Dutch Disease in the USA

It may be strange to say it, but the financial sector in the US has come to resemble the oil industry.

Traditionally, the financial sector’s role has been informational and intermediary — capital markets, rating agencies, insurers, investment banks, brokerages, and savings institutions all observe economic facts, convert weighings of risk and reward into estimations of value, and grease the conduits through which investors purchase claims on firms at prices consistent with those valuations. Sure, every day since the first hustler stood under a buttonwood tree on lower Manhattan, there has been scandal. But the financial sector as a whole has been something of a humdrum affair, an old fashioned sort of eBay where suppliers and demanders of capital meet on roughly even terms, and marketmakers take a small cut for their troubles.

Over the past few years, though, the financial sector’s role has changed owing to a single, simple fact. Debt has been mispriced. It is too expensive. Purchasers of debt, the lenders, have not asked their agents on Wall Street (or in the City) to drive a hard bargain for them. They’ve simply offered to purchase a wide variety of debt at whatever the going price is, regardless of whether that price has been inflated by the impact of their own continuous demand. Who are these easygoing lenders? Read Brad Setser a lot and you’ll figure it out. But we don’t much care. All that matters is that they are foreign. Americans aren’t the ones overpaying for debt.

The mispricing of debt has created richer opportunities on Wall Street than taking small cuts off of essentially fair deals. Instead, the difference between the “right” price of a debt security by traditional valuation models and what price-insensitive purchasers are willing to pay has become a source of profit. This is one way that Wall Street has come to look like the oil industry. Just as Shell profits from the spread between what it costs to extract oil and what the market will pay for it, financial firms now profit from the difference between the interest rates a fair borrower would expect to pay and the unusually low interest rates lenders are actually receiving. That spread is taken in a lot of pieces. A large fraction of it is taken by the borrowers themselves, and the rest is divided among financial intermediaries. But like oil wealth, from the perspective of the domestic economy, that entire spread is free money. It is real wealth, exchangeable for external goods and services, that is not taken from any domestic player.

Debt is similar to oil also in the sense that it must be prospected before it can be extracted, refined, manufactured, or sold. Wall Street knew it had a potential fountain of wealth when it discovered limitless, price-insensitive demand for debt. But in order to actually drink from that fountain, players had to produce debt to supply that demand. And that’s not easy. Foreign purchasers of debt may be price-insensitive, but they won’t buy just anything. They won’t cut a check to your grandma in exchange for a handwritten IOU. They want liquid debt securities with good ratings, maybe government or agency-backed, etc. The wildcatters of today’s great debt rush are the innovators who find ways to supply that voracious demand, and thereby get a piece of that rich spread. Innovation is not dead in America, and the variety of techniques and schemes out there for getting a cut from debt-mispricing is enormous. They include the much ballyhooed excesses of the mortgage industry (persuade people to borrow and refi as much as possible against homes, concede great rates to sophisticated borrowers but get what you can from fools, securitize all the paper in a form that price-insensitive buyers will take or that price-sensitive buyers find more appealing than overpriced alternatives). The current private-equity and M&A booms are means of manufacturing borrowers who profit from the sale of overpriced debt. Abnormal returns to hedge-funds result from leverage taken on at costs not commensurate with the risks. The alphabet soup of structured finance. The list goes on and on. (As a side-effect, in order to capture the surplus created by the mispricing of debt, American firms and households have had to borrow more money than they might have otherwise. That creates risks, but that’s not our concern here.)

The result of all this activity for the American economy has not been dissimilar to what natural gas famously did for the Dutch in the Sixties. The sudden, exogenous wealth in a single tradable (debt) provokes capital inflows that bolster America’s currency, and hurt the competitiveness of other US industries in world markets. [1] Labor markets begin to skew towards the booming tradable sector (debt and finance), while layoffs mount in other tradables industries. Nontradable services surge from the injection of exogenous wealth, and are drawn to serving the booming finance sector, the source of it all.

All in all, I think it is accurate to claim right now that the United States is suffering from “Dutch Disease”, with a little twist. America’s “resource curse” doesn’t come from some newfound ocean of oil. (Thank goodness for that.) Our curse is that our paper is suddenly unusually valuable, and that we are skewing our economy towards mining, packaging, and exporting ever more of the stuff. Unlike oil, our capacity to produce paper will never be exhausted. But the strange circumstance whereby American IOUs command a high price in real goods from abroad may end as suddenly as it began. Or it may continue for a long time. A repricing of US paper is an event far less predictable than the exhaustion of an oilfield. Unfortunately, our capital markets don’t seem to know how to price or hedge that kind of risk.

It is nice, in the moment, to be overpaid for something. But I hope we are not overpaid for too long. A resource curse is still a curse.

Update: A quick Google search indicates this is not a novel idea. An anonymous reader of Steve Sailor’s website makes the same point, more sharply and concisely than I have, and in January 2005! (You’ll have to search for “dutch” to find it on the long page; the direct link is broken. I think the anonymous reader’s piece on Dutch Disease is quite good, but don’t endorse the rest of the content.)

[1] An obvious, and true, objection is that the US dollar has been depreciating against currencies that float, not appreciating. But the capital inflows — the purchases of overpriced debt — are coming from countries that control their dollar exchange rates. The argument is that dollar’s nominal stability represents an appreciation, given that increases in the relative purchasing power of currencies from the debt-purchasing nations fail to result in the expected nominal dollar decline.

Update History:
  • 26-Apr-2007, 3:10 p.m. EDT: Added update with reference to an earlier piece quite similar to this found via Google.