The Dot-Com Bubble, the Bush Deficits, and the US Current Account

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1 The Do-Com Bubble, he Bush Deficis, and he US Curren Accoun Aar Kraay The World Bank Jaume Venura CREI and Universia Pompeu Fabra December 2005 Absrac: Over he pas decade he US has experienced widening curren accoun deficis and a seady deerioraion of is ne foreign asse posiion. During he second half of he 1990s, his deerioraion was fueled by foreign invesmen in a booming US sock marke. During he firs half of he 2000s, his deerioraion has been fuelled by foreign purchases of rapidly increasing US governmen deb. A somewha surprising aspec of he curren debae is ha sock marke movemens and fiscal policy choices have been largely reaed as unrelaed evens. Typically, sock marke movemens are inerpreed as reflecing exogenous changes in perceived or real produciviy, while budge deficis are undersood as a mainly poliical decision. We challenge his view here and develop wo alernaive inerpreaions. Boh are based on he noion ha a bubble (he do-com bubble) has been driving he sock marke, bu differ in heir assumpions abou he ineracions beween his bubble and fiscal policy (he Bush deficis). The benevolen view holds ha a self-validaing change in invesor senimen abou wha oher invesors would do led o he collapse of he sock marke bubble and he budge deficis were a welfare-improving policy response o his even. The cynical view holds insead ha he collapse of he bubble was due o an increase in he probabiliy ha a new adminisraion would ry o appropriae rens from foreign invesors hrough budge deficis. Subsequen evens were consisen wih his change in expecaions. This is a draf of a chaper forhcoming in R. Clarida (ed.) G7 Curren Accoun Imbalances: Susainabiliy and Adjusmen, NBER. We are graeful o Fernando Broner, Joseph Gagnon, and Maury Obsfeld for heir useful commens, and o Pierre-Olivier Gourinchas and Hélène Rey for sharing heir daa. The views expressed here are he auhors and do no reflec hose of he World Bank, is Execuive Direcors, or he counries hey represen. 1

2 0. Inroducion Since he early 1990s he Unied Saes has experienced seadily widening curren accoun deficis, reaching 5.7 percen of GNP in 2004 (see op panel of Figure 1). These deficis are large relaive o he pos-war US hisorical experience. Wih he excepion of a brief period in he mid-1980s where curren accoun deficis reached 3.3 percen of GNP, he US curren accoun has ypically regisered small surpluses or deficis averaging around one percen of GNP. As a consequence of he recen deficis, he US ne foreign asse posiion has declined sharply from 5 percen of GNP in 1995 o abou 26 percen by he end of 2004 (see boom panel of Figure 1). The goal of his paper is o provide an accoun of his decline ha relaes i o oher major macroeconomic evens and helps us o grasp is implicaions for welfare and policy. Any aemp o do his mus ake ino consideraion a major change in he paern of asse rade beween he US and he res of he world (see Figure 2). During he second half of he 1990s, he US accumulaed foreign asses and liabiliies a he rae of $765 billion and $965 billion per year. Abou wo-hirds of his consised of increases in he volume and value of equiy holdings. This paern reversed sharply in he firs half of he 2000s. The worldwide collapse in equiy prices erased a subsanial fracion of he asses and liabiliies ha he US had accumulaed during he 1990s, resuling in an increase of US ne holdings of equiy of abou $232 billion per year. Despie his, he US ne foreign asse posiion declined a he rae of $296 billion per year as US ne holdings of deb (boh public and privae) declined a he rae of $528 billion per year. While in he second half of he 1990s equiy was driving mos of he changes in US foreign asses and liabiliies, in he firs half of he 2000s hese changes were mainly driven by deb. This change in he composiion of he US curren accoun is a naural reflecion of he wo major macroeconomic evens of his period. The firs one is he do-com bubble of he 1990s. Beween 1990 and he peak in mid-2000, US equiy prices increased nearly five-fold, and he growh rae of equiy prices 2

3 acceleraed from 10.4 percen per year beween 1990 and 1995, o 21.2 percen per year beween 1995 and 2000 (see op panel of Figure 3). The value of US sock marke capializaion grew even faser, doubling beween 1990 and 1995, and hen ripling beween 1995 and he peak in 2000 (see boom panel of Figure 3). The sock marke boom in he res of he world was less specacular, bu sill quie impressive by hisorical sandards. Equiy prices in he major foreign markes grew 7.9 percen per year during he second half of he 1990s. As is well known, his episode ended wih a sharp downward adjusmen ha sared in By 2003 equiy prices in he US and abroad had fallen by 30 percen, and sock marke capializaion had fallen by abou 25 percen. Since hese changes in equiy prices have aken place agains a background of relaively low ineres raes and low inflaion, being in he sock marke surely was a good idea in he second half of he 1990s bu a lousy one in he firs half of he 2000s. The second major macroeconomic even was he reemergence of large fiscal deficis in he Unied Saes afer he Bush adminisraion ook over in 2001 (see Figure 4). Unlike he 1980s, he 1990s were a period of declining budge deficis and small surpluses. Afer 2000 budge deficis reappeared wih a vengeance however, reaching 4.8 percen of GNP in As a resul, US public deb has increased from 33 o 37 percen of GNP beween 2001 and An inriguing feaure of his recen period is ha large budge deficis have no been accompanied by any significan increase in he cos of borrowing for he federal governmen (see Figure 4). Roughly speaking, he 1970s were characerized by low budge deficis and low ineres raes, while he period feaured high budge deficis and high ineres raes. Bu over he pas 10 years his paern has unraveled, wih fairly high ineres raes and low deficis during he second half of he 1990s, followed by low ineres raes and large budge deficis since Wha are he links beween he sock marke bubbles, budge deficis, and curren accouns? As a firs cu a his quesion, we develop in Secions one and wo a convenional macroeconomic model ha crudely, bu effecively, encapsulaes convenional views of he US curren accoun defici. According o 3

