Exorbitant Privilege and Exorbitant Duty

Pierre-Olivier Gourinchas

UC Berkeley & SciencesPo

H ́el`ene Rey

London Business School

Nicolas Govillot

French Treasury

Roundtable on Treasury Markets and Debt Management

November 2012, Washington DC

1 / 48
Three Important Facts on US External Accounts

• A World Banker’s Balance Sheet

• “Exorbitant Privilege” in normal times

• “Exorbitant Duty” in crisis times

2 / 48
Exorbitant Privilege

• Modern meaning: (Gourinchas and Rey (2007))

• Excess return of US external assets over US external liabilities.

• Important for long run sustainability (relaxes US intertemporal

constraint). Stable external position despite trade deficits.

• Asymmetric external balance sheet: World Banker;

• First contribution: Positive excess returns in good times.

4 / 48
Exorbitant Duty

• Second contribution: document a new stylized fact:

• Large US valuation losses in crisis times

• Transfers wealth from the US to the rest of the world.

• Precisely at times when the global marginal utility of

consumption is high.

• We call this the ‘Exorbitant Duty’

6 / 48
A Theoretical Framework

• Third contribution: Model to make sense of these facts;

• ‘Exorbitant Privilege’ and ‘Exorbitant Duty’ are two sides of

the same coin;

President Roosevelt, undelivered Jefferson Day address, April 11,

1945:

“Today we have learned in the agony of war that great

power involves great responsibility.”

• Leads to an alternative interpretation of the role of the center

country in the International Financial System:

• global shocks

• risk appetite

• fiscal capacity

7 / 48
External Balance Sheet

• Updated and improved data set of “From World Banker to

World Venture Capitalist”, 1952Q1 to 2009Q4

• Use historical data on positions (annual), flows (quarterly) and

asset and asset price series for valuations.

• More detailed decomposition on liability side (corporate and

government debt estimated separately)

• Use detailed wartime Treasury Surveys of cross border holdings

(1941, 1943) to cross check our initial positions. Surveys of

strategic importance (reparations, and identification of foreign

agents)

’investigations to uncover enemy agents and enemy assets,

especially after our entry into the war, were greatly facilitated

by the [1941 Treasury Census of foreign-owned assets in the

US].’

’The [1943 Treasury Census of American-owned assets in

foreign countries] had its principal use in the war settlements,

although it provided much greatly needed information during

the latter part of the military phases of the war.’[Introduction

to the 1941 and 1943 Surveys]. 8 / 48
Methodology

P

i

t+1 = P

i

t + F

i

t+1 + V

i

t+1 + OCit+1

where

• P

i

t

: Positions for assets i at the end of period t (BEA, FoF,

surveys);

• F

i

t

: gross financial flows during period t (Balance of

Payments);

• V

i

t

: Valuation gains or losses attributed to currency and local

asset price movements;

• OCi

t

: Other changes reported by the BEA (in Q4);

Reconciliation item.

9 / 48
US Net Foreign Asset Position (percent of output)

-60

-50

-40

-30

-20

-10

0

10

20

1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008

NA/GDP cumCA

Source: BEA, SCB, 1941-43 Treasury Surveys, and authors’ calculations

10 / 48
US Gross Asset Position (percent of output)

0

20

40

60

80

100

120

140

1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008

Gold Non Gold Debt Direct Investment Equity

Source: BEA, SCB, 1941-43 Treasury Surveys, and authors’ calculations

11 / 48
US Gross Liabilities Position (percent of output)

0

20

40

60

80

100

120

140

1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008

Other Government Debt Corporate Debt Direct Investment Equity

Source: BEA, SCB, 1941-43 Treasury Surveys, and authors’ calculations

12 / 48
‘Exorbitant Privilege’

• Gourinchas & Rey (2007) documented excess returns on US

external assets of 3.32% for 1973-2004.

• across asset classes (e.g. equity premium)

• but also within asset class;

• Measuring returns

R

i

t+1 =

P

i

t + I

i

t+1 + V

i

t+1

P

i

t

where

• R

i

t+1 return on asset class i between t and t + 1;

• I

i

t+1 investment income in t + 1 (from BoP);

• V

i

t+1 valuation gain or losses in t + 1;

15 / 48
Recent Literature on ‘Exorbitant Privilege’

• Obfsteld & Rogoff (2005): 3.1% for 1983-2003

• Lane & Milesi Ferretti (2007): 3.9% for 1980-2004

• Curcuru, Dvorack & Warnock (2008): 0.72% for 1994-2005

• Forbes (2008): 6.9% using Curcuru et al (2008)’s

methodology for 2002-2006

• Issue?

P

i

t+1 = P

i

t + F

i

t+1 + V

i

t+1 + OCit+1

• How to treat OCt? mismeasured capital gain, financial flows,

or initial position?

