The long-term costs of bailouts and nationalization of mortgage debt on inflation and external debt

After years of reading his weekly commentary, I have finally managed to detect a small mistake (actually two) in John Hussman's otherwise implacable logic. Let's see that paragraph, which is about the consequences of the current and future enormous issuance of Treasury debt:

It may not appear to be costly at present, since risk-averse individuals conscious of credit risks, and foreign countries running massive trade surpluses, are still willing to accumulate the Treasury securities being issued, with no apparent impact. But ultimately, those securities will either stand as claims on our future national production, or they will be inflated away. Either the Treasury securities will retain value, so that holders such as China get to use them to acquire our productive assets in the future, while we ultimately tax ourselves in order to pay off that debt, or we must dilute the ability of those Treasuries to claim real goods and services, which is another way of saying we inflate away the debt.

There are two mistakes here, a tiny one and a more important one. First, it is wrong to say that foreigners will in the future acquire more U.S. productive assets: they already, today, by buying these newly issued securities, receive a higher share of U.S. national income through interest. Interest comes from taxes, which are paid thanks to productive assets. In other words, whether foreigners swap their Treasuries for U.S. equities or stick with their Treasuries, they still claim larger share of U.S. assets.

The second, bigger mistake is to believe that the U.S. can choose to swap an international redistribution of wealth problem (the 'either' part of Hussman's argument) for a national redistribution of wealth through inflation. There is no free lunch. 'Inflating away' the national debt is not a good expression as the debt doesn't really go 'away': it is just swapped for other securities, while the same amount is owed to foreigners.

To be specific, inflation will not resolve anything because it will result in a deterioration in the trade balance (higher pricing power to foreign producers), which itself will result in a deterioration in next external assets (claims on foreign assets minus domestic assets owned by foreigners). When all is said and done, the U.S. NIIP (Net international investment position) would have been the same with or without inflating the debt away, or maybe even worse due to the fact that some foreign producers are better positioned for a high inflation environment (think commodity exporters), and because a collapsing dollar will allow foreign investors to buy U.S. assets on the cheap.

Inflation does redistribute wealth from savers to borrowers inside a country. It does not allow a nation to escape from transferring its wealth abroad. There is only one way to do that: default.

"Never sell America short"

That is what a friend of my father's told him in the late seventies, when many people were long-term bearish on the US. Today, even though the US has been disappointing to the perma-bulls for many years in a row, the consensus still seems to be that America will manage to put its house in order and reemerge as the leading economic powerhouse it has been for decades.

I have doubts. For several small reasons: the same as everyone else's (BRICs and the European Union for example) and my own (the 24 percent dropout rate in California highschools and the reticence of conservative politicians to engage the country more profoundly in biotech research because of religious views come to mind, but there are many others).

But my doubts arise mostly for the following reason: the still persistent triumphalism of some important circles of the country's elite, and most notably the Federal Reserve. Not just the FOMC, but just as importantly the research team (composed of some of the most talented economists in the world) which provides the basis for the Fed's analysis and policy, and also influences Congress, the White House, think tanks, you name it. When one of them tries to raise his voice, he is rarely listened to (think Poole on the GSEs many years ago).

The trigger for my posting this was reading a new paper by Carol C. Bertaut, Steven B. Kamin, and Charles P. Thomas (How Long Can the Unsustainable U.S. Current Account Deficit Be Sustained?). Their conclusion: "All told, it seems likely it would take many years for the U.S. debt to cumulate to a level that would test global investors’ willingness to extend financing." (Funny, the absolute level of the dollar and the fact that long-term Treasury rates relative to the past few years are still high despite the economic downturn would argue otherwise). Since I didn't really care for their model (it's a partial-equilibrium) or their conclusion for that matter, I jumped to the assumptions that they used to project the income balance. The income balance is the difference between the US foreign assets returns and the rest of the world's returns on their claims in the US (the net share of US production that is sent abroad as dividends or interest income).

I found exactly what I was expecting to find (p. 9): "(...) the rates of income on U.S. private portfolio assets and liabilities have been roughly similar in recent years and are projected to remain so, at a level close to the projected U.S. short-term rate of interest, going forward." It continues: "Historically, income rates on U.S. direct investment abroad have exceeded that on foreign direct investment in the United States. Although this gap has narrowed over the past decade, it remains large and we project it to remain large in the future." Why would that be? The answer is on footnote 6: "A number of explanations have been advanced for the asymmetry of rates of return on direct investment, including greater efficiency of U.S. firms, better project selection by U.S. firms, younger and thus less mature investments for foreign firms in the United States, greater competitive pressures in the U.S. market, or differences in tax treatment. (See Higgins, Klitgaard, and Tille, 2005.) None of these factors seem likely to disappear in the near term."

Naturally, none of these factors seem likely to disappear and I won't even try to argue why they probably will. The point is that none of these factors have actually been proved to be the reason of the persistently low income deficit of the US. As it has been argued by many authors, these factors are actually smoke and the true reasons behind the low income deficit are: poor balance of payment accounting and reconciliation, and/or statistical flukes, and/or temporary beneficial movements in rates, and/or difference in tax treatment of direct investment. This latter factor is actually cited by Bertaut et al. but the authors don't state, or take into account in their model, that this makes the income balance look better than it actually is! (For a review of the reasons behind the "mysteriously" low income deficit and net debt of the US, see my 2007 paper).

The point of this post is not to point out a misargument in Bertaut et al. paper. I just wanted to show, using a subject that I am familiar with (the US BoP), the wrong attitude of the governing elite of the US. In their analysis, these influent intellectuals very often use optimistic (sometimes overly so) assumptions. I will turn long-term bullish on the US once I can see that it does what the wise man advised: "prepare for the worst, hope for the best". What I see today would be more along the lines of "prepare for the best, if the worst comes... who could have known?"

My paper is online!

I set up this blog in order to provide a public link to my paper on the U.S. NIIP:

http://www.fileden.com/files/2007/5/12/1072901/On%20the
%20behaviour%20of%20U.S.%20foreign%20balances.pdf

If anyone knows a better way (more direct) to host files online, let me now.

I'll try to post a few comments on the markets and the economy from time to time.