4 hese views, is appearance in he second half of he 1990s refleced an increase in US produciviy relaive o he res of he world ha led invesors all over he world o place heir savings in he US sock marke. The siuaion reversed and US produciviy declined in 2000, leading o he sock marke collapse. Bu he curren accoun defici coninued despie his, now fueled by he drasic change in fiscal policy implemened by he Bush adminisraion. This change is usually aribued o purely exogenous facors such as he cos of he wars in Afghanisan and Iraq, as well as a desire o cu axes. This policy is however unsusainable and somehing mus evenually give. Mos observers hink ha his episode will end wih a painful fiscal adjusmen, alhough here are also hose who argue ha he resoluion will enail some defaul on he par of he US governmen. 1 Alhough he convenional view is coheren and well-grounded in heory, i has difficuly accouning for wo aspecs of he daa. The firs is observed movemens in he sock marke. If he sock marke only conains producive firms, is value should reflec ha of he price and quaniy of capial hey hold. Bu i is hard o find evidence of increases in eiher of hese variables ha would jusify he more han hree-fold increase in US sock marke capializaion ha occurred during he second half of he 1990s. And i is even harder o find evidence ha would jusify a one-quarer decline in he firs few years of he 2000s. 2 The second aspec of he daa is he behavior of ineres raes. The model predics ha he US fiscal expansion should increase he ineres rae as governmen deb crowds ou capial from he porfolios of invesors. Bu he evidence shows exacly he opposie. The real ineres rae fell from above hree 1 Few would argue ha he US governmen will fail o make sipulaed paymens, bu sill some hink ha here is some probabiliy ha he US governmen effecively defauls on is obligaions by engineering a high and unexpeced inflaion ha reduces he real value of hese paymens. 2 Hall (2000, 2001) has argued ha in fac such a large increase in he capial sock did occur during he 1990s. In paricular, he argues ha his increase ook he form of inangible capial such as brand loyaly as well as unique organizaional srucures based on efficien use of informaion echnology. While his view migh have seemed reasonable in he lae 1990s before he sock marke declined, i is far less appealing oday since i is is difficul o explain why so much of his inangible capial abruply vanished in he second half of

5 percen in he second half of he 1990s o almos zero percen in he early 2000s. 3 Wha has been driving he sock marke during he las decade? Why did he ineres rae fall in he mids of one of he larges fiscal expansions in US hisory? We argue in Secion hree ha he difficulies of he convenional view are closely linked o is underlying assumpion ha all savings are channeled ino efficien invesmens. If financial markes do no work as well, he economy migh conain invesmens ha deliver a rae of reurn ha is below he growh rae of he economy. These invesmens are inefficien since hey absorb on average more resources han hey produce. 4 I is well-known ha in his siuaion boh sock marke bubbles and governmen deb can play he useful role of displacing inefficien invesmens, raising he ineres rae and hence he consumpion and welfare of all. Moreover, hose who creae he bubbles and/or issue he deb receive rens ha can be inerpreed as a fee for providing his service. 5 A crucial and novel aspec of he model presened here is ha i provides a formal descripion of how bubbles and deb inerac wih each oher as hey compee for a fixed pool of savings. In Secions four and five we show ha hese ineracions provide a new perspecive on recen macroeconomic evens. In Secion four we consruc an equilibrium in which he sock marke iniially creaes a bubble ha eliminaes inefficien invesmens. The world economy operaes efficienly and he ineres 3 A popular explanaion for he decline in ineres raes is ha a global "glu of saving" has appeared coincidenally a he same ime as he fiscal deficis (see for example Bernanke (2005)). According o his view, governmen deb need no displace capial from he porfolio of invesors. As we shall see laer our sory is consisen wih his observaion. In fac, we provide a novel explanaion of he "glu of saving" based on he collapse of he bubble. 4 The resources devoed o keep hese invesmens are roughly equal o he growh rae imes he capial sock. The resources obained from such invesmens are roughly equal o he rae of reurn imes he capial sock. If he growh rae exceeds he rae of reurn, he economy obains addiional resources by eliminaing hese inefficien invesmens. See Abel e al. [1989]. 5 The paper ha discovered dynamic inefficiency is Samuelson [1958]. See also Shell [1971] for a revealing discussion of his problem. For he analysis of governmen deb, see Diamond [1965], Woodford [1990] and Hellwig and Lorenzoni [2003]. For he analysis of sock marke bubbles, see Tirole [1985], Grossman and Yanagawa [1993], King and Ferguson [1993], Olivier [2000], Venura [2002, 2003]. 5

6 rae and welfare are boh high. Bu susaining a bubble requires ha curren invesors believe ha fuure invesors will buy i from hem. A some poin, here will be a self-validaing change in invesor expecaions abou wha oher invesors will do and his riggers he collapse of he bubble. As a resul, inefficien invesmens reappear and he ineres rae declines. The governmen reacs o his by running large budge deficis and expanding public deb sufficienly o crowd ou hese inefficien invesmens. According o his benevolen view, budge deficis consiue a welfare-improving policy response o he collapse of he bubble. Moreover, hey also provide a windfall for he US governmen since i allows i o appropriae he value of he bubble. Secion five consrucs an alernaive equilibrium which again begins wih he sock marke creaing a bubble ha eliminaes inefficien invesmens. The governmen iniially refrains from running budge deficis and his creaes space for he bubble o grow. A some poin, invesors revise upwards heir expecaions of he likelihood ha here is a change in governmen and he new governmen would use fiscal policy o appropriae he windfall associaed wih replacing he bubble wih governmen deb. This change in invesor expecaions leads o he collapse of he bubble. There is hen a change in governmen and he new governmen sars a fiscal expansion ha validaes he expecaions of invesors. The ineres rae need no increase because he collapse of he bubble forces savers o seek alernaive invesmens and his raises he demand for governmen deb. This fiscal policy implemens a ransfer from he owners of he bubble a home and abroad o he US governmen. In his cynical view, budge deficis consiue a beggar-hy-neighbour policy ha is responsible for he collapse of he bubble. Ineresingly, he benevolen and cynical views are observaionally equivalen. In boh of hem, he collapse of he bubble is accompanied by a decline in he ineres rae and a large fiscal expansion ha leads o a high bu sable level of deb. In boh views, his high level of deb is compaible wih he US running budge deficis forever (alhough smaller han he curren ones). In boh of hem, he US ne foreign asse posiion can remain negaive forever. In boh views, he collapse of he bubble generaes a loss for shareholders a home 6

