Money for Nothing: The Importance of Stocks over Flows

Economists are fond of making a distinction between flow and stock concepts, and woe to one who confuses the two.  A flow is a variable measured over time, such as the budget deficit.  A stock is an accumulation of flows and is measured at one time, such as the US government debt.  Income is a flow, while savings is a stock term.

Turning to the US external accounts, stock and flow are also important.  The US annual current account deficit is a flow term. The net international investment position is the associated stock term.  The idea here is that as a result of the US buying more goods and services from the world than it sells, foreign investors accumulate claims against the US.  These claims take the form of portfolio investment, such as stocks and bonds, but also direct investment, as factories and property.

It sounds straightforward, but it is anything but. Last year, the US recorded a current account deficit of $466 bln.  Counter-intuitively, and overlooked by economists and policymakers, the US net international investment position improved by $470 bln.

Let that sink in.  The US bought $466 bln more goods and services than it sold the world and yet foreign claims on the US fell, and not by an insignificant amount. The US lived 2.4% beyond its means in 2017, and  it owed the world less.  Is this the closest thing to money for nothing?

The increase in the flow (deficit) did not adversely impact the debt (stock).  But that is because the flow swamped by the size of the stock.  By the US government accounting, Americans owned about $27.6 trillion of foreign assets at the end of last year.  Foreign investors owned around $35.5 trillion of US assets.

A small change in the valuation of the large stock of assets can outweigh the impact of an annual change in flows.    The valuation adjustments include changes in the dollar's value.  For example, last year's dollar decline increased the value of the foreign stocks and bonds Americans own.  The dollar's decline does not impact the dollar value of foreign ownership of US stocks and bonds.  Similarly, if the basket of international equities Americans own outperforms the basket of American stocks that foreign investors own, the US net international investment position improves.

The reason that the flow (current account deficit) did not produce a larger stock (US indebtedness by this measure) is that the stock is so large than the valuation changes offset the flow in full and more.  This is an important development that has far-reaching implications because there is good reason to expect the stock to continue to increase so over time.  The significance of the annual change arising from the current deficit on the US net international position will continue to shrink.

The valuation of the existing stock will continue to drive the net international investment position. It means that the flow will not be particularly helpful in forecasting or assessing the change in the net international investment position.

It also implies that the reference point needs to be reconsidered.  Economists think of the net international investment position in terms of GDP.  The roughly $7.5 trillion deficit is almost of 50% of GDP.  However, the more impactful comparison may be the stock of assets.

If the value of foreign claims on the US fell by 20%, due to the combination of the dollar's decline and underperformance of US asset markets, it is possible that the net international position moved into balance.  Yet there is no urgency.  Fast-forward a decade or two.  The stocks could be sufficiently large as to require considerably smaller adjustments to valuations.  Zoom out half a century, and it could be a rounding error.

Of course, this presupposes the broad continuation of an era of high mobility of capital and extensive cross-border ownership (globalization of finance and production).  And this is not even to discuss why the basket of America's foreign assets appear to consistently earn a higher return than the foreign investment in the US.