VoxEU Column International Finance

The $2 trillion dollar question: How about US demand and output?

The US net international investment position declined by an astounding magnitude in 2008. Does that imply a massive contraction in US consumption? This column provides empirical evidence that large swings in the US current account are driven by transitory shocks that don’t significantly alter consumption.

In a recent Vox column, Gian Maria Milesi-Ferretti estimated that the US current account deteriorated by 15% of GDP in 2008. This record fall was driven by the $1.2-1.3 trillion losses on US-owned foreign assets, mostly equities and foreign direct investment. In previous years, capital gains had actually allowed the US to run a substantial trade deficit while leaving its foreign wealth essentially unaffected. Trade in international financial markets provides a country with opportunities to smooth consumption against shocks affecting domestic incomes and diversify risk. However, as long as markets remain incomplete, it also exposes a country to sizeable external financial shocks – a point implicitly stressed by the analysis of Milesi-Ferretti.

So, the question is – to what extent can such a huge and rapid deterioration of external wealth drive a contraction in US consumption and domestic demand? By the same token, how much of the low US saving in the past can be attributed to capital gains? In this column, we argue that the answer is – not much.

Output, foreign investments, and consumption

The results from our joint work recently published as a CEPR discussion paper can help shedding some light on the reason why. Namely, looking at the US for the past decades, we are able to quantify in an empirical manner the relative importance of permanent and temporary variations in US net output (net of government spending and investment) and US holdings of foreign assets and liabilities, all adjusted for capital gains and losses, and assess how these influence US consumption. The methodology builds on Lettau and Ludgvison (2004).

In our study, we classify disturbances according to their persistence (permanent vs. transitory) and their incidence (net output vs. assets/returns). We should stress that, although our methodology does not allow us to identify shocks in a structural sense (we cannot say whether disturbances in our model originate in technology, expectations, government behaviour etc.), our permanent shock has a natural structural interpretation as a supply shock, as it raises net output in the long run.

A key finding in our analysis is that most of the variation in the stock of US foreign assets and liabilities is driven by temporary disturbances. This is true both at both short and long horizons. Looking at the forecast error one and four quarters ahead, 87% to 90% of its variance for gross assets and liabilities is explained by temporary shocks. This percentage is only slightly lower for horizons up to 20 quarters. It remains above 50% at a 40 quarters horizon. When we combine assets and liabilities as to obtain a proxy of the current account as the change in net foreign assets, it turn out that temporary shocks explain 95% of its variation at all horizons.

Net output is also driven by temporary shocks in a substantial way. However, most of the temporary disturbances to output occur at business cycle frequencies, between one and eight quarters ahead. In the long run (40 quarters), net output is almost exclusively driven by permanent shocks.

So, in light of our empirical results, the large swings in the US current account stressed by Milesi-Ferretti are to a large extent driven by temporary disturbances moving both US foreign assets and liabilities.

Temporary and permanent shocks

Not surprisingly, much of this variation is due to stochastic variations in returns. Figure 1 shows the transitory variations in US assets (upper panel) and liabilities (lower panel) we extract from our model, together with a four-quarter moving average of rates of return, calculated including capital gains and losses – the dataset we use is derived from the work of Lane and Milesi-Ferretti (2007) (but results are identical if we use the dataset by Gourinchas and Rey 2007). The blue broken line plots the transitory component of the stocks of asset and liabilities (please see our paper for details); the black line to returns. In the graph, we have made a normalisation such that, whenever gross positions are above trends, transitory components are positive.

Figure 1. Transitory variations in assets, liabilities, and returns

It is apparent that transitory swings in gross positions are persistent and large, especially during the 1990s. Periods in which foreign assets are above trend (e.g. 1994-1999) are followed by periods in which the opposite is true. At its peak in 1999, the transitory component of foreign assets was 2.15% of its permanent component. Translated into dollar amounts, this means that assets exceeded their long-run trend by as much as $56,729 dollars per person (in 1996 dollars), well above the median annual household income!

The cyclical components of assets and liabilities shown in the graph are clearly correlated with transitory movements in rates of return, which are equally large and persistence. The correlation coefficient is .37 and .44 for assets and liabilities, respectively. The correlation remains high at different time horizons, i.e. between returns today and assets one, two, three, and four quarters ahead, reflecting persistence.

What about consumption? The striking finding of our analysis is that US consumption only responds to permanent shocks – the above temporary fluctuations are completely smoothed, also thanks to foreign borrowing and lending. The following graph shows the response of consumption together with that of net output, assets, and liabilities, to the unique permanent shock we find in our four-variable system. A permanent shock that increases net output in the long run has a natural interpretation as a supply shock, possibly reflecting technology.

Figure 2. Responses to a permanent shock

As shown by the graph, net output jumps initially and then grows smoothly. Consumption adjusts quite swiftly, in practice reaching its new long run level in four quarters. Both assets and liabilities increase, but the latter rise more than the former, so that a current account deficit results.

Conversely, consumption is essentially insulated from all temporary disturbances. Not only by those moving net output in the short run – to be attributed to the business cycle – but also those moving returns on foreign assets, which have been significantly large well beyond business cycle frequencies.


Our results show that much of the movements in valuation-adjusted gross external positions by the US are of transitory nature, although these movements are quite persistent. This suggests that, while transitory build-up of assets and liabilities can be expected to revert to trend at some point in the future, the process may take quite some time. Yet, the process of adjustment to these shocks, no matter how long it lasts, is not relevant for US consumption. Large corrections of US demand required by external balance works mainly via changes in permanent income.


Editors' note: This column is a Lead Commentary on Vox's Global Crisis Debate where you can find further discussion, and where professional economists are welcome to contribute their own Commentaries on this and other crisis-linked topics.



Corsetti Giancarlo, Panagiotis Konstantinou (2008), “What Drives US Foreign Borrowing? Evidence on External Adjustment to Transitory and Permanent Shocks,” CEPR Discussion Paper 7134
Gourinchas, P.-O. and Rey, H. (2007), “International Financial Adjustment,” Journal of Political Economy, 115, 665-703
Lane, P. R and Milesi-Ferretti, G.-M. (2007) “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities: 1970-2004,” Journal of International Economics, 73, 223-250
Lettau, M. and Ludvigson, S. (2004) “Understanding Trend and Cycle in Asset Values: Reevaluating the Wealth Effect on Consumption,” American Economic Review, 94, 276-299
Milesi-Ferretti Gianmaria, (2009), “A $2 trillion question,” VoxEU, 28 January.

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