7 and abroad and a windfall for he US governmen. The only difference beween he wo views lies in he shock ha caused his chain of evens. While in he benevolen view his shock is a change in invesor expecaions abou oher invesors, in he cynical view his shock is a change in invesor expecaions abou he governmen. In boh inerpreaions, subsequen evens corroboraed he corresponding change in invesors expecaions. Of course, his is no he firs paper o be wrien on he US curren accoun defici. A subsanial lieraure in he pas few years has sudied he deerminans and susainabiliy of he US curren accoun defici. Much of his lieraure has adoped wha we have ermed as convenional views wihou much discussion, and has insead focused on deermining is implicaions. Mos noably, Obsfeld and Rogoff [2000, 2004, and 2005], Blanchard, Giavazzi and Sa [2005], and Roubini and Seser [2004] have all argued a large curren accoun reversal is ineviable and will likely be accompanied by a large and disrupive depreciaion in he dollar. 6 The wo papers ha are perhaps closer o his one are Venura [2001] and Caballero, Farhi and Hammour [2005]. Boh of hese papers challenge convenional views and sress insead he effecs of an expecaions-driven sock marke bubble on he US ne foreign asse posiion. Venura emphasized he role of he do-com bubble as he main driver of he curren accoun deficis during he second half of he 1990s, and argued ha hose deficis would be susainable in he absence of a bubble collapse. Unlike his paper, Venura did no offer a formal model connecing sock marke bubbles and he ne foreign asse posiion, nor did he analyze he poenial ineracions beween bubbles and fiscal deficis. Caballero e al. sudy a one-counry model in which high expecaions abou he fuure creae sufficien savings o fund he invesmen necessary o validae hese expecaions. In conras, we work wih a world 6 We do no analyze he implicaions of our scenarios for he real exchange rae, alhough i would be sraighforward o do i. The resuls would also be sraighforward and sandard. The real exchange rae would move in opposie direcion o he curren accoun and he magniude of he change would depend on he usual parameers, i.e. he elasiciy of subsiuion beween raded and nonraded goods and he elasiciy of subsiuion beween raded goods produced a home and abroad. 7

8 equilibrium model in which here is a fixed pool of world savings and he sock marke bubble, capial, and public deb compee for i. While Caballero e al. place he savings decision and adjusmen coss in invesmen a cener sage of heir sory, we insead emphasize he porfolio decision and financial marke imperfecions. 1. A model of crowding-ou wih deb and capial This secion presens a sylized model of produciviy, deb and deficis. I depics a world where young individuals save o provide for heir old age consumpion. These savings are used o finance boh producive invesmens and governmen deficis. Fiscal policy is used o redisribue consumpion across differen generaions. In paricular, deficis finance addiional presen consumpion by crowding-ou producive invesmens and lowering fuure consumpion. This model consiues a useful saring poin for our argumen, since i nealy encapsulaes convenional views on he effecs and he susainabiliy of fiscal deficis. Consider a world wih wo regions: US and ROW. This world is populaed by overlapping generaions of young and old. Each generaion conains a coninuum of members wih aggregae size one ha are evenly disribued across he wo regions. Le I and I* be he ses of US and ROW residens, respecively. As usual, use an aserisk o denoe ROW variables and omi he aserisk o denoe US variables. There is a single good ha can be used for consumpion and invesmen. Each generaion receives an endowmen of his good during youh, which is evenly disribued among all is members. The endowmen grows from one generaion o he nex a a (gross) rae γ. We normalize unis so ha he endowmen of generaion is equal o γ, and we express all quaniy variables as a share of his endowmen. The young are paien and risk-neural, and hey maximize expeced old age consumpion. Given his objecive, he young save all heir income and he 8

9 old consume all of heirs. Since he income of he young consiss only of he endowmen menioned above, our normalizaion implies ha all he quaniy variables are o be inerpreed as a share of world savings. The income of he old consiss of he reurn o heir savings plus a ransfer from he governmen which could be posiive or negaive. We shall assume hroughou ha his ransfer is independen of an individual s acions. Therefore, he only imporan decision in any individual s life is how o inves his/her savings so as o maximize is expeced reurn. This porfolio choice is a he hear of he sory we wan o ell here. The menu of invesmen opions available o he young consiss of governmen deb and firms. Governmen deb consiss of one-period bonds. We assume ha fiscal policies are consisen in he sense ha, if he marke decided no o roll over he deb, he governmen would be able (and willing) o generae enough of a surplus so as o redeem all he bonds issued. This ensures ha deb paymens are made wih probabiliy one. I also implies ha deb issued by US and ROW governmens mus offer he same ineres rae. Le r +1 be his common (gross) ineres rae for holding governmen deb from dae o dae +1. Firms are invesmen projecs run by enrepreneurs. A fracion κ of hese projecs is locaed in he US (alhough some of hese projecs migh be managed by ROW enrepreneurs). We assume ha his share can vary sochasically over ime wihin he uni inerval. Firms purchase capial during he enrepreneur s youh, produce during he enrepreneur s old age and hen disribue a single dividend per uni of capial before breaking up. This dividend or producion is random and has a mean π. To finance he purchase of capial, firms can use privae or inernal funds (i.e. he enrepreneur s own savings) or hey can go public and raise exernal funds in he sock marke (i.e. he savings of young oher han he enrepreneur). Firms ha are financed by inernal funds offer an expeced gross reurn equal o π. Firms ha are financed by exernal funds are 9