16 / 48
US Gross External Returns

average returns 1952:1-2009:4 1952:1-1972:4 1973:1-2009:4

(a) : Valuations

r

a − rl 2.69% 1.30% 3.47%

r

a 5.84% 5.04% 6.30%

r

l 3.16% 3.74% 2.83%

(b) : Financial Flows

r

a − rl 1.49% 1.25% 1.62%

r

a 4.91% 4.71% 5.02%

r

l 3.42% 3.46% 3.40%

(c) : Mixed

r

a − rl 2.44% 1.28% 3.11%

r

a 5.76% 4.96% 6.21%

r

l 3.31% 3.68% 3.11%

Table : Panel (a): “Other changes” allocated to valuations; Panel (b): to

financial flows; Panel (c): to valuations, except for debt assets and

liabilities. r

a

refers to gross assets, r

l

to gross liabilities. Annualized

quarterly real returns.

18 / 48
Excess Returns by Asset Class

r

o

r

d

r

di re

(a) : valuations

1952:1-2009:4 -0.63% 4.71% 4.00% 4.11%

1952:1-1972:4 -2.02% 4.79% 2.24% 3.96%

1973:1-2009:4 0.16% 4.67% 4.99% 4.19%

(b) : financial flows

1952:1-2009:4 -1.37% 3.01% 1.99% 2.09%

1952:1-1972:4 -2.12% 3.98% 2.24% 3.59%

1973:1-2009:4 -0.94% 2.45% 1.85% 1.23%

(c) : mixed

1952:1-2009:4 -0.63% 3.01% 4.00% 4.11%

1952:1-1972:4 -2.02% 3.98% 2.24% 3.96%

1973:1-2009:4 0.16% 2.45% 4.99% 4.19%

Table : Panel (a): “Other changes” allocated to valuations; Panel (b): to

financial flows; Panel (c): to valuations, except for debt assets and

liabilities. r

o

refers to the ‘other assets’; r

d

to ‘debt’; r

di to direct

investment and r

e

to equities. Annualized quarterly real excess returns.

19 / 48
‘Exorbitant Privilege’

• Excess returns between 1.62% and 3.4% p.a.

• After 1973, collapse of fixed exchange rate system. Higher

return and higher volatility.

• Important to look at long periods.

21 / 48
Real Quarterly Returns on US Gross Assets and Liabilities

-20%

-15%

-10%

-5%

0%

5%

10%

15%

1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008

Liabilities Assets

Quarterly returns deflated by US Personal Consumption Expenditure deflator. Source:

BEA, SCB, 1941-43 Treasury Surveys, and authors’ calculations.

22 / 48
US Net Foreign Asset Position (percent of output)

-35

-30

-25

-20

-15

-10

-5

0

5

10

15

20

1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008

Source: BEA, SCB, 1941-43 Treasury Surveys, and authors’ calculations

24 / 48
‘Exorbitant Duty’

• During latest crisis, US net foreign asset position deteriorated

massively

• Between 2007:4 and 2009:1, NA drops from USD -1.6tr to

USD -4.29tr, a decline of USD 2.7tr

• Over same period, cumulated current account represents

-809bn,

• Valuation loss of USD 1.9tr, or about 13.4% of US GDP,

25 / 48
U.S. External Debt and Equity, percent of US GDP

20

30

40

50

60

0

10

20

19521954195619581960196219641966196819701972197419761978198019821984198619881990199219941996199820002002200420062008

Debt Liabilities Equity Liabilities Debt Assets Equity Assets

Source: BEA, SCB, 1941-43 Treasury Surveys, and authors’ calculations

26 / 48
Heatmap of Gains and Losses on NIIP

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2000 km

2000 mi Map data ©2011 Geocentre Consulting, MapLink, T

The figure reports total valuation gains/losses. Dark red: losses in excess of $600bn.

Light red: losses smaller than $600bn. Light green: gains smaller than $400bn. Dark

green: gains in excess of $400bn. Source: from Gourinchas, Rey and Truempler (2011)

27 / 48
Global Insurers/Liquidity Providers

• Global Liquidity Providers: U.S. (6%), Euro (1.36%),

Switzerland (10.6%) and China (3.5% of GDP)

• US (6% of GDP): losses on equity portfolio assets

• Eurozone (1.36%) and Switzerland (10.6%): losses on direct

investment and debt portfolio assets

• China (3.5%): numbers are subject to more caution. Increase

in DI liabilities and depreciation of Euro-denominated reserves

assets.

• Global Liquidity Absorbers: other Emerging Market

Economies (Russia, Emerging Asia, Brazil...); U.K.

• Gains on equity liabilities

• UK, additional gains on debt liabilities ($515 bn)

29 / 48
‘Exorbitant Duty’

• Deterioration also present to a smaller degree in earlier

episodes

• Worsening of US net foreign asset position occurs largely

through a valuation loss: risky assets collapse, while US

government debt increases in value.

• This valuation loss transfers wealth from the US to the rest of

the world.

• US provides a transfer at times when the marginal utility of

consumption is high.

• We interpret the ‘exorbitant duty’ as an insurance payment

and the ‘exorbitant privilege’ as the corresponding insurance

premium.

32 / 48
A Simple Model of Insurance Provision

• 2 countries, Home (US) and Foreign (∗), equal size 1/2.

• Endowment economy: yt

, y

∗

t

. Global output  ̄ytiid.

