Dark Matter Rationalizations

It is unlikely that Michael Gold (Jeff Goldblum) knew anything about economic dark matter when he spoke to Sam Weber (Tom Berenger) in the 1983 classic The Big Chill. Michael's view on the importance of rationalizations, however, may go a long way in explaining how some economists get through the day in a world that has become dangerously unbalanced.

Michael Gold: I don't know anyone who could get through the day without two or three juicy rationalizations. They're more important than sex.
Sam Weber: Ah, come on. Nothing's more important than sex.
Michael Gold: Oh yeah? Ever gone a week without a rationalization?

Dark matter? Rationalizations?

The story begins back in November with a study published by Harvard economists Ricardo Hausmann and Fredrico Struzenegger, Can Dark Matter Prevent the Big Bang? (PDF). In this work, the authors put forward the theory that the U.S. really isn't the great debtor nation that most believe it to be (and as government statistics indicate) because our assets abroad are not properly valued.

Indeed, by their calculations using net earnings on U.S. investments overseas, instead of owing the world $2.5 trillion, the rest of the world owes us $600 billion. In the conclusion to their original work, they state:

The income generated by a country’s financial position is a good measure of the true value of its assets. Once assets are valued accordingly, the US appears to be a net creditor, not a net debtor and its net foreign asset position appears to have been fairly stable over the last 20 years. The bulk of the difference with the official story comes from the unaccounted export of knowhow carried out by US corporations ... Globalization has made the flows of dark matter a very significant part of the story and the traditional measures of current account balances paint a very distorted picture of reality. In particular, it points towards imbalances that are not really there, making analysts predict crises that, for good reason, remain elusive.

Yes, unaccounted for knowhow explains why the imbalances that many fear could lead to ruin are really not cause for alarm. If the accounting were done properly, all the shipping containers headed east across the Pacific, many of which return empty, would be more than offset by knowhow going in the opposite direction.

Michael Mandel at BusinessWeek was quick to pick up on this theme. The timing was opportune, as the savings glut thesis for global imbalances does not seem to be getting the traction that it did when originally posited by, among others, new Fed Chairman Ben Bernanke. In this post on his BusinessWeek blog back in December, the story seemed to have completely captured his imagination:

The trade statistics are terrible at tracking cross-border flows of intellectual property. For example, when Intel sets up a chip fabrication plant in Ireland, that country reaps the benefit of Intel's designs, and all of Intel's accumulated wisdom about how to run a fab successfully. In effect, a massive amount of intellectual property has been exported to Ireland, without showing up in the trade statistics at all.

These massive and unobserved exports of intellectual property--"dark matter"--imply that the U.S. is actually running a much smaller current account deficit than the official data shows.

This later became the basis for last week's BusinessWeek cover story, where for some reason, the Intel example of setting up a wafer fab was changed from Ireland to Israel.

Brad Setser at RGE Monitor was next to offer an opinion. As he was cited by Hausmann and Struzenegger in an unflattering manner in their original work, his analysis was a passionate and detailed. Here are some of the key points:

Dark matter doesn't stem from particularly high reported returns on US investment abroad. It stems from unusually low returns on foreign investment in the US.
...
That brings me to the second source of "dark" matter -- the gap between the return that foreign direct investors report on their US income and the return that US firms report on their direct investment abroad. In 2004, the US received $128 billion more than it paid out.
...
Sum up the evidence, and my bottom line is simple. I suspect a lot of dark matter has its origins in what some have called one of the dark sides of globalization. Corporate tax arbitrage.

The Economist then commented on the study in mid January. This often times dour lot of dismal scientists didn't think much of the premise or the conclusions. In their typical sardonic style they draw the following conclusion:

Not all physicists regard dark matter as an elegant theoretical solution to the mysteries of the universe. Many think it is a bit of a fudge. Just a few months before the concept was introduced into economics, two theorists were hoping to dispel it from physics. Physicists, you see, expect beauty as well as truth from their theories. Economists, alas, must settle for one or the other.

Michael Mandel's thoughts on this subject then re-emerged in the form of BusinessWeek cover story, where the original study results were applied to more statistics coming out of government agencies. In addition to the current account deficit, apparently the unaccounted for know-how can help to explain why the savings rate really isn't as low as most think, and why GDP is understated:

Everyone knows the U.S. is well down the road to becoming a knowledge economy, one driven by ideas and innovation. What you may not realize is that the government's decades-old system of number collection and crunching captures investments in equipment, buildings, and software, but for the most part misses the growing portion of GDP that is generating the cool, game-changing ideas. "As we've become a more knowledge-based economy," says University of Maryland economist Charles R. Hulten, "our statistics have not shifted to capture the effects."

Barry Ritholtz at the Big Picture opined that BusinessWeek was missing the bigger picture (naturally) and chided the authors for their perhaps disingenuous approach:

Perhaps BusinessWeek is addressing a different audience -- the large group of people who in poll after poll rate the president poorly on his handling of the economy.