10 subjec o agency coss equal o α and offer an expeced gross reurn π-α. 7 Therefore, invesing in self-financed firms is preferred o holding socks of raded firms. Throughou he paper, we assume ha he economy is sufficienly producive, i.e. π>γ. This ensures ha he expeced reurn o capial exceeds he growh rae of savings. For he nex couple of secions, we furher assume ha agency coss are no oo severe, i.e. α<π-γ. This is equivalen o saying ha financial fricions are small and he sock marke is close enough o he fricionless paradigm. This assumpion urns ou o be crucial and will be removed in Secion hree. Each generaion conains wo ypes of young: enrepreneurs and shareholders. The former have good invesmen projecs ha hey can conver ino a firm, while he laer do no. For simpliciy, assume boh regions have he same disribuion of ypes. I follows from our assumpions ha enrepreneurs eiher inves in heir own self-financed firms or buy governmen deb, while shareholders are forced o choose beween holding socks of publicly raded firms and governmen deb. 8 Therefore, we can wrie he expeced consumpion of he differen individuals as follows: (1) E C i,+ 1 max{ π,r+ 1 } + E Ti, + 1 = max{ π α,r+ 1 } + E T i,+ 1 if if i is an enrepreneur i is a shareholder 7 Agency coss arise from incenive problems ha are creaed by he separaion beween ownership and conrol. One example is he cos of monioring he manager o ensure ha he/she does no embezzle funds from he firm. Anoher example is he efficiency loss due o less han opimal effor in siuaions where shareholders imperfecly observe he manager s acions or informaion se. 8 Who runs publicly raded firms? Remember each generaion conains a coninuum of individuals wih aggregae income equal o γ. Assume each ( infiniesimal ) enrepreneur can run a ( non-infiniesimal ) firm of size υ. If his enrepreneur uses only inernal funds, his/her expeced uiliy is π γ di. If his enrepreneur uses exernal funds, his/her expeced uiliy is old age consumpion is (π-α) γ di+m; where m is he manager s fee. Since here is free enry, he equilibrium manager s fee is m=α γ di. Since his fee is infiniesimal, i consiues a negligible cos for a non-infiniesimal firm of size υ and we can disregard i. Therefore, he model depics a world where a small subse of enrepreneurs use exernal funds o build large firms ha are raded in he sock marke, while a large subse of enrepreneurs runs small firms using inernal funds. 10

11 where T i,+1 is he ransfer ha old individual i receives from is governmen 9 (remember ha all quaniy variables are expressed as a share of he world endowmen). We assume he measure of his se is ε. Unless r +1 π, enrepreneurs enjoy higher expeced consumpion and herefore higher welfare han shareholders because of heir abiliy o manage firms. 10 Le D be oal (US plus ROW) governmen deb, and le δ be he fracion of his oal ha has been issued by he US. Then, we can wrie deb dynamics as follows: r + 1 (2) D + 1 = D + γ T * i I I i, + 1 (3) δ + 1 D + 1 = δ D+ 1 Ti, T i I I* i I i, + 1 Equaion (2) shows ha deb equals o deb paymens plus he primary defici. The laer is nohing bu he sum of all he ransfers received by he old. Equaion (3) shows how he US share evolves, for given primary deficis of he wo regions. We assume ha governmens never defaul on heir debs. This assumpion will be removed laer, bu i urns ou no o be crucial. The ineres rae depends on he amoun of deb ha he governmen is rying o place in he marke. In paricular, we have ha: π α π (4) r = [ π α, π] + 1 if if if D D D < 1 ε = 1 ε > 1 ε 9 We are assuming here ha only he old receive ransfers. 10 This comparison holds boh he ransfer and he dae of birh consan. Remember ha expeced consumpion is measured as a share of he endowmen and herefore welfare is given by γ E C i,+1. A shareholder of a fuure generaion migh enjoy more welfare han an enrepreneur of he presen generaion. 11

12 Equaion (4) shows how he ineres rae increases wih deb. For low values of deb, he ineres rae is π-α as he marginal buyer is a shareholder. For high values of deb, he ineres rae increases o π as he marginal buyer of deb is now an enrepreneur. An imporan observaion is ha he assumpion ha financial fricions are small implies ha he ineres rae always exceeds he growh rae. Le K denoe he world capial sock, which is: (5) K = 1 D Equaion (5) simply says ha capial and deb mus add o world savings, since hey are he only invesmen opions available. Le NFA be he US ne foreign asse posiion, i.e. he difference beween US wealh and he US capial sock. This is a measure of US capial expors o he res of he world, and is given by: (6) NFA = (0.5 δ ) D + (0.5 κ ) K Equaion (6) shows ha he ne foreign asse posiion of he US conains wo pieces. The firs erm is he difference beween he deb held by US residens and he deb issued by he US governmen, ha is, he firs erm is US ne borrowing. The second erm is he difference beween he capial sock owned by US residens and he capial sock locaed wihin he US, ha is, he second erm is US ne holdings of equiy. 11 The mechanics of his model are as follows: Equaions (2)-(4) joinly deermine he dynamics of deb and he ineres rae for a given sequence of 11 Noe ha US residens own half of he world deb and half of he world capial sock. This only because we have assumed boh regions have he same populaion size, he same disribuion of ypes and he same endowmen. This is jus a harmless simplificaion as i is sraighforward o generalize he model o include asymmeries in hese variables. Noe also ha since we have assumed ha governmen deb consiss of one-period bonds and firms las only one period, he curren accoun is equal o he ne foreign asse posiion and we can use Equaion (6) o alk abou eiher concep. This is anoher simplificaion, of course, since he real world conains long-lived asses. Bu i will no play a role in wha follows. 12