• Representative household with CRRA preferences:

Et

P∞

s=t

β

t

c

1−σ

t / (1 − σ),

• US has more tolerance for risk: σ < σ∗

(interpreted broadly as

access to technology to reduce risk)

• Markets are complete.

33 / 48
A Simple Model

• Ex-ante symmetric equilibrium:

1

2

c

Ey ̄

+

1

2



c

Ey ̄

σ/σ∗

=

y ̄

Ey ̄

.

US ‘insures’ foreign against bad times.

• Implements allocation with US equity holdings of

σ

∗/ (σ + σ∗

) > 1/2: leveraged external portfolio

• Autarky risk-free interest rate (w/output log-linearly

distributed, variance σ

2



)

E ln R

aut

t = − ln β −

σ

2

2

σ

2



.

• lower autarky interest rate abroad since σ

∗ > σ due to

precautionary saving (Mendoza et al (2009); Caballero, Farhi

& Gourinchas (2008))

• US runs trade deficit

34 / 48
Risk Sharing with Heterogenous Risk Aversion

The figure is drawn under the following assumptions: Ey ̄ = 1, σ = 2, σ∗ = 5.

35 / 48
A Model of Global Disasters and Insurance

• Simple model is too stylized

• single good, so no difference in risk-free returns

• symmetric size

• no episodes of global stress

• Richer model includes:

• multiple goods (traded and non-traded) (Hassan (2009))

• differences in size (Hassan (2009))

• global disaster risk (Barro (2006) and Rietz (1988))

• differences in ‘fiscal capacity’ (size)

36 / 48
A Model of Global Disasters and Insurance

• 2 countries, Home (US) and Foreign (∗), home size α.

• Endowment economy:

• y

T

t

, y

∗T

t

traded,

• y

N

t

, y

∗N

t non traded.

• Global output of traded good  ̄y

T

t = αy

T + (1 − α)y∗T .

• Representative household with CRRA preferences and σ ≤ σ

∗

:

Et

X∞

s=t

β

t

c

1−σ

t / (1 − σ),

• CES preferences over T and N consumption:

c =



γ

1/θ 

c

T

θ−1

θ + (1 − γ)

1/θ 

c

N

θ−1

θ

 θ

θ−1

• Resource constraints: c

N = yN and αcT + (1 − α)c∗T =  ̄yT

• Markets are complete internationally.

37 / 48
Business Cycles and Disasters

• Output Process:

ln y

T

t = ln (γ) + 

T

t + vt

ln y

N

t = ln (1 − γ) + 

N

t + vt

• 

i

iid log-normal, sector & country specific;

• vt

is a stationary Barro-Rietz process:

• with probability pd output falls by (1 − b) across sectors and

countries.

• with probability pn output recovers

• Fiscal capacity: recovery rate r on government bonds may

differ across countries during disasters: r > r

∗

.

41 / 48
Calibration

Parameters:

• γ: 0.25. Share of traded goods

• θ: 1 (el. of subst. b/w T and N)

• σ: 3 (so goods are gross substitutes)

• σ

2



: 0.02 (bus. cycle shocks)

• pd : 1.17% cond. prob. of disaster (from Barro (2006))

• pn: 2% cond. prob. of recovery

• b: 0.42 collapse in output in disaster (from Barro (2006))

• r

∗

: 0.75 foreign recovery rate

45 / 48
Model Simulation

Parameters (1) (2) (3) (4)

α 0.75 0.75 0.75 0.75

θ 1 1 1 1

σ

∗

4 3 4 4

b 0.42 0.42 0.42

r

∗

1 1 0.75

Equity Premium (n.) 0.13 4.08 4.52 4.52

(percent) (d.)

T-bill excess return (n.) 0.03 0.04 -1.87 0.34

(percent) (d.) 0.04 -0.36 0.10

NA excess return (n.) 0.00 0.00 0.15 0.15

(percent) (d.) 0.00 0.17 0.17

Trade Balance (n.) 0.00 0.00 -0.72 -0.72

(% of output) (d.) 0.00 1.38 1.38

Net Foreign Assets (n.) 0.00 0.00 0.00 0.00

(% of output) (d.) 0.00 -14.48 -14.48

Net Debt Liabilities (n.) 7.54 0.17 55.09 55.09

(% of output) (d.) 0.28 86.33 86.33

46 / 48
Conclusion

• Three stylized facts:

• World Banker

• ‘Exorbitant privilege’

• ‘Exorbitant duty’

• Our simple model accounts broadly for these facts. Interprets

the US as provider of insurance against global shocks. Model

emphasizes the role of:

• greater risk appetite in US (capacity to handle risk)

• disaster risk (important for wealth transfers)

• fiscal capacity (important for risk free debt return)

• Model does not account for large net borrower position of the

US in good times.

• One interesting possibility: the role of pecuniary externalities

in incomplete market models: foreign countries accumulate too

much reserves, and the US accumulates too much debt;

• Suggests that the US may face a Triffin-like problem as the

demand for insurance may eventually exceed it’s fiscal capacity.

48 / 48