What BW fails to grasp is that most people aren't thinking about the economy; I'm not sure if all that many people even have an opinion on the Macro issues. But they do have a sense of their own financial situation: Are they getting ahead, are they falling behind, is their standard of living rising or falling, how much confidence do they have about the future, etc.

On that score, much of the country has become increasingly pessimistic.
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Perhaps BusinessWeek's editors need to get out of the office more . . .

The comments section of this post at the Big Picture speaks volumes about the disconnect between cheerleading economists for government statistics and the view on the ground. There is talk of BusinessWeek subscription cancellations, worried business elite, the GaveKal iPod economy nonsense, and more. Here's a sampling:

Anonymous: We've now reached the undeniable point where what is good for the top 10% of income-earners is NOT good for the rest of America. Somehow this disconnect must be resolved... in favor of the majority of us.

Emmanuel: Honestly, though, did we expect anything different? Just as CNBC plies its trade by puffing up everything out of proportion, so does BusinessWeek. You don't sell copies with a headline like "Why the Economy is Weaker Than You Think."

Contrast this with the tone of the comments on Mandel's BusinessWeek blog which continues to include a creepy picture of a Harvard economics PhD peering down at the tired masses from a lofty Wall Street perch:

Kartik: This is why I read everything that Michael Mandel writes, because he really is thinking ahead, and in a way that no one else can match.

Mike McCarthy: I think this is an important issue and I wish our friends in the accounting and finance world would take it on seriously. As a professor and consultant in branding, I believe that we need better metrics for capturing the investment, development and value of intangibles such as brands and intellectual capital.

Jim: I read your article and think it is one of the best articles I have read in a long time. I personally have thought for a while things were better than were being reported.

Wow. Where do you go from there? The differences seem irreconcilable - the worst part is that neither side of the debate appears to be much interested in listening to opposing views. Both sides can't be right.

Well, maybe one side is less open to suggestion than the other. This side does seem more apt to seek information and embrace theories that confirm beliefs already held.

Let's see, where has that gotten us into trouble before?

The Wall Street Journal picked up on the brewing controversy referring to economic dark matter as "Spackle for Economic Anomalies".

To many economists and investors, this smacks of a desperate effort to ignore a dangerous mountain of debt.
...
The Bureau of Economic Analysis, keeper of the international-trade data questioned by Messrs. Hausmann and Sturzenegger, has no plans to even try to measure dark matter. "I'm really uncomfortable about trying to take implicit differences and label them as having a certain cause and then putting them into our accounts," said BEA Director Steven Landefeld. He says he has been hearing dark-matter-like theories since he joined the BEA in 1991.

Continuing the cosmological theme here, the spackle analogy sounds eerily like Einstein's cosmological constant fudge factor which was, by far, his greatest career blunder. Einstein's error resulted from an incorrect fundamental assumption about whether the universe was static or expanding, and necessitated a bit of spackling to make the equations look right.

Could there be parallels with incorrect fundamental assumptions about the continued role of the U.S. as the world's economic super power?

And, finally, Rob Peebles over at Prudent Bear looked up the data and, like Brad Setser, found that whatever happened in 2004 is very different than what happened in the first three quarters of 2005. Maybe super-low interest rates for 2002 thru 2004 have distorted the picture just a bit.

Balanced or not, the income that the Harvard pals are basing their asset values on is evaporating faster than spilled gasoline. Yes America earned a net $36.2 billion on investments in 2004, but look what’s happened since:

Q1 04: $15,022
Q2 04: $5,922
Q3 04: $6,254
Q4 04: $3,236

Q1 05: $643
Q2 05: -$1,541
Q3 05: $512

The numbers in the above table come from line 74 of a migraine-inducing spreadsheet produced by the Bureau of Economic at http://www.bea.gov/bea/newsrelarchive/2005/trans305.xls

According to the numbers, if there is dark matter out there, the returns on the stuff are dwindling.

Yes, maybe it was all an illusion - a convenient set of data that helps to explain an uncomfortable situation to those who would rather go on believing what they want to believe.

What thoughts are held here that might possibly add to the discussion?

Anyone looking to justify their narrow view of the world with statistical fudge factors probably deserves the criticism that they get. Any economic pundits willing to disregard the plight of workers in this country who are getting squeezed by poor wage growth and not-so-benign inflation might in fact be surprised at what results.

In the end there is only one statistic that matters, and that is the ability to provide for one's family. When the heads of households can't do this, unrest results. Unrest leads to change through whatever means available - violent or non-violent.

This is not always a tidy process.

There is a groundswell of dissatisfaction in this country by non-homeowners, and as the wealth illusion fades for current homeowners under the weight of oppressive debt, the dissatisfaction is likely to spread.

Unfortunately there are few reliable metrics for measuring dissatisfaction or unrest - all of a sudden, one day, it just becomes a problem.

It's hard to imagine how dark matter adds to the discussion of dissatisfaction and unrest. More likely, as this sort of thinking trickles down, the "disconnect" problem between the business elite and the growing ranks of unwashed masses is exacerbated.

It seems Michael Gold makes a bit more sense than Michael Mandel in this case - for some people at least, rationalizations are more important than sex.