13 primary deficis. Wih hese dynamics a hand, Equaions (5) and (6) deermine he world capial sock and he paern of rade. Wih he help of an addiional assumpion on how hese deficis are disribued among old individuals, Equaion (1) describes he welfare of differen individuals. I is sraighforward o see ha his world economy has a unique equilibrium. We use i nex o inerpre he evoluion of he world economy during he las decade. 2. Convenional views Alhough sylized, his model capures well convenional views of he sources and effecs of he large and persisen deerioraion in he US ne foreign asse posiion during he las decade. According o hese views, in he second half of he 1990s he US became a more aracive place o inves relaive o he res of he world. Tha is, he number of good invesmen projecs in he US grew relaive o ROW (i.e. here was an increase in κ ). Many have idenified he boom in he informaion echnology (IT) secor as a main reason for his. Alhough his secor grew rapidly worldwide in he second half of he 1990s, he US benefied more from his growh due o is srong echnological lead relaive o Europe and Japan. Ohers have poined o he flurry of currency and banking crises in emerging markes as he main reason for he US becoming a more aracive place o inves relaive o ROW. These crises, which sared in Mexico and moved o Eas Asia and Russia, led o a downward reassessmen of he expeced reurn o emerging marke projecs. For eiher or boh of hese reasons, he sory goes, invesors all over he world decided o pu heir savings ino he US sock marke and his is wha generaed he curren accoun deficis of he second half of he 1990s. This is consisen wih he evidence repored in Figure 2 ha, in he second half of he 1990s, a large componen of he change in he US ne foreign asse posiion consised of a decline in ne holdings of equiy. The sory becomes a bi fuzzy when i comes o explaining he reversal in ne holdings of equiy ha ook place in he firs half of he 2000s, also repored in Figure 2. In he conex of our 13

14 model, his reversal could be seen as a decline in he number of good invesmen projecs in he US relaive o ROW (i.e. here was a decrease in κ ), alhough here is scan direc evidence supporing his view. Alhough his accoun migh sound reasonable a a superficial level, i should be me wih a healhy dose of skepicism afer looking a he acual numbers. Remember ha he value of he sock marke increased hreefold from 1995 o 2000 and hen declined by one quarer from 2000 o If he sock marke conains only producive firms, is value mus reflec ha of he sock of capial held by hese firms. Tha is, he increase in sock marke capializaion requires a comparable increase in he price of capial, in he quaniy of capial or in boh. To he exen ha capial is reproducible, is price canno exceed he cos of producing addiional unis. In he model, his cos is consan and equal o one. Naurally, we could exend he model o allow for congesion effecs on he cos of capial as in he popular Q-heory of invesmen. Bu i seems unlikely ha such an exension would be able o explain much of he rise in he value of he sock marke. 12 I also seems unlikely ha his rise and fall can be explained by changes in he quaniy of capial. In he model world savings grow a a consan rae γ, and so a large increase in he US sock of capial would have o be associaed wih a decline in ROW s sock of capial. However, he increase in sock marke capializaion ook place all around he indusrial world. Naurally, one could exend he model o allow for exogenous increases in savings and herefore he capial sock. Bu his would no ge us very far quaniaively. Since he US capial sock is abou wice US GNP, a hree-fold increase in he capial sock during he second half of he 1990s would have required asronomical invesmen raes! Some have argued ha he boom in he sock marke in par refleced he accumulaion of inangible capial such as brand loyaly or unique organizaional 12 Hall [2001] esimaes he price of insalled capial in he US since 1946, and finds ha his price increased by only abou 25 percen during he second half of he 1990s. See also Hall [2004] for an aemp o measure he cos of capial. 14

15 srucures. 13 The accumulaion of his kind of capial did no require invesmen as convenionally measured, and herefore consiued a windfall o is owners. There was, in fac, some evidence in he 1990s poining in his direcion: for example, he emergence of business models buil on he efficien use of informaion echnology as a valuable form of inangible capial (mos noably, various forms of e-commerce). However, while he accumulaion of his inangible capial could in principle accoun for he run-up in he value of sockmarke during he 1990s, i seems much harder o argue ha i was he decumulaion of his form of capial ha was behind he sock marke decline in he second half of Why would he value of organizaional forms based on he use of informaion echnology such as e-commerce suddenly have vanished in he second half of 2000? The quesion hus remains: how did he value of he sock marke grow so much in he second half of he 1990s and hen drop in he firs half of he 2000s? Of course, here have also been many voices arguing ha he US sock marke during his period was fueled by a bubble raher han by an increase in US produciviy relaive o he res of he world. According o his alernaive view, foreign invesors were no buying US firms in he IT secor because of heir high produciviy. Insead, hey were buying hem because hey were expecing o resell laer a a higher price. The appearance of a bubble migh bring huge capial gains o hose ha are able o creae i, and his could explain he massive increases in equiy prices during he second half of he 1990s. Bu o realize hese capial gains one mus firs find buyers for he bubble, and his is only possible if he bubble promises a sufficienly aracive reurn. Tha is, a bubble can be creaed if and only if i is expeced o grow fas enough so as o jusify buying i. I is possible o examine his alernaive inerpreaion wihin our model. To do his, we formally define a sock marke bubble as a siuaion in which firms wihou capial are valued and raded in he sock marke. We refer o hese firms 13 See Hall (2000, 2001). I could also be ha his inangible capial already exised, and i was he demand for i ha increased during his ime. To he exen ha inangible capial was irreproducible, is price could also have increased. 15

