Lecture 1B: The NIIP-NII paradox

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Two abbreviations carry this chapter. NIIP: what the country owns abroad minus what it owes, a stock (see the previous chapter). NII, net investment income: the income residents earn on their foreign assets minus the income foreigners earn on their claims on the country, a flow per year. For a normal debtor both are negative: you owe money, so you pay interest. The puzzle is that the United States owes far more than it owns and still receives more income than it pays. The chapter gives two explanations and asks you to calculate with them. The calculations only use percentages and multiplication; the trick is to keep assets, liabilities and their two different returns apart.

The NIIP-NII paradox

If you have a credit card debt, you pay interest. The US is the world's largest debtor, so you would expect it to pay net interest to the world. Instead it receives net investment income: NIIP < 0 but NII > 0. Two explanations:

Explanation 1: dark matter. Maybe the US is not really a debtor. American firms investing abroad bring know-how, brands and reputation (intangible capital) that statisticians do not value properly, so A is underestimated. The income from that capital is recorded, though. So we can estimate the "true" NIIP (TNIIP) from the income, as if NII is the return on TNIIP:

NII = r × TNIIP, so TNIIP = NII / r. With NII = $0.1909 trillion (2020) and r = 5%: TNIIP = 0.1909 / 0.05 = $3.8 trillion.
Dark matter = TNIIP − recorded NIIP = 3.8 − (−11.1) = $14.9 trillion.
So in this view, the rest of the world owed the US $3.8 trillion instead of the other way round.
Weakness: $14.9 trillion of invisible wealth seems far too large to be missed by statisticians and tax authorities. And r is not observed but chosen: a lower r gives even more dark matter.

Why the assumed return r decides everything

The dark-matter estimate divides a known income (0.1909 tn) by a return that nobody observes. With r = 5% the "true" position is 3.8 tn; with r = 4% it is 4.8 tn; with r = 3% it is 6.4 tn. A small change in the assumption moves the answer by trillions, which is the main criticism of the method: it does not measure dark matter, it assumes a return and backs out whatever position fits. When you get this question, state the formula, fill in the numbers, and add one sentence on this weakness.

Explanation 2: return differentials (the "exorbitant privilege"). The US earns more on what it owns than it pays on what it owes:

US assets abroad are mostly risky, high-return: foreign shares and direct investment (owning foreign firms).
US liabilities are mostly safe, low-return: Treasuries that foreigners (including central banks) hold because the dollar is the world's main currency. This advantage is called the exorbitant privilege.
How big must the return gap be? NII = r_A·A − r_L·L. With A = $32.2 trillion, L = $46.3 trillion, NII = $0.1909 trillion and r_L = 0.37% (real return on Treasury bills): r_A = (0.1909 + 0.0037 × 46.3) / 32.2 = 0.0112, so r_A = 1.12% and r_A − r_L = 0.75 percentage points. A modest premium.
Refinement: since about 2010, foreigners hold roughly half US shares and half US bonds. If shares earn the same in and outside the US, r_L = ½(r_A + r_B) with r_B = 0.37%. Then 0.1909 = r_A × 32.2 − ½(r_A + 0.0037) × 46.3, which gives r_A = 3.06% and an equity premium over bonds of 3.06 − 0.37 = 2.69 points. Very plausible.

The mirror image: China. Because the world's assets and liabilities cancel out (NIIP_US = −NIIP_{rest of world}, and the same for NII), someone must have the opposite paradox: a positive NIIP but negative NII. China does: its NIIP grew from about zero (before joining the WTO in 2001) to $2.2 trillion in 2020, while its NII has mostly been negative (around −$50 bn). The reason: China saves in safe, low-yield assets (US government bonds) while foreigners own high-yield direct investment in China.

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