Reaction to BCA Report on Trade Deficit

I'm current reading the latest Special Report from BCA Research (subscription required) on the U.S. trade deficit. In the past, I have read reports on the US trade deficit from GaveKal Research, in a 45 page report on the subject, 13D Research, in comments spread throughout his newsletters, and two Harvard professors, in a report on economic 'dark matter'. Up until now, the majority of the 'unsustainable deficit' talk has been from the mainstream pundits and market commentators and newspapers. All of the aforementioned reports, on the other hand, came out against the unsustainable argument and argued, for a variety of reasons, that the deficits were entirely sustainable.

While I am only half way into the BCA report, written by Managing Editor Martin H. Barnes, it was clear from the start that his aim was to discredit each and every claim against the unsustainable view (and by his word choice, he clearly has read the same reports above). He starts by listing each of the reasons people have given for why the deficits are sustainable. His list includes:

• Economic measurements of "nationals trade balances has become increasingly meaningless" thanks to the effects of globalization. This argument has often been made by GaveKal.
• The last argument I want to talk about is the 'dark matter' report that I suggest everyone read. They essentially argue that since American-owned assets abroad earn more income than foreign-owned assets in America, the true value of America's assets actually outweighs its liabilities and the US is actually a net creditor.
• The deficit is essentially sustained by foreign purchase of US assets. This essentially represents foreign ownership of our country. Yet GaveKal has argued that comparing this number to GDP, the annual output of our country, makes less sense than comparing it to the total net wealth of the US. They find that while the current account deficit of 2005 represents 1.4% of US wealth, that wealth has been steadily growing by 6% since 2000. "The conclusion is clear: if America’s wealth keeps growing about as fast as it has in the past decade, the current account will remain sustainable, whether it stays at $700 billion, falls to $500 billion or soars to $1 trillion a year (as we believe it might in the coming years as China exports its over-capacity problems)."
  

For me, this is the first time I've seen a report from an institutional source coming out in favor of the unsustainable view. I will continue to read it with interest and add to this post as I go.

Meaningless Numbers
The explanation for this argument comes primarily from a report by GaveKal entitled Accountants vs Economists. Essentially, while an economist recording trade numbers would say a $225 net loss results for the US economy on the sale of a $700 Dell PC based on trade flow, an accountant would record $245 in profits for US companies and $40 in profits for foreign companies based on profit margins. In other words, while an economist's method of measuring sales results in trade imbalances, US companies are making all the profits. Viewed in this context, the imbalances are caused by US companies profitably moving their production overseas, and the current arrangement is quite desirable and certainly sustainable.

The report from BCA misinterprets this argument, and attempts to disprove it by showing the steady level of imports/exports between companies and their foreign affiliates. However, this wrongly ignores the fact that most manufacturing is being done by Asian companies, independent of the companies they manufacture for. Asia has become the world's manufacturing plant. Companies have taken the capital-intensive, low-profit part of their three-step design-manufacture-sell process and exported it to Asia, freeing up capital and increasing corporate earnings (this is the definition of a platform company, a company that designs locally, manufactures where its cheapest, and sells everywhere). Indeed, as this happens, companies become better able to finance themselves and as their capital needs decrease less national savings are needed for investment (perhaps a cause of the low U.S. savings rate?). Meanwhile, the capital intensive development of Asia requires high savings rates to support investment.

Dark Matter
The basic idea behind the unsustainable deficit is that as our foreign-held debt continues to rise, eventually the costs of paying interest on that debt will spiral out of control. However, despite an current account deficit accumulation over the past 24 years (1980-2004) of 4.5 trillion dollars, the US actually earned 30 billion dollars on its net financial position. This must mean that the US earns much greater income on its assets abroad than foreigners who own assets in the US. In other words, although an American company might make a $1,000,000 investment in China, and a French company might make a $1,000,000 investment in America, the value of that investment should not be its cost, the $1,000,000, but rather it should be valued properly by its income. Since American investment abroad takes expertise, knowledge, and experience and applies it in a risky environment, the return on their investment is high. However, since the foreign investment in America is often for real estate (Japanese buying Rockefeller Center in the 80s) or other low-risk investment purposes, its return on its investment is lower. The foreigners except this lower return, because the risk is also much lower in America, where property rights are respected. The difference between the U.S. being a net debtor of $2.5 trillion dollars, using cost-based asset values, and the U.S. being a net creditor of $600 billion dollars, using income-based asset values, is $3.1 trillion dollars of unaccounted for US assets that the authors label dark matter .

The BCA report, however, dismisses this theory as probably partially true, but wildly over exaggerated. Furthermore, current trends suggest that the gap between US and foreigners returns on their investments may be narrowing. The author suggests that "any overstatement of the current account deficit is unlikely to exceed $100 billion" dollars.

The US Consumer Bank
A central bank's role can be described as the lender of last resort. In other words, they are the final bank that all banks can turn to in their time of need. The report argues that the US consumer has acted as the "consumer of last resort" for the global economy, while economic impotence has struck Europe and Japan

Asian central banks have supported excessive consumer spending by accumulating massive dollar reserves. Yet this intervention is necessary because without the US consumer, these countries would have no where to export.

Conclusions
Ultimately, the report takes a surprisingly optimistic tone. Although the report was mainly devoted to shooting down the arguments for the long-term sustainability of the deficits, so to does it argue against those pessimists who think it will all "end in tears". They suggest that although the situation is unsustainable in the long-run, it can and will continue in the short run, and will gradually correct without too much pain to the global economy. The report is persuasive and offers an insightful alternative to this previously two-sided debate, as well as a good summary of the other two sides.

Please comment if you have any thoughts on the subject. This was meant to be a reaction to the BCA Special Report, and is far from a comprehensive review of the issue. If there's interest, I'd love to go into it further.

Comments

[Brian]

You know I am interested in this; did you see the Ersnt & Young report on China's nonperforming loans? -Brian