16 as bubbly firms, as opposed o he producive firms ha own he capial sock. The quesion is wheher bubbly firms can survive in a sock marke ha also conains producive firms. Le B be he asse bubble (or aggregae value of bubbly firms as a share of world savings). Since bubbly firms do no disribue dividends, he reurn o holding hem consiss only of heir price appreciaion. Therefore, he young will buy hese firms if and only if he expeced rae of price appreciaion is high enough: E B+ 1 (7) γ r + 1 if B > 0 B Oherwise, he young would prefer o hold shares in producive firms or governmen bonds. A bubble can herefore creae is own demand only by growing on average as fas or faser han he ineres rae. Bu he growh of he bubble canno be so fas so as o ougrow world savings, i.e. B 1 mus hold in all daes and saes of naure. And his requiremen is incompaible wih Equaion (7) if he ineres rae exceeds he growh rae. Therefore, we conclude ha bubbly firms canno survive in he sock marke in his case. Our assumpion ha financial fricions are small implies ha he ineres rae always exceeds he growh rae and herefore rules ou he possibiliy of sock marke bubbles. This, we hink, is he firs serious shorcoming of he sandard or convenional view. This view also holds ha he curren accoun deficis coninued afer 2000 due o he sharp change in fiscal policy implemened by he Bush adminisraion (i.e. an increase in he US primary defici ha leads o an increase in δ ). This fiscal policy consiss of spending more, cuing axes, and financing he resuling budge deficis by issuing governmen deb. Overwhelmingly, his change in policy has been inerpreed as a poliical decision and no as an economic policy response o a specific macroeconomic disurbance. In oher words, he US fiscal expansion has been reaed as an exogenous shock o he macroeconomic landscape. Much of he incremen o public deb has been placed abroad. Beween end-2000 and end-2003 US public deb increased by $500 billion, while foreign holdings of US reasury bills increased by almos he 16

17 same amoun. And o he exen ha public deb has been placed a home, i likely has crowded ou US corporae deb and forced firms o place an increasing fracion of heir own deb abroad. Through hese direc and indirec channels, he budge deficis of he Bush adminisraion accoun for a subsanial par of he large increase in ne borrowing from abroad shown in Figure 2. The imporan quesion is wheher his siuaion is susainable and, if i is no, how he necessary adjusmen will look. To answer his quesion, we use he model o analyze he effecs of a fiscal expansion in he US. The experimen is as follows. Iniially boh regions have no deb and follow balanced-budge policies, i.e. D =0 and T 0. A i, = i I I* some dae, he US swiches is policy for exogenous reasons and decides o increase spending, cu axes and finance he resuling defici by going ino deb, while ROW keeps is budge balanced, i.e. T = T 0 and T 0. The i I i, > * i I i, = quesions we address nex are: Wha are he possible endings for his fiscal episode? Wha are is welfare consequences? When he fiscal deficis appear, governmen deb sars growing a an acceleraing rae, crowding ou he invesmens of he shareholders. The growh of he deb is fueled direcly by he deficis, bu also indirecly by unfavourable deb dynamics resuling from he ineres rae exceeding he growh rae. In fac, i is his second componen growing over ime ha leads o acceleraing deb growh. If he fiscal expansion lass long enough, he deb also sars crowding ou he invesmens of he enrepreneurs. A his poin he ineres rae goes up, deb dynamics become more unfavourable and deb accumulaion furher acceleraes. As deb accumulaes, US ne borrowing abroad increases. Since he deb crowds ou capial from he porfolios of invesors worldwide, US ne holdings of equiy decline in absolue value. This siuaion is no susainable since he acceleraing growh rae of deb is incompaible wih a fixed pool of savings, and he US evenually mus go hrough a period of fiscal adjusmen. This essenially means ha he US mus 17

18 reverse is fiscal policy (since i does no wan o defaul) and sar running sufficienly large surpluses, i.e. i I T i, γ r = T < D. No surprisingly, he γ magniude of he fiscal adjusmen increases wih he level of deb. When he deb is higher, he surpluses need o be larger, las longer, or boh. Assuming ha he US governmen only makes ransfers o US ciizens, he fiscal expansion increases he welfare of curren US generaions in derimen of fuure ones. Afer all, in his model a policy of budge deficis is nohing bu a policy of passing he bill forward. When his policy is implemened, he old consume beyond he reurn o heir savings and pass he bill o he nex generaion. This bill includes heir exra consumpion plus he ineres. Raher han paying he bill, he nex generaion furher increases i by also consuming more han he reurn o heir savings and hen passes he bill along o he following generaion. This keeps going on for as long as he governmen follows a policy of running deficis and rolling over he deb. Bu he bill is growing oo fas and mus evenually be paid. This is wha a fiscal adjusmen is all abou. The longer i akes for his adjusmen o happen, he larger is he final bill and he coslier will be for he US o face i. The welfare of presen generaions is also affeced by he fiscal expansion indirecly hrough is effecs on he ineres rae. High ineres raes raise he expeced consumpion of young shareholders boh in he US and ROW. Since ineres rae coss are added o he bill, fuure generaions of US residens are also supporing higher consumpion of curren ROW generaions. This consiues a posiive spillover of he US fiscal expansion on ROW. The fiscal adjusmen will eliminae i and his is why ROW residens migh prefer his o happen as lae as possible. Of course, one could argue ha his scenario is unrealisic since i assumes ha he US governmen will honor is deb in all coningencies. Bu 18

19 relaxing his assumpion has only minor effecs on he overall sory. To see his, replace Equaions (2) and (4) for hese sraighforward generalizaions: 14 (8) r + 1 D + = γ i I I 0 D * + 1 T i, + 1 wih prob. 1 µ wih prob. µ π α + µ π + µ (9) r = [ π α + µ, π + µ ] + 1 if if if D D D < 1 ε = 1 ε > 1 ε where µ is he (exogenous) probabiliy ha he US governmen defauls on is deb. A reasonable assumpion is ha his probabiliy grows as he deb increases, bu we need no make i here. Equaion (8) recognizes ha now deb can be defauled upon, while Equaion (9) recognizes ha he expeced reurn on governmen deb includes he promised reurn minus he expeced loss from defaul. Noe ha defaul risk makes deb dynamics even more unfavourable by raising he ineres rae. In oher words, defaul risk makes he curren siuaion even more unsusainable. Wih a posiive defaul probabiliy he US fiscal expansion migh have a differen ending. If he curren defici goes on long enough and he required fiscal adjusmen becomes oo large, he US governmen migh simply defaul on is deb. In his case, he adjusmen akes place in a dramaic fashion. The generaion of old (US and ROW) shareholders ha suffers he defaul pays he enire bill for he excess consumpion of is US predecessors. Since half of he shareholders are no US residens, half of he bill is herefore paid by ROW ciizens. In his scenario, curren US economic policy is simply increasing consumpion and welfare of curren US residens a he expense of fuure US and ROW residens. This consiues a negaive spillover of he US fiscal expansion on ROW. A fiscal adjusmen would ensure ha his scenario does 14 One can hink of defaul as surprise inflaion ha erases he real value of he deb. Here we are also assuming ha he ROW governmen keeps wih is policy of having no deb. Oherwise, we should also break down Equaions (8)-(9) ino heir wo regional componens. 19

