This project develops new theories and methodologies to understand the determinants of net and gross foreign assets, the trade balance and the exchange rate. It quantifies their respective roles in the dynamics of countries' external deficits. The investigators constructed a disaggregated database of U.S. foreign assets and liabilities to obtain novel insights into the predictability of asset returns and exchange rates and the importance of valuation effects for the sustainability of external deficits. They will extend this work along three dimensions. First, they will do a similar analysis with other countries, contrasting large financially developed economies (UK, Japan) with small open economies (Canada) as well as emerging markets. Second, they will develop new theories of portfolio investment where international wealth transfers and predictable excess returns play a key role. Lastly, the investigators use their methodology to analyze fiscal adjustment.
The Intellectual Merit of this proposal is to further our understanding of how financial globalization affects the process of external adjustment. Traditional models focus on deficit countries restoring external balance through future changes in net exports. For the US, the investigators find that revaluations of foreign assets and liabilities are a quantitatively important -and stabilizing- channel as well. This research helps also identify important determinants of asset returns and currency movements. For the US exchange rate, the investigators' model outperforms the random walk out-of-sample from one quarter to four years. The proposal extends the empirical analysis in order to assess the importance and direction of valuation effects for other countries. The proposal also develops a class of general equilibrium dynamic models consistent with observed patterns of capital flows, asset prices, currency fluctuations and net exports. Those models feature home bias in equity and international wealth transfers, elements rarely incorporated in open economy models and yet crucial for realism. The proposed models allow the investigators to study the effect of demand and supply shocks or changes in portfolio preferences such as erosion of home bias or loss of international currency status on the capacity of countries to accumulate foreign debt. Finally the proposed activity extends our understanding of government debt dynamics by measuring the importance of valuation effects for fiscal adjustments.
The proposed activity has many Broader Impacts. First, the project provides a new perspective on the issue of current account sustainability by highlighting the role of capital gains and losses on gross foreign assets and liabilities. It provides a theoretically grounded measure of external imbalance and constructs a database to implement it. Initial results show that US external imbalances are currently smaller than in the mid 1980s. This fact alone is important for the policy debate. Second, the investigators' framework suggests that the impact of monetary and fiscal policy on external accounts operates inter alia through valuation effects via exchange rate changes. These effects play very differently in developed economies and in emerging markets where most liabilities are in dollars. They have implications for the choice of exchange rate regime. Third, predictability of the returns on net foreign asset positions and of the exchange rate has important consequences for financial markets, the design of effective economic policies, and hedging strategies for international businesses. Fourth, the proposed methodology can also be applied fruitfully to the analysis of other imbalances. The investigators propose to look at fiscal imbalances where valuation effects (via inflation) may be important. Finally the quarterly database of US foreign assets and liabilities at market value that the research team constructed has already raised the interest of other researchers and organizations (IMF, BIS). The NBER has asked them to participate in a special conference on G7 current account imbalances. They are planning to build similar databases for other industrialized as well as emerging countries. These data could be used for the testing of a wide array of open economy macroeconomic theories.
