Why are Americans better at FDI?

Matthew Higgins, Thomas Klitgaard, and C?dric Tille have an article in the Federal Reserve Bank of New York's December 2005 edition of Current Issues in Economics and Finance on net flows in international investment income. Given the fact that foreigners currently have a net claim on $2.5 trillion in U.S. assets, onme would expect the U.S. to be paying out a lot more in interest, dividends, and profits to foreigners than Americans would receive from their investments. The weird thing is that, so far, this hasn't been true. Last year the U.S. earned $36 billion more on their foreign investments than foreigners earned in the United States. The question is, why? Higgins et al have a simple answer and a more complex answer. The simple answer is that foreigners are investing heavily in fixed-income, interest-bearing assets, while Americans concentrate their outflows in riskier but more rewarding areas -- foreign direct investment and foreign portfolio investment. This result is actually consistent with a point I was trying to make before about the comparative advantage Americans hold in risk attitudes. What really intrigues me, however, is this fact -- even if one limits the discussion to FDI, Americans do better abroad than foreigners do here: [T]he rate of return on U.S.FDI assets has consistently been higher than that on FDI liabilities (Chart 4). Since 1982, the rate of return on FDI assets has, on average, exceeded that on FDI liabilities by 5.6 percentage points, and not once during this period has the differential dropped below 3.2 percentage points. Surprisingly, perhaps, there is no consensus about the reason for this large and persistent difference in rates of return.... Since 2000, the U.S. rate of return on FDI has risen from 5.4 percent to 8.6 percent, an increase of 3.2 percentage points; the foreign rate of return on FDI in the United States has risen from 2.0 percent to 4.3 percent, an increase of 2.3 percentage points.Had rates of return on FDI remained at their 2000 values, U.S. net income receipts would have been $33 billion lower in 2004.... Seeking to shed light on the puzzle, we examine FDI returns by industry and country. Unfortunately, our analysis deepens the puzzle rather than solves it: with few exceptions, the U.S. rate of return advantage holds across industries and countries. of U.S. firms at about the advanced-economy average. This puzzle is pretty damn important. The gap in returns is significant enough so that Harvard economists Ricardo Hausmann and Federico Sturzenegger talking about this as "dark matter", explaining why the U.S. has been able to run a persistent current account deficit without any decline in the U.S. surplus on investment income. Higgins et al proffer some possible explanations -- tax differentials, less experienced foreign investors, U.S. firms are better governed and more efficient, or the U.S. market is just more competitive and so profits will be lower here. Only the last argument persuades me much. Higgins et al also don't think this situation will persist. Haussman and Sturzenegger, on the other hand, push the argument that US has a comparative advantage in FDI very hard: Imagine the construction of EuroDisney at the cost of 100 million (the numbers are imaginary). Imagine also, for the sake of the argument that these resources were borrowed abroad at, say, a 5% rate of return. Once EuroDisney is in operation it yields 20 cents on the dollar. The investment generates a net income flow of 15 cents on the dollar but the BEA [Bureau of Economic Analysis] would say that the net foreign assets position would be equal to zero. We would say that EuroDisney in reality is not worth 100 million (what BEA would value it) but four times that (the capitalized value at our 5% rate of the 20 million per year that it earns). BEA is missing this and therefore grossly understates net assets. Why can EuroDisney earn such a return? Because the investment comes with a substantial amount of know-how, brand recognition, expertise, research and development and also with our good friends Mickey and Donald. This know-how is a source of dark matter. It explains why the US can earn more on its assets than it pays on its liabilities and why foreigners cannot do the same. We would say that the US exported 300 million in dark matter and is making a 5 percent return on it. The point is that in the accounting of FDI, the know-how than makes investments particularly productive is poorly accounted for.... In a nut shell our story is very simple. The income generated by a country?s financial position is a good measure of the true value of its assets. Once assets are valued accordingly, the US appears to be a net creditor, not a net debtor and its net foreign asset position appears to have been fairly stable over the last 20 years. The bulk of the difference with the official story comes from the unaccounted export of knowhow carried out by US corporations through their investments abroad, explaining why the US appears to be a consistently smarter investor, making more money on its assets than it pays on its liabilities and why the rest of the world cannot wise up. In addition, the value of this dark matter seems to be rather stable, indicating that they are likely to continue to compensate for the measured trade deficit. Globalization has made the flows of dark matter a very significant part of the story and the traditional measures of current account balances paint a very distorted picture of reality. In particular, it points towards imbalances that are not really there, making analysts predict crises that, for good reason, remain elusive.They might be right -- but they don't have any evidence that this is true beyond the persistence in the gap between U.S. and foreign rates of return in FDI. This is a really, really interesting puzzle, however -- and I'm very surprised some B-school professor hasn't written something so definitive on the topic that the book is a must-read. Maybe I'm out of it, but I haven't seen any book like this. In lieu of a tome, commenters are free to figure out and post on this puzzle for themselves.