20 no happen and, as a resul, ROW residens migh prefer he US o reduce is budge deficis even if his lowers he ineres rae. Anoher problem wih his sandard sory is he behavior of he ineres rae. While he model predics ha he US fiscal expansion will increase he ineres rae, he evidence shows exacly he opposie. Figure 4 showed ha, in he mids of one of he larges fiscal expansions in US hisory, he ineres rae fell from above hree percen o close o zero percen. The model can accoun for his observaion if here is a decline in he expeced reurn o capial (i.e. a decline in π or ε) and/or an increase in agency coss (i.e. an increase in α). 15 Given he magniude of boh he fall in ineres raes and he increase in budge deficis, he decline in produciviy and/or a increase in agency coss would have o be very large. There is scan evidence for a major decline in world produciviy. And despie he inense media coverage of some financial scandals such as Enron or Parmala, i also seems unlikely ha fricions in financial markes increased dramaically overnigh. Anoher popular hypohesis for why ineres raes have fallen is ha a global "glu of saving" appeared (see Bernanke (2005)). According o his hypohesis he increase in saving exceeded he increase in public deb, leading o a decline in ineres raes. There are various explanaions for where hese savings are coming from, including an increased appeie for reserves by Asian cenral bankers, and windfall of rising oil prices in he high-saving oil producing counries. While hese sories abou exogenous shocks are reasonable, we shall argue below ha anoher explanaion for he "glu of saving" is he collapse of he bubble iself. Once he bubble was no longer available, savers endogenously shifed o oher asses, mos noably, US governmen deb. To sum up, he model crudely bu effecively encapsulaes convenional views of he US curren accoun defici. Is appearance in he second half of he 1990s reflecs an increase in US produciviy relaive o he res of he world ha 15 We have assumed ha π, α, and ε are consan. Noe however ha all he equaions of he model sill apply if we assume ha hese parameers vary sochasically over ime. 20

21 led invesors all over he world o place heir savings in he US sock marke. This siuaion ended wih he sock marke collapse in Bu he curren accoun deficis coninued afer his now fueled by he drasic change in fiscal policy implemened by he Bush adminisraion. This policy is however unsusainable and somehing mus evenually give. Mos observers hink ha his episode will end wih a painful fiscal adjusmen, alhough here are also hose who argue ha he resoluion will enail some defaul on he par of he US governmen. The sylized model developed above shows how all of hese observaions fi ogeher. Bu he model is no free of problems, hough. I canno explain observed movemens in equiy prices, and i can only explain why he ineres rae fell in he mids of one of he larges fiscal expansions in US hisory by appealing o exogenous changes in saving or produciviy. How can we come o grips wih hese observaions? The preceding analysis relies o a large exen on he condiion ha he ineres rae exceeds he growh rae. This condiion rules ou he exisence of sock marke bubbles and underlies he noion ha a policy of coninued fiscal deficis is unsusainable. Bu his condiion is no saisfied in he daa. Figure 5 plos he ex-pos real one-year Treasury bill rae and he real GDP growh rae for he US since Wih he excepion of he 1980s, he ineres rae has been consisenly below he growh rae for almos all years during his period. More imporanly for our purposes, since 1992 ineres raes have averaged 1.7 percen while GDP growh has averaged 3.3 percen. As we shall show nex, he behavior of he world economy is quie differen when he growh rae exceeds he ineres rae. 3. A model of crowding-ou wih deb, bubbles and capial Assume nex ha agency coss are severe, i.e. α>π-γ. This is equivalen o saying ha financial fricions are large and he sock marke is far from he fricionless paradigm. In his case, he world economy can experience sock marke bubbles, i.e. he sock marke migh conain unproducive or bubbly firms 21

22 ha never deliver a dividend. The only reason o hold hese firms is o realize capial gains. We assume ha creaing bubbly firms is simply a maer of luck and enails negligible coss. Naurally, all young ry o creae hem and hose ha are successful obain a ren by selling heir bubbly firm during old age. 16 Le N i, be he ren ha individual i receives. We generalize Equaion (1) as follows: (10) E C i,+ 1 E + 1 max π,r+ 1, γ B = E max π α,r+ 1, γ { B N } + E T { B N } + 1 B i,+ 1 E T + E N i,+ 1 i,+ 1 + E N i,+ 1 if if i is an enrepreneur i is a shareholder where N = is he oal value of he bubbly firms ha appear a dae. N i, * i I I Noe ha he expeced (gross) reurn on holding a bubbly firm is equal o he (gross) growh rae of is price. This growh rae is equal o he expeced value of omorrow s bubbly firms a dae +1, i.e. γ +1 { B N } E ; divided by heir value a dae, i.e. γ B. 17 Equaion (10) exhibis wo differences wih respec o Equaion (1). Bubbly firms are now included in he menu of asses and his affecs he expeced reurn on he savings of he young. In addiion, he creaion of new bubbly firms generaes rens for he old and his consiues an addiional source of income. Equaions (2) and (3) describing deb dynamics sill apply, bu we mus modify Equaion (4) describing he ineres rae as follows: 18 π α π (11) r = [ π α, π] + 1 if if if D D D < 1 ε B = 1 ε B > 1 ε B 16 Success is nohing bu a posiive realizaion of an individual-specific sunspo. 17 Equaion (6) implicily assumed a fixed number of bubbly firms. In his case, he expeced growh rae of he bubble equals he expeced price appreciaion of exising bubbly firms. 18 We assume again ha governmens never defaul on heir debs. As shown before, i is sraighforward o generalize he analysis o he case in which here is an exogenous probabiliy ha governmens defaul on heir debs. 22

