these economists, so long as the dark matter phenomenon holds true, there is little to fear from the growing imbalance in the net investment position as net income flows will remain US positive.

Net income flow in the external accounts can perhaps be easier to consider if viewed more simply as debt service. If you as an asset holder could go ever deeper into debt, but your debt service payments never exceeded asset income, you could continue to increase your debt with impunity. Until, that is, the curious condition was resolved.

Once debt service payments started to rise above asset income you would probably have to stop taking on additional debt and would likely look to pay off the old debt. Once the balance sheet becomes net income negative, the day of reckoning has arrived. This is the classic currency crisis of banana republics around the world. The greater the income outflow the greater the trade surplusses must be to compensate. It looks to me as if the US is nearing a similar state of affairs.

US net investment income has been trending lower since a peak in 1984, as one would expect with the positive net investment position shrinking to zero during the 80s and going negative ever since. There is, however, an anomalous spike in net investment income data for 2003 and 2004, which is the basis for the dark matter speculations.

My sense is that ultra low US rates and recent corporate tax breaks for foreign earned income explain the anomalous behavior of the net income data better than the dark matter hypothesis. As the effects of the tax breaks recede and US rates normalize and quite likely, assuming the Fed intends to save the US$ eventually, exceed foreign rates, net investment income will become negative better reflecting the negative net investment position.

Once faith in dark matter is shaken, perhaps the economic powers that be will take a fresh look, a concerned look at the ever widening current account gap.


Joe said...

Please send me the graph jparrette@cox.net i will post it at the Pru Bear site.

I am trying to get a blog going at Xanga and it is giving me fits so I know your pain.