23 Equaion (11) recognizes ha deb and he bubble boh compee wih capial for he savings of he young. In order o creae is own demand, he bubble mus grow sufficienly fas: (12) E { B N } r = γ B if B > 0 Equaion (12) ensures ha he young are willing o buy bubbly firms. I applies whenever bubbly firms have a posiive value in equilibrium. We shall consruc laer equilibria in which bubbly firms no only survive in he sock marke, bu drive all producive firms ou of i. Finally, le β be share of all bubbly firms creaed by US residens. I hen follows ha: (13) β + 1 B+ 1 = β B+ 1 Ni, N * i I i I I i, + 1 The presence of a bubble naurally affecs asse rade. The world capial sock is now given by: (14) K = 1 D B and he capial sock of he US is hen κ (1-D -B ). The US ne foreign asse posiion is now given as follows: (15) NFA = (0.5 δ ) D + (0.5 β ) B + (0.5 κ ) (1 D B ) Equaion (15) is a naural generalizaion of Equaion (6) and includes an addiional piece of he ne foreign asse posiion of he US. This piece is he second erm and consiss of he difference beween he share of he bubble held by US residens and he share of he bubble creaed by hem. Now, he US ne 23

24 holdings of equiy are given by he sum of he second and hird erms of Equaion (6). The mechanics of his model are very close o hose of he model in secion 1: Equaions (2), (11), (12) and (13) describe he dynamics of deb and he ineres rae for a given sequence of bubbles and deficis. Wih hese dynamics a hand, Equaions (14) and (15) deermine he world capial sock and he paern of rade. Wih he help of addiional assumpions abou he creaion of new bubbly firms and he disribuion of deficis among individuals, Equaion (10) describes he welfare of each individual. This world economy has many equilibria now, each of hem corresponding o a differen se of (consisen) assumpions abou he behavior of bubbles and deficis. We shall laer consruc some of hese equilibria and examine heir implicaions. This model allows us o sudy he large and persisen deerioraion of he US ne foreign asse posiion under he more realisic assumpion ha he ineres rae falls shor of he growh rae. As is well known, his condiion implies ha he world economy conains pockes of dynamically inefficien invesmens. 19 The logic behind his inefficiency is disarmingly simple and well undersood: every period young shareholders inves γ (1-ε) unis of he single good, while old shareholders receive a reurn o heir savings ha on average equals r γ -1 (1-ε). If r <γ, i is welfare-improving o implemen a social conrac whereby all young shareholders are forced o sop invesing and insead give all of heir income o he old shareholders. This social conrac would liberae an 19 In an influenial paper, Abel e al. [1989] noiced ha capial income exceeds invesmen in indusrial counries and hen argued ha his observaion is incompaible wih he view ha hese counries conain dynamically inefficien invesmens. Their argumen is misleading however. To see his, noe ha in our world economy capial income is [π-α (1-ε)] γ -1 while invesmen is γ. The observaion ha capial income exceeds invesmen, i.e. π-α (1-ε)>γ; does no rule ou he possibiliy ha here exis pockes of dynamic inefficiency, i.e. γ>π-α. The observaion ha capial income exceeds invesmen only implies ha he average invesmen is dynamically efficien. Bu his is no incompaible wih he saemen ha he marginal invesmen be dynamically inefficien. Abel e al. [1989] did no noice his because hey assumed hroughou ha financial markes are fricionless and, as a resul, all invesmens exhibi he same reurn. This corresponds o he special case of our model in which α=0. This is a crucial and ye unrealisic assumpion. Once we remove i, he argumen of Abel e al. does no go hrough. 24

25 amoun of resources equal o (γ-r ) γ -1 (1-ε) per period, and hese resources would go direcly o he pockes of he fuure shareholders. Moreover, he generaion ha sars he social conrac would ge an upfron fee (for is service o sociey) ha equals he endowmen of he firs generaion of young ha paricipae in he social conrac, i.e. γ (1-ε). This social conrac herefore improves on he marke and raises he consumpion and welfare of all generaions. 20 A firs sigh, he pracical difficulies in implemening his social conrac appear overwhelming. Bu his is only a false appearance. I has been known for a long ime ha governmen deb and sock marke bubbles can boh crowd ou inefficien invesmens and improve welfare. Complying wih he social conrac during youh and giving he endowmen o he old can be seen as equivalen o purchasing he righ o receive he endowmen of he young during old age. Bu his exacly wha governmen deb or sock marke bubbles are. When he young buy any of hese asses from he old (and hus give he old heir endowmen), hey are doing so in he expecaion of reselling hem o he young laer during heir old age (and herefore receiving he endowmen of he young). In his way, governmen deb and sock marke bubbles eliminae inefficien invesmens and liberae resources ha increase he consumpion of all fuure generaions. Since issuing deb or creaing bubbly firms has negligible coss, hose ha creae hem receive in addiion an upfron fee or ren which equals he full value of he asse creaed. This upfron fee or pure ren is exacly wha T i, and N i, are. As he previous discussion hins, he presence of pockes of dynamically inefficien invesmens migh lead o a subsanial rehinking of he role of fiscal policy. Naurally, fiscal policy sill redisribues consumpion across generaions. Bu now i also eliminaes inefficien invesmens. Since bubbles are an alernaive and marke-generaed soluion o he same problem, his observaion raises some ineresing and sill unanswered quesions: Under wha condiions does fiscal policy complemen sock marke bubbles as a mechanism o 20 Since enrepreneurs receive an expeced gross reurn o heir savings ha exceeds he growh rae, heir invesmens are dynamically efficien and he governmen should no ry o eliminae